CTP Exam Quiz 06

Non-cash payment methods
A non-cash payment method has three main phases: issuing payment, clearing payment, and settling payment. The issuing phase includes instructions about the amount to be paid, the recipient of the payment, and the method of payment (i.e. check, wire transfer, money order, etc.). The clearing phase is when the given instructions are transmitted to the parties concerned. The settlement phase is the active part where funds are actually transferred from one account to another. That is, one account is debited and the other is credited with the specified amount.

Non-cash payment methods
Two kinds of non-cash payment methods that use physical mediums are checks and credit/debit cards. In the U.S., there are three electronic payment networks. The automated clearing house (ACH) is a network that is used for smaller value electronic payments. Fed wire and the Clearing House for Interbank Payment System (CHIPS) facilitate immediate wholesale electronic funds transfers.

Settling payments
When a bank receives a payment either through check or electronically, it may or may not be final. Wire transfers (i.e. Fedwire) are final. However, Regulation E requires that consumers be given a certain amount of time to challenge a check, credit card, or debit payment or to return the purchased item. This kind of payment is provisional because the credited account could have the credit reversed. Usually, challenging a payment must be done within 60 days of the transaction, after which time the payment can be settled.

Settling payments
The payment settlement phase transfers the funds by debiting one account and crediting the other matched account. This is adjusting the accounts. There are various ways a depository institution can settle payments. Intra day settlement adjusts all accounts at set intervals throughout the day. Net settlement matches transactions as they occur, but does not actually transfer funds until the end of the day. Gross settlement payments adjust accounts on a per item basis.

Check clearing process
Even though the use of checks is declining in favor of electronic payments, checks are still the most common method of non-cash payment used in the U.S. In addition to personal information about the consumer, a check contains several key pieces of information that is necessary for clearing purposes. Much of this information is preprinted on the bottom of the check on the magnetic Ink Character Recognition (MICR) line. The 9 digit transit routing number (TRN) identifies the issuing bank. The TRN enables the recipient bank to route the information back to that issuing bank for clearing. The recipient bank adds, also with magnetic ink, the check amount on the MICR line.

Check clearing process
The TRN enables the recipient bank to route the information back to that issuing bank for clearing. The recipient bank adds, also with magnetic ink, the check amount on the MICR line. Checks are sorted according to TRN numbers and then bundled into a ‘cash letter’ which include a list of the included items. Legally, these checks must be presented to the issuing bank in order for clearing and then settlement to occur.

Physical proximity can delay check clearing. Even though the Check 21 legislation has expedited the check clearing process, there are still other factors that could delay the availability of funds including the time a check was deposited and the location of the depository institution. Final settlement occurs at the issuing bank location since that bank must confirm the check instructions as valid. This location is the TRN on the check and is considered the payment endpoint. Issuing banks that are located within one of the 12 Federal Reserve district cities are considered ‘city
item’ endpoints.

Issuing banks that are located within one of the 12 Federal Reserve district cities are considered ‘city item’ endpoints. Issuing banks located outside a Fed city but within proximity to a Federal Reserve regional check processing center (RCPC) are considered RCPC endpoints. Issuing banks located even further away from district cities or from RCPCs are considered ‘country items’ endpoints. The greater the physical distance from a District city, the longer the clearing time of the check. Some banks receive in excess of $10 million per day in payments. These banks are considered high dollar group sort (HDGS) endpoints. The Federal Reserve considers HDGS to be specific RCPCs and reviews them every six months.

Timing can delay check clearing. Check clearing can also be delayed by timing. If a check is deposited after a bank’s ledger or deposit cutoff time, it will be considered deposited on the following day. ATMs require physical deposit transferring to the appropriate facility for processing. Therefore, banks set earlier ledger cut off times for ATM deposits.

Banks also have a schedule for when they will make funds available for payment of checks (i.e. grant credit for a deposit). If the deposit misses that day’s availability time, it will have to wait until the next business day’s availability time. Automated check processing equipment assigns the deposit a ‘proof of deposit’ (POD) which is the time funds will be available for the deposit. These bank availability schedules are part of the reconciling process and so are necessary. However, they can delay the clearing of checks.

Paper-based payment methods
There are other kinds of paper-based payment methods. These include money orders, Traveler checks, Cashier’s/Certified checks, Sight and time Drafts, Draft, and Pre-authorized Draft/checks. Money orders and Traveler’s Checks are pre-paid cash equivalents that can be bought from banks and the US Postal Service. A cashier’s check has largely replaced the certified check. Funds for it are taken from the bank’s own account and must be signed by an authorized bank officer.

Paper-based payment methods
Sight and time drafts are like money orders in that they can be immediately exchanged for cash. They are used for international trade and have other qualifying information associated with them. Drafts are paid by the payor, not the bank and are used when firms, like insurance companies, want to verify signatures and review the account activity. Pre-authorized draft is used for recurring payments. The recipient initiates the withdrawal. ACH debits are now replacing this type of payment method.

Credit cards
A variety of credit card types have been emerging and displacing physical cash as a payment method. P-cards (purchasing cards) are low value cards authorized for specific employees to acquire needed materials quickly without going through the time consuming acquisitions process. Debit cards immediately deduct payment from the debit card holder’s account. Online debit cards require a PIN to authorize purchases. The funds can be transferred using just regional electronic networks or, if necessary, national networks.

The funds can be transferred using just regional electronic networks or, if necessary, national networks. Offline debit cards do not require a PIN to authorize purchases. Funds are transferred using the same national networks as credit cards use. Smart cards are like prepaid credit cards and are referred to as Stored Value Cards (SVC). They have a micro processor that can update information as the card is used. SVCs have varying degrees of use and sophistication. Phone cards and gift cards are common examples of SVCs.

Credit card transactions are processed in much the same way as checks are processed. The majority of these transactions are processed by the Federal Reserve using ACH electronic networks. The ACH network is most suitable for processing high volume, low value, and electronic transactions using a batch processing method. This means the transactions are received and held in batches until the batch is forwarded to the appropriate bank for clearing.

When a purchase is made with a credit card, the customer is considered the originator and the merchant is the receiver. The merchant electronically sends the information to their financial institution, the receiving depository financial institution (RDFI). The RDFI the contacts the credit card holder’s financial institution which is the originating depository financial institution (ODFI) for authorization. When authorization is granted, the ODFI is debited and the RDFI is credited for the amount specified and value is transferred from one account to the other. Because these transactions occur immediately, there are no float times associated with the ACH system, as there is with checks and other non-cash payment systems.

Check clearing process
Even though the use of checks is declining in favor of electronic payments, checks are still the most common method of non-cash payment used in the U.S. In addition to personal information about the consumer, a check contains several key pieces of information that is necessary for clearing purposes. Much of this information is preprinted on the bottom of the check on the magnetic Ink Character Recognition (MICR) line. The 9 digit transit routing number (TRN) identifies the issuing bank. The TRN enables the recipient bank to route the information back to that issuing bank for clearing.

Paper-based payment methods
There are other kinds of paper-based payment methods. These include money orders, Traveler checks, Cashier’s/Certified checks, Sight and time Drafts, Draft, and Pre-authorized Draft/checks. Money orders and Traveler’s Checks are pre-paid cash equivalents that can be bought from banks and the US Postal Service. A cashier’s check has largely replaced the certified check. Funds for it are taken from the bank’s own account and must be signed by an authorized bank officer. Sight and time drafts are like money orders in that they can be immediately exchanged for cash.

Fedwire
To maintain security of funds, the Federal Reserve Regulation J regulates wire transfers of funds between depository institutions and conforms to the Uniform Commercial Code (UCC). The Federal Reserve Bank system operates the funds transfer system known as Fedwire for real time gross settlement (RTGS) of large value transactions of financial depository institutions. Fedwire also operates the National Book-Entry System (NBES) for the securities industry, which includes transfer of U.S. Treasury securities. Fedwire operates depository transactions from 12:30 a.m. until 6:30 p.m., and the NBES from 8:30 a.m. until 3:15 p.m. Eastern Standard Time.

Fedwire operates depository transactions from 12:30 a.m. until 6:30 p.m., and the NBES from 8:30 a.m. until 3:15 p.m. Eastern Standard Time. All Fedwire transfers are final at the time of transfer. The Federal Reserve Bank of New York hosts accounts for banks that deal regularly in international payments in U.S. dollars. These banks are members of the Clearing House Interbank Payments System (CHIPS) which uses Fedwire to clear and settle transactions. In fact, CHIPS transactions comprise the bulk of Fedwire dollar volume.

CHIPS
When banks in different parts of the world need to transfer funds in U.S. dollars instantly, the Clearing House Interbank Payment System (CHIPS) is used to do so. It is an international wire transfer system. To maintain security, the CHIPS requires members to use a Universal Identity number (UID) to conduct transactions. Each CHIPS member bank is assigned a UID when establishing an account with CHIPS. This six digit number is linked to the account information without the identity of the account holder being revealed to transaction participants. This maintains confidentiality but also reduces errors and expedites transactions.

CHIPS
This six digit number is linked to the account information without the identity of the account holder being revealed to transaction participants. This maintains confidentiality but also reduces errors and expedites transactions. Members of CHIPS are monitored by the New York State Banking Department since the Federal Reserve Bank of New York is the depository institution that arranges for the CHIPS transfers via Fedwire. CHIPS is also able to interact with the Society for Interbank Worldwide Interbank Financial Telecommunications (SWIFT) system which is a financial cooperative owned by over 7000 member financial institutions around the world. SWIFT provides secure financial messaging for its members. Fedwire cannot transfer as much information as SWIFT can.

Federal Reserve’s PSR
Because of the increasing transfer of high value funds between depository institutions, the risk of bank failure is also increasing. Not all banks have sufficient funds to complete these transactions. Consequently, the Federal Reserve has developed a Payment System Risk (PSR) policy that all Federal Reserve member banks must adhere to. The PSR policy covers fraud, credit, and systemic risks. Currently, checks represent the most common form of fraud risk.

Signature forgery, unauthorized modification of amounts and/or recipient and unauthorized copying of checks are the main forms of check fraud. The Check 21 legislation helps minimize check fraud by expediting the check clearing process. Credit cards represent another major source of fraud, particularly the unauthorized use of credit card numbers. This risk can be mitigated by use of credit card activity monitoring programs that alert the card holder to unusual activity. Fraud risk is minimal with ACH transactions and Fedwire wire transfers due to the very limited access to these systems and the accountability features of these electronic systems.

The Federal Reserve has developed the Payment System Risk (PSR) policy to address the growing risk problems with the various payment methods. Three kinds of risk that the policy addresses are credit, fraud, and systemic. Credit risk arises when the originating financial depository institution (OFDI) has insufficient funds to settle funds transfers. The PSR requires that a bank’s customers undergo a complete credit analysis prior to granting use of wire transfer and ACH services. Wire transfers make depository institutions most vulnerable due to their high value.

The PSR requires that a bank’s customers undergo a complete credit analysis prior to granting use of wire transfer and ACH services. Wire transfers make depository institutions most vulnerable due to their high value. ACH transfers are limited to $99 million per transaction, which in theory should not increase risk significantly. However, the less costly ACH transfers are not monitored as thoroughly as wire transfers and more funds of high value are being settled through ACH in multiple transactions.

Systemic risks
The Federal Reserve has developed the Payment System Risk (PSR) policy to address the growing risk problems with the various payment methods. Three kinds of risk that the policy addresses are systemic, credit, and fraud. Systemic risks are those that could affect the entire system, in this case the entire banking system. For example, if a major bank fails, any other banks that regularly transfer funds to and from it are vulnerable to failure as well. This could lead to a system wide failure. One reason a bank fails is because of insufficient funds to cover posted debits.

Overdrafts can then occur in the institution’s Federal Reserve account. Too many overdrafts in a day that are not offset by credits can destabilize the system. So, the PSR policy sets daylight (i.e. business day) overdraft limits for the account. There can be many overdrafts within a single day that are largely offset by credits.

ACH payment formats
When Payments are made using the Automated Clearing House (ACH) system, the payments are categorized and formatted according to the kind of payment which can be prearranged or not prearranged. The prearranged formats are used for business to business or business to consumer transactions. They are for making regular payments such as payroll, mortgage/lease, invoices, taxes, etc. The basic formats include prearranged payment of deposit (PPD), cash concentration and disbursement (CCD), cash concentration disbursement plus any additions (CCD+), corporate trade exchange (CTX), and re-presented check (RCK).

ACH payment formats
ACH formats that are not prearranged and are primarily for consumer purchases and payments include point-of-purchase (POP), Telephone Initiated Entry (TEL), customer initiated entry (CIE), and internet initiated entry (WEB). When consumer checks are sent to a lockbox, they need to be put in an ACH format before they can be sent on for clearing. The accounts receivable truncation (ARC) format is used for this conversion.