BAS-BN203-Payments

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1. Payment System Certification ........................................................................................ 4

Introduction ........................................................................................................................... 4

a. Payments Landscape........................................................................................................ 4

b. Retail and Wholesale Payments........................................................................................ 6

c. Payment Instruments ........................................................................................................ 6

d. Payment Channels ............................................................................................................ 7

2. Payment Life Cycle ....................................................................................................... 11

Introduction ......................................................................................................................... 11

a. Payment Initiation ............................................................................................................ 12

b. Payment Processing ....................................................................................................... 13

c. Payment Clearing and Settlement ................................................................................... 13

3. Payment Systems ......................................................................................................... 18

Introduction ......................................................................................................................... 18

a. Retail Payment System ................................................................................................... 19

b. Corporate /Wholesale payments ..................................................................................... 28

4. Payment Instruments .................................................................................................... 44

a. Cash ............................................................................................................................... 45

b. Non Cash ........................................................................................................................ 47

5. ATM Operations, clearing and settlement ................................................................... 62

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6. Payment Clearing and Settlement (other than ATM) .................................................. 68

a. Types of Clearing ............................................................................................................ 68

b. Managing Check Returns ................................................................................................ 78

c. Clearing and Settlement of Electronic instruments .......................................................... 79

7. Payment Messaging System ........................................................................................ 93

a. Different Communication Networks ................................................................................. 93

b. Different formats ............................................................................................................. 96

8. Regulations and Compliance ..................................................................................... 107

a. UK 108

b. USA .............................................................................................................................. 109

c. European Union ............................................................................................................ 110

d. Detailed Regulation-USA .............................................................................................. 111

e. Detailed Regulations in UK ........................................................................................... 118

f. Bank of International Settlements................................................................................... 120

Glossary .......................................................................................................................... 122

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1. Payment System Certification

Introduction

Learning Objective: The learning objective of this chapter is to obtain a broad overview of

the various the payment systems by introducing basic concepts of payment systems. It

explains key concepts in terms of their historical evolution, classification of payment

channels, systems and instruments which will be elaborated further in the following chapters.

a. Payments Landscape

Background

The primary goal of any national payment system is to enable the circulation of money in the

economy. It is recognised world wide that an efficient and secure payment system is an

enabler of economic activity. In olden days the consideration was through a system called

the barter system. People used to exchange goods for goods or commodities were

exchanged against precious metals like gold.

Over a period of time there was a need for a formal and common medium of exchange.

In modern times the medium of exchange has become more complicated from a single

currency to a multiple currencies across multiple products and multiple channels.

People can now hold money in the form of legal tender like currency notes, plastic money in

the form of Credit, Debit and other types of Prepaid Instruments. Money can also be held in

the form of mobile wallets and the modern digital models including alternate payments like

PayPal, Serve etc. The future of money vests in multi-channel integration between plastic

money and mobile money

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The circulation of money cannot be free and needs to be regulated. It is the primary

responsibility of the respective nations to undertake the same.

Evolution of Payments

The evolution of the payment system is closely related to the evolution of money.

The earliest form of money was commodity money. They varied from cowry shells, animal

hides, and leather goods. Even cattle, once upon a time were used as commodity money.

The saga of commodity money was replaced by metallic money which comprised of precious

metals, gold and silver. In the later stages the concept of standard coins was introduced.

In 1913, The Federal Reserve of US issued what was called a $ 50 Gold certificate. Any

holder of this certificate held title to 2.41896 troy oz of Gold (at $US20.67 per troy oz.) which

could be redeemed at any bank or from the U.S. Treasury itself at any time.

Another form or substitute of money was the bill of exchange. The history of The Bill of

Exchange dates back to the 18th century which was used basically by traders across the

world. The goods were issued by traders against a bill of exchange. The value written on the

Bill of Exchange was the value payable for the underlying trade transaction.

Over a period of time, paper money slowly gave way to Cheque1 (spelt Check in US

English).The cheque is a variant of bill of exchange. Cheques were an outcome of the

Banking evolution.

Market Participants:

The large scale evolution of the payment product has led to the formation of a number of

participants in the landscape.

1
Henceforth these terms Check and Cheque will be used interchangeably

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The key participants are

Banks and Financial Institutions

Clearing and Settlement Agencies (both in the private sector and public sector)

Payment Service Providers like VISA/MasterCard etc

b. Classification of Payments

Retail Payments

Payment Systems can be classified into Retail and Wholesale payments systems. Retail

payments refer to the payments affected by individuals through multiple channels. Generally

the ticket size of a retail payment is smaller in nature compared to a wholesale transaction.

Retail Payments can also be further classified into domestic payments and cross border

payments. Example of cross border payment is an NRI remitting money from a foreign

country to India. There are multiple channels and currencies involved, in such process of

payment and settlement

Wholesale Payments

Wholesale payments can be broadly classified into Government Services Payment and Non

Government payments. Government Payment would typically include tax receipts and

administrative payments like salary to government employees.

Non Government payments are affected by all types of corporates irrespective of their size.

They could include salary payment, vendor payment, payment for procurement and other

payments. The wholesale payments can also be classified further into domestic payments

and cross border payments.

c. Payment Instruments.2

Payment instruments are instruments used as a medium to transact. The payment

instruments have evolved over a period of time from basic currency notes to electronic
2
Detailed discussion is done in the respective sections. This is a high level overview.

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medium. In terms of money supply, the developed and developing nations have variations in

terms of currency usage.

They can be broadly classified into two categories as cash and non cash instruments. Non

cash Instruments can further be classified into paper based and electronic based

instruments. Paper based instruments include:

Travellers Checks

Checks

Bankers Check

Money order

Electronic based instruments include:

Wire Transfer

Direct Debit to Bank Accounts

Direct Credit to Bank Accounts

Mobile Payments linked to Bank Account

Cards- Debit card/credit/Prepaid/Gift cards

d. Payment Channels:

The payment instruments can be transacted only through the respective delivery channels.

The channel and instrument go hand in hand. Both of them cannot exist in isolation. There

are number of channels which can be used for transacting these instruments.

Most of the electronic instruments are transacted across the Internet Channel.

The Payment channels are:

Traditional Branch banking wherein the customer walks into the branch and withdraws /

remit cash.

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 Traditional Branch banking channel also has been made electronic by Banks like SBI

where they have installed POS machines for even deposit and withdrawal of cash. This

is a very cheap substitute of an ATM Machine.

The POS machines are installed within the premises of the bank itself. There can be a

number of POS machines within a branch as it requires only power and a connection to

the core banking solutions of the bank.

Internet is a Direct Banking channel which can be used by retail as well as corporate

customers for various purposes like;

B2B : Business to Business

B2C: Business to Consumer. E.g. Dividend Distribution by companies

C2B: Consumer to Business. E.g. Utility Payments

G2C: Government to Consumer. Social security doles paid to citizens.

C2G: Consumer to Government. The different types of taxes consumer has to pay to

the government.

Automated Teller Machine (ATM) is one of the most popular Direct Banking channels for

retail cash payment. It is available 24*7, both for domestic and cross border purposes.

ATM Machines have evolved beyond the normal Cash vending machines. They also now act

more like a kiosk wherein one can book tickets, refill mobile prepaid cards. Banking services

like check book request can be done through an ATM Machine. Even Tax payments can be

done on ATM machines in certain countries.

In countries like Singapore there are multi-slot ATMs, for topping up the other types of cards

like the travel card.

ATMs will become more and more sophisticated in the days to come.

Point of Sale (POS)-This is one of the largest electronic channels. It is used primarily for

purchase of merchandise and services. The POS machine can accept all types of cards

for processing.

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Of late, certain countries have allowed withdrawal of cash at any POS terminal subject to

certain conditions. There is no need for a card holder to buy merchandise from the

merchant. The customer can just swipe the card at a POS machine and withdraw cash. The

POS terminals have a bigger reach as compared to the ATM Machines. The cash withdrawal

option is different from the cash back option. The cash back option is the discount offered on

purchase of merchandise.

Mobile payments will be the future of technology. There are various means of affecting

such payments. It could be a simple SMS based or through application downloaded on

the mobile phone or contact-less payment at merchant location using the mobile phone.

Mobile Payments should not be confused with Mobile Banking. Mobile banking is

basically related to the banking services using the mobile phone as a channel. Usually,

they are non financial in nature like balance enquiry, check book request and other

services. It also may include transfer of funds to certain pre-specified accounts.

Mobile payment on the other hand goes beyond banking transactions and can be used

for third party transactions as well. The third party transaction could be purchase of

merchandise at a super market. Instead of swiping the card, the mobile will be used as a

mechanism to pay to the super market.

Person to Person (P2P) Payment Systems-This is the new buzzword in the payment

industry. The most popular P2P Payment system is PayPal. In a P2P setup, both, the

buyer and the seller need to have an account with PayPal and the money transfer is

made instantly.

Visa has recently announced the launch of their P2P Payment service. They have partnered

with Cash hedge and Fiserv, two companies which are into P2P financial transactions.

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Payment Systems of UK:

Currently in UK there are four distinct Payment Systems

Cheque & Credit Clearing Company- This is the orthodox paper based clearing and

settlement system.

BACS- This is used for electronic payment schemes. There are two products offered by

BACS; Direct debit and Direct Credit

CHAPS- It is the electronic bank to bank payment and works on the principle of Real

Time Gross Settlement.

Faster Payments This is the latest in breed payment system wherein the customer can

transfer money through the telephone channel or the internet channel.

Payment Systems of USA

The Federal Reserve operates the following payment systems in USA

Check services- The orthodox paper based clearing and settlement services. The

electronic images as defined by Check 21 regulation are also settled and cleared

through this mechanism.

Automated Clearing House Services (ACH) - This is a mix and match of paper based

and electronic instruments. The data based on the paper instruments is captured in an

electronic format and the electronic details are transmitted to the settlement institutions.

National settlement Services This is a multilateral netting based on electronic files

uploaded by the institutions.

Fed wire Fund Services- This service is similar to the CHAPS of UK. This is also a Real

Time Gross Settlement System.

In addition to the Federal Reserves payment system, there is one more popular

payment system which is owned by banks and privately operated. This is popularly

known as CHIPS (Clearing House Interbank Payment Systems)

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2. Payment Life Cycle

Introduction

The learning objective: The learning objective of this chapter is to explain the life cycle of

the various types of Payment. The payment instruments can be classified into retail and

wholesale based on the business segment. The life cycle is further classified as debit or

credit life cycle.

Business Cycle

There is a business cycle behind most of the corporate payment transactions. Behind every

business cycle there is a business process. The business cycle varies depending upon the

types of business like manufacturing or services business.

The payment cycle consists of two aspects i.e., payment and receipts which are two sides of

the same coin. Hence there will be a receipt process and a payment process in each

transaction.

Some illustrations of the Payment business cycles are:

Salary Payment to employees ;

Receipt of salary by employees;

Vendor Payments for procurement of goods either for consumption or manufacture;

Payment of Statutory dues like Income Tax, Withholding Tax, Service Tax, Custom

Duties and Central Excise;

The most common jargon used in huge MNCs for the payment cycle is P2P (even SAP

uses this). P2P stands for Procure to Pay Cycle or Purchase to Pay Cycle. There are

various stages in this cycle which culminates into payment.

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a. Payment Initiation

The payment process can undergo a number of stages from payment initiation to payment

processing and finally leading to clearing and settlement. In order to have clarity of the

concepts, various illustrations have been discussed below. The payment mode in the

illustration is the physical paper check.

Retail Credit Payment Life cycle

The first stage is the initiation of the payment.

Scenario: Mr. John receives his salary check from Wal-Mart, his employer. Mr. John has his

account with Wells Fargo while Wal-Marts banker is Citi Bank. The salary check will be

drawn on Citibank and is referred to as the paying banker. Mr. Johns bank is referred to as

the Collecting Bank. It is also assumed that the branches of the bank are situated in

Washington DC.

The diagram below depicts the typical inter-bank check clearing and settlement process

through a Central Bank or Clearinghouse. The steps are as follows:

Step 1: Mr. John will deposit his check with Wells Fargo Washington Branch

Step 2: Wells Fargo, after authenticating the check, accepts the check for collection. At the

end of the day, the bank accumulates the checks received from its customers and sorts

them into three categories viz. checks drawn on Wells Fargo Washington Branch, checks

drawn on other branches of Wells Fargo and checks drawn on other banks. Checks drawn

on other banks will be sent to the service branch of Wells Fargo for collection. The checks

drawn on Wells Fargo will be processed at the branch itself.

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b. Payment Processing

Step 3: The Service branch of Wells Fargo will collect the checks from the various branches

across Washington and send them to the clearinghouse.

Step 4: At the clearinghouse, the checks are exchanged. Wells Fargo will hand over all the

checks they have collected drawn upon the other members of the clearing house, and collect

all the checks drawn on them. Thus the check will go back to the Citibank, which is a drawee

Bank. Service branch of Citibank may or may not send the check to drawee branch of

Citibank.

c. Payment Clearing and Settlement

Step 5, 6 & 7: The Citibank will cross check the balances of Wal-Mart account and other

particulars of the check. In case the check is found to be in order and there is sufficient

balance in Wal-Mart account, the check will be honored. In case sufficient funds are not

there in the Wal-Marts account in Citibank, the check is dishonored. In case of dishonor, the

check will physically traverse back all the way through the same route to the Johns bank i.e.

Wells Fargo .The Bank in turn will hand over the check to Mr. John. The figure 1 below

depicts this process.

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Figure 1: Check Clearing and Settlement

Check Clearing and Settlement

Wal-Mart John
1
(Payer) (Payee)

Clearing
House 7 2

6
5
Citibank Wells Fargo
2
4 3

The physical check movement is one of the processes within clearing. This is followed by the

settlement process. The clearing house will then have to either debit /or credit the net

amount to individual banks accounts with the settlement bank for the checks processed.

In the days of non automation, this clearing and settlement process was fully manual. The

first phase of automation of this process was the introduction of MICR technology. The

Magnetic Ink Character Recognition (MICR) automated the sorting of checks bank and

branch wise. During the process of sorting the checks bank wise by the MICR sorter, the

MICR sorter system in the back end also stored the amount to receive/to pay .This netted

amount is the clearing figure for that settlement cycle.

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Retail Debit Payment Life cycle

Mr. John after receiving the salary from Wal-Mart may require the money for the following

purpose.

Liquid Cash for day to day/household expenses

Payment of rent for his residence

Payment for electricity consumption

Payment of telephone/Mobile bill

Remittance to parents

Routine Payments at various Shops

Cash can be withdrawn either across the counter of a bank or through ATM. Cash can also

be withdrawn even at any POS (Point of Sale) machine as well in certain select countries.

The rent will be paid through a check which in turn will undergo the same cycle as the salary

payment cycle, discussed above.

The payments to electricity, telephone, mobile phone companies, etc are commonly referred

to as utility payments. Utility payments are also paid by check or cash. However, as the

payment of bills by cash involves visiting each Service providers office, the utility payments

should ideally be made by way of check instead of cash. The check will be deposited by

John at the respective utility centers. These utility companies will in turn deposit the same

into their bank. This will also undergo the same check processing cycle as mentioned above.

A citizen would have to use either the drop box for depositing the physical checks, which is

quite common these days, or visit the respective utility offices. If the customer wants to remit

cash for each utility, he would have to visit each centre which is cumbersome. Many

countries have introduced the concept of single window concept were all utility payments

can be done under one roof.

Similarly for Government Tax payment, the citizen had to visit different offices for different

types of taxes. The Government under e-Governance also has introduced a single window

concept for all government payments.

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In all the above scenarios the amount as per the check deposited will be debited (subtracted

from the account balance of the consumer, Mr John) through a clearing and settlement

process.

Corporate Payment life cycle

Corporate Debit Payment Life cycle

The corporate has to pay for multiple purposes depending on the nature of the corporate.

Corporate can be broadly classified into Manufacturing Sector and Services Sector. The

payments of both the sectors vary based on the industry specific requirements.

In a typical car manufacturing industry like Volkswagen, they will have the following

requirements:

P2P cycle for raw materials

In the Purchase to Pay Cycle (P2P) cycle, the car manufacturer will place an order for

multiple items from multiple vendors. The tyres may be procured from Good year, The Dash

board from Pricol and Spark Plugs from Bosch etc.

The procurement can be from domestic market wherein the payments are made in the local

currency. There can be certain spare parts which may be imported for which payments need

to be made in foreign currency. For the sake of simplicity, let it be assumed that payments

are in domestic currency.

There is an elaborate P2P cycle, which is not the point of discussion here. The payment is

the last leg of the P2P cycle. The finance department will issue checks to the vendors like

Bosch, Pricol and Good Year.

These vendors on receipt of the checks will in turn deposit the same with their respective

bankers. These checks undergo the same cycle as the retail credit payment life cycle

mentioned above. In a large industry the cycle and the number of payments could be mind

boggling.

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The second major payment of a corporate is salaries and wages. Wages are paid basically

for unskilled and semi skilled workers. This payment is generally in cash. The white collared

workers are paid salaries and the same is credited to their bank account. For instance,

Infosys alone has 130,280 employees as on 31st march 2011 (Source Infosys Annual Report

2010-11-Introduction-30 years of Infosys). Such payments will be periodical and repetitive in

nature.

This will include domestic as well as cross border payments.

The third type of Debit Payment of the manufacturing companies would be statutory dues

related to the manufacturing cycle like Value Added Tax, and other types of tax. In case of

employee payment, the statutory levies could be Gratuity Payments, Social Security

Payments etc.

Another bulk payment requirement is the payment of dividends to the shareholders. A

company like Infosys had 416,623 distinct shareholders as on 31st March 2011(Source

Infosys Annual Report 2010-11, page 75). All these investors need to be paid the dividend at

periodic basis. There could be a number of other miscellaneous payments like Rent, Utility

Payments and Administrative overheads.

Corporate Credit Payment Life cycle

The receipt cycle in terms of volumes typically relates to utility companies like the telecom

and power companies. They have to bill the customers periodically (monthly/ quarterly)

Best examples are the telecom/electric supply companies which have been growing

exponentially. These companies have receipts from multiple channels and multiple modes.

The number of receipts could be mind boggling.

There is no difference in the clearing and settlement process for retail and corporate

payments.

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3. Payment Systems

Introduction

Learning Objective: The objective is to understand payment systems section in terms of

retail and corporate entities.

Paper based instruments are handled in a different manner as compared to the electronic

instruments. Every payment system, regardless of whether being electronic or physical

paper has a clearing and settlement process. The underlying principles are same though the

process may be different. Electronic instruments like virtual cards and the internet channel

as well as concepts like PayPal are addressed in this section.

There are a number of process variations in handling Government and non-Government

corporate payments. The workflow for receipt process has a number of variations. In this

section processes will be discussed with respect to retail and wholesale products. Paper

based clearing and settlement section will be discussed separately.

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a. Retail Payment System

The Retail Payment system can be classified as follows:

Figure 2: Retail payment System

Retail Payment

Direct Merchant
Cash Withdrawals & Payment for purchase Recurring utility
Deposits of Merchandise and payments
services

Branch ATM Phone POS Internet

The types of the retail system can be broadly categorised into three as depicted above.

Due to technological advancement service requirements of the customer can be fulfilled

through multiple channels. The customer service approach has moved to a multi-channel

approach.

Branch Banking

This is the oldest of the payment channels. This is also known as brick and mortar channel.

The customer had to physically visit the bank for cash withdrawals and deposits within the

stipulated timings. The biggest constraint in the branch banking was the rigidity in the timings

of the branches. The second drawback was that the customer belonged to the specific

branch of the Bank and not to the bank which would mean that if a customer belonged to X

branch of a bank, he could not undertake his banking activities in Y branch of the same

bank.

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Over a period of time the concept of specialised branches was introduced. Examples of

specialised branches are Foreign Exchange Branch, Industrial Finance Branch etc. The

branches servicing retail customers were branded as Personal Banking Branches. In a

typical large scale branch, multiple departments still exist.

The typical branch has the following payment related departments

Cash receipts

Cash payments

Remittances Department which issues Demand Drafts, Pay Order, Gift Checks, Wire

Transfers etc.

Teller department in most of the banks undertakes these multifarious functions.

Clearing Department for receipt and delivery of customer checks and subsequent

processing.

Automated Teller Machines

This is the first electronic direct banking channel which is more than four decades old.

During this period ATM has evolved from being a plain vanilla cash dispensing product to a

more complicated kiosk and vending machine. Both debit and credit cards are used in ATMs

for withdrawal of cash and operations are linked to specified accounts. In certain pre-paid

cards, withdrawal of cash is not permitted.

ATM and the POS technology, in terms of establishing a connection, are quite similar. The

difference is the final settlement process. Up to the point of authenticating the customer, it is

the same. ATM is further bifurcated on the basis of magnetic and smart card readers. ATM,

in terms of communication, requires a higher bandwidth as compared with a POS machine

and one may not come across Public Switch Telephone Network (PSTN). The VSAT, leased

lines and ISDN are the most popular modes of connectivity for ATMs.

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ATM Business Models

There are bank owned as well as white label ATMs. In a white label ATM, the concept is

similar to white label cards. White label ATM is owned by service provider and billing

happens based on the number of transactions. In white label environment, the ATM will not

have the name of any specific bank. The ATM displays the types of cards it will accept (Visa,

MasterCard, etc). White label model is most popular in the US and Canada. Canada has

more than 25% of ATMs in the white label environment. TNS Smart Network is the biggest

white label ATM service provider in Canada with more than 13,000 ATMs. Some reputed

ATM vendors are Diebold, NCR and Euronet. In India, white label ATM concept is presently

at nascent stage.

Multi-Purpose ATM/Kiosks

ATMs have transformed from conventional cash dispensing machines to a multipurpose

utility. They can now be used for mobile top-ups, dispensing movie tickets, and topping up

the public transport system. Singapore has a unique system of merging an ATM transaction

and a public transport smart card.

ATM will have two slots, one for cash withdrawal and the other for smart card used for public

transport. Both cards will be inserted simultaneously and using ATM cards, transport smart

cards can be easily topped up. This has been modified further, with a single card currently

being used as a smart card cum ATM card. ATMs are also used to deposit cash and checks.

In case of deposit of cash, it has to be in a sealed envelope and through a specific slot

provided for cash deposit. Modern Kiosks also have intelligence to read the type of currency

being deposited.

ATM Trends

One will be surprised to observe that one can withdraw cash from an ATM even without any

type of card (be it debit or credit).The mobile phone payment system has enabled ATM as

an additional channel.

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Mr. Walker is a customer of Axis Bank and has not availed the Debit card cum ATM Card

facility. Mr. Walkers friend has remitted him cash through a mobile payment. This mobile

phone payment is supplemented by a unique code which is known to Walker and is received

on Walkers mobile phone on receiving the payment.

Mr. Walker can walk into the ATM of Axis Bank, key in his Mobile number and this unique

code. On authentication, the cash will be dispensed by the ATM machine. This may sound

like a fiction but is true. In Japan ATMs are Braille enabled as depicted below.

Figure 3: Sample ATM Screenshot

Multi-lingual ATMs are equally popular in many Asian countries. Biometric ATMs are aimed

at the illiterate segment of the users. Touch screen ATMs are another product variant from

the convenience aspect.

ATM Vendors:

ATM Vendor Market is highly overcrowded. Diebold is one of the oldest ATM

Vendors.

The other top vendors include NCR Corporation, Euronet.

There are a number of other providers with local presence as well.

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Phone Banking

Phone Banking as a channel is not as popular as other channels. This channel is basically

used by customer to record their customer grievance rather than as a transaction channel.

This channel can manage service requests like Fax on demand as well as automated

balance enquiry etc. IVR (Interactive Voice Recognition) is the technology used to reduce

manpower and the subsequent cost.

This channel also handles transactions after due authentication

Point of Sale

The largest channel through which transactions happen is POS. The number of POS

terminals is manifold, as compared to the number of ATMs. POS is primarily used for the

purpose of purchasing the merchandise and services. The POS machines are normally

placed at the merchant location. Typically, POS machines will be provided by the acquirer

Bank. These machines can either be owned by the merchant or the acquirer Bank.

In case a merchant owns the machine, the cost of purchase will have to be borne by the

merchant. In case the POS machine is owned by the acquirer bank, then the merchant has

to pay monthly rent. It makes business sense to lease out the POS machine rather than own

the same. Due to intense competition, the monthly rentals model is also slowly becoming

defunct.

PC POS

The concept of PC POS is related to the integrated approach towards various functions.

In PC POS the POS is not a stand alone. The merchandise billing will happen on the PC of

the Hypermarket and once the billing happens, the Card details are also entered on the

same machine and the card is swiped therein without an external POS. An external device

will print the charge slip.

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Picture courtesy: http://dppsouth.com/pos.aspx

Smart Card Technology

Smart cards can be classified into contact cards and contactless cards.

Contactless cards/proximity cards do not require physical contact of the card with the card

reader. This type of card is very popular for public transport where the user need not take it

out of the wallet. All the user has to do is just to show it in front of the reader. The technology

being used in such cards is the use of radio frequency identification technique. It requires the

card to be in proximity to an antenna to communicate. Contact Cards have an area which

has to come into physical device for operating the card. Hybrid smart cards which have both

contactless and contact option are also available.

EMV (Europay MasterCard Visa) has created specifications that define the communication

protocol between contactless card and merchant terminal. It is absolutely necessary for the

interoperability of the cards, else the card becomes unusable. The current version of EMV

standards is 4.2, released in June 2008. It also encompasses specifications, test procedures

and compliance processes managed by EMV (www.emvco.com). It is not enough that the

smart cards are EMV compliant. Devices like readers also need to be EMV compliant. Only

then the two will work in tandem.

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Connectivity

Connectivity is central to the entire business of POS. Loss of connectivity is a direct loss of

customer especially in case of sale of goods. Hence it is important that the high availability of

the system is a critical success factor of the POS. In order to ensure this high availability,

there are a number of connectivity modes available to the merchants at affordable prices.

One of the critical success factors for electronic POS (for magnetic and smart cards) is the

establishment of communication between merchants and acquirers. If connections are not

established, it can come to a standstill.

Communication channels between merchants and acquirers are as follows:

PSTN (Normal Telephone lines-Public Switch Telephone Network)

GPRS: New technology used for mobile is also used for wireless POS. Many petrol

pumps use this technology as the device is mobile and the swiping happens in front of

the customers.

CDMA POS machines are also available in certain countries.

Wi-Fi POS is also catching up.

New trends in Connectivity

The mobility of the merchant is restricted by the POS machine being installed and a

connection required. In US, the revolution is through square up (refer squareup.com). There

is a small square device which acts as a POS terminal and the same is attached to the

Mobile phone. Using this device, the mobile phone becomes a POS machine. This leads to

device convergence where a merchant without a POS machine can convert the mobile to a

POS terminal.

Cash at POS

It has been already mentioned that the number of POS terminals are manifold compared to

ATM reach. This opens up one more avenue for withdrawing cash. A debit card customer

can walk into any merchant establishment where a POS is installed and request for a cash

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withdrawal even without making any purchase or merchandise. There are limits on the

amount of cash that can be withdrawn. Also the cash dispensing at POS is generally done

on the POS which belongs to the Issuer only.

Internet Channel

Internet Channel is the emerging channel after POS and ATM. Unlike other channels, the

payment system is a bit different. In case of ATM, there is a need of an ATM card or a

mobile phone. In case of POS also, there is a need of a card. In the internet channel the

card or the existing bank account of a customer can be used for e-commerce or transfer of

funds transaction.

This is typically referred to as an IPG (Internet Payment Gateway). There is a recent concept

in cards called virtual cards.

Figure 4: Internet Channel

Internet Channel

Virtual Cards like Online Payment

Credit/Debit/Prepaid service like Pay Pal
EntroPay of Visa/ Bank Account
Card
MasterCard

Credit/Debit and Prepaid Cards

This is the oldest payment channel used over the web. There are certain security concerns

like user identification on the usage of this card on the web. Most countries have enhanced

the security of the cards by introducing measures like two factor authentication (2FA), one-

time passwords etc.

Payments 26
i. Virtual Cards

The pitfalls of the physical cards are addressed by a variant of the physical cards. The virtual

cards unlike the physical cards are generated and stored in the computer. In this card there

is no compromise on the card details. A sample virtual card is depicted as follows:

The leading companies like MasterCard Visa etc are in the fray in the e-wallet segment. The

e-wallet can be created from the existing bank account or from the transfer of money from

other cards. It is as good as a prepaid card which is issued without any credit check. There

are no hassles of storing and protecting the same.

Bank Account

The payment for purchase of merchandise can be one directly from the bank account. The

payment from bank account can either be credited to the merchant directly or through an

aggregator. The reputed aggregator in US is Yodlee, Mycheckfree etc. The Indian counter

part of bill aggregators is Bill desk, Billjunction etc. However the operational model is

different from the US Model.

Online Payment services

This is the emerging business model and is referred to as a P2P (Person to Person)

Payment model. The most popular P2P is the PayPal which is a subsidiary of eBay. PayPal

is an online payment service. In this model the buyer and seller has the account with PayPal.

Once a retail customer makes a purchase and uses the PayPal account the amount is

transferred instantly to the seller provided the seller also has an account with PayPal. It is as

good as an internal transfer. The settlement mechanism will be discussed subsequently.

Payments 27
This model has wide acceptability in terms of convenience and security. One need not key in

the credit card information in a PayPal scenario .It is as simple as using an email.

PayPal has also introduced mobile phone linked payments. PayPal has also diversified from

just payments to cross border money transfers as well. PayPal is like a pre-paid card. The

account can be topped up or balance can be withdrawn at the convenience of the customer.

The PayPal account can be funded by any of the following ways

Bank Account

Debit or Credit Card

Cash via MoneyPak. Moneymaker is pre-paid instrument which is available in retail

stores. The customer can purchase Moneymaker and use it to top up the PayPal

account.

Loyalty points which can be converted to cash

b. Corporate /Wholesale payments

Largest payments and receipts, after retail segment are in the corporate or wholesale

segment. The Corporate payment cycle can be classified as Government and Non-

Government payments.

Government Services Sector

The Government in different countries is providing services to its citizens. In certain

economies, like India, they may also be running certain companies (PSUs) like BHEL, Indian

Oil, etc. The payments need of the Government services sector is huge and distinct from

manufacturing sector needs. The manufacturing sectors payments needs are discussed

subsequently.

Receipts

The receipt and payment system is also critical and backbone of the economy. Receipts of

Government are typically the tax collection.

Payments 28
Tax receipts can be in the form of

Cash

Check

E-payments

Bankers Check

Or any other paper based instruments.

Governments can pass local regulation to accept a specific mode of payment. In certain

geographies e-Payments have become mandatory beyond a certain threshold limit.

Payment related services for the Government Sector:

In the absence of e-Payments system, there is a huge effort and cost, required for the Bank

or the Government to undertake a reconciliation of records of remittances, as per the bank

record with the records as submitted by the tax payer.

The data is getting captured at multiple entry points and there can be data entry errors in the

critical fields. Consequently, the records of the tax payer vis-a-vis the Government records

may not reconcile and tally. This can result in two scenarios. In the first scenario, the

genuine tax payer is denied the credit of tax. In the second scenario, there can be inflation of

tax and false showing credits to the wrong tax payer.

In an e-Payments scenario, the clients tax details like Social Security Number (SSN),

Permanent Account Number (PAN) are validated before remittance. This results in accurate

reporting. Another advantage of E-payment, compared with the paper based, is assessment

of the return/refund process.

Government Payments received by banks is a two step process.

The tax payer remits the money to his/her bank. The tax collecting banks after the

reconciliation of the data transfers the funds to the account of the government, which may be

with the central bank of the country or any other pre-designated account of the government,

with any other Bank.

Payments 29
One more complication in this transfer process is the multiple element of tax in a single

payment of the taxpayer. As an Illustration, a company like Infosys, makes payment of

Service Tax to the tune of INR 112,300/-.This payment has three components viz. Service

Tax, Education Cess and Secondary Education Cess. The Split of the amount would be

100,000+12,000+300. In addition to this bifurcation, the corporate company will have to

differentiate the payments based on the services offered. They would have offered

consulting services as well as back office processing. The consulting related service tax will

have to be shown under management consulting services, while the back office services will

be classified as business auxiliary services. These amounts, from an accounting

perspective, will have to be remitted to three different accounts of the government.

A sample Service tax challan with code classification is depicted below. The code

'00440225' is for Business auxiliary services and the remaining for Education Cess and

Secondary education Cess respectively.

Similar tax structure exists for Income Tax payments, where there is a concept of surcharge,

delayed payment interest, etc. In case of Income Tax, the payments are further classified

based on the nature of payment, which could be more than thirty types in India. This needs

to be reported as well as accounted separately. All countries may or may not have similar

tax structure.

A sample income tax challan depicting the payment components is as follows:

This challan has three distinct components.

1) The section under which the tax is deducted.

Payments 30
2) The tax paid by tax payer or due to regular assessment.

3) The amount bifurcation as discussed above.

Another dimension, which is not there below, is the year for which the tax is being remitted.

This is critical from the taxpayers perspective.

Government Payments

The Government payments comprise basically salary payments to the government

employees, government expenditure, social security doles, tax refunds etc. The Government

payments are mostly in the form of checks or direct credit to the beneficiarys account. In

order to have a meaningful MIS out of the Government payments, the physical checks will

have separate MICR codes. Generally, Government cheques are treated as good for

payment.

Non Government Payments

The requirements of the Manufacturing and trading sector are different from the

requirements of the services sector. The needs are on both sides of the payment cycle i.e.

Receipts and Payment. The words Credit and Debit are also used for receipt and payment

respectively.

Payments 31
The corporate makes the payment for the following:

Vendors for procurement of raw materials

Dealers for sales sourced

Wages and salaries

Expenses reimbursement to staff members

Statutory Dues like Sales Tax, Service Tax, Income Tax, Tax deducted at source

Statutory Dues on HR like Provident Fund, ESI, Income Tax

Utility Payments like rent, telecom charges, electricity charges, maintenance charges

Vehicle lease rentals and fleet management charges like diesel, petrol etc

Raw Materials Payment Cycle

The procurement of raw materials payment life cycle has already been discussed in the

previous Section. The additional point to be noted is the payment mode. The payment mode

could be a paper based instruments or electronic credit to the Vendors account. In case of

bulk purchases, there can be complexities in the payment terms. Payment to vendors could

be a bullet payment or staggered payments. In case of bullet payment, it can either be

advance payment or on the basis of receipt of goods based on the Purchase order terms

and conditions. A staggered payment is one in which the payments are made over a period

of time and in bits and pieces. It is very important to track these payments to a specific asset

in order to avoid duplicate payment.

This section is restricted only to domestic payments. The cross border payment cycle will be

discussed in the subsequent sections.

Dealer payment: It varies from company to company and is one of the most complicated

payment models. There are two basic models of dealer payments. Model one, wherein the

dealer deducts his commission (compensation) and remits the net amount of the sales

proceeds to the manufacturer. Model two, wherein the gross amount is remitted to the

manufacturer. The dealer is then paid the commission at periodical rests. Both of these

Payments 32
models co-exist in the market. Over and above the distributor commission, there is another

payout to the dealer called incentives. Incentives are paid for meeting the sales target. Here

again, the payment mode can be paper or electronic. The number of dealers in the payment

eco system will be much more than the vendors.

Wages and salaries: They have been already discussed in the earlier sections.

Expense reimbursement to staff members: Based on the seniority of the employee in an

organisation, there will be an expense reimbursement matrix. For the lower level employees,

the expense reimbursement can be in cash, paper-based or electronic credit to their

account. In case of senior management, they are provided with corporate cards. The

payments are made directly to the Card issuers by the corporate for the billings made for the

corporate card.

Statutory Dues: All statutory dues are paid either by paper mode or electronic mode and

the complexities of the payment have already been discussed in the above section. All

statutory dues have to be paid within the specific deadlines stipulated by the respective Acts.

Utility Payment: The utility payments are recurring in nature. There are two types of

recurring payments. The first type is, the amount fixed in every cycle for a specific period of

time: e.g. fixed recurring utility payment is rent for the premises or maintenance charges of

the premises. The second type is, the amount varying with every billing cycle. E.g. electricity

charges, telecom charges, mobile phone bills, etc.

The mode of payment can be paper based or electronic. In electronic mode, it can be as

follows:

Electronic Payment initiated by the Manufacturer /service provider, each time when the

bill is received.

Scheduling the bill on the bank portal or any third party online bill payment service

providers.

Auto debit instructions to the bank or the service provider. In this case, as and when the

bill is generated and presented to the bank, the account can be debited.

Payments 33
 Auto debit for rent and non-routine service providers also are managed by banks. These

are referred to as standing instructions. In a standing instruction mode, the account of

the manufacturer is debited by the bank. The bank may either effect the payment by

issuing a paper instrument or an e-payment from its side.

Vehicle Lease rentals: This is also one of the major payouts in the manufacturing sector.

Canada has a unique product. The Petro Canada issues a petro card which is a mixture of a

Petro card as well as a credit card. The fleet management has a number of issues like

pilferage, fraudulent reporting of expenses etc. A card driven payment system is most suited

for the fleet management.

Dividend Payment: The same has already been discussed in earlier section.

Work flow of paper based instruments

There are different workflows associated with the paper based instruments.

Figure 5: Workflow 1: Instrument originated by the Manufacturer:

Write and Dispatch to Bank

Countersign Track Delivery
Print payee Reconciliation

Write and Print: This is the first stage of the workflow. Banks provide continuous stationery

to their clients to facilitate bulk printing. This bulk printing can happen directly from the

accounting system or through stand alone software.

Counter-sign: The checks have to be signed /countersigned based on the operating

instructions given to the bank by the manufacturer.

A sample grid would look like the one given below:

Payments 34
 Amount Signatory1 Signatory2

< INR 10000 Finance Officer Not required

>INR 1,00,000 and Finance Officer Finance Controller

<5,00,000

>5,00,000 Finance Controller Managing Director

Dispatch to Payee: The instrument has to reach the payee finally. It could be through hand

delivery, ordinary post, courier etc.

Track Delivery: The delivery needs to be tracked systematically. Most courier companies

offer online tracking of the shipment. Department of post for example tracks the shipment at

a very granular level. All returns of the shipment also need to be monitored and necessary

escalation matrix needs to be built.

Bank Reconciliation: There are number of intermediary steps like clearing and settlement.

These will be discussed in the subsequent section. This section deals with the workflow from

the check drawer perspective. Once the check is presented by the payee and the check is

cleared, the debit entry of the check will be reflected in the bank statement. Once the entry is

seen in the bank statement, the entire cycle comes to an end.

Figure 6: Workflow 2: Instrument originated by the Bank:

In cases where a bankers check is required instead of a check, the work flow will be slightly

different.

Request to Dispatch to Bank

Cross Verify Track Delivery
Bank Payee Reconciliation

Payments 35
Request to bank:

The manufacturer can request the same through a request. In case of net banking, the

request for bulk payments happens in two ways. The customer enters the details, like the

payee name, amount of bankers check, the place where it is to be drawn, on the portal. The

second way is the facility to upload the same data on the portal of the bank.

The instruments will be signed by the bank officials. The customer has to only cross verify

that the same has been issued as per the instructions. It may be difficult with huge volumes.

Moreover, with the Straight Through Process (STP) in place where the details are uploaded

by the customer, there is no need for such cross verification. The balance process remains

the same

Workflow 3: Instrument originated by the Bank and dispatched by the bank:

The Banks, as a part of their payment products have been continuously innovative in coming

up with new products. For large corporate, the dispatch of the instruments was becoming

difficult to manage. This aspect was taken over by the bank.

Figure 7: The modified workflow for this scenario will be as follows:

Bank Prints the

Dispatch to Payee Bank
Request to Bank Instrument
by Bank Reconciliation
(Local/Remote)

Request to Bank: Same as workflow 2

Bank Prints the Instrument: The bank has the option to print the instrument locally or

remotely. Remote printing is a recent process and all banks may or may not offer this facility

as a part of their payment product. Local printing refers to printing the instrument at the

Payments 36
branch where the request is given or at a central location. This is true for electronic requests

only.

For e.g. the customer Volkswagen has its banking account with ICICI Bank Hosur Road

Bangalore. The request for instruments is uploaded on the portal of ICICI Bank. The cash

management department of ICICI, which handles Payment products, is at Majestic. Based

on the banks internal business process model, the instruments could either be printed at

Hosur Branch or at the cash management department.

Remote printing facility is best explained by an illustration. Using the same example,

Volkswagen has to make around 100 payments to different vendors in Kanpur. Volkswagen

has already uploaded a file with the details of the client amount and location through the

website of the Bank.

The bank downloads this file from the portal and uploads it, into the core banking system or

the payment software, and triggers the printing. The Core banking system has the

functionality to trigger this printout on a printer located in the ICICI Bank, Kanpur. The

advantage of such set up is the speed in which the payee gets the payment. The dispatch

cost for the bank also reduces as it will be a localised dispatch within Kanpur rather than a

dispatch from Bangalore to Kanpur.

Dispatch to Payee by Bank: This activity is taken over by the bank from the customer and

the tracking of the same is also handled by the bank.

Bank reconciliation process still vests with the customer.

Dividend Payment workflow:

The workflow for dividend is quite different .The dividend instruments are pre-printed

instruments and customized as the name and amount vary with each instrument. They are

generally printed using technology process, away from the bank premises. The signatures

Payments 37
are also embedded on the instrument. The company issuing the dividend can decide the

threshold limit of the dividend amount beyond which it will require a manual signature.

Dividend payments are now more through electronic debit / credit rather than paper-based.

Other Innovative paper-based products

Multi-city Check: The dealers and other payees of the manufacturer need not necessarily

be stationed in and around the bank branch where the manufacturer is located. Centralised

implementation of Core Banking System by major Banks has made this possible.

If the payees accounts are in a bank branch which is in the vicinity of the manufacturer, then

the payee is said to be within the local clearing area (more of it later in the next section).

Let us use the Kanpur example. The 100 dealers of Volkswagen have to be paid in Kanpur

while Volkswagen account is in Hosur ICICI Bank. In addition to the remote printing option,

there is facility of Multi-city check book facility. In a multi-city check book facility, the payment

is similar to a local clearing. In the absence of multicity check, the instrument will be treated

as an upcountry and the time taken to get the payment will be more than 10 to 15 working

days.(Upcountry check will be discussed in further detail in the subsequent section)

Correspondent Banking: The payment canvas is not as simple as one could contemplate.

The Kanpur example is further complicated. Volkswagen is banking with Hosur branch of

ICICI Bank. Let it be assumed that ICICI Bank does not have a branch in Kanpur. In this

scenario, neither the remote printing will work nor will the multi-city check option work.

Normal upcountry checks will take 10-15 working days for the payee to get the proceeds.

This problem was overcome by a new product called a Correspondent Bank instrument.

ICICI Bank will tie up with banks which have a presence in Kanpur, say Syndicate Bank .The

same scenario has already been discussed in previous Section.

Payments 38
The correspondent bank demand drafts from the banking angle can again be classified as

below.

Correspondent
Bank DD

Pre Funded Post Funded

The correspondent bank earns the commission/ exchange for issuing the DD. In addition,

the correspondent bank may or may not earn float funds depending upon the above

scenario.

Pre-funded DD: ICICI Bank, for example, on a single day across all its branches issues DDs

worth INR 5,000,000/- drawn on Syndicate Bank. Under the pre-funding arrangement, ICICI

will have to pay the full amount to Syndicate Bank within a stipulated time which could be

two to three working days depending upon the terms and conditions of the correspondent

banking arrangement.

Post-funded DD: ICICI Bank, for example, on a single day (1st August 2011) across all its

branches issues 50 DDs worth INR 5,000,000/- drawn on Syndicate Bank. Of these 50 DDs,

10 DDs were presented to Syndicate Bank by the payees bank on 11th August 2011).

Syndicate Bank will claim this amount from ICICI Bank only on or after 11th August 2011.

Once the claim is made, ICICI Bank will have to pay the same within two or three working

days depending upon the arrangement.

The balance of INR 4,000,000 will still be with ICICI Bank till such time the instruments are

presented to Syndicate Bank. Clearly, Syndicate Bank is in an advantageous position in the

pre-funded scenario as it will be enjoying the INR 5,000,000, till such time all the instruments

Payments 39
are presented for payment. This float funds is over and above the DD Commission the bank

will be earning.

In the post-funded scenario, the bank will only earn the DD commission. In the

correspondent bank model, in addition to the DD discussed above, Volkswagen could also

be handed over check books of Syndicate Bank, Kanpur. Volkswagen will daily give a list of

Checks issued from the Syndicate Bank to ICICI Bank and ICICI Bank in turn will fund the

current account of Syndicate Bank, Kanpur on an ongoing basis.

Receipts

The corporate also receives payments on the following:

Sale Proceeds

Tax Refunds

Miscellaneous

Compared with payments, the nature of receipts are very much limited. Sales proceeds form

the major chunk of the receipts. The mode of receipt could be paper-based or electronic. In

case of paper-based, the receipt scenario is exactly the same as the payment scenario in

terms of the instrument type.

The receipt department will have to sort the instruments which they receive based on the

following:

Local Clearing Checks

This will include checks of the Banks within the local clearing house, multi-city checks (check

by a vendors Bank in Kanpur but the check can be paid in Bangalore).Technically, they are

treated as locally payable clearing checks. The payee generally gets the payment to his

account within two to three working days.

Transfer checks.

When checks of customers where the payees account and the drawees account are within

the same bank, they are cleared through Internal Clearing /or collecting from other Branch.

However, CBS implementation allows instant direct debit/ credit. This could also include DDs

Payments 40
drawn by the same bank. Instant or same day credit is done based upon the balances in the

drawees account.

Upcountry Check (UCC)

This will include Customer Checks as well as checks issued by the Banks but cannot be

presented locally. As already mentioned, the time limit for getting the payment used to be

anywhere between 10 to 15 working days. The checks may be drawn on upcountry places

where there is branch of the Bank as well as a place where the customers bank does not

have a branch. Volkswagen receives a check drawn on Punjab and Sind Bank in Bhatinda.

ICICI Bank may not have a branch in Bhatinda. In this scenario, the check will be handled

through a correspondent bank.

Volkswagen receives a check which is drawn on State Bank of India Lucknow where ICICI

has a branch. The same will be sent to Lucknow ICICI Bank and for Lucknow ICICI Bank this

will be a local clearing instrument.

This waiting period is a bit too long. Based on the creditworthiness of the payee, the bank

may fund the payee by check. Volkswagen has received checks worth INR 500,000 from a

customer in Bhatinda in Punjab. Volkswagen can request the banker to discount the check

and credit the account immediately. This is possible and Volkswagen will get the credit

immediately. However, commercial interest will be charged by the bank from the date of

discount till the date of getting the credit. In addition to the interest, the bank can also charge

commission and out of pocket expenses. The processes of parting away the money to the

payee before the receipt of the proceeds is called check discounting or check purchase.

Implementation of CBS by banks makes is possible for almost all local and outstation checks

payable at the local clearing house.

Payments 41
Services Sector

The receipt and payment scenario for Services Sector will have other dimensions besides

what is applicable to Manufacturing. In terms of the number of receipts to payment, the

scenario is exactly opposite. For instance, the telecom service providers like Airtel and

Reliance. They are more of a receipt oriented company compared with manufacturing. They

will also have most of the payments which are applicable to the manufacturing.

The mode of receipt will be:

Physical Paper based instruments

The instruments could be deposited by subscribers at the branches or the drop boxes of the

service providers located in different areas. These drop boxes are opened once a day and

the checks are aggregated at a common location. The service provider can insist that the

subscribers need to give only local clearing checks.

The receipt department will have to segregate the checks into

Local Clearing Checks

Transfer Checks.

The process of the local checks and transfer checks has already been mentioned above.

Similar to the payment reconciliation, the receipt reconciliation and check dishonour

management also needs to happen systematically.

In addition the service company may have all India presence and will definitely not collect all

the checks across its branches to a common place. The collection of checks will be

decentralised.

A company like Airtel may have a presence in 20 cities and 20 collection centers. The bank

for Airtel is HDFC Bank. The checks collected at the 20 centers will be deposited with the

local branches of HDFC Bank. The proceeds would be credited to a single account of Airtel.

This may lead to huge reconciliation issues. Consequently, this type of huge receipts is

handled by cash management software and reconciliation becomes automatic.

Payments 42
It may so happen that the HDFC Bank may have a presence only in 18 cities out of the 20

centers. In such situations, Airtel will be forced to open an account with a different bank. As

a result, Airtel finance department will have to manage multiple accounts and multiple

reconciliations.

Such reconciliation is a cumbersome job and there is specialised software for managing the

reconciliation. Banks also have specialised software for managing such type of high volume

of transactions. They are called cash management products.

Net Banking Payment

Utility companies also receive net banking payments through bill aggregators as mentioned

in the earlier section. The aggregators have, through optimum use of technology, provided

excellent features on their portal in terms of alerts, reminders, etc.

Card Payments

There are two ways in which the card can be used for effecting payments. The first method

is the use of POS machines wherein the subscriber walks in to the outlet of the service

provider and swipes the card. The second method is where he uses the card on the internet.

In this channel also the role of the bill aggregator is critical.

Auto Debit instructions

The subscriber can give auto debit instructions to either his banker or to the card issuer.

The authorisation is given to debit his bank account for the bill amount. The subscriber can

also define a threshold limit beyond which the billing amount should not be debited to his/her

account. The auto debit can also be revoked by the subscriber whenever he so desires. The

subscriber can also change the auto debit instructions from one bank to another bank.

It is interesting to note that auto debit instructions also can be given on the cards. Generally

they are given on credit cards. The advantage of giving auto debit on the card is twofold.

One the credit period to pay the bill is extended to around two months based on the billing

cycle on the card.

Payments 43
Such periodical debits are processed by third party agencies and presented to bank for auto

debit through ECS facility.

Illustration: Tom has a billing cycle on his mobile phone as 15th to 14th. The bill is

dispatched on 20th and the due date is 5th of the subsequent month. His credit card has a

billing cycle of 1st to the last day of the month and the due date for the card payment is 20th

of the subsequent month. The July mobile phone bill will be debited to his card account on

5th of August. His credit card debit, also in auto debit, to his bank account will happen on 20th

September. This translates into 45 days of free credit. The second advantage of the debit to

the card is the loyalty points one earns on the card spending.

4. Payment Instruments

The learning objective of this chapter is to understand the different types of payment

instruments. There are a number of paper-based instruments as well as electronic

instruments used for effecting payments. The paper-based instruments have a number of

variations based on the drawer, drawee and payee. The various permutations and

combinations can lead to complexity in the process and the manner in which payment

instruments are handled.

Drawer is the person who makes the check.

Payee is the recipient of money.

Drawee is the bank or financial institution where the check has to be presented for

payment.

The details are illustrated in the specimen in this chapter elsewhere.

Payments 44
Classification of Payment Instruments

Payment instruments can be classified as cash and non cash instruments as shown in the

figure below.

a. Cash

Cash in a common mans parlance refers to money in the physical form of currency which

includes bank notes and coins. The words cash and currency are used interchangeably.

Currency is generally accepted as a medium of exchange.

The monetary authority of the country regulates the supply of currency notes and coins. As

currency notes are legal tender, they can easily be exchanged. It becomes very difficult to

establish legal ownership of the currency. One who holds the currency is said to be the

owner of the same.

The monetary authority of respective countries can impose restrictions of the free movement

of money domestically as well as outside.

While travelling abroad, carrying of currency beyond the stipulated limit can tantamount to an

offence and penalties and fines can be imposed on the person found carrying the same.

A currency of one country may not get accepted in another country due to various economic

reasons. In certain countries, the payment can be made in the local currency as well as any

other hard currency. USD is considered to be a hard currency, since it is accepted freely in

almost all countries.

A foreign traveller will often need currency of the country to which he is travelling. Hence,

there is need to convert the currency of his home country to the currency of the country to

which he is travelling.

For example, if John is travelling from India to USA, he will need US Dollars for his trip, for

which he has to approach the money changer. The money changers are regulated by the

monetary authority of the respective country. Money changers are classified into Restricted

Money Changers and Full Fledged Money Changers.

Payments 45
In case of Restricted Money Changers, they can only buy foreign currency but cannot sell.

Most five star hotels are restricted money changers. The travellers can pay in foreign

currency for their stay in the hotel. However, money collected from the hotel guest will have

to be surrendered to a bank or to any other full-fledged money changer.

Full-fledged money changers on the other hand can buy and sell foreign currency and

travellers checks. Travelex is one of the Full fledged money changers. Consequent to

modernisation and technological development, money changers have diversified from pure

money changing business to travel and tour operators etc.

There are certain dynamics of converting the currency from one currency to another. This

can vary from country to country. This is beyond the current scope.

In many countries, there are limitations on payment by cash on payment transactions. The

transactions beyond this limit need to be made only by check, draft, etc.

Figure 8: Classification of Payments Instruments

Payment
Instruments

Cash Non
Cash

Non cash instruments can further be classified as paper-based and electronic-based

instruments which are shown in the figure below. Various instruments under paper- based

and electronic-based are also shown in the figure below.

Payments 46
 Figure 9: Classification of Payments Instruments

Non Cash

Paper Electronic

Based

Check Travelers Wire Direct Credit

Check to Bank
Transfer
Account

Bankers Money Order

Direct Debit Cards-Debit
Check
to Bank /Credit/Prepaid/
Account Gift Cards

Mobile Payments
Linked to Bank
Account

b. Non Cash

The non cash instruments are regulated by certain laws and there are a few technical

jargons relating to the same .These definitions need to be understood before the subject is

introduced. The paper based non cash instruments are classified as Negotiable instruments,

which means that they can be transferred by endorsement and delivery.

Payments 47
The bill of exchange and Check are two examples of Negotiable Instrument.

Bill of exchange: This is defined by most of the statutes (regulations) like the Bill of

Exchange Act 1882. The Negotiable Instruments Act of 1881 of India defines that A bill of

exchange is an unconditional order in writing, addressed by one person to another, signed

by the person giving it, requiring the person to whom it is addressed to pay on demand or at

a fixed or determinable future time a sum certain in money to or to the order of a specified

person, or to bearer.

Check: It is also defined by the statutes. It is a variant of the bill of exchange. A check is a

Bill of Exchange drawn on a banker payable on demand

A check is the most popular paper based payment instrument. The definition of the check

has already been discussed earlier. Check is similar to a bill of exchange. A bill of exchange

is a kind of promissory note without interest and is a written order by one person (drawer,

maker, or payer) to pay another (payee) a specific sum on a specific date sometime in the

future. The bank making the payment is known as the drawee bank or the paying bank. A

check is a negotiable instrument and there are specific laws in different geographies on the

term and nature of the law across geographies. These laws may be called the Negotiable

Instruments Act/Bill of Exchange Act etc.

Depending on the type of mechanism to handle the check, the local regulator can define the

dimensions of the check, the type of ink to be used for printing, the font size as well as the

positioning of the various attributes of the check like account number, routing number, etc.

Checks are issued by banks as well as Credit Unions in USA.

A check is drawn by the holder of the account favoring the Payee. Using the same example

of previous section where John is the employee of Wal-Mart, John will be the payee of the

check, the drawer will be Wal-Mart and the drawee bank will be Citibank.

Payments 48
 Payer/Drawer

Payee

Drawee Bank

Wal-Mart may have USD 10,000 balance in the account but may issue checks for more than

the balance available in anticipation of credits in the account.

There is every possibility that the check may not be honored by the bank on presentation.

The check can be dishonored (returned) by the drawee bank and the physical instrument is

sent back to the payee through the payee bank for two reasons viz. technical reason or

financial reason. Financial reason is that there is no sufficient balance in the account. A

technical reason could be the check not signed by authorised signatory, check bearing a

date more than six months old, etc. There can be a number of reasons for technical

rejection.

In case of checks returned for financial reasons, there are legal remedies for the payee to

proceed against the drawer.

Travelers Check

Carrying currency during travel is not only cumbersome but also highly risky. If the currency

is stolen, the traveller will find it very difficult to replace the same. Therefore, a need was felt

Payments 49
for an alternative instrument which is easy to carry and, at the same time, provide protection

to the traveller, in the event of the same being stolen or misplaced.

This resulted in one of the paper instruments called the Travelers Check. The travelers

check can be stopped from payment in case of loss, based on the operational guidelines.

Travelers Check can be classified into Domestic and Foreign Currency Travelers check.

For use within the home country, it is known as domestic travelers check, while that in

foreign currency is a foreign currency travelers check.

The biggest drawback of the travelers check, compared with a currency notes, is the

liquidity. The travelers checks are not accepted by all and sundry. Only those merchants

who have tied up with the issuing company alone would accept the same. Travelers checks

will not be issued in all the denominations like a currency note.

One of the pioneers of the travelers check is the American Express Bank. Similar to the

dynamics of currency conversion for foreign currency notes to another currency, there are

certain dynamics for travelers check as well. In case of Travelers check, one can purchase

the same by giving domestic currency notes or debiting the bank account. The rate

mechanism applicable to Travelers Check is known worldwide as TC Buying Rate or TC

Selling Rate.

The currency buy and sell rate will not necessarily be the same as the TC buying and selling

rate.

Payments 50
A specimen of the Travelers check is displayed below

Image Courtesy: http://thailandlandofsmiles.com/

Travelers checks are now being issued in Pre-paid Smart Card format by banks, which can

be operated at any ATM globally. The withdrawal of cash happens in the local currency of

that country.

Bankers Check

The biggest risk of a check drawn by a customer is the risk of dishonor. Many governmental

institutions may not accept checks issued by the customers. The payee can insist on a

check drawn by a bank.

The checks drawn by banks on banks are known by different name in different countries.

The synonyms for the Bankers Check are:

Cashiers Check

Tellers check

Bank Check

Bank Draft

Demand Draft

Pay Order

Gift Checks

Payments 51
 Over and above the name variation, there are slight product variants as well within the bank

checks.

The possible scenarios are as follows:

Domestic Bank Checks

Sr. No Scenario Illustration

1. Drawee Bank = Drawer Bank and Drawee A check drawn by Wells Fargo

Branch = Drawer Branch. New York Branch on Wells Fargo

In some countries if the Drawer and Drawee New York Branch

is the same, the name of the Bank and the

branch is displayed only once on the

instrument.

This is popularly known as Tellers Check or

Cashiers Check or Payment Order

2. Drawee Bank= Drawer Bank and Drawee A Check Drawn by Wells Fargo

Branch <> Drawer Branch New York Branch on Wells Fargo

This is popularly known as Demand Draft Washington Branch

3. Drawee Bank<> Drawer Bank. This is a Option 1: A Check Drawn by Bank

very common business situation. It is not of the West Los Angeles Branch

necessary that the drawee bank will be on Wells Fargo bank New York

present at all locations where the customer Branch.

needs the funds. In this case the stationery will be

Bank of the West has presence only in 19 of of Bank of the West

the 50 states of USA. A customer of the Los Option 2: Wells Fargo will hand

Angeles Branch of the bank wants a over a number of blank Demand

Demand draft drawn on New York. Bank of Drafts on their stationery.

the West does not have a branch in New In both the options the signature

Payments 52
 York. However the Bank of the West cannot on the DD will be of the Bank of

refuse the services to the customer. the West Employees. The

Bank of the West will enter into a signature of all the officers of Bank

correspondent banking arrangement with of the West will be available with

Wells Fargo. Wells Fargo

This arrangement is also called a DD

Drawing arrangement

4. Drawee Bank<> Non Bank Drawer. Thomas Cook New York Branch

In certain circumstances, in certain draws a DD on Wells Fargo.

countries, a non Bank entity is also allowed In this, the stationery will mostly

to draw a DD on the Drawee bank based on be of Wells Fargo

the DD Drawing arrangement

B. International Bank Checks

5. Drawee Bank= Drawer Bank, Drawee Mr. Smith wants to send a DD for

Branch <> Drawer Branch and Currency not USD 1000 for subscription for a

equal to Home Currency magazine. He is resident in India

This is popularly known as Foreign and has a rupee account in

Currency Demand Draft Citibank, Kolkata. The payee is

Wall Street Journal. He will

approach his bank for the same.

Citibank Kolkata will issue a DD

drawn on Citibank New York for

the same.3

3
The dynamics of conversion will be discussed subsequently

Payments 53
6. Drawee Bank<> Drawer Bank and Currency Mr. Smith wants to send a DD for

not equal to Home Currency* USD 1000 for subscription for a

. This is a very common business situation. magazine. He is resident in India

It is not necessary that a bank in India will and has a rupee account in

be present at all locations outside India Oriental Bank of Commerce,

where the customer needs the funds. Kolkata. The payee is Wall Street

Oriental Bank of Commerce does not have Journal. He will approach his bank

branches in USA .Oriental bank of for the same.

Commerce will have to identify a bank in Oriental Bank of Commerce

USA on whom they can have a Foreign DD Kolkata will issue a DD drawn on

Drawing arrangement or Foreign Wells Fargo(The foreign

Correspondent Banking arrangement correspondent) New York for the

same.4

Normally the stationery used will

be the Wells Fargo Stationery but

signed by the authorised

employees of Oriental Bank of

Commerce.

7. Drawee Bank<> Non Bank Drawer and Mr. Gautam wants to pursue

Currency not equal to Home Currency*. studies abroad and wants to take

In certain circumstances, in certain a DD drawn on a Bank in

countries, a non Bank entity is also allowed Germany for immigration purpose.

to draw a Foreign DD on the Drawee bank The travel agent for Gautam is

based on the DD Drawing arrangement. Thomas Cook and Thomas Cook

4
The dynamics of conversion will be discussed subsequently

Payments 54
 takes care of the requirements

Many a time, customer would not like to go from end to end.

to many different points for fulfilling the Thomas Cook is empowered by

service needs. Deutsche Bank to issue Bankers

check drawn in Euros.

Normally the stationery used will

be of Deutsche Bank Stationery

but signed by the employees of

Thomas Cook.

* Based on country to country the size and dimensions of the instruments can vary. Certain

details mentioned on the DD will not be conspicuous on the face of the DD.

In the facsimile sample given below the drawer of the DD is clear but the drawee branch is

not seen anywhere. The sort code at the bottom will be used to interpret the drawee branch.

Serial No 6: Foreign DD Drawn by Deutsche Bank Kolkata on Deutsche Bank Germany

Payments 55
Serial No 7: Foreign DD issued by Thomas Cook on Deutsche Bank Germany

Gift Checks

These are a variant of the demand drafts. Gift Checks are in fixed denominations like USD

50, USD 100, etc. The maximum denomination of Gift checks is limited to smaller value. The

appearance and the background of the Gift check would be thematic and highly presentable

to make it more appealing. Such checks can be presented in merchant establishments for

purchases to the extent of gift value. Recently, gift cards are issued and presented in

prepaid card format which can be operated at ATMs

Money Orders

Another product variant of the Tellers check is the money order. Money orders can be

issued by Post Offices, Financial Institutions and Non Financial Institutions. Money Orders

can be purchased from any general stores in USA. However, with the Know Your Customers

(KYC) norms prevalent, easy availability has been reduced to a large extent.

In USA, there has been a high instance of fraud and forged money orders. This product is

also at the fag end of the product life cycle. The US Postal Money Order continues to be one

of the most popular instruments as evidenced by the check services data provided by the

Federal Reserve.

Payments 56
Source: http://www.federalreserve.gov/paymentsystems/check_postalmosprocannual.htm

A facsimile of the US Money Order is as below:

Source: https://www.usps.com/shop/accepting-money-orders.htm

1-The Money order serial number

2-The security band

3- Denomination of the Money order

4- Cents of the Money order

Payments 57
Wire/Cable Transfers

In the chronological order of evolution of payment instruments is the wire transfer. In the

days of yore (olden days), the entire cycle of payment used to be time consuming. If an

employee of an organisation was paid the salary by check, the check had to be dispatched

by post to the payee and then he deposits it in his bank and there was a process of clearing.

The time taken to get the same converted to cash was too long. Consequently, banks had to

think about an alternate mode which could reduce the time lag of payee receiving the funds.

The Wire Transfer Product was an outcome of that need.

Domestic Wire Transfer

A wire transfer scenario (depicted below) was in vogue prior to the implementation of core

banking solutions. This product has become redundant in the current scenario. Wire transfer

has been replaced by a technologically sophisticated product like RTGS (Real Time Gross

Settlement for large amounts).

Mr Arun is a resident of Rameswaram. His son Mr Varun is studying in IIT Kanpur. Mr. Varun

would require pocket money on a regular basis for meeting his day to day expenses. Mr.

Aruns bank is Tamilnadu Mercantile Bank while Varuns account is in Punjab National Bank.

Mr Arun has the following option under normal circumstances:

Take a DD on a monthly basis and dispatch it to his son who in turn, will deposit the

same in his bank. The average time to get the proceeds would be one week.

Send the check of Tamilnadu Mercantile Bank to Varun. This is the slowest process and

will be discussed in the upcountry check collection cycle.

There is an absolute emergency for Mr. Varun and requires money urgently. Mr. Arun will

have to first locate a Punjab National Bank nearest to his house. He will have to remit the

money in the bank and request for a wire transfer. The money will be transferred to Mr.

Varuns account within a day. Here the scenario is that, core banking facility is not available

at Punjab National Bank. If CBS is implemented (which is the case now), cash is deposited

Payments 58
in the account of Mr. Aruns son directly, and he can withdraw the cash at next moment

through his ATM card at his location.

In a domestic wire transfer, the applicant (Mr. Arun) and the beneficiary (Mr. Varun) both will

have to transact through the same bank. The synonym for wire transfer is Telegraphic

Transfer or Telex transfers. In the days of yore, the telegram or telex were the medium used

to communicate within the branches of the bank. Telegraphic transfers are very costly

compared with the demand draft route.

With CBS implementation, wire/ cable transfers have become very rare.

International Wire Transfer:

Mr. Nelsons hails from Karaikudi (in Tamil Nadu) and his son, Mr. Wilson is studying in

London School of Economics (LSE) London. In order to meet the monthly expenses, Mr.

Nelson has to remit GBP 500 every month. Mr. Nelsons Bank account is with City Union

Bank in Indian rupees while Wilson is banking with Standard Chartered bank.

He can send a Foreign DD as mentioned above through courier. Courier charges were

exorbitant in olden days and wire transfer was found to be a cheaper than DD. City Union

Bank will have a foreign correspondent banking arrangement for GBP. This arrangement

can be either with Standard Chartered or Barclays Bank.

If the correspondent is Standard Chartered, it will be an internal payment. If it was Barclays

the cycle is more complicated.5 International Transfers are also called SWIFT Transfer.

Direct Debits

Direct Debit is a direct outcome of technological progression and implementation of Core

Banking Solutions in Banks. Direct Debits are basically undertaken for recurring payments of

fixed amount. Examples can be rent. The standing Instructions are maintained in an account

to undertake this type of transactions.

5
Will be discussed as part of clearing and settlement

Payments 59
Direct Credits

Direct credits are generally used by corporates and the same has already been discussed in

the Corporate Credit Payment Life Cycle.

Mobile Phone Payments

Mobile Phone Payments is the order of the day. There are different mobile phone payment

models in vogue.

Model 1:

The common example is the ngpay in India. This model is basically used for M-Commerce

Payments. The customer has to download a thin application on the mobile phone. Once the

same is downloaded, the user can undertake multiple types of activities on the mobile phone

depending upon the type of service available on ngpay. It could include banking services like

balance enquiry, check book request, etc. In an M-Commerce application, ultimately the

payments have to be done using either the banking account or the Card.

Model 2:

Mobile Phone to Mobile Phone payments: Mr. John wants to make a payment to Mr. Smith.

Mr. Johns Bank is Union Bank of India and Mr. Smiths Bank is Axis bank. Mr. John can

affect a Mobile Phone to Mobile Phone Transfer or a Mobile Phone to Account Transfer.

Using the mobile phone, Mr. John can effect a payment to Smith. Smith gets the money

instantly. Smith can also go and withdraw the cash from the ATM of Axis Bank even without

an ATM Card. The mobile phone message will have a code which can be used to enter in

the ATM and withdraw cash.6

Type of Cards

Cards can be classified based on various categories like Business Usage, Issuer,

Technology used etc.

6
Detailed process will be discussed in clearing and settlement

Payments 60
The basic types of cards are

Credit Card

Charge Card

Debit Card

ATM Cards

Credit Cards Cum ATM Cards

Travel Currency Cum ATM Cards

Gift Cards

Petro Cards, Corporate Cards

Other Prepaid Cards

Though the process underlying will be more or less similar, the business usage from a

payment perspective is same. Hence the same has not been elaborated.

Payments 61
5. ATM Operations, clearing and settlement

Introduction:

The learning objective of this chapter is to understand the complexities involved in ATM

clearing and settlement process related to ATM and POS Operations. In terms of volume of

transactions, the POS transactions outnumber the ATM transactions as the number of POS

in any country is far more than the ATMs.

ATM Operations

Transaction Types

The transaction type is critical to the clearing and settlement process. The transactions are

of two types as mentioned below:

Sr. Transaction Type Example

No.

1 On-Us The issuer and the acquirer is the same

A customer of ICICI Bank holding an ATM card withdraws cash

from an ICICI bank ATM

2 Across network The issuer is different from the acquirer.

(Off-US) A customer of ICICI Bank holding an ATM Card withdraws

cash from a HDFC bank ATM

The routing rules could be very complicated based on the BIN (Bank Identification Number)

and card type. This is typically managed by an application layer switch rather than a

hardware level switch. Every ATM switch will have to identify a transaction as On-Us or

across network transaction. If the transaction is On-Us, the transaction will directly go and hit

the core banking system of the bank. In the above example, the transaction will go and hit

the ICICI Bank Core banking system directly.

In the second example, the transaction will land on the VISA or MasterCard switch and then

based on the BIN on the card, the transaction will be routed to the respective bank. In this

case it is the HDFC bank.

Payments 62
This may be confusing for a newcomer in the financial domain. A similar example is mobile

switching. A Vodafone subscriber dials a Vodafone number. This is an On-Us transaction. A

Vodafone subscriber dialing Airtel or a BSNL Land line will be across the network. The

intelligence has to be built in the Vodafone switch to route the same to BSNL or Airtel.

Cash Management in ATM

This process is highly people oriented. Each ATM requires refill of the cash at periodic

intervals. The cash is filled in the cash bins within the ATM. Each ATM will have separate

cash bins based on the denomination.

The most important point to note in a cash bin is that it does not have a sensor to sense the

currency notes dispensed. The below diagram depicts a front loading ATM Machine with four

cash bins.

Cash Bin 1
Cash Bin 2
Cash Bin 3
Cash Bin 4

Courtsey:http://moryabdi.deviantart.com/art/ATM-Automatic-Teller-Machine-57377879

Programmatically, one has to define cash Bin number with the denomination. For e.g. if

Cash bin 1 is defined as INR 500 note, and if customer has requested for INR 1000

withdrawal, all that the system will do is dispense two notes from that bin. It may so happen

that the person loading the cash bin, may load the bin 1 with INR 100 instead of INR 500.In

that case the customer will be dispensed with INR 200 when the request for withdrawal is

Payments 63
INR 1000/-.Such abnormal incidents do keep occurring, as this is a manual process. Even

fake currencies can creep into the ATM as well.

Cash replenishments can be done either by the bank officials or it can be outsourced. There

are a number of models in which the cash replenishment can be outsourced. It could be

outsourced to the ATM vendor itself. It could also be outsourced to a third party other than

the ATM vendor.

Onsite Vs Offsite

An ATM machine within the premises of the bank itself is referred to as an onsite ATM. An

offsite ATM, as the name indicates is away the premises of the bank. This could be typically

in airports, hospitals, shopping malls, etc. Most banks have a mix and match of the offsite

and onsite ATMs. Typically the onsite ATM cash replenishment will be managed by the bank

while the offsite will be outsourced.

Offline

In certain geographies, one may come across a concept of an offline ATM. An offline ATM

will undertake cash disbursal even when the ATM is not connected to the host due to a

number of reasons. The network connectivity could be down. The Banks host could be

down or the banks core banking solution could be down as a part of maintenance or any

other reason.

Under such circumstances, the customer would be able to withdraw a fixed amount with a

maximum cap. All such withdrawals do not validate the customer balances in the account.

Only when the connectivity is established, the account would be debited. There is an

element of risk in an offline scenario. The customer may withdraw more than what is

available in the account.

In the initial evolution of the ATM, offline ATM was a common phenomenon. In modern

times, even when the Core Banking system is not available due to end of day process etc.

the balance is dumped in a separate file and is available to the ATM host. Once the end of

Payments 64
day process is over, the transactions are posted to the core banking system. However, due

to advancement in technology, all ATMs of major Banks are 24* 7 online

Clearing and Settlement

Once a transaction is authorised, ATM Transaction has to be cleared and settled on an

ongoing basis. Typically it is a daily settlement. The settlement cycle is best explained with

the help of an example.

The scenario is the Cashtree ATM Network Managed by Bank of India. For the sake of

simplicity; it is assumed that there are only three banks in the network viz. Bank of India,

Dena Bank and Yes bank.

On a particular day, the total transactions done by three banks are as follows:

Table 1 Total transaction for the day on the ATM of the three banks in the network

Bank On-Us On-Us Across network Across network

Count Value count Value

Bank of India 10 35000 70 85000

Dena Bank 5 5000 25 30000

Yes bank 20 20000 40 60000

On-Us transactions are transactions of customers doing transactions on the respective

ATMs. Across network transactions need to be further segregated as below.

The across network transactions can be of any of the other two banks i.e., the total across

network transactions of 70 on Bank of India ATMs can be of customers of Dena Bank as well

as Yes Bank. The same needs to be further bifurcated for clearing and settlement process.

Table 2 shows this bifurcation in the form of a matrix for clarity purpose.

Payments 65
Table 2: Across network transactions

Bank Bank of India Dena Bank Yes Bank Total Value

Count Value Count Value Count Value

Bank of India NA NA 30 40000 40 45000 85000

Dena Bank 15 15000 NA NA 10 15000 30000

Yes bank 20 25000 20 35000 NA NA 60000

Total Value 40000 75000 60000

Table 3 Settlement Figures.

These figures are arrived based on the vertical and horizontal total of table 2

To pay To Receive Net Settlement fees @

INR10 per
transaction(On-Us
+across network)
Bank of India 85000 40000 -45000 700

Dena Bank 30000 75000 +45000 300

Yes bank 60000 60000 0 600

Total 175000 175000 0

Bank of India is the settlement bank for the Cashtree network. All the banks have to maintain

an account with the Bank of India.

The process of arriving at the net amount is called the clearing process. The process of

debiting the account and crediting the respective bank account is the settlement process.

Over and above the gross amount, the settlement fees will also be debited to the respective

accounts.

The settlement fees are generally linked to the number of transactions. In the above

example, the settlement fees are shown in table 3. There can be different models of

Payments 66
charging as well as settling the fees. The fees need not be charged for On-Us transactions.

Similarly, settlement of fees can be done on a daily basis, weekly, monthly etc.

The illustration is very simple, but given the number of banks, the same is very complex. The

complexities become manifold with the customer not getting the money, wrong debit etc.

The National Financial Switch(NFS) operated by National Payment Corporation of India

(NPCI) in India is one of the biggest ATM Switch providers and has more than 80,000 ATMs

under the network. The statistics of the NFS for the last five months is reproduced below to

give a feel of the voluminous data handled by the Switch providers.

Source: http://www.npci.org.in/nfsvolume.aspx

The above statistics only gives the count of cash withdrawal transaction, but does not

indicate the value of transaction. The value is as per the graph below

Source: http://www.npci.org.in/nfsvolume.aspx

Payments 67
6. Payment Clearing and Settlement (other than ATM)

Learning Objective:

The learning objective of this chapter is to understand the intricacies of the clearing and

settlement activities related to paper based and electronic transaction types.

The clearing and settlement is the backbone of the payment systems and there are a

number of risks involved in the same, which includes systemic risks as well. The core

principles of clearing and settlement remain the same. However the modus operandi can

change from instrument to instrument as well as channel.

Paper Based

a. Types of Clearing

Clearing and Settlement of paper-based instruments

The learning objective of this chapter is to understand the nuances of the paper-based

instruments. The handling of paper-based instruments is very complex compared with the

clearing and settlement process of ATM and POS.

Paper-based instruments also have embraced technology and different countries have

adopted technology differently.

Background

The paper-based instruments are handled in a number of ways. It varies from country to

country and there can be vast differences in the manner in which they are handled.

There are a number of jargons associated with the paper-based instruments and their

clearing processes.

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Paper-based clearing and settlement can be classified as follows:

Type of Instrument Details Remarks

Local Clearing Instruments, This can again be sub classified as

which includes multi-city checks Interbank, High value and MICR.

and instruments which are at par.

Upcountry Checks Collection This can again be sub classified as direct

Physical movement
(UCC), which is not a member of dispatch to drawer or through
of checks
the local clearing house correspondent bank

National Clearing Select metros are covered under this

Speed Clearing A wider area comes under local clearing

despite geographical distances

Image of the check Check 21 in US, Check An image is transmitted for the purpose

as it is truncation (CTS) in India of payment rather than the physical

instrument. In physical check, the

original instrument will be with the

drawer whereas in the CTS mode, the

instrument will be with the Collecting

Banker.

Conversion of the ACH (Automated Clearing house) The details of the check are data

check into an in USA captured and transmitted through an

electronic form electronic file. There is a huge difference

between check truncation and this

process. In case of check truncation the

image of the check is mandatory. Here,

only the contents are transmitted without

the original instrument.

Payments 69
Paper Based clearing in Indian

Local Clearing

The same has already been discussed in the earlier section.

There will be a number of banks which will be a part of the clearing house.

All the banks will have to carry the checks to the clearing house within the stipulated time as

defined by the clearing house rules and regulations.

In a manual environment, the bank (prior to automation) had to sort the check bank wise and

furnish a clearing statement as well.

Each Bank who is a member of the clearing house will have to give a similar statement of

count and value drawn against each bank. Each bank will have to drop the checks in a

manual box of each member bank and handover the clearing statement as above to the

clearing bank.

The clearing and settlement bank, which is conducted by RBI or by any other Bank, will

finally arrive at the amount receivable and payable by each Bank and the net amount will be

credited / debited to that particular Banks account with the settlement bank.

The process of arriving at the figures to pay and receive is called clearing.

With the advent of automation like MICR technology, banks did away with the manual

preparation of the above clearing schedule. The bank routing number (MICR Code), the

check number and the account number was pre-printed on the instrument. The amount had

to be encoded on the MICR band.

The banks had to make batches of the MICR checks and send to the clearing bank, along

with count of batches, total instruments and amount. The instruments are processed using a

MICR reader and sorter, which may be as big as a tennis court. A typical sorter of IBM is

depicted below

Payments 70
As per the RBI Statistics, Mumbai clearing House alone has processed 19.5 million

instruments in June 2011. The MICR centre works overnight. The reader and sorter will

multi-function. One is to sort the instrument bank-wise and each instrument will land in a

separate pocket. Simultaneously the clearing statement will also be arrived at without any

human intervention.

The statistics in terms of the dominance of paper based versus electronic is depicted below:

Source:http://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/08T_CS090811F.pdf

Payments 71
Local clearing was earlier categorised into three

High Value checks: Checks whose value is more than 0.5 million and geographically

within 1 km radius of the clearing house

Interbank Clearing: Instruments like DD and Pay Order drawn specifically by banks on

other banks

MICR Checks: Other instruments.

Certain geographies may not have the above bifurcation.

Upcountry Check Collection

The upcountry check was briefly discussed in the earlier section. The same example of the

previous section is also used here to elaborate further.

Volkswagen may be banking with ICICI Bank, Hosur branch and it has to pay 100 dealers in

Kanpur. The scenario envisaged is that ICICI Bank does not offer multi-city check facility

and, at the same time does not have a presence in Kanpur.

Navnit Motors is one such dealer in Kanpur and Volkswagen has issued the ICICI Bank,

Hosur check and dispatched it to Navnit Motors. The bank of Navnit Motors is Kanpur

District Co operative bank. The check is dated 1st August and received by Navnit motors on

4th August.

Navnit Motors will deposit this check into their bank on 5th August. As ICICI Bank is not

present in Kanpur, Kanpur District Cooperative cannot present the check in local clearing, as

discussed above.

There are two ways in which this instrument can be handled.

Method 1: The instrument is sent back to ICICI Bank, Hosur. The Kanpur District

Cooperative bank will request to issue a DD favoring them on Kanpur.

ICICI Bank may have a correspondent bank arrangement with Canara Bank. ICICI bank, on

receiving the check will debit the Volkswagen account and issue a DD on Canara bank.

Again, the same will have to be dispatched back to Kanpur. On receiving the Canara Bank

DD, the Kanpur District Cooperative bank will present the same in a local clearing and credit

Payments 72
the proceeds to Navnit Motors account. The time for the entire cycle would be not less than

10 to 15 working days.

Method 2: The Kanpur District Cooperative Bank would have entered into a correspondent

banking arrangement with Corporation Bank. The Cooperative Bank will hand over this

instrument to Corporation Bank, Kanpur.

Corporation Bank, Kanpur in turn, will send it to Corporation Bank, Bangalore. The

Bangalore cash management branch would present the ICICI Bank check in local clearing of

Bangalore. Once the instrument is cleared, Corporation Bank Bangalore will intimate

Corporation Bank, Kanpur.

Corporation Bank, Kanpur will issue a pay order and hand over the same to the Cooperative

Bank. This pay order will be presented by the Cooperative Bank in local clearing of Kanpur.

However, in both the methods, the physical instrument has to travel back all the way to ICICI

Bank, Hosur or Corporation Bank, Bangalore.

Both these methods are inefficient processes due to the physical movement. There is a time

delay in receipt of the proceeds. The probability of losing the instrument in transit is also

high.

National Clearing

The RBI in order to address the issue of Upcountry collection (UCC) came out with new

services called National Clearing, post implementation of MICR technology. In the first phase

of National Clearing, the four metros were covered. This again was during the absence of

the at par check service.

A Chennai-based customer receives a check drawn on Punjab National Bank, Delhi. He will

deposit the same with his banker, City Union Bank. City Union Bank will send the check to

RBI Chennai (this is the difference between upcountry and National clearing). RBI Chennai,

in turn will send the same to RBI Delhi and RBI Delhi will present the same in the local

clearing.

Payments 73
If the check is honored, RBI Chennais account will be credited by RBI Delhi. RBI Chennai

will pass on the credit to City Union Bank. The twin advantages of National clearing are that-

the deadlines within which the credit has to happen are met and at abysmally low cost,

compared with the upcountry check collection. The only limitation is that National Clearing is

not available across all the cities and towns in India

Speed Clearing

The proliferation of MICR technology to other local clearing centers in the country paved way

for the introduction of this service. This service is an extension of the local clearing across

geographies. Sixty centers across India are now covered under Speed Clearing. In this

service, the check drawn on these sixty centers are cleared and settled in two days in line

with local clearing. Hence, the process of upcountry check collection (UCC) becomes

redundant in such cases.

Speed clearing was a direct outcome of the introduction of Core Banking System (CBS).

Paper based Clearing in UK

The clearing function of UK is undertaken by The Check and Credit Clearing Company. The

Payment Council of UK had initially taken a very bold decision to set a target end date for

paper instruments as 31st Oct 2018. However, they have rescinded this decision on 12th July

2011 .This reversal of decision is a critical indicator that the phasing out of physical paper is

difficult. As per the statistics of the UK Payment Council, 171 million checks amounting to

173 billion were cleared during 2011-Q2. This excludes Euro checks and US Dollar

Checks.

In addition to check clearing, The Check and Credit Clearing Company handles credit

clearing. A credit clearing is a physical paper based interbank clearing for credit items like

dividend warrants. It runs parallel to the check clearing system. The volume in credit clearing

is around 10 % of the total check volume.

The basic difference between the UK Model and the Indian model is the settlement entity. In

India, the clearing and settlement is undertaken by the same entity like RBI, SBI etc. In UK,

Payments 74
the clearing is undertaken by The Check and Credit Clearing Company, while the settlement

is undertaken by the Bank of England.

Clearing Timelines in U.K

The timelines for clearing of instruments in UK is popularly known as 2-4-6 or 2-6-6,

depending upon the type of account. This was introduced in November 2007.

The 2-4-6 cycle is for current and basic accounts.

The customer deposits the cheque with his banker before the cut off time
stipulated by the bank
Day 0 Eg. The cheque is deposited on Monday

The interest on the money starts accruing from this day

Eg. Wednesday
Day 2

Bank allows the withdrawal of the money

Eg. Friday
Day 4
The customer is ensured that, the money is his, unless there is a fraud and
collusion. The instrument cannot be returned after this date.
Day 6 Eg. subsequent Tuesday

For Savings account, the cycle is 2-6-6

Payments 75
 The customer deposits the cheque with his banker before the cut off time
stipulated by the bank
Day 0 Eg. The cheque is deposited on Monday

The interest on the money starts accruing from this day

Eg. Wednesday
Day 2

Bank allows the withdrawal of the money

Eg. subsequent Tuesday
Day 6
The customer is ensured that, the money is his, unless there is a fraud and
collusion. The instrument cannot be returned after this date.
Day 6 Eg. subsequent Tuesday

Paper based clearing system of US

The statistics of the commercial checks collected through the Federal Reserve on a quarterly

basis is reproduced below.

Courtesy: http://www.federalreserve.gov/paymentsystems/check_commcheckcolqtr.htm

The above data excludes the Government Checks and Postal Money orders. The paper

checks in US are managed by the Federal Reserve and are referred to as The Paper Check

Clearing Services. They operate two services viz. Forward Paper Check Clearing Services

and the Return Paper Check Clearing Services.

The Federal Reserve undertakes clearing of multiple types of instruments which could

include city, upcountry, Treasury checks and Postal Money orders. The sorting of these

instruments will be undertaken by the Federal Reserve.

Payments 76
 Check Truncation (Check 21 of US):

The physical movement of the checks in the local clearing process is a very cumbersome

process. There are inherent inefficiencies in the process like loss or theft of instrument, etc...

The substitute for the movement of physical check from the Collecting Bank to the Paying

Bank is the movement of the image of the check. The concept of check truncation is the

transfer of the image of the check in place of the physical check.

India has adopted the check truncation technology in the NCR (National Capital Region)

wherein, around 80,000 checks are getting cleared on a daily basis. The Chennai check

truncation process is currently in pilot phase.

Check truncation in US is popularly known as Check 21. Check 21 is a federal law that is

designed to enable banks to handle more checks electronically, which should make check

processing faster and more efficient. Prior to this, banks had to physically move original

paper checks from the bank where the checks are deposited to the bank that pays them.

This transportation can be inefficient and costly. Check 21 became effective on October 28,

2004. Technological changes also need to be supported by necessary legislation. Check 21

is the legislation which paves way for technological implementation.

Conceptually, the work flow of physical check and Check 21 is the same, except that, the

image is exchanged instead of the physical paper, in Check 21.

Federal Reserve has a number of services under the Check 21 schemes like FedForward

Services, Fed Receipt Plus etc. The nomenclature used by Fed reserve for the Check 21

services and the Physical Check services are same.

Payments 77
b. Managing Check Returns

In the paper-based clearing as well as electronic clearing, the critical component is the

managing of returns.

A check or electronic instrument presented for clearing to the drawee bank need not always

be good for payment. The returns could be classified into technical returns and Non

technical returns.

An instrument could be returned on a number of technical grounds. Some of the technical

returns are:

Post Dated Instrument.eg. A check presented on 15th October 2011 while the check is

dated 15th November 2011;

The account of the drawer is closed;

The account of the drawer can be frozen on number of reasons like Income Tax

attachment, Garnishee order etc.;

Words and figures mismatch;

Stale instrument. This is typically applicable only to paper-based instruments. It can be

country specific. In India, currently stale check is one which is more than 3 months old as

on the date of presentment Signature mismatch.

The Non-technical reasons are basically financial reasons where there is no balance in

the drawers account. Insufficient balance in an account can be an offence and can have

legal remedies.

The payee bank can also return the check as well as E-payment instructions.

Some of the reasons for the same are

The payee name and account number mismatch(Paper as well as electronic)

Payee account closed

Payee Account frozen for credits

Payments 78
The return handling cycle and process will be exactly similar to the normal cycle

c. Clearing and Settlement of Electronic instruments

Different geographies have different payment systems and jargons even though they are

very similar to each other. The second objective is to understand the jargons related to e-

payment based on geographies.

The volumes of electronic payments have been outgrowing the paper based payment

system. Every country handles the electronic payments differently and the jargons used also

could be different.

Electronic Payment Systems of USA

The most popular systems which manage the electronic debit and credit are ACH, Fed wire

and CHIPS.

Fedwire

Fedwire is operated by The Federal Reserve of the USA. Fedwire is used by funds as well

as for settlement of Government Securities. In this section only the funds part of Fedwire will

be discussed.

Fed wire funds is a Real Time Gross Settlement (RTGS) system operated by The Federal

Reserve System and used for time critical payments. Fedwire funds are used for transferring

reserve account balance of depository institutions, high value domestic payments, inter-bank

transfers, third party transfers and high value inter-corporate payments.

The two key differences with ACH are that the Fedwire is used for high value transactions,

while ACH is used for low value or retail transactions. The mode of operation of Fedwire is

Real-Time while that of ACH is in batches .As the name suggests, the settlement is Gross,

i.e. transaction by transaction, whereas in ACH it is netted off.

The Fedwire is open from 9.00 am (ET) to 6.30 pm (ET).

The quarterly statistics of the Fedwire is depicted below:

Payments 79
Courtesy: http://www.federalreserve.gov/paymentsystems/fedfunds_qtr.htm

As the name suggests, it is an RTGS payment system and the transaction is settled

transaction by transaction and there are no complications. If Bank of America (BOA) New

York branch remits USD 1 00,000 on account of Wall-mart to Citibank Chicago for onward

remittance to Client Smith, the account of BOA will be debited instantaneously and the

Citibank account will be credited.

If there is a reverse transaction from Citibank to BOA, there will be a debit to Citibank

Account and Credit to BOA.

The Fedwire transaction can happen in three ways:

Offline Transactions: In this, the institution which wants to undertake a transaction will

telephonically place an instruction to the Wholesale Operations Site (WOS) of Federal

Reserve. This offline mode is used by volume fund transfer customers. Around 500

offline entries are processed daily.

The offline route is also used by the institutions which are facing ad hoc system

unavailability, which could be due to multiple reasons.

STP Transactions: In a straight through processing environment, the transaction flows

from the institutions proprietary system which could be a core banking software to the

FedLine direct access solution. In this, the transaction flows directly to the Fedwire

system without any human intervention. The product used for this is FedLine Direct

Message.

Non-STP Environment: In this setup, the institution will have a Fedwire connection

wherein the transactions will be captured separately. This can be used by institutions

with very little transactions.

Payments 80
The flipside of the same is duplication of entry into the proprietary banking system as well as

the Fedwire system. This could also lead to human errors.

CHIPS:

CHIPS are an acronym for Clearing House Interbank Payment Systems. This is a private

electronic funds transfer system operated by large private banks in New York for

international movements of funds. Financial transactions like foreign/domestic trade

services, international loans, syndicated loans, foreign exchange sales/purchases, etc.

are done through CHIPS. Domestic EFT (Electronic Funds Transfer) payments are also

done through CHIPS.

The end functionality of Fedwire funds and CHIPS are similar. When a customer walks into a

bank and requests for a wire transfer, it is the prerogative of the bank to decide whether the

wire transfer has to happen through Fedwire or CHIPS. The customer will have no role to

play in this.

The process flow with time lines for CHIPS is summarised as follows:

Courtesy: http://www.chips.org/about/pages/000702.php

Payments 81
CHIPS vs. Fedwire:

The position of CHIPS Vis--vis Fedwire has a very unique position. CHIPS is a customer as

well as a competitor of Fedwire.

For instance, a customer walks into a branch of Wells Fargo for an RTGS remittance to his

friend who is banking with Citibank. Both, Citibank as well as Wells Fargo are members of

CHIPs as well as Fedwire. It will be the prerogative of Wells Fargo to decide which network

to use for the remittance.

Banks which have positive closing balances at the end of the day in the CHIPs system

receive the amounts in the form of Fedwire payments.

Both CHIPS and Fedwire offer the same remittance facility and are competitors.

Each system has its own file messaging system. Fedwire has its own proprietary messaging

format.

There are four formats related to the funds transfer viz. Fedwire, CHIPS, SWIFT and ISO

22002.

In order to understand the technology, one needs to know all the four formats. In terms of

dollar volumes of Fedwire and CHIPS, Fedwire is slightly higher than that of CHIPS

Courtesy: http://www.chips.org/docs/000652.pdf

Payments 82
Electronic Payments Systems of the UK

There are three key systems in UK for the electronic payment viz.

BACS

CHAPS

Faster Payments.

Each of them is discussed in detail

BACS

BACS Stands for Bankers Automated Clearing Service. BACS is a membership based

industry body, incorporated more than 40 years back. It is owned by more than 15 banks.

BACS offers five different types of products for the financial services sector.

The connectivity of BACS network is something unique. BACS uses BACStel-IP which is a

multi-layered, highly advanced online submission channel.

The summary of volumes of three of the five products of BACS is reproduced below:

Courtesy: http://www.BACS.co.uk/BACS/SiteCollectionDocuments/Processing_stats.pdf

BACS Direct Debit

A Direct Debit is an instruction from a customer to their bank, authorising an organisation to

collect varying amounts from their account as long as the customer has been given an

advance notice of the collection amounts and dates.

It is the preferred payment method for over 48% of the UK bill paying population.

Payments 83
 BACS Direct Credit

A Direct Credit enables large and small organisations to make payments by electronic

transfer directly into bank or building society accounts.

Direct Credit is mainly used for paying wages and salaries. Over 70% of the UKs workforce

is paid via Direct Credit. In total, Direct Credit is used to pay over four million wages every

week and nearly 20 million salaries a month.

Direct Credit can also be used for a wide variety of other payments. Over 1,50,000

organisations use Direct Credit for supplier payments, pensions, employee expenses,

insurance settlements, dividends and refunds.

Standing Orders

Standing order is one of the oldest electronic payment methods. It can be an internal or an

external standing order. It is also referred to as standing instructions in certain geographies.

An Internal Standing Order is one, in which the senders and the receivers account is within

the same bank.

If the receivers bank is different from the senders bank then, it is deemed to be an external

standing order.

Standing orders are used typically to handle recurring payments like rent, society charges,

etc. and the amount is also fixed. They can be executed with different frequencies like

weekly, daily monthly, etc. In an internal standing order, the credit is received by the payee

instantaneously and will not be routed through BACS (it is similar to On-Us transactions of

ATM or POS)

The internet and phone transactions are additional channels through which the transactions

can be executed.

CHAPS

CHAPS Sterling is a same-day automated payment system for processing sterling payments

made within the UK between its member banks. CHAPS is an RTGS system similar to the

Fedwire of USA.

Payments 84
CHAPS was earlier used to operate the Sterling and the Euro currency. In the latter half of

2009, the Euro transfers were discontinued.

The services are used not only for inter-bank transfers but also for corporate and large value

payments as well.

Faster Payments

Faster Payments is the latest product to be introduced in UK in 2008. The Faster Payments

are managed by CHAPS clearing company which manages the CHAPS product.

All banks are not members of the Faster Payments network. It is an alternative to the BACS

network. BACS network handles the five products mentioned above viz. Standing Orders,

Direct Debit, Direct Credit, Telephonic Orders and Internet Orders whereas, The Faster

Payments network accepts only Internet, Telephonic and Standing orders.

While BACS used to take three days for the entire payment cycle, Faster Payments takes

only one day.

There are few prerequisites for the payments to be affected through Faster Payments

network.

The receivers bank and the payers bank should be part of the Faster Payments network.

In UK, each bank is identified by a unique six digit code referred to as sort code. One can

use the website of the UK Payments administration to check the sort codes and the facilities

offered by the respective bank.

http://www.ukpayments.org.uk/sort_code_checker

A sample sort code checker output is reproduced below

Payments 85
 Each bank can impose limits on the par value under Faster Payments.

A sample limit of the few banks is reproduced below:

Bank Availability Value Limit

Retail customers- 2,500

Bank of Scotland Yes, phone and internet
Corporate customers- 99,999*

Retail customers- 10,000

Barclays Yes, phone and internet
Corporate customers- 100,000

Only available to corporate

Citibank 100,000
customers via Internet

Courtesy: http://www.ukpayments.org.uk/faster_payments_service/value_limits/

A bank can connect to the Faster Payments Service in three ways to receive or send the

payments:

Direct connectivity from the banking systems to the Faster Payments. The messaging

standard used is the ISO 8583 which is also being used for credit card as well as ATM

Transactions.

File input module is the standard batch mode where the transactions are uploaded into

the system. In this method, transactions can only be sent, but not received. The receipt

of transactions will have to happen through the sponsoring member.

Payments 86
 Direct Corporate Access: This model is similar to the file input method. Instead of the

member uploading the file, the corporate directly uploads the same.

Electronic Payment Systems of Europe

The introduction of Euro in 2002 brought about a sea change in the way the payment

mechanism in Europe worked. There are two major payment services in Europe managing

the Euro viz. SEPA and Target2.

The European Payment Council (EPC) is the decision making and the coordinating body of

the European banking industry in relation to payments. It is the EPC which develops the

payment schemes and frameworks necessary for SEPA.

SEPA

The origin of the Single Euro Payments Area (SEPA) is a direct outcome of the introduction

of the new currency Euro. The geographical area covered under SEPA includes all the EU

member states as well as Norway, Iceland, Liechtenstein, Switzerland and Monaco.

The products offered under SEPA are:

SEPA Credit Transfer Scheme(SCT) and

SEPA Debit Transfer Scheme

SEPA Cards

SEPA Mobile

SEPA Credit Transfer Scheme (SCT)

The SCT was introduced in 2008 and more than 4500 banks across 32 countries are

members of the same. Credit transfers are used for corporate credits like Dividend warrants,

Salary credit etc.

SEPA Debit Transfer Scheme

There are two types of SEPA Debit Transfer scheme viz.SEPA Core Direct Debit scheme

(SDD) and SEPA Business to Business Direct Debit scheme (B2B)

Payments 87
The SDD is used for affecting direct debits from the customer account. The prerequisite for

the same is that both the debtor and the creditor should hold an account with a credit

institution located within SEPA.

A mandate needs to be signed by the debtor to authorise the creditor to collect the payment

and to allow the debtor bank to pay those collections. The mandate can be in paper form or

electronic form. The mandate will automatically expire in 36 months after the last initiated

direct debit.

In case of B2B, the functions are similar to SCT. In case of B2B, the debtor is not entitled to

obtain a refund of an authorised transaction. B2B is not available to a retail consumer.

The ISO 20022 formats are being used by SEPA for messaging. It takes a maximum of three

working days for execution of the transaction.

There is a set of defined business rules for SEPA debit and credit which needs to be

adhered to.

The identifier used for the transactions is the IBAN (International Bank Account Number) and

BIC (Bank Identifier Code).

SEPA Cards:

The aim of creating a SEPA for cards is to enable European customers (card-holders and

merchants) to use general purpose cards in order to send and receive payments and

withdraw cash in euro throughout the SEPA area with the same ease and convenience as

they do in their home country. The SEPA cards along with mobile are in the evolution stage.

RTGS in Europe

Europe also has two systems like the US. These two RTGS Systems are Target2 and

EURO1.

TARGET2

TARGET2 (Trans-European Automated Real-Time Gross Settlement Express Transfer) is

the RTGS system used for Euro payments. TARGET2 as the name suggests, is the second

Payments 88
version of TARGET. The first version was released in late 90s and the TARGET2 was

released in November 2007.

TARGET2 is operated by European System of Central Banks (ESCB).

EURO1

The second settlement system is EURO1 operated by the Euro Banking Association (EBA).

EBA Clearing

In addition to handling EURO1, EBA also handles two other products viz. STEP1 and

STEP2.

EURO1 handles high value payments while STEP1 handles low value transactions. Smaller

banks are generally not a part of the EURO1 network due to cost and other reasons.

The business logic and functioning of STEP1 is similar to CHIPS of USA. All balances of the

participants with the member banks will have to be settled by the end of day through a

EURO1 transfer. The timelines for STEP1 is less than the EURO1, which is evident from the

diagram below:

STEP2 is also a clearing entity which handles a number of products. The first product of

STEP2 was XCT transactions. XCT transactions are typically small value credit transactions,

Payments 89
not exceeding EUR 50,000 transactions. Later on, the SEPA credit and debit products, as

discussed above, were introduced. The direct credit and debit products are handled as ACH

transactions in USA. The functionality of EBA with regard to the SEPA transactions is similar

to the BACS direct debit and direct credit of UK.

The XCT product will have to mandatorily move to SCT of SEPA by end November 2011.

The XCT volumes are hardly 10 % of the SCT volumes.

The STEP2 is also known as PE-ACH (Pan European ACH). Finally all STEP2 transactions

have to be settled by banks through either EURO1 or TARGET2. XCT transactions are

settled through the EURO1 while SEPA transactions are settled through TARGET2.

Electronic Payment Systems of India

The electronic payment systems in India have also evolved during the last ten years. India

also offers almost all the products in line with the international products.

The chronological order in which the products have been introduced in India is

ECS(Debit and Credit)

NECS(Debit and credit)

RTGS

NEFT

Electronic Clearing Service (ECS):

ECS is the short form for Electronic Clearing Service. The MICR technology was the

predecessor for the ECS service.

ECS can be debit or credit. Debit ECS is used for payment of utility bills like telephone,

electricity etc. Credit ECS is used typically for dividend payments in India.

The credit ECS is explained using the dividend payment of Infosys. Infosys had 416,623

distinct shareholders as on 31st March 2011(Source Infosys Annual Report 2010-11 page

75). The total number of distinct instruments to be issued for the dividend would be 4,16,623.

Let us assume that of the said numbers, the customers having accounts in the four metros

Payments 90
and four sub metros is around 3,00,000. For these shareholders, dividends can be credited

directly to their accounts through ECS.

Infosys will have to issue physical dividend warrants for the remaining very large number of

shareholders. Assuming that ECS is offered at these eight locations (prior to introduction of

NECS), Infosys would have to create eight files (containing electronic information) for each

location and send it to their respective banks at these eight locations.

These banks will then send the files to the respective clearing house for effecting the

necessary payments. The file formats are defined by the RBI from time to time. There are

timelines also defined by RBI for a number of sub processes before the final settlement.

Each member bank will have to adhere to the same.

National Electronic Clearing Service (NECS):

NECS was introduced in 2008 and is a variant of ECS. The first difference is that the file can

be given to a central location instead of giving the file to multiple locations. The second

difference is that, if the bank is having core banking, there are no geographical restrictions

on the account holders branch. Thus, the NECS has a much wider reach compared with

ECS

RTGS:

The acronym 'RTGS' stands for Real Time Gross Settlement, which can be defined as the

continuous (real-time) settlement of fund transfers individually on an order by order basis

(without netting). 'Real Time' means the processing of instructions at the time they are

received, rather than at some later time. 'Gross Settlement' means the settlement of fund

transfer instructions occurring individually (on an instruction by instruction basis).

Considering that the funds settlement takes place in the books of the Reserve Bank of India,

the payments are final and irrevocable.

There is no branding of this service in India. It retains its original name. RBI operates the

RTGS system. Only transactions above INR 200,000 can be remitted through this system.

More than 74,000 branches across the country are a part of the RTGS framework. The

Payments 91
Reserve Bank of India has mandated that the receiving bank has to ensure that the

beneficiary's account is credited within two hours of getting the credit notification on its

payment system gateway.

The RTGS service window for transactions is open from 9.00 am to 4.30 pm on weekdays

and 9.00 am to 1.30 pm on Saturdays.

NEFT

NEFT (National Electronic Funds Transfer) is used for transaction value less than INR

200,000.

The core difference between NEFT and RTGS is that the former is settled on a deferred net

settlement while the latter is always on a real time. Every transaction of RTGS will hit the

RBI current account. NEFT settles transactions in batches. In a deferred net settlement, the

settlement takes place with all transactions received till the particular cut off time. NEFT

operates in hourly batches. There are 11 settlements on weekdays and five settlements on

Saturdays.

Effective 1st March 2010, RBI has introduced the mechanism of Positive Confirmation to

flow from destination bank/branch to originating bank/branch confirming the date and time of

credit. This information can then be used by the originating bank to SMS or e-Mail the

originator about the status of the transaction.

Payments 92
7. Payment Messaging System

The learning objective of this chapter is to understand the various payments related

messaging system and jargons.

In the early stages of technological evolution, development of the payment systems was

regional in nature. USA had its own protocols and messaging system for Fed wire. In UK,

the BACS and CHAPS had their own standards.

Globalisation led to inefficiencies in the system and interoperability of the systems was

becoming difficult. This led to a new school of thought and looked at global standards for

messaging. Major standards like SWIFT, EDIFACT, EBICS, ISO 22000 and ISO 8583 are

discussed in the below sections.

a. Different Communication Networks

SWIFT

SWIFT (Society for Worldwide Inter-bank Financial Telecommunication) is operated by

banks throughout the world to facilitate international payments. This is one of the oldest

international standards. SWIFT is basically a message transmission system and does not

deal in any funds, as compared with Fed wire and CHIPS. This was founded in 1973 by 239

banks spread over 15 countries to create a unified international transaction processing and

transmission system. The society is a not-for-profit organisation established under the

Belgian law with its headquarters in Brussels.

The main features of SWIFT are:

Operational 247 throughout the year

Transmission of message to any part of the world in real time

Standardised message formats for inter-bank transactions using about 400 different

standardised formats

Acknowledgement of all messages- accepted or rejected

Payments 93
 Maintaining confidentiality of information

Assurance of accuracy and timely delivery of validated messages.

Message Types in SWIFT:

SWIFT has developed standard message formats to take care of each business area

separately. The Message Type is referred to as (MT) in short.

The MT types for the various lines of business are as follows:

MT Type Description

100 Customer Payments & Checks

200 Financial Institution Transfers

300 Treasury Markets Foreign Exchange, Money Markets & Derivatives

400 Collection and Cash Letters

500 Securities Market

600 Treasury Markets-Precious Metals

700 Documentary Credits & Guarantees

800 Travelers Checks

900 Cash Management & Customer Status

SWIFT Currency Codes

Each currency in the financial markets is identified by a three-letter code. The first two letters

USUALLY represent the name of the country and the third letter the name of the currency.

For example, as seen above, the Indian rupee is represented as INR, IN standing for India

and R for rupee. Similarly, for US dollar it is USD. However, a significant deviation from

this rule is the EUR, where EUR could stand for Europe or Euro (the name of the common

Euro zone currency).

SWIFT Net

SWIFT Network has also progressed with the advancement of technology and has

embraced technology and devised new products.

Payments 94
SWIFT Net is SWIFTs advanced Internet protocol-based messaging platform. It offers four

complementary messaging services viz.

FIN

InterAct

FileAct

Browse

FIN enables the exchange of messages formatted with the traditional SWIFT MT standards.

These standards cover a wide range of business areas and are widely used and accepted

by the financial community. FIN works in store-and-forward mode and offers extensive

value-added functionality, such as message copy, broadcasts, and online retrieval of

previously-exchanged messages.

Inter-Act enables the exchange of messages formatted with the new XML based SWIFT MX

standards. SWIFT Net offers increased flexibility. In addition to store-and-forward

messaging, it also supports real-time messaging as well as real-time query and response.

InterAct uses the new XML-based MX standards. Both FIN and InterAct enable the

exchange of messages on a message per-message basis, and support the exchange of

messages using proprietary formats in the context of market infrastructures.

File-Act enables the transfer of files in a secure and reliable manner. It is most efficient

when used to transfer large batches of messages, such as bulk payment files, very large

reports, or operational data.

Browse enables SWIFTNet users to browse securely on financial websites available on

SWIFTNet using standard Internet technologies and protocols such as HTTP-S and HTML.

EBICS:

EBICS stands for Electronic Banking Internet Communications Standards. EBICS is a

regional standard used in Europe. SWIFT is predominantly a standard used between

financial institutions. EBICS can be used for corporate to bank communications as well as

bank to bank messages.

Payments 95
Advocates of EBICS argue that the communications protocol offers a less complex and less

expensive solution than SWIFT with good enough levels of security to satisfy most routine

transaction types.

Indirectly EBICS is a competitor to SWIFT. However, the reach of SWIFT is much more

widespread when compared with EBICS.

EBICS has the following distinct advantages

A common standard for customers as well as banks

Supports XML, HTTPS, etc

End-to-end encryption at transport and application level

b. Different formats

EDIFACT is an acronym for EDI For Administration, Commerce and Transport. It

coordinates International standardisation by working through the UN/ECE (United

Nations/Economic Commission for Europe). It provides the following:

An international EDI standard

A set of syntax rules

Data elements, segments and codes

Messages

An EDIFACT message is a single business document. Each message is identified by a six

character name. From the buyer-side these include:

ORDERSPurchase Orders

CUSDECCustoms Declaration

IFTMINInstruction Message

REMADVRemittance Advice

PAYORDPayment Order

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Seller-side messages include:

IFTMANArrival Notice

CUSRESCustom Response

INVOICInvoices

ISO 20022:

ISO 20022 is also known as UNIFI (UNIversal Financial Industry message scheme). The

official definition form www.iso20022.org is:

UNIFI provides the financial industry with a common platform for the development of

messages in a standardised XML syntax, using: A modeling methodology (based on UML),

to capture in a syntax-independent way, financial business areas, business transactions and

associated message flows. A set of XML design rules to convert the messages described in

UML into XML schemas.

SWIFT is embracing ISO 20022 as the preferred XML format for messages exchanged on

the SWIFTNet service used by over 8,000 financial institutions in over 200 countries, to

exchange financial transactions

ISO 20022 is one of the key unifying standards that will harmonise payment technologies

and standards throughout the European Union with the Single European Payments Area

(SEPA). For example, ISO 20022 will be a foundational standard for TARGET 2 (Trans-

European Automated Real-time Gross Settlement Express Transfer System), the next

generation, real time settlement system for Pan-European payments.

Vendors Financial application vendors, including the larger ERP players like Oracle and

SAP are building ISO 20022 into their products. You can expect niche treasury workstation,

accounts payable and accounts receivable platform vendors to adopt the standard as well.

ISO 8583

Another popular standard related to the payment standard is the ISO 8583. ISO 8583

standard is a messaging format used for communicating the delivery channels like ATM and

POS with the Card issuer. This format is used only for payments in card industry.

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The ISO 8583 comprises of three parts viz.

MessageType One or more Data elements in the

Indicator(MTI) Bitmaps,which is an message
indicator of which data
elements are present

MTI is a four digit numeric field which indicates the type of message.

Cross Border Payment Lifecycle

The learning objective of this chapter is to understand the cross border payment life cycle

which is a critical component of the entire payment system.

In the earlier sections, the domestic scenario has been dealt for wholesale banking as well

as retail domestic payments. The advent of globalisation mandated the need of the

movement of goods and services across continents and the payments had to be made in a

currency other than the domestic currency.

Labour started migrating across continents and there was a need for remittances. The

remittances form a major chunk of cross border transactions.

Let us understand the jargons that are used with respect to a country or a bank.

Figure 10: Overview of Cross Border Remittances

Remittances

Inward Outward

Retail Corporate Corporate Corporate

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Inward Remittances: They are remittances received from abroad into the country. The retail

remittances are typically money sent from abroad by emigrants, such as non-residents. This

money could be for consumption or for the purpose of investment into bank deposits. The

other type of inward remittance could be fees of International students studying in foreign

country and their maintenance allowance sent by their parents, etc.

Examples of Corporate inward remittance would be proceeds of export of Goods and

Services. Infosys develops software for Reebok and Reebok has to pay Infosys. This will be

in US Dollars. Similarly, there will be hosiery exporters from Tirupur who will be paid in

foreign currency for their exports.

The inward remittance can be in any currency. In addition to the currency, each inward

remittance has to be further classified for statistical and monitoring purposes. Some of the

sub-categories would be advance payment, final Payment, etc.

Modes of Retail Inward Remittance

The money from abroad can be remitted in the following modes:

Demand Draft (in the target currency)

Direct Bank Credit

Transfer to Card

Instant Money Transfer

Demand Draft

Mr Ahmed, a worker in Riyadh, would like to send some money to his friend who is having a

banking account in India. He would walk into Al Rajhi Exchange and request for a demand

draft. The demand draft given to him would be in INR and not in SAR. Money changers can

also issue paper instruments since they would have entered into correspondent banking

arrangements with Indian banks. NRI customers will also require rupee drafts for their other

type of investments in India like Mutual Funds, etc.

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Direct Bank Credit

In a direct bank credit, the beneficiarys account is directly credited without any human

intervention. The remitter from his country will request for a direct transfer. This will again

work through the correspondent banking route.

Transfer to Card

This is an innovative service provided by both VISA and MasterCard. Mr Joseph works in

Dubai and can transfer money to his or his relatives Credit/Debit card instantaneously. He

would walk-in to the UAE Exchange office in Dubai and request for this service. The card

holder can withdraw this cash from any ATM or use this at any POS machine. All money

changers do not offer this service.

Instant Money Transfer

The biggest drawback of cross border payment is the time delay in obtaining the fund and

routing the money through a bank account. In addition, most of the emigrants in Middle East

region are blue collar workers. Mr Ahmed is working in Dubai airport and hails from

Chavvakad, a hamlet in Kerala. His mother is staying in Chavakkad and does not have a

bank account. Mr. Ahmed has to send money, monthly for her sustenance. Even Mr Ahmed

may not have a bank account in Dubai. He will be receiving his payments in cash.

People like Ahmed would like to avail an instant money transfer facility, wherein his mother

gets the money without routing through the bank account. There are a number of service

providers for instant money transfer. Some of them are

Xpress Money which is a product of UAE Exchange itself

Western Union Money Transfer

Moneygram

Ezremit

All these providers work through a network of agents which could include post offices, local

mom and pop stores, etc. Xpress money has around 80,000 agents in India, while Western

Union has around 50,000 locations.

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The process is a four step process:

Step 1: Mr Ahmed will walk into one of the branches of the money changers say UAE

Exchange and pays UED. The UED will be converted into INR rupees at a specific

conversion rate.

Step 2: A notification is sent immediately to the receiving agent. Simultaneously the remitter

has to communicate the unique identifier to the beneficiary.

Step 3: The beneficiary has to walk into agents office with this unique identifier and

necessary photo ID proof. The agent on verifying the credentials will hand over the cash to

the beneficiary.

Step 4: A reverse intimation is sent to the remitter on receipt of the money by the

beneficiary.

Restrictions on Instant Money Transfer

Each country will have restrictions on cash movement. Cash withdrawals are important from

the perspective of layering as per the Anti Money Laundering Guidelines (AML).

As per the local requirements, maximum payout amount should not be more than $2,500

US dollars (or in rupee equivalent) per transaction.

Maximum cash payout for all Indian nationals and all residents (Indian or Foreign) is

50,000 in rupee; payouts over 50,000 in rupee can be paid by local crossed check only.

There is no cash payout limit for foreign passport holders in India.

As per government requirement, a payee can only receive a maximum of 12 transactions

per calendar year.

Receiver must present valid identification.

Receiver must present correct Money Transfer Control Number (MTCN).

Sender's full address must be included on all money transfers to India.

Pursuant to Indian government regulations, money transfer payments are reserved for

private consumer use only and cannot be used for commercial or business purposes, for

purchase of property, or for investments.

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 Paying location is required to maintain a photocopy of identification documents

presented by the Receiver.

A new International Money Transfer destination has been created called 'India Tsunami

Region' for transfers to these regions. It is necessary to verify the destination state with

the sender before sending to India.

Outward Remittance: Money remitted from one country to another is referred to as

outward. This could be remitted by individuals (resident as well as expatriates) and

corporates.

Indian Oil Corporation is a major importer of crude oil. The payment for crude has to be done

in USD. Indian Oil Corporation will have to resort to an outward remittance for the payment

of crude oil purchases.

Other examples of outward remittance have already been discussed in earlier section of

International Wire transfer, which is reproduced below:

Mr. Nelson hails from Karaikudi (in Tamil Nadu) and his son, Mr. Wilson is studying in

London School of Economics (LSE) London. In order to meet the monthly expenses, he has

to remit GBP 500 every month. Mr. Nelsons Bank account is with City Union Bank in Indian

rupees while Wilson is banking with Standard Chartered. He can send a Foreign DD as

mentioned above through courier. Courier charges were exorbitant in olden days and wire

transfer was found to be a cheaper than DD.

City Union Bank will have a foreign correspondent banking arrangement for GBP.This

arrangement can be either with Standard Chartered or Barclays bank. If the correspondent is

Standard Chartered, it will be an internal payment. If it was Barclays, the cycle is more

complicated.

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This example is further expanded to complete the cycle. Two scenarios are envisaged

Scenario 1 Scenario 2

Applicant (Nelsons)Bank City Union Bank City Union Bank

Currency of remittance GBP GBP

Amount of remittance 500 500

Correspondent Bank of the Standard Standard Chartered-London

Applicant Bank (Nostro Account) Chartered-London

Beneficiary(Wilsons) bank account Standard Chartered Barclays Bank-Scotland

in GBP Scotland

Steps in processing

Step 1 Mr Nelson will have to pay the INR equivalent of GBP 500 to City Union Bank
along with the Bank charges. This will happen in Karaikudi Branch.
Step 2 The Karaikudi branch of City Union Bank will pass on this message to their

International branch, as the Karaikudi branch is not undertaking foreign exchange

business. All branches of the bank may not be permitted to undertake forex

business. If the branch is allowed to undertake the forex business, then the Step 3

mentioned below will also be managed by Karaikudi branch.

Step 3 The International branch of City Union Bank (CUB) will send a SWIFT message

MT103 to Standard Chartered London Office.

City Union Bank also has to maintain a correspondent bank account in GBP with

Standard Chartered. This account is called a Nostro account. CUB has to ensure

that there is sufficient balance in their Nostro account for effecting this transfer.

(International branch will have a daily process to reconcile all the Nostro Balances

on a daily basis. Nostro Balances will be communicated by MT940 by Standard

Chartered to CUB)

The Swift Message MT 103 will contain the beneficiary details like name of the

beneficiary, the bank details of the beneficiary, the Nostro Account number of the

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 correspondent bank.

Step 4 Standard Chartered will receive the MT 103 at their London office. The transaction

can be an STP transaction which will directly hit the Banking system of SCB

London.

Step 5 a For Scenario 1.

As the Nostro account and the beneficiary account is within SCB, the transaction

of debiting the Nostro account and crediting the Beneficiary account will be an

internal one.

Step 5 b For Scenario 2a-Barclays Bank is having an Account with Standard

Chartered Bank London.

In this scenario SCB will effect an internal transfer from the Nostro account of

CUB and credit the Barclays account.

SCB will also send an intimation to Barclays with the beneficiary details who in

turn will credit the Wilsons account

For Scenario 2b-Barclays Bank is not having an account with Standard

Chartered Bank London.

Standard Chartered will use the CHAPS network or the Faster Payments for

onward remittance to Mr Wilsons account.

Alternatively Standard Chartered can also issue a paper instrument and courier it

to Barclays bank, in which case there will be processing delays of physical check

clearing

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Corporate Remittances

The corporate remittances can also be classified into Inward and Outward as mentioned in

the diagram in the earlier section.

Examples of Corporate remittances are also dealt with, in the earlier section. The cycle for

the outward remittance is the same as above and will not be discussed. Only the applicant

and the beneficiary, instead of being individuals will be corporate entity. Unlike a retail

transaction, the payment is the last leg of the entire business transaction. The business

cycle is beyond the scope of this certification.

In case of inward remittances, the only mode of payment will be direct bank credit. Cash will

not be paid to corporates.

Foreign Exchange is a scarce resource for India and, there are local regulations which

prohibit any individual or corporate entity to hold the foreign exchange for a long time.

A decade back, if Infosys had exported software worth USD 100, 000 and they had to

receive the foreign exchange payment within six months of invoicing. Moreover, Infosys

would have to surrender the entire 100,000 USD and receive INR for the same.

Over period of time, when the foreign exchange scenario eased in the country, exporters

were allowed to retain a part of their foreign exchange earnings in foreign currency itself,

instead of surrendering the same.

This was referred to as Exchange Earners Foreign Currency (EEFC) account. In the initial

stages of EEFC account, RBI permitted exporters to hold not more than 15 % of the

earnings in foreign currency. Presently, exporters are allowed to hold up to 100 % of their

earnings in foreign currency.

The philosophy of EEFC account is very simple. An exporter will also need foreign currency

for payment of salaries to their foreign staff. Also, they would like to import certain materials

like software, etc. for which they would require foreign currency for effecting payments for

the same. This would mean only buying and selling foreign exchange and paying of bank

charges and bearing the exchange loss. This has been overcome by EEFC account. The

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EEFC account is in the form of current account with no interest being paid on them. Check

book facility is also allowed in these accounts.

Certain developing countries also will be having this product conceptually, though it will be

named differently.In any international market the beneficiary has absolute freedom to

maintain the account in the currency of the choice of the customer.

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8. Regulations and Compliance

The learning objective of this chapter is to understand the regulations governing the

payment system.

Safety, security, soundness and efficiency of payment systems assume critical importance

from the angle of systemic stability. Smooth functioning of payment systems becomes vital in

the light of inter-linkages they have with other financial systems.

Payment and settlement systems constitute the backbone of any financial economy. With

the objective of ensuring efficient and faster flow of funds among various constituents of the

Financial sector, the concerned regulators need to control and regulate the payment and

settlement systems.

The system also has to be safe, efficient and secure in order to control Money Laundering

activities across continents.

The important aspects of efficient and effective payment and settlement systems are,

Safety Keeping the risks in various payment system products at the minimum and

manageable, if they are necessary and unavoidable.

Security Giving confidence to stakeholders that the payment systems can be trusted

and are reasonably protected from threats and vulnerabilities.

Soundness Demonstrating the capability and ensuring that the payment systems

function in a non-disruptive manner.

Efficiency Providing measures to ensure that the payment systems are cost-effective,

reliable and promote financial and economic stability.

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 Accessibility To ensure reach of various payment systems at reasonable cost to

various segments of the populace.

From a regulatory point of view, the flow of money is also tracked on a common identifier

like SSN (Social Security Number) post the Dubai Crisis. The Bahrain government has

linked all money flow to the work permit popularly known as IQAMA. The immigration

authority by swiping the IQAMA can get an overview of the total loan outstanding, the

value of outward remittances etc.

The movement of money has to be closely regulated to control the Anti-Money

Laundering. The products of the future will be highly technology driven and compliance

oriented.

Each product/instrument needs to be regulated to prevent misuse. There should be legal

remedies for the same in the event of misuse.

The words compliance and regulations are used interchangeably. In the context of US,

compliance refers to compliance to Laws and Regulations. The laws can be either of criminal

nature or civil nature or can be in the form of regulations.

An act is something which is enforceable under law, while industry compliance may be an

agreement between industry and stake holders, but may not be enforceable under law.

The key regulations related to the Payment are as follows:

a. UK

The Bill of Exchange Act, 1882 relates to the paper instruments like check and bills of

exchange

Settlement finality in payment and securities settlement system:- This Directive aims to

reduce the systemic risk inherent in payment and securities settlement systems and to

minimise the disruption caused by the insolvency of a participant in such a system.

The Money Laundering Regulations, 2007 came into effect from 15th December 2007. In

the payment industry, the AML (Anti-money laundering) and KYC (Know your customer)

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 are critical guidelines. The source of funds and the end use of funds need to be tracked

systematically. In a paper-based payment mechanism the trail of money can be easily

established but in an electronic payment, tracking is more difficult. There is a process of

layering in AML which happens more in the electronic environment compared with the

paper-based payment.

b. USA

Uniform Commercial Code: Articles 3 and 4 of this code govern the issuance and

transfer of negotiable instruments and are related to the paper instruments.

Federal Reserves Regulation E deals in the Electronic Funds Transfer Act. It is

applicable to debit card transactions. It is interesting to note that this regulation is not

applicable to paper instruments as the name of the regulation suggests. This regulation

is also not applicable to ACH (Automated Clearing House) transactions even though they

are electronic.

Federal Reserves Regulation J governs the payment transactions which are affected

over the Fedwire Transfer.

ACH Rules and Regulations are issued by National Automated Clearing House

Association (NACHA).

CHIPS Rules and Procedures are applicable to fund transfers made through Clearing

House Interbank Payments System.

Check21 is a Federal law to enable banks to handle more checks electronically. It

mandates the electronic image to be a substitute of the physical check and mandates

that the electronic image is equivalent to physical paper.

AML Guidelines: In USA there a are a number of AML Rules and Regulations

I. FINRA AML Rule 3310

II. USA PATRIOT ACT

III. U S Treasury Department Rules

Payments 109
Settlement needs to be controlled and regulated as any systemic failure to a settlement

system can lead to collapse of the economy.

Some of the regulations could be directly related to the payment systems while some of

them will be indirectly related to payment systems. AML guidelines are an example of

indirect regulations. It is very difficult to identify indirect regulations and their impact on the

payment systems.

c. European Union

i. SEPA

SEPA (Single European Payment Area): This is the latest payment mechanism .In

international markets one can maintain multi-currency accounts. SEPA Currently operates in

32 countries and cross border payments can be effected on a common platform. SEPA can

be used for domestic payments as well.

ii. Payment Services Directive (PSD)

The first core principle of any payment system is The system should have a well founded

legal basis under all relevant jurisdictions. The legal aspect of SEPA was addressed by the

EUs payment services directive, which became a law on 1st November 2009. This rule

ensures that rules on electronic payments are the same in all the 30 countries.

The directive uses the term payment service providers which encompasses banks as well

as payment institutions comprising money remitters, retailers and phone companies. It

covers all kinds of electronic and non-cash payments, ranging from credit transfers, direct

debits, card payments and money remittance to mobile and online payments. It does not

cover cash and check payments.

Payments in any European currency, including the Euro and the Sterling Pound (GBP) are

covered under PSD as long as the payment service providers for both, the payer and payee

are located in one of the thirty countries.

Payments 110
d. Detailed Regulation-USA

Check21

This is directly related to the Payment system. Check 21 is a Federal law which is designed

to enable banks to handle checks electronically.

The legislation:

Facilitates the use of imaging for check processing

Fosters innovation in the check collection system

Improves the overall efficiency of the nations payment system.

The legislation does not require any individual institution to change its current check-

processing methods or to process checks electronically, until it determines electronic

processing is advantageous to its particular business operation.

The primary purpose of the legislation was to facilitate electronic check exchange by

authorising a new negotiable instrument called a "substitute check". Substitute checks

facilitate electronic check exchange by enabling a bank to create a substitute check for

presentment to banks with which it has no pre-existing agreement to exchange electronic

images. Specifically, the regulation defines a "substitute check" as a paper reproduction of

the original check that contains an image of the front and back of the original. Since

substitute checks are checks, they are subject to existing check law.

A "reconverting bank is defined as the bank that creates a substitute check or, if a person

other than a bank creates a substitute check, the first bank to transfer, present, or return a

substitute check, or a paper or electronic representation of a substitute check.

The Check21 Act is designed so that losses associated with a substitute check are borne by

the reconverting bank. Therefore, there are certain requirements established for these

banks.

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Each reconverting bank must:

Identify itself as a reconverting bank on the substitute

Preserve all previous reconverting bank identifications;

Ensure that the substitute check bears all previously applied endorsements; and

Identify the bank that truncated the original check.

The law also stipulates that a bank that transfers presents, or returns a substitute check,

makes two warranties under the Act:

A legal equivalence warrantythe substitute check meets the requirements for legal

equivalence; and

A duplicative payment warrantyno bank, drawee, drawer, or endorser will be asked to

make a payment on a check, it has already paid

Both warranties apply to substitute checks and paper or electronic representations of

substitute checks. Whenever a bank transfers, presents or returns a substitute check for

which it receives consideration, the bank is automatically making these two warranties.

These warranties can also flow back to the first reconverting bank.

Banks that transfer, present or return a substitute check or a paper or electronic

representation of a substitute check also indemnify subsequent parties against losses due to

the receipt of a substitute check in place of the original check. A valid indemnity claim can

only be made by a recipient of a substitute check. As with the warranties, the indemnities

also flow back to the first reconverting bank.

Check 21, like PSD also has a number of new protections to consumers.

Banks that provide their customers with cancelled checks in periodic statements need to

comply with a requirement to provide a disclosure of consumer rights under the new law.

Check 21 requires banks to provide this disclosure in a number of circumstances.

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 All existing customers who routinely receive cancelled checks in their periodic statement

must be provided with a disclosure not later than the first statement after October 28,

2004.

All new customers who will receive cancelled checks or substitute checks must be

provided with a disclosure when the customer relationship is established.

Customers who receive substitute checks on an occasional basis must also be provided

with the disclosure.

If a bank provides a substitute check in response to a consumers request for a copy of a

check, the bank must provide the disclosure at the time of the request, if feasible, and,

otherwise, no later than when the bank provides the substitute check.

Consumer Awareness is only one of the compliance requirements set out in the law and

regulation. A bank that provides a substitute check to a consumer also must be prepared to

comply with Check21s Consumer Expedited Recredit Rights for addressing errors relating

to substitute checks.

The re-credit rights are similar to the refund rights under PSD.

Rules and regulations for EFT in USA

The Check21 is a Federal law which is applicable to substitute checks. However, there are a

number of other EFT products which also need regulations. The ACH of USA is deemed to

be an EFT. All ACH is governed by Regulation E of the Federal Reserve and the NACHA

Rules.

NACHA is an acronym for National Automated Clearing House Association. NACHA is

responsible for managing the development, administration and governance of the ACH

network.

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Regulation E has 15 sections and the key sections are as follows

Section Headings Section description.

General disclosure States that a financial institution may combine the disclosure

requirements; jointly information required by the regulation with that required by other laws

offered services such as the Truth in Lending Act or the Truth in Savings Act as long

as it is clear and understandable and is in a written form that

consumers can keep.

Issuance of access Stipulates that a depository institution may issue an access device

devices (such as a debit card) only if a consumer has requested it either

orally or in writing

Liability of consumer Limits a consumer's liability for unauthorised electronic fund

for unauthorised transfers, such as those arising from loss or theft of an access

transfers device, to $50; if the consumer fails to notify the depository institution

in a timely fashion, the amount may be $500 or unlimited.

Initial disclosures Requires financial institutions to provide to consumers initial

disclosures of the terms and conditions of EFT services. Institutions

must disclose the consumer's liability for unauthorised EFTs, the

types of EFTs the consumer may make and any limit on the

frequency or dollar amount; fees charged by the institution; and error-

resolution procedures. Institutions must also provide a summary of

various consumer rights under the regulation

Change-in-terms States that if there are adverse changes in fees, the consumer's

notice; error- liability, types of transfers available, or limits on transfers, the

resolution notice institution must provide a change-in-terms notice at least twenty-one

days before the changes take effect. The institution must periodically

send a reminder of the error-resolution procedures. It may send a

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 detailed notice annually or provide an abbreviated notice with each

account statement.

Receipts at States that, consumers must be provided documentation in two

electronic terminals; forms: terminal receipts and periodic statements. Consumers must

periodic statements receive a receipt when they initiate an electronic transfer and monthly

in the form of periodic statements. Both documents must include the

type of electronic transfer; the amount and date of the transaction;

the location of the terminal; and other information

Pre-authorised Requires financial institutions to provide the consumer with some

transfers form of notice that electronic transfers that recur at substantially

regular intervals, such as the direct deposit of salaries or benefits

and the pre-authorised payment of bills, occurred as scheduled.

Procedures for States that if a consumer notifies an institution that an error involving

resolving errors an EFT has occurred, the institution must investigate and resolve the

claim within specified deadlines. Errors covered by this requirement

include unauthorised EFTs, incorrect EFTs, and the omission from

an account statement of an EFT that should have been included.

The basics definitions of the type of ACH are covered under the NACHS Operating rules.

There are eight articles in the NACHA and number of sections and sub section under each.

The NACHA rules have been revamped with effect from 1st January 2011.

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Article No Article Description

One General Rule

Two Rights and responsibilities of ODFIs, their originators and Third-party senders

Three Rights and responsibilities of RDFIs and their receivers

Four Rights and responsibilities of ACH Operators

Five Rights and responsibilities of Gateways for IAT entries

Six Rights and responsibilities of Association and National associations

Seven Settlement

Eight Definition of terms

The Money Laundering Regulation 2007

This is an indirect regulation related to payment systems. As is seen from the earlier section,

every country has an AML regulation. This regulation came into force from December 2007.

USA PATRIOT Act of 2001

This Act is an indirect Act related to the Payment industry. It is applicable to all the financial

institutions. This Act is intended to curb terrorist activity and other related issues. PATRIOT

is an acronym and stands for Uniting and Strengthening America by Providing Appropriate

Tools Required to Intercept and Obstruct Terrorism.

There are Ten Titles to this Act. The critical title related to the payment industry is Title III,

which is also known as International Money Laundering Abatement and Anti Terrorist

Financing Act of 2001.

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There are a number of sections that directly relate to the payment industry at large. The key

sections of the Title III are:

Sec No Section Description

Sec 311 Special measures for jurisdiction, financial institutions, or international transactions

of Primary Money Laundering Concern.

Sec 312 Special due diligence for correspondent accounts and private banking accounts

Sec 314 Cooperative efforts to deter money laundering

Sec 325 Concentration accounts at financial institutions

Sec 326 Verification and identification: this is one of the most important sections. This

prescribes minimum standards for financial institutions and their customers,

regarding the identity of the customer that shall apply with the opening of the

account with the financial institution

Sec 352 Anti-money laundering programs. This section requires financial institutions to

establish AML programs that encompass at least the following:

Policies

Procedures and controls

Designation of compliance officer

An ongoing employee training program

Independent audit function to test programs

Sec 362 Establishment of a Highly Secure Network to improve communications among

organisations, to enable financial institutions to file all reports electronically.

Payments 117
e. Detailed Regulations in UK

Payment Services Regulation (PSR) 2009

This is a direct regulation related to the payment system. Financial Services Authority (FSA)

was appointed by the UK Government as the competent authority for most of the Payment

Systems Directive. Accordingly, with effect from 1st Nov 2009, the Payment Service

Regulations (PSR 2009) came into effect.

The PSR created a new class of regulated firms known as Payment Institutions (PI) which

should either be authorised or registered with FSA. The PI will include non-bank credit card

issuers, non-bank merchant acquirers, banks, building societies-money issuers and money

remitters.

The regulation is divided into nine parts and is an 81 page document.

Part Description

One Introductory Provisions

Two Registration

Three Authorised Payment Institutions

Four Provisions Applicable to authorised payment Institutions and small payment

institutions.

Five Information requirements for payment services

Six Rights and obligations in relation to the provision of payment services.

Seven The authority

Eight Access to payment systems

Nine General

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Benefits to consumers

All the regulations are framed with the end consumer in mind. The PSR brings in a number

of benefits to the consumer.

Some of them are:

The key information required before and after payment needs to be communicated to the

consumer.

The key terms and conditions like processing time, spending limits, charges and refund

rights needs to be communicated.

Any changes to the terms and conditions as well as charges have to be communicated

to the consumer at least two months in advance.

The consumer has to be informed after each payment.

The payments have to be made within the deadlines stipulated. From 1st January 2012,

all payments will have to be made by the end of next day.

Refund rights.

In case of an unauthorised debit, the consumer has the right to request for immediate

refund as long as the consumer notifies the payment service provider within 13 months

of the debit date.

If there has been an authorised payment without stating the amount, e.g. through a

direct debit or a card payment for hotel or car bookings and the amount debited is not

what was reasonably expected, then one is entitled to challenge it by contacting your

payment service provider within eight weeks. The payment service provider will then

have to reimburse you within ten days or justify its refusal.

In the event of incorrect processing (such as failed to pay, debited the wrong amount,

paid late or paid twice) the consumer has the right to request for proper rectification with

the service provider as long as the consumer notifies the payment service provider within

13 months of the erroneous entry.Bank of International Settlement (BIS) and its role in

payment Systems

Payments 119
f. Bank of International Settlements

In addition to the local regulations, the Bank of International settlement (BIS) plays a major

role in the payment systems worldwide.

The Committee of Payment and settlement Systems (CPSS) under the BIS, contributes to

strengthening the financial market infrastructure through promoting sound as well as efficient

payment and settlement systems. It is the standard setting body for the payment and

securities settlement worldwide.

There are a number of recommendations and committees set up from time to time. The

landmark document is the Core Principles for Systematically Important Payment Systems.

The ten core principles as per the said document are:

The system should have a well founded legal basis under all relevant jurisdictions.

The systems rules and procedures should enable participants to have a clear

understanding of the systems impact on each of the financial risks they incur through

participation in it.

The system should have clearly defined procedures for the management of the credit

risks and liquidity risk, which specify the respective responsibilities of the system

operator and the participants which provide appropriate incentives to manage and

control those risks.

The system should provide prompt final settlement on the day of the value, preferably

during the day and at minimum by the end of the day.

A system in which multilateral netting takes place, should, at minimum, be capable of

ensuring the timely completion of settlement in the event of an inability to settle by the

participant, with the largest single settlement obligation

Assets used for settlement should preferably be a claim on the central bank where other

assets are used. They should carry little or no credit risk and little or no liquidity risk.

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 The system operator, the participants and any relevant third party have agreed on a set

of security policies and operational service levels that have to be met by all of them.

These policies and service levels are in line with international standards in terms of

confidentiality, integrity, authentication, non-repudiation and availability of information as

well as auditability of processes and procedures.

The system should provide a means of making payments which is practical for its users

and efficient for the economy.

The system should have an objective and publicly disclosed criteria for participation,

which permits fair and open access

The systems governance arrangements should be effective, accountable and

transparent.

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Glossary

ACH- Automated Clearing House- This is specific to USA.

BACS- Bankers Automated Clearing System of UK

CHAPS- It is the electronic bank to bank payment and works on the principle of Real Time

Gross Settlement.

Check21- It is synonymously used for processing of checks as well as law. Check21 is a

Federal Law enacted to legalise the electronic copy of the check. Subsequently the handling

of electronic copy of the check was also referred to as Check21

CTS- Check Truncation System. A generic term used to convert a check to an electronic

image. Check 21 is in effect, a CTS.

ECS- Electronic Clearing Service

EFT- Electronic Funds Transfer. It is more a generic term and can encompass ECS, RTGS,

NEFT, etc.

EMV- Europay MasterCard Visa. It is a consortium of the global network companies and

primarily intended to standardise the technology aspects.

Faster Payments The channel in UK for transferring money through the telephone channel

or the internet channel.

Fedwire Fund Services- This is the RTGS system of USA and its equivalent in UK is the

CHAPS.

KYC- Know Your Client. In the light of money laundering, the KYC norms are becoming

stringent across the globe

MICR- Magnetic Ink Character Recognition. This is a technology which is used for

automating the check clearance process

NACHA- National Automated Clearing House Association. This body manages the

development, administration and governance of the ACH network.

National Settlement Services This is a multilateral netting based on electronic files

uploaded by the institutions in USA. Its product equivalent is the NEFT of India

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NEFT- National Electronic Fund Transfer. It is more of a branding in India.

ODFI- Originating Depository Financial Institution. Used in USA in the context of ACH. It is

the organisation which originates the ACH.

PSD- Payment and Settlements Directive of UK. It is the regulation which also guides SEPA

RDFI- Receiving Depository Financial Institution. Used in USA in the context of ACH. It is the

organisation which receives the ACH.

RTGS- Real Time Gross Settlement. As the name suggests, it is settled transaction by

transaction. In certain countries, the product has been branded while in certain countries

they use the word RTGS itself.

SEPA- Single European Payment Area. SEPA Currently operates in 32 countries and cross

border payments can be effected on a common platform.

SWIFT- Society for Worldwide Inter-bank Financial Telecommunication. It is a payment

facilitator. It does not handle funds like RTGS etc.

TARGET2- Trans-European Automated Real-Time Gross Settlement Express Transfer is

the RTGS system used for Euro payments.

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