How Do Payments Work?
Most of us are under the impression that when we swipe our credit card at a store or cash a check via our mobile app, these funds are transferred instantly. But in most cases, these funds won’t be moved to their final destination for another 2–3 days. In this blog post, I will outline how the major payment rails in the United States work.
Automated Clearing House (ACH)
The ACH Network processes $41 trillion worth of transactions annually. These transactions include direct deposits for payroll, automatic bill payments, and deposits into brokerage accounts. There are two different types of transactions that can be made over the ACH Network: credit transactions and debit transactions. If you initiate a credit transaction, you are giving/pushing funds to someone.* If you initiate a debit transaction, you are taking/pulling funds from someone.
All ACH transactions must originate from a bank. If one wanted to pay someone using the ACH Network, they would first need to find a bank that could act as the Originating Depository Financial Institution (ODFI). The individual/company who is originating the request is responsible for authorizing that the bank account is real and has sufficient funds. The originating party would send their ODFI a file that included the transaction details, which the ODFI would then send to the central clearinghouse in the ACH Network. An important thing to note with the ACH Network is that these transactions are not processed in real time. The ODFI groups their ACH transactions into batches during the day and then sends these out periodically. When these transactions arrive at the clearinghouse, the clearinghouse will inform the receiving financial institution, and they will post a debit or credit to the proper account. At the end of the day, the clearinghouse will calculate each bank’s net transactions with one another and settle the difference by transferring money between the bank’s account at the clearinghouse.
There are two different institutions that manage the ACH clearinghouses: the Federal Reserve and The Clearing House. The Clearing House is a private company, made up of a consortium of large banks. If you are interested in learning why The Clearing House is the only private sector ACH clearinghouse, check out this explanation by John Petersson on Quora.
ACH transactions tend to take between 2–3 days and cost between $0.14 to $0.95. There are a couple reasons for this delay:
1) Since the ODFI does not send all their transactions in real time, there is a delay between when the transaction is filed and when the clearinghouse receives the transaction.
2) The ACH Network operates on the philosophy of good faith; banks will credit the receiver’s account before the money is actually transferred because they assume that the originating account exists, the transaction wasn’t fraudulent, and there are sufficient funds to complete the transaction. But this is not always the case. When a problem occurs, the originating financial institution has up to 24 hours to issue any reject codes regarding the transaction. Even though the receiving institution will receive funds the following day, they place the money on hold before the funds are released to the customer to ensure that there are no reject codes for the transaction. Jordan Lampe, who works at Dwolla, has outlined some other reasons why ACH payments take so long. Read his explanation here.
The ACH Network is currently developing same day ACH payments. To learn more about the future of same day ACH transactions, check this out.
Fedwire is a Real Time Gross Settlements network in the United States. Rather than sending out transactions in a batch, Fedwire settles every transaction individually in real time. All banks that hold an account at the Federal Reserve can participate in the network, but only credit/push transactions can be made via the Fedwire network.
A member bank initiates a Fedwire transaction and will send instructions to their federal reserve bank to deposit money into the receiving bank’s account at the Federal Reserve. These transactions will occur instantly.
Banks tend to charge consumers $15 for Fedwire transactions, which means that only larger value transactions are processed via Fedwire. Also, once a transaction has been processed, the transaction cannot be reversed, unlike the ACH Network.
Clearing House Interbank Payments System (CHIPS)
CHIPS is a wire transfer network similar to Fedwire. The differences are that CHIPS is owned by The Clearing House, is not real time, and is less expensive than Fedwire. CHIPS nets all the transactions at the end of the day, similar to the ACH Network.
Similar to Fedwire, transactions via the CHIPS network cannot be reversed, which is a reason why CHIPS is faster than the ACH Network.
Credit Card Network
If you are interested in learning how credit card transactions work, check out this link to Zach Perret’s answer on Quora. At the end of the transaction when the Card Issuer needs to transfer funds for the purchase to the Merchant Account, the Card Issuer will use the ACH network to transfer these funds.
Electronic Funds Transfer(EFT)
While doing research for this article, I came across a lot of references to an Electronic Funds Transfer. An EFT is any digital money transfer, which includes ATM withdrawals, direct deposits, or electronic check conversions. An EFT can use payment rails such as the ACH Network.
Interbank Networks are agreements between financial institutions that give customers of the member institution access to ATMs from any of the other financial institutions in their interbank network.
When you use an ATM, the ATM terminal will read your card number and forward this to the network host, which will forward it to your bank/card issuer. If a withdrawal is initiated, the ATM will withdraw funds from the merchant’s bank account and will later reimburse the merchant with funds from your bank account via the ACH Network.
How do Companies use these Rails?
PayPal: PayPal uses the ACH Network to transfer funds from a user’s PayPal account to their bank account and vice versa. If the user chooses to pay with their credit card through PayPal, the transaction will use the credit card network.
Venmo: If users have a Venmo balance, they can instantly send money to their friends. These transactions do not leave the Venmo platform. (The same applies for PayPal.) When the user deposits or withdraws money from their linked bank account, Venmo uses the ACH Network to process these transactions.
Robinhood: I recently choose to open a Robinhood account the other day. In order to deposit money into your account, the Robinhood app makes a debit ACH transaction to the linked bank account.
There is no payment rail in the United States that is low cost, widely adopted and instantaneous. In the UK, there is the Faster Payments network, which has all three characteristics listed above. Recently, the Federal Reserve has initiated a committee to develop a faster payments network in the United States, but an agreed upon system hasn’t been implemented. There are a few reasons that a faster payments network is needed, especially given the fact that Amazon can deliver packages faster than payments can be settled:
1) For people who do not have large savings accounts and are living paycheck to paycheck, waiting 2–3 days for money to transfer can have significant impacts.
2) Account balances can be settled in real time when a product is given to the customer. Companies don’t have to worry about shipping a product to a customer before they have been transferred the funds.
*From Richard Gendal Brown: “[When you deposit money in a bank,] it becomes one of their liabilities. That’s why we say our accounts are in credit: we have extended credit to the bank.”
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