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Table of content
Payment
Payment refers to the transfer of funds from one party (such as a person or company) to another.
2. Type of Payment Order
2.1.. Cheques
These are instruments drawn by the Payer directing the designated receiver which is mostly the Financial Institution, for payment o\f a specified amount to a third party
2.2.. Debit Card
Is a plastic card which provides an alternative payment method to cash when making purchases. Its functionality is more similar to writing a cheque as the funds are withdrawn directly from the cardholder's bank account at the Point Of Sale.
2.3.. Credit Card
Is a plastic card that does not withdraw money at the Point Of Sale. Instead, it gives the user a credit period (usually 30 to 60 days) to effect payment of the transaction amount.
2.4.. Electronic Money
Also known as electronic cash, electronic currency, digital money, digital cash or digital currency - refers to money which is exchanged electronically. Typically, this involves use of computer networks, the internet and digital stored value systems. Electronic Funds Transfer (EFT) is an example of electronic money
2.5.. Other Paper Based Instruments
Funds transfer can also be initiated as an original letter or a fax which would be received by the Payer's Financial Institution (FI). The FI creates a manual payment order based on the Payer's instruction.
All the above mentioned instructions can generate either a debit transfer or a credit transfer as per the client's requirement.
2.6.. Credit Transfers
‘ Credit transfers’ is where a large number of payments is directly credited to the bank accounts of various payees without having to issue paper instruments. This means that there is one single consolidated debit to a customer account and a large number of credits to various payees. It is used by corporate clients and institutions for repetitive payments. For example: interest (on deposits and loans) and dividend amounts (on shares and investments)
2.7.. Debit Transfer
‘Debit transfers’ are also known as ‘preauthorised transfers’ and is an efficient method of effecting periodic and repetitive payments by a 'direct debit' to the customers' accounts. This also results in placing one single consolidated credit to the account of the receiver. For example, it is used extensively in collection of electricity bills, telephone bills, loan instalments, insurance premium, club fees, etc. by the Utility Service Providers. The customer’s authority to debit his account for Utility Services is required to execute a debit transfer
3. Parties involved in executing a payment order
3.1.. Payer
The party initiating / making the payment. He is also referred to as the ‘Ordering Customer’.
3.2.. Payee
The party receiving the payment. He is also referred to as the ‘Beneficiary’.
3.3.. Ordering Institution
The financial institution (FI) that receives a payment order from the payer and executes the transfer.
3.4.. Beneficiary Institution
The financial institution with which the beneficiary holds an account.
3.5.. Intermediary Institution
If the ordering institution and the beneficiary institution do not have an account relationship, an intermediary institution is used to transfer funds between the two.
4. Types of Payment Systems
A Payment system is a mechanism facilitating transfer of funds between the payment parties i.e. payer, payee, intermediary intuitions (like banks) and regulatory bodes.
4.1.. Manual or paper based payment systems
Where payment instruments are physically exchanged after which the funds are transferred from the Payer to the Payee
Examples of paper based instruments - Demand Draft, Pay Order, Cheque etc.
4.2.. Electronic Payment System
Where payment orders are electronically transmitted and is usually settled immediately.
Examples – Telegraphic transfer, ATM etc
5. Method of receipt of Payment Instruction
The method of receiving a payment instruction is related to the type of payment system and can be broadly classified as
5.1.. Non-electronic or Paper Based Payment Instruction
This refers to instructions submitted by the customer either 'in person' or through telephone or fax.
5.2.. (^) Electronic Payment Instruction
This refers to instructions submitted by the customer through electronic means such as Internet Banking, Electronic Banking Channels or the SWIFT system
6. Basic Payment Categories
From bank’s perspective payments may be classified into various categories:
6.1.. Based on movement of funds
Outgoing Payments– Refers to payments made by a bank, from the account of the Payer (by debit to his account) to an external party.
Incoming Payments– Refers to payments received by a bank, from an external party to the credit of the Payee’s account.
Internal Payments– Refers to payments made by the Payer to the Payee, where both parties hold account with the same bank.
Redirected Payments– Refers to an incoming payment received from the Payer’s bank, which is re- directed as an outgoing payment to the Payee’s bank. That is, the bank performing this task acts as the intermediary institution.
6.2.. Based on Value of funds
Low Value payments– usually refer to low value retail payments. For example: Payment of salaries, Electricity bills and other utility payments.
High Value Payments– refers to large-value, time-critical payments which are essential to the proper functioning of the financial system. For example: Settlement of interbank money market operations.
Low Value Payments High Value Payments
7.3.. Verification of the capacity of the payer
The most important check performed by the payer’s bank (Ordering bank), prior to execution of a payment order is to ensure the availability of sufficient:
- Credit limit against the facility granted (or)
- Cash balance in the payer's account
If the credit facility or cash balance is insufficient the bank will decide whether to accept the payment by providing an overdraft facility or reject the payment depending on the value and the relationship of the customer with the bank.
The 'balance' check refers to the following:
- Value Balance: Real Time Balance or Present Time Balance. Interest is charged / credited to the account based on this balance.
- Cleared Balance: This balance includes forward debits and credits to the account. This balance shows the actual funds available for the client.
In short, Cleared Balance = Value Balance + Future value Debits and Credits.
- Book Balance: This balance includes forward debits and credits of the account plus the uncleared cheque deposits in the account.
In short, Book Balance = Cleared Balance + Uncleared Cheque Deposits.
- Available Balance: This balance is Cleared balance + Unutilised Facility Limit.
If an account does not have facility limits, Cleared Balance and Available balance will be same.
7.4.. Execution of the payment order by the ordering bank
Once the ordering bank is satisfied as regards the authenticity and the financial ability of the payer, the bank initiates and transmits the payment message to facilitate transfer of funds to the beneficiary. The payment message generally includes the following information:
- Sending bank details
- Payment type (local or cross-border)
- Receiving bank details
- Transaction Reference Number
- Value date, currency and amount
- Ordering customer details
- Beneficiary details
- Charges instructions, if applicable
- Details of payment, if applicable
The minimum information that must be contained in a payment message is governed by the bank's internal policies, regulatory bodies, clearing systems and/or SWIFT.
It is imperative for the ordering bank to perform the correct routing and follow the cut-off times of the systems used to avoid delay in execution of payments.
Straight Through Processing (STP)
When a client initiates a payment electronically with complete and correct data, the payment process takes place without any manual intervention. This is referred to as Straight Through Processing (STP). If manual intervention is required to fix the error and transmit the payment, it is referred to as Non STP.
In other words, Straight Through Processing refers to the process in which banks receive and forward payment orders on-line and process them without manual intervention.
STP benefits for the bank include:
- Reduced cost per transaction (as there is no cost of human intervention)
- Reduced Operational risk and associated errors
- Improved client satisfaction resulting from quicker execution of client instructions
STP benefits for the client include:
- Reduced cost per transaction, since the bank charges for STP is much lesser than the bank charges for Non STP
- (^) Faster transfer of funds to the beneficiary
Non-Straight Through Processing (Non STP)
Sometimes, the ordering bank's payment system cannot process the online payment orders initiated by the client as STP because of:
- (^) Errors in formatting
- Local regulatory requirements
- Client specifications (including manual payment orders)
- Insufficient funds in the account / insufficient limit
- (^) Account status being ‘Dormant’, ‘Pledged’ etc.
The process where banks need to manually intervene to fix the errors in the payment order before execution is referred to as 'Non-Straight Through Processing'. This is discouraged by banks considering the time and cost involved in the repair process and the final execution of the payment.
Fiatting
Before a payment can be executed, the account from which it is debited is checked to ensure that it is active and that it has enough balance to carry out the transaction.
When a payment order cannot be processed as straight through by the bank due to insufficient funds / limits in the payer's account or when the status of the payer's account is dormant or pledged, the payment order gets diverted to a separate error - rejection queue of the banks transaction processing system.
Such payments are subsequently either accepted or rejected by the bank's CAO (Credit Authority Officer) or the fiatteur in consultation with the CRO (Credit Risk Officer).
This process is known as Fiat.
1.. Clearing
Clearing is the method by which funds are transferred from one member bank (of the clearing system) to another.
A clearing system is defined as the process of transmitting, reconciling (matching the credit and debit amount in a bank’s ledger), and confirming payment orders prior to settlement of the same. Clearing system constitutes an integral part of the over-all payment systems.
Clearing systems vary across countries and currencies. A key consideration for any bank in the selection of a clearing partner is its ability to quickly provide efficient clearing solutions, irrespective of the country or currency.
Clearing systems follow a set of procedures through which banks present payment instruments and exchange data relating to payment orders at a single location (usually called the Clearing House).
A Clearing House is a voluntary association of banks which acts as a central location or central processing mechanism through which financial institutions agree to exchange payment instructions. Each member of the clearing house maintains an account with the clearing house that is used in the final settlement of payments. The institutions settle for items exchanged at designated times based on the rules and procedures of the Clearing House. This designated time is called the cut off time.
There are two major types of clearing systems:
- Manual clearing system – which involves physical movement of the payment instruments across the banks.
- Electronic clearing system – which involves electronic exchange of financial information across banks, based on which the final settlements are done.
7.5.. Manual Clearing System
Manual clearing systems are used to process paper based (non-electronic) payment instructions.
For example, when a client initiates the payment transaction by depositing the payment instrument in his/ her bank. The payee’s bank then manually presents the physical instrument (for example – Cheque) to the Payer’s bank. This manual or physical presentation is both an operational and legal requirement.
Processing electronic transfers through a RTGS system is expensive and is more suited for low-volume, high-value transactions. It lowers settlement risk, besides giving an accurate picture of an institution's account at any point in time.
Gross settlement exposes the bank to less credit risk than net settlement as payments are made with finality rather than being netted at the end of the day.
In a net settlement situation, there is always a chance that the other bank could go out of business during the day and then the final net payments would not be made.
Net Settlement Systems
RTGS Systems
Types of Payments
Low Value Payments High Value Payments
Advantages Low transaction costs
Relatively less liquidity needed (only the net amount needs to be transferred)
Same day settlement
Disadvantages Settlement after one or two working days System risk (errors in calculation of the net amount may lead to delays)
High transaction Costs High liquidity needed (immediate settlement requires the gross amount to be debited to the bank's account.)
8. Routing
In banking terminology, ‘routing’ refers to directing a payment to the appropriate intermediary financial institution in the beneficiary's country. Routing of payment orders is primarily determined by the place where the accounts are maintained. For this reason, banks make a distinction between:
- Local transfers via local clearing centre
- Local transfers via correspondent banks
- Cross-border transfers via correspondent banks
- Cross-border transfers via international clearing systems
3.. Local transfers via a local clearing centre
Domestic or Local transfers involve:
- Transfer of funds from the Payer to the Payee
- In the local currency
- With the destination or beneficiary account in the same country
4.. Local transfers via correspondent banks
In certain local transfers, when the payer's (ordering) bank does not have an account with the local clearing centre, it will route the payment to their correspondent requesting them to further transfer the payment to the beneficiary's bank.
5.. Cross border transfers via correspondent banks
Cross border transfer include:
- Transfer of funds from Payer's account
- In local and/or foreign currency
- To an account in another country
OR
- Transfer of funds from Payer's account
- In foreign currency
- To an account in another local bank
6.. Cross-border payments through an international clearing system
As explained earlier, cross border payments include:
- A transfer between two accounts held in different countries.
- Transfers between two accounts in the same country but in a different currency than that of the country in question
In some cases, cross border transfers are not executed via local clearing institutions or via correspondent banks but through an international clearing system
9. Charges
Banks incur a cost in executing the payment order of the client (e.g. transfer charge) and also charge a fee for the service rendered. Both these together constitute the ‘charges’ levied by the bank from its client.
Banks usually have a schedule of charges (tariff) applicable for each financial product delivered / service rendered. This tariff could be ‘standard’ (applicable for all clients) or ‘special’ (applicable only for select high net worth clients of the bank).
It is important for the payer and the beneficiary to know who is liable to pay the transaction charges. With international payments it is usual that the payer’s bank and the beneficiary’s bank charge their respective customers. If it is the intention of the payer that their bank charges are also to be borne by the beneficiary, then the payer must state this explicitly in the payment order.
The following are the ‘charges’ codes used by the payer’s (ordering) bank in international funds transfer messages, based on the instructions received from the payer:
- Charge Code: OUR - All Charges will be paid by the Payer (Ordering Customer)
- Charge Code: BEN - All Charges will be borne by the beneficiary.
- Charge Code: SHA - Charges will be shared by ordering customer and beneficiary.
10. International Bank Account Number (IBAN)
Each bank constructs the account numbers differently in each country. To combat this problem, banks in several European countries – including all EU countries – currently use the International Bank Account Number (IBAN) in order to improve the speed and efficiency of cross-border credit transfers.
The IBAN concept was developed by the European Committee for Banking Standards (ECBS) and by the International Organization for Standardization (ISO) and is an internationally agreed standard (ISO 13616:1997).
It was created as a viable and practical international bank identifier to uniquely identify the account of a customer at a financial institution. This assists with error-free cross-border payments and improves the potential for Straight Through Processing with a minimum change within domestic schemes.
13. Electronic Clearing & Settlement Systems
3.7.. US-Fedwire
Fedwire is a Real Time Gross Settlement Funds Transfer system operated by the Federal Reserve Banks that enables financial institutions to electronically transfer funds between its more than 8,900 participants.
The average daily value of transfers over the Fedwire Funds Service is approximately 2.3 trillion dollars and the daily average number of payments is about 532,000.
The Fedwire, a Federal Reserve funds transfer system, is a real-time method of transferring funds and transaction information between two financial institutions utilizing their Federal Reserve accounts.
The process typically takes only a few minutes and is final once executed. Even if the sending bank fails to settle, the Federal Reserve guarantees the funds transferred to the receiving bank.
This system is reliable, but is relatively expensive compared to cheques and ACH transactions.
3.8.. US-CHIPS
The Clearing House Interbank Payments System (CHIPS) was established in 1970 to replace the cheques used in international USD transactions between foreign and U.S. banks with electronic payments.
Any U.S. commercial bank can join CHIPS. CHIPS currently has about 60 U.S. and international bank participants and clears more than 95% of international payments made in U.S. dollars.
CHIPS is a "real-time" netting system, which allows for finality of payments at the time of their release.
CHIPS Fedwire High Value Low Value Domestic & International Payments Domestic & International Payments Less Time Critical Time Critical Netting RTGS Privately owned by FI Part of regulatory body 47 members 9000 members
3.9.. UK-CHAPS
CHAPS (Clearing House Automated Payments System), created in 1984, is a RTGS system used for urgent, high-value payments. CHAPS processes 99% of all high-value, same-day GBP transfers.
Because of its automated design, CHAPS ensures a virtually instantaneous credit to the receiving bank's account and speeds final payment to the beneficiary, and allows the system to offer same day valuation for all payments.
3.10.. UK-BACS
BACS(Bankers Automated Clearing Services) serves as an automated clearing house for the following payments:
- Direct debits
- Standing orders
- Other automated credit transfers
BACS is used for low-value, high-volume payments. Payments may be made individually or in batches.
CHAPS BACS High Value Within a day 3 working days to clear Real time High on Charges Low on Charges
7.. Europe-TARGET
TARGET (Trans-European Automated Real-time Gross settlement and Express Transfer system). TARGET provides real-time gross settlement for cross-border Euro payments. This system is relatively expensive, but the additional cost ensures same-day value. Since TARGET is a real-time system, payments will typically reach their destination within a minute or two of being debited from the sending participant's account. TARGET provides intra-day finality, as settlement is final once funds have been credited.
An important use of TARGET is to enable central banks to mobilize liquidity around Europe in order to manage monetary policy in the European Union. TARGET is similar to the Fedwire system in the U.S.
8.. Europe-EBA
EBA is an alternate settlement system to TARGET for settling Euros. The Euro Bankers Association, an association of major banks, operates a settlement system that is typically used for financial transactions. EBA is a net settlement system. At the end of the day, the net positions of EBA members must be settled via TARGET.
Basically, EUR can be cleared in any country in the Euro Zone. However, London and Frankfurt (seat of the European Central Bank) have attracted most of the EUR Clearing. In London, the Euro Banker's Association (EBA - also being the name for the Clearing) runs the EUR Clearing. The Frankfurt local EUR Clearing is called EAF (Euro Access Frankfurt), the international EUR Clearing is called ELS (Euro Link System).
For high value payments within the Euro Zone, the respective Central banks are connected via the Real- Time Gross Settlement System (RTGS) called TARGET and all payments are cleared via this system. All member states need to have a gross settlement system in place in order to minimize the risk of having to unwind the clearing because a bank became insolvent.
EBA has three sub components namely:
- EURO1 – High value payment system
- STEP1 – Commercial transaction payment system
- STEP2 – SEPA Credit Transfers payment system
9.. Europe-SEPA
SEPA (Single Euro Payments Area)
An area in which consumers, companies and other economic actors will be able to make and receive payments in euro, whether between or within national boundaries under the same basic conditions, rights and obligations, regardless of their location.
SEPA consists of:
- the single currency,
- a single set of euro payment instruments – credit transfers, direct debits and card payments,
- efficient processing infrastructures for euro payments,
- common technical standards,
- common business practices,
- a harmonised legal basis, and
- Ongoing development of new customer-oriented services.
Why is there a need for SEPA?
There has been a single market since 1992 and euros have been used since 1999, but payment services and instruments remain fragmented
The introduction of the Euro as the single currency of 12 countries of the euro area will be completed only when the Single Euro Payments Area becomes a reality.
Electronic payments, such as direct debits (commonly used for paying gas, water and electricity bills) and debit cards are increasing in popularity but often cannot be used across member states.
Due to the original domestic focus the intersection between the national payment systems is inefficient and creates higher costs for the banks.
The heavy costs of international transfer reduce the attraction of cross-border investment and trade.
Stakeholders may also be subject to different rules and requirements depending on their country of origin.
