This is the second article of how money moves. For the first article, please take a look at how money moves around in the banking system. For this article, we will look at how payments are cleared and settled. As a “fintecher” interested in payments, it’s important to understand the basics. I will start with the US system. What I have found is that you will find a lot of similarities with other countries, so it’s important to understand one really well. As a matter of fact, I found a number of clear and settlement system in Asian designed with the US or UK model as reference.
The US payment clearing and settlement system is comprised of 3 different systems: Fedwire, CHIPS, and ACH. CHIPS and Fedwire are considered wire transfer. Each with a different goal and purpose.
Fedwire, CHIPS, ACH
The acronynms means:
CHIPS: clearing house interbank payment system
ACH: automated clearing house
Fedwire and CHIPS are used for large value domestic and international USD payments. The difference between Fedwire and CHIPS:
- Fedwire is owned by the Fed. CHIPS is owned privately, by banks that use it.
- CHIPS has 59 members. They are mostly large US banks, and US branch of other international banks. Fedwire has over 9000.
- CHIPS is netted, so not real time. Fedwire is not netted, so it’s real time.
- Fedwire is more expensive than CHIPS
ACH is batched. It’s mostly for low value, but high volume. It’s genernally for domestic. The fee is lowest of the 3.
Let’s take a closer look at how ACH works:
We will start with a very simple example: John in bank A wants to pay $100 to Bob at Bank B.
Usually, the bank will have a cut-off time, say 7pm. Any request received after, like 7:01 pm will be processed the next day. The bank will process all its ACH requests, check for errors (a good design would have caught the error when users entered the info). Then generate a consolidated SFTP file of all the transactions. The file is sent from Bank A to the Federal Reserve before the Fed’s cut off time, say 12am. When the file is sent to the Fed, your account will be debited with $100. The next morning, after Federal Reserve processed the transaction, Fed will ask Bank B to credit $100 to Bob’s account. And that’s pretty much it.
However, the problem with ACH is that it can take up to 3 days to settle. This is because:
- The protocol does not provide confirmation on successful transaction.
- Only message it provides is when there is return (error). The receiving bank, which only receives the message on +1 day, has till end of +2 day to finish process. Hence return message will be received by the sending bank on +3 day.
Let’s take a closer look at the scenario described above. ACH is one of the popular method used in business payment. Assume supplier A requests payment from manufactuer B:
- A sends requests (SFTP) to its bank (OFDI — originating financial depository institution) — by day 1 7:00 pm
- Bank prepares the file, checks for errors (bank account #, any other format error), and sends the file to Fed — by day 2 12:01 am ←- I personally think the validation should be done in real time when user enters the info or uploads the info.
- The Fed process all the files uploaded, prepares the result file, and send the file to receiving banks — by day 2 5:00 am
Because the receiving bank has till the end of next day to finish process the request, if there is an error with, the sending bank won’t be notified until day 4. Continuing from above:
- RFDI -> Fed -> OFDI. Receiving bank has till the end of next day to finish process the request. Receiving bank sends the request to Fed, and then to the sending bank — by Day 2 5:00 am to Day 4 12:01 am
- OFDI -> Supplier A — by Day 4 5:00 am. Supplier A got the error message that manufacturer B does not have enough fund.
As you can see, if you are a supplier trying to get paid, it will take you 3 days for you to find out that the payment failed. You will not be a very happy supplier. There is effort underway for same-day ACH settlement. However, we will not go into it in this article. Next, I plan to look into CHIPS and Fedwire.