Pay By Group University: Payments 102
Welcome back to our multi-part series on the ins and outs of payments in the United States of America! Last time we learned about payments systems and their end users and providers, the various payment systems models and functions, and payment categories. Now we’ll dive right into payments systems flows, ownership and regulation of payment systems, and more!
Payments Systems Flow - A Bit of Pushing and Pulling
Switching in open loop payments systems (which we learned in the previous article falls under the umbrella term “Processing”) is a message flow from the first intermediary, to the payment network, and on to the second intermediary in a unidirectional flow. The content of the message depends on whether the payment is a push or a pull payment, which are defined as:
- Push payment: an end party sends money via a payments system to a second end party. Wire transfers are a type of push payment. Basically, the first intermediary debits itself at the first end party’s instruction, and tells the second intermediary to credit itself and transfer funds to the second end party.Push payments are generally much safer than pull payments since the party who has funds sends the money, and its bank or other intermediary can confirm sufficient funds are available when initiating the transaction.
- Pull payment: an end party collects money via a payments system from a second end party. Checks are pull payments. Essentially, the first intermediary credits itself and tells the second intermediary to debit itself on behalf of the first end user, using (for example) a check issued by the second end user to authorize the transaction. Pull payments are riskier than push payments as they’re subject to “bouncing” due to nonsufficient funds (or NSF). The intermediary that initiates the transaction can’t directly confirm sufficient funds are available to credit its customer, and the authorization from the second party (e.g. a signed check, a card swipe with signature) could potentially be forged.
Payments Systems Settlement
In an open loop system, settlement refers to how intermediaries receive or send funds to one another in order to cover transactions between end parties. Settlement in open loop systems can be done one of two ways:
- Net settlements - net amounts due to or from participating intermediaries in a given system are calculated on a periodic, usually daily, basis. At the end of this period, each intermediary is given a net settlement total and either funds an account with a related settlements bank for that amount (a net debit position), or is informed that funds totalling that amount are available to be drawn from their settlement account (a net credit position). ACH, card networks, and checking are all net settlement systems in the United States.
- Gross settlements - every transaction is settled as it’s processed, as in the FedWire system where the sending intermediary’s account at a Federal Reserve Bank is debited and the receiving intermediary’s account at a Federal Reserve bank is credited without the need for end-of-day settlement. Specific end party settlement processes differ between payments systems depending on a system’s rules, outside regulations, and prevailing market practices.
Virtual Payments Systems - Cash and Checks
In the U.S., cash and checking operate on a “virtual” basis, meaning that there is no formal payments system that end parties or intermediaries actually join.
Cash transactions are settled directly between the involved parties, acting as a push system. Checking operates as a pull system that automatically includes all banks, so it’s considered a virtual system since they don’t have to “join.” Banks do typically join at least one clearing house to switch and settle the checks they receive, but since checks are tightly regulated by U.S. law the rules covering these clearing houses are relatively limited.
Payments Systems Ownership
Payments systems can be owned by one or more banks or by privately-held or publicly-traded corporations. Over time, many previously bank-owned systems (such as the MasterCard, Visa, and Discover card networks) have transitioned to alternative ownership models.
Well-funded payments systems (like card networks) tend to create defined products that member intermediaries share with their end users whole cloth, while systems with smaller budgets (such as ACH) typically set operating rules and/or platforms which participating intermediaries use to create defined products.
Payments Systems Regulation - Making It All Work Together
U.S. payments systems are regulated by a combination of law (and regulations made by government agencies to carry out the law) and private rules. The primary issuer of regulations in the U.S. is the Federal Reserve Board. Private rules are usually agreement-based network-wide rules or contracts applying to various services offered by the system.
As described in the previous article, payments systems typically require any joining parties (intermediaries in open loop systems, end parties in closed loop systems) to abide by that system’s rules. Since the contract between intermediaries and their end-party customers often include provisions dictated by these rules, the end parties in open loop systems are incidentally bound by some of these requirements as well.
These system operating rules make collaboration between participating members possible by defining technical and processing standards, membership and payment acceptance requirements, exception processing and dispute resolution, processing fees and interchange, and usage of system brands and marks. As such, these rules are vitally important since a given system could include literally millions of participants.
As markets and technologies evolve, new operating rules must be introduced to cover emerging products and/or transaction types. Changes to existing operating rules can have enormous impact to participants of and providers to a payments system due to the possible need for investment, changes in technical standards or the allocation of risk, and more. As mentioned in our previous article, this leads to a lengthy process of change potentially lasting several years.
Nearing the Finish Line
That’s it for Payments 102! Next time we’ll wrap up our introduction to the basics of payments with an overview of economic models for payments systems, risk management, cross-border payments, and more!