Automated Clearing House (ACH) was created in the 1970s, as an electronic replacement for paper check transactions.
The checking system is one of the oldest payment systems in the US. A check is essentially a piece of paper that instructs a financial institution to pay funds from one specified account into another specified account (whether in the same or different financial institution).
Clearing Houses were established to help banks clear settle checks between each other. They facilitated the exchange of checks and calculated daily net settlement amounts per bank. The use of Clearing Houses makes checking an open loop payment system. Open loop systems, such as checking or ACH rely on intermediaries (banks, credit card networks, etc) to connect end parties (individual accounts).
In the late 1950s, magnetic ink character recognition (MICR) became widespread. This technology encodes the check number, account number, and bank routing number at the bottom of a check.
ACH became a natural extension of MICR use: it was created as a way to exchange MICR data directly, rather than extracting MICR data from paper checks.
Early ACH focused transactions that were:
- High-volume
- Low-risk
- Repetitive
Over time, ACH expanded to all US financial institutions, becoming so ubiquitous that it is not connected to every US demand deposit account. This popularity is not particularly surprising, because ACH was designed to be a low-cost utility, giving banks a profitable alternative to processing and storing paper checks.
ACH is the only payment system in the US that is capable of handling both push and pull transactions. The difference between these two types is as follows:
- Push transactions (ACH Credit): the customer initiates the transaction by pushing the money out of their account.
- Pull transactions (ACH Debit): the payee (typically a business) pulls the money out of a customer’s account by using their account and routing numbers.
In both cases, ACH works as follows:
- A bank originates the transaction. This bank is called an ODFI (Originating Depository Financial Institution). Banks send ACH entries in batches, on some predetermined schedule.
- An ACH operator (The Federal Reserve or The Clearing House) sorts the entries into deposits and payments.
- Once the entries are sorted, the ACH operator sends the relevant entries to the RDFI (Receiving Depository Financial Institution).
- The RDFI receives the entries and debits or credits its customers accordingly.
- Money is settled between the banks at the end of the day.
Since 2001, ACH payments have been available online.
In 2015, NACHA (the organization regulating the ACH network) created Same Day ACH, which would settle transactions within the same day, rather than the previously standard 2–3 working days. However, while it is a big improvement, Same Day ACH is not real-time, it still depends on batch processing.
Currently, in 2021, ACH remains the best option for low-cost payments, especially as it has become faster than the checking system it was built to replace. However, because ACH is owned by the participating banks, financial institutions can block certain kinds of transactions, forcing consumers and merchants to use alternative, more expensive payment methods.
When ACH was developed, it was imagined as a radical improvement over antiquated technology (paper checks). Today, half a century later, both ACH and checking remain among the most used payment systems in the United States. A few years ago, a new payment system — Real Time Payments (RTP) was developed, allowing for even faster electronic money transfers. As technology moves forward, so will payment systems, as consumers and businesses both want payments to be faster, cheaper, and more convenient. We are excited to see what the next phases in payment systems are going to be.
