FRB: Appendix 1 to FRB Testimony, Rivlin -- The payments system -- September 16, 1997 The Federal Reserve Board eagle logo links to home page

Appendix 1 to testimony of Vice Chair Alice M. Rivlin
The payments system
Before the Subcommittee on Domestic and International Monetary Policy of the Committee on Banking and Financial Services, U.S. House of Representatives
September 16, 1997

Appendix 1
Noncash Payment Instruments Used in the United States and How Are They Processed

I. Noncash Payment Instruments
Noncash payment instruments are instructions that are authorized by the party making the payment to pay a specific sum to a receiver. The most common noncash payment instrument in the United States is the paper check. Checks are used by individuals, businesses, and governments; they are almost universally accepted; and they are convenient, familiar, and reliable.

In 1996, roughly 64 billion checks were written with a value of approximately $75 trillion. Over the last ten years, the number of checks written in the United States grew at an average annual rate of approximately 3 percent. The growth rate declined over the last five years to about 2 percent annually, which appears to be due to the rapid growth in the use of electronic payments, such as the automated clearing house (ACH), credit cards, and debit cards.

The ACH is a value-dated, nationwide electronic payment service that is typically used to process recurring payments. Both credit transactions, such as payroll, social security, pension, and vendor payments, and debit transactions, such as mortgage, insurance, and bill payments are processed over the ACH.1

Although participation in the ACH is voluntary, almost every bank in the United States receives ACH payments for its customers. The total number of ACH transactions processed in 1996 amounted to approximately 4.0 billion payments, with a value of about $12.1 trillion. During the last ten years, the volume of ACH transactions grew at an average annual rate of 15 percent.

Credit and debit cards provide consumers with a convenient method for purchasing a variety of goods and services. When a bank issues a credit card, it grants the cardholder a line of credit, enabling the cardholder to make purchases or to draw cash up to a prearranged amount. Purchases made on credit cards are billed at the end of a payment cycle and accrue interest charges if not paid in full by a specified date, while cash withdrawals generally accrue interest immediately upon withdrawal. Purchases made using a debit card are deducted directly from the cardholder's account at the issuing bank. Purchases are limited to the amount of funds in the cardholder's account. In 1995, approximately 16.9 billion payments, with a value of about $955 billion, were made using credit and debit cards. Over the past five years credit card use has been growing at an annual rate of about 7 percent. Debit cards use has been growing at a more rapid annual rate of about 48 percent, albeit from a relatively small volume base.

Large-value funds transfer systems are electronic payments systems that are used for large-value, time-critical payments. The Federal Reserve operates the Fedwire funds transfer system and the New York Clearing House operates the Clearing House Interbank Payments System (CHIPS). Fedwire funds transfers are used to make a wide variety of payments, including settlements for the purchase and sale of funds banks lend to each other overnight (fed funds), payments for securities transactions, payments to disburse loan proceeds or to repay loans, settlements for real estate transactions, and payments for other business and retail purposes. In contrast, CHIPS payments are principally used to make interbank payments for international transactions, including dollar payments resulting from foreign exchange transactions and Eurodollar placements and returns. In 1996, approximately 136 million large-value funds transfers were processed with a value of about $581 trillion. The volume of large-value funds transfers has grown at an average annual rate of almost 6 percent over the last decade.

Like the Fedwire funds transfer system, the Fedwire book-entry securities service is a real-time electronic system that is used to transfer U.S. Treasury, federal agency, and mortgage-backed securities issued by government sponsored enterprises and to effect payments for those transfers. During 1996, the Federal Reserve processed about 13.1 million book-entry securities transfers, which have grown at an average annual rate of nearly 5 percent over the last ten years.

II. Payment Processing Systems Work
Payment processing encompasses the systems and procedures that are used to authenticate a payment instruction and to effect the transfer of funds from the bank account of the person making a payment to the bank account of the receiver. The most simple case is when the person making a payment and the receiver maintain accounts at the same bank. This type of payment transaction is called an "on-us" transaction. On-us transactions are settled by posting accounting entries on the books of one bank. The clearing and settlement process is more complex when the party making the payment and the receiver maintain their deposit accounts at different banks. This type of payment is called an interbank transaction. Because of the large number of banks in the United States, the majority of non-cash payments are interbank transactions. The following provides an overview of how interbank payment transactions are cleared and settled.

Checks--As noted earlier, approximately 64 billion checks were written in the United States in 1996. About 30 to 35 percent of these checks were on-us checks and did not need to be cleared. The remaining 42 to 45 billion checks were cleared and settled through the interbank check collection market.

Interbank checks must be transported and presented to the paying bank to obtain payment. A variety of methods are used by banks to collect interbank checks. When banks receive sufficient volumes of checks drawn on an individual paying bank, they may ship the checks directly to the paying bank. In 1996, about one seventh of the interbank checks were presented directly to paying banks by collecting banks.

Banks also may choose to exchange checks at clearinghouses. There are over 150 local and regional check clearinghouses and one national clearinghouse in the United States. Banks that participate in a clearinghouse typically establish operating rules for the clearinghouse and agree to exchange checks with each other at a specified time at a designated location. In 1996, about a quarter of interbank checks were exchanged at clearinghouses.

The majority--over 60 percent--of interbank checks, however, are collected using intermediaries, such as correspondent banks and Federal Reserve Banks. In 1996, the Federal Reserve Banks collected about third of all interbank checks, and correspondent banks collected about a quarter of them.

Virtually every bank has interbank checks that it must collect each day and it determines how to collect those checks based on its processing capabilities, the prices charged by various intermediaries, and the time within which an intermediary provides access to funds collected from check deposits. At the close of the banking day, each bank sorts the interbank checks it has received. If the checks are to be presented directly to the paying bank, the checks are packaged for delivery via prearranged air or ground transportation. If the checks are to be presented to other members of a clearinghouse, a bank messenger will typically present them to other clearinghouse members at a designated time each day. Any remaining checks will be deposited for collection with an intermediary. Both correspondent banks and Federal Reserve Banks use similar procedures to process and collect checks. For example, when checks are deposited with a Federal Reserve Bank for collection, the local Federal Reserve Bank office will begin sorting the checks to local paying banks and to nonlocal Federal Reserve Bank offices. Nonlocal checks are shipped to other Federal Reserve Bank offices around the country via the Federal Reserve's Interdistrict Transportation System (ITS), which is a network composed of private air and ground couriers that operate under contracts with the Federal Reserve to ship checks.2 After all of the checks have been received and sorted, the Federal Reserve Bank office makes checks available for pickup or arranges to have them presented to the paying bank via a private courier.

Correspondent banks that present checks directly to paying banks or present them at a clearinghouse sort those checks to the individual paying banks; other checks that will be collected by an intermediary are sorted based on the requirements of the intermediary. Correspondent banks arrange with private couriers to deliver checks to paying banks for presentment or to other intermediaries for collection.

Automated Clearing House--The ACH is a fully electronic payment service. ACH transactions are transmitted via data communications networks to one of four ACH operators--the American Clearing House, the Federal Reserve, the New York Automated Clearing House Association, or Visa, U.S.A. Individual payment instructions are grouped into batches and the batches are grouped into files for transmission to an ACH operator.

ACH payment instructions are transmitted to ACH operators one or two days before the date on which the payments will be settled and are delivered to receiving institutions several times a day as they are processed. ACH processing is very similar to check processing except that the payment instructions are in electronic form, and sorted and transmitted electronically to receiving banks.

On the settlement date for ACH transactions processed by the Federal Reserve, the Federal Reserve Banks post the appropriate debit and credit entries to the accounts of sending and receiving banks. Private-sector ACH operators use the Federal Reserve Banks' net settlement service to settle the transactions that they transmit among their participants.

The Federal Reserve is the dominant provider of ACH services. Banks originate approximately 80 percent of all interbank ACH transactions through the Federal Reserve. In addition, the three private ACH service providers send another 10 percent of ACH transactions to the Federal Reserve for transmission to banks that use only the Federal Reserve's ACH service.

Credit and Debit Cards--Credit and debit card networks are electronic networks designed to provide communications links between participating merchants, banks, and the network operator. Visa and MasterCard operate the two largest credit card networks in the nation. These networks are used to transmit information between network participants.

When a consumer uses a credit card, the merchant transmits the cardholder's credit card information along with the amount of the transaction to his/her bank, which is called the acquiring bank. The acquiring bank transmits this information to the network operator used by the card-issuing bank. When the card-issuing bank receives the information from the network operator, it either approves or rejects the transaction and this response is transmitted via the network to the merchant. The merchant will then complete the sale and the card-issuing bank will bill its customer at the end of the month.

When a consumer uses a debit card, the transaction may be either offline or online. The way that offline debit card transactions are processed is similar to the way that credit card transactions are processed. The transaction information is transmitted from the merchant's acquiring bank to the network operator used by the card-issuing bank. If the transaction is authorized by the card-issuing bank, the merchant completes the sale and the amount of the purchase is debited from the cardholder's account a few days later by an ACH transaction. If the transaction is online, the cardholder enters a personal identification number (PIN) that is transmitted with the payment information through the network. If the transaction is authorized by the card-issuing bank, the merchant completes the sale and the card-issuing bank posts a debit to the cardholder's account immediately.

The settlement process for credit card and offline debit card networks are similar. At the end of the day, the acquiring bank transmits a file containing all transactions that have been authorized by its affiliated merchants to the network operator. The network operator transmits a file to each card-issuing bank containing its cardholder's transactions. The card-issuing banks use this information either to bill their credit card customers or to post debits to their debit card customers' accounts. Because a bank may be both a card issuer and an acquirer, at the end of any particular day, it may be either in a net credit or net debit position. On the settlement date, which is usually the day after the purchase date, banks that owe money initiate wire transfers to the network operator's clearing bank, which then issues wire transfers to banks that are owed money.

The settlement process for online debit card networks is somewhat different. At the end of the day, the acquiring bank creates an ACH debit file to each card-issuing bank for its cardholders' online transactions. When the acquiring bank receives funds, it credits the accounts of its merchants for the transactions.

Large-Value Funds Transfers--The Fedwire funds transfer service is, for the most part, a fully electronic service like the Federal Reserve's ACH service. Sophisticated data communications and data processing systems ensure that each transfer is authorized by the sender and that it is not altered while under the control of the Federal Reserve. Although a few banks continue to initiate Fedwire funds transfers by telephone, more than 99 percent of all Fedwire funds transfers are initiated on-line through personal or mainframe computers.

There are, however, important differences between the Fedwire funds transfer and the ACH services. The Fedwire funds transfer service is a real-time, gross settlement system in which banks initiate transactions that are final and irrevocable. Conversely, the Federal Reserve does not guarantee ACH transactions and reserves the right to revoke payments if a bank is not able to fund its obligations by the time the Federal Reserve completes posting its books on the settlement day. In addition, Fedwire funds transfers are originated as single transactions whereas ACH files contain numerous transactions destined for many receiving banks.

Unlike the Fedwire funds transfers, CHIPS transfers are not final until the end of the business day when CHIPS' participants complete the net settlement for the transfers that they have exchanged.

Nearly 61 percent of the total number of large-value transfers were processed over Fedwire, but 57 percent of the total value of these transfers were transferred over CHIPS.

Book-Entry Securities Transfers--The Federal Reserve's Fedwire book-entry securities service has two distinct components: a safekeeping component and a transfer and settlement component. Safekeeping consists of record keeping and account maintenance for depositors of securities. The transfer component permits depositors of securities to transfer ownership of the securities against payment.

Fedwire book-entry securities transfers are processed individually, in much the same way that Fedwire funds transfers are processed. Thus, the Fedwire book-entry securities service is a real-time processing service and transactions are settled immediately after they are received by the Federal Reserve. Specifically, when the Federal Reserve receives a request to transfer a security, it determines that the security is held in safekeeping for the bank requesting the transfer and electronically withdraws the security from the institution's safekeeping account. It then electronically credits any associated payment for the securities to the account of the bank requesting the transfer, deposits the book-entry security into the safekeeping account of the receiving bank, and debits that bank's account for the amount of the transaction. The Federal Reserve guarantees payments to banks sending book-entry securities transfers.

Overall, the Federal Reserve processes over 60 percent of all secondary market transfers of government securities, with the remainder processed on the books of other market participants, primarily the two major clearing banks--Chase and Bank of New York.


1 When ACH credit transactions are processed, the payor's bank sends funds to the payee's bank. When ACH debit transactions are processed, the payee's bank requests the payor's bank to send funds.

2 More detailed information on the ITS network that transports checks among Federal Reserve Bank offices is provided in Appendix 2.

Main text | Appendix 2

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Last update: September 16, 1997, 1:30 PM