By Ian McCue, commerce and retail reporter at Grow Wire
⏰ 8-minute read
- The foundation of today’s U.S. payments system was set up decades ago when technology was far less advanced and batch processing made sense.
- Today’s technology provides speed and convenience that has increased customer expectations for banking and financial services.
- In the U.S., the large number of financial institutions and the diversity among them make it more difficult to adopt faster payments.
Nearly every day, most people swipe a credit card or send or receive money from their bank account via ACH (Automated Clearing House) without thinking twice about how those payments are actually executed.
Payment processing is a multi-step, complex process, and it’s fundamentally changing as people use new methods to send and receive money.
PayPal, Venmo, Zelle and Apple Pay are increasingly popular methods for peer-to-peer payments and have started to move into the business sector, as well. They have not only given people more options for exchanging money but increased expectations around the speed and ease of moving funds.
Those rising expectations were a big reason why the Federal Reserve created the Faster Payments Task Force in 2015 to make recommendations about developing and supporting faster payments in the U.S. But before jumping into options in the U.S. for faster payments, it’s crucial to understand how money moves today and why it is often slow.
How ACH works
Many recurring bill payments – like those for cars, electricity and mobile phones – are processed through ACH debit. More than 90% of employees receive their paychecks today through direct deposit, which is powered by ACH credit.
The ACH Network, established and run by a not-for-profit called Nacha, began in the 1970s as a way to reduce paper checks by electronically transferring money between bank accounts and last year processed 23 billion payments.
ACH debits are more common than ACH credits, and here’s how they work:
- It starts with the biller (for example, a utilities company), who initiates the payment, sending its bank an ACH file with transaction details.
- The biller’s bank batches that ACH file with others and at the end of the day sends them to a clearing house like the Federal Reserve or The Clearing House.
- The clearing house records everything and sends the ACH file to the bank of the payer (in this example, a homeowner who gets electricity and gas through this company).
- Both banks use their settlement accounts to temporarily fund the transaction before settlement.
- Finally, the payer’s bank verifies the account information and available funds and settles the transaction if everything lines up. If not, the biller (i.e., the utilities company) receives an ACH return.
It’s important to note that the biller’s bank sends out these ACH files in batches at the end of the day and only on business days. Settlement typically takes two or three business days.
The slowness of ACH payments can be attributed to the fact that this infrastructure was set up in the 1970s and ‘80s. The American banking system went electronic before most industries, at a time when computers and telecommunications were quite expensive. So financial institutions would store up transactions and process them in batches overnight.
“The architecture of those systems has fundamentally not changed because it worked, it was efficient and if something’s not broken you tend not to fix it,” said Trevor LaFleche, senior director of product management for enterprise payments solutions at Fiserv, one of the leading providers of financial technology.
“The architecture of [ACH] has fundamentally not changed because it worked ... if something’s not broken you tend not to fix it."
How credit card payments work
Credit cards operate on their own set of payment rails and resolved some issues around certainty of payment with real-time authorization. Here’s how authorization and settlement for credit cards works:
- A shopper puts their credit card into a point of sale system, and it sends card information to the merchant’s bank.
- The merchant’s bank then routes that information to the card network, which requests authorization from the cardholder’s bank.
- The cardholder’s bank checks to make sure the shopper has enough money available and sends approval or denial back to the merchant.
- At day’s end, the merchant sends a batch of authorized transactions to its bank, which then sends the files to the card network.
- The card network will pass it on to the cardholder’s bank, which charges the account.
- Lastly, the cardholder’s bank transfers money (minus fees) to the merchant’s bank, generally settling the payment within 48 hours.
Credit card payments involve a complex -- though simplified from the original -- system of bank communications.
Falling behind a fast-moving world
One of the fundamental problems with ACH is there is no way to ensure enough money is actually in the sender’s account or all account information is accurate until it tries to settle the transaction. So it could take a few days for the biller to learn of an ACH return caused by a payer with insufficient funds or incorrect account information.
In addition, the fact that settlement takes several days poses particular challenges for businesses. If a company is a supplier for other companies who pay it via ACH, there is no guarantee of good funds. The transaction is based on trust and presents an obvious risk.
Delayed receipt of payment can create cashflow issues, as well. If a coffee shop deposits its earnings in a bank account via ACH on Tuesday but the money doesn’t show up until Thursday or Friday, the business may struggle to make payroll or have to wait to purchase supplies like more coffee beans and cups.
On the consumer side, it can be difficult to calculate a true account balance. For example, imagine a car payment is scheduled for the 15th of every month and an auto-deposit for a savings account on the 17th, but the account will not reflect those withdrawals until multiple business days after the transaction date. That makes overdrafts more common and money management generally more challenging.
Although consumers and companies have worked around these issues for many years, technology has raised the bar. Everyone can see their checking account balance or the performance of an investment account with a few taps on their smartphone.
“The best experience you have on a website or an app or a phone is really setting your expectation of what you want every service provider to be like,” LaFleche said. “If you can book a hotel halfway across the world and get confirmation instantly that a reservation has been made … or you track a package and you can pretty much watch the UPS guy walk up to your door, that’s what you also expect from a big part of your life, which is financial services.”
“If you can book a hotel halfway across the world and get confirmation instantly … that’s what you also expect from a big part of your life, which is financial services.”
Steve Ledford, senior vice president of products and strategy at The Clearing House, agrees that customer expectations are the driving force behind faster payments. But he points out that another reason real-time payments are now a focus is the current availability of improved technology that makes real-time payments possible and useful.
“Everybody has access to technology that allows them to do things instantly,” Ledford said. “That means that if we can build payments into that infrastructure, they can move more quickly too.”
As consumers increasingly make purchases instantly online, they look for the same accessibility in their finances.
Progress on faster payments
Major progress has already been made on the faster payments front, especially over the last three years (we’ll explore these efforts more in a future article). A few major initiatives that are already live include:
- The Clearing House’s RTP network: This new set of real-time payment (RTP) rails went live in 2017 and uses a “credit push” to move money and settle transactions in an average of two to three seconds.
- Nacha’s Same Day ACH: Launched in 2016, this service allows transaction files received by 2:45 p.m. ET to be processed same day, versus the typical two to three days. Today, Same Day ACH accounts for only about 1% of ACH payments.
- Visa Direct: Another credit push system, Visa Direct leverages existing debit card rails to move money between people with Visa debit cards.
- MasterCard Send: Like Visa Direct, MasterCard Send pushes money onto users’ debit cards, though it can utilize most cards, regardless of brand.
Obstacles to faster payments
It has taken the U.S. longer than many other countries to get this far for a multitude of reasons. One is that setting up a new and improved payments infrastructure in the United States is especially challenging both because of the volume of financial institutions (11,000-plus) and their decentralized nature. Banks in the U.S. range from household names, like JPMorgan Chase and Wells Fargo, to small community banks and credit unions.
In many other countries, central banks comparable to the Fed have more power over the financial industry so landmark changes are easier to implement. For example, when the United Kingdom’s Faster Payments Service started in 2008, the regulator simply mandated that financial institutions support the new system.
“The biggest obstacle is that in the U.S., adoption of faster payments methods is entirely voluntary,” Scott M. Lang, AAP chief of staff for Nacha, said. “As technology has changed the way businesses want to make payments, the industry has responded by developing and offering many faster payments options. As these options multiply, organizations seek clarity in understanding the different options.”
“The biggest obstacle is that in the U.S., adoption of faster payments methods is entirely voluntary."
Once any country sets up a new payment system and banks connect to it, the subsequent challenge – one that’s often overlooked – is making sure it’s easy for businesses and consumers to use on the front-end. To drive adoption of a new network, the user experience must be convenient and offer the protections consumers have come to expect.
“Not that it’s easy, but the easy part is the [payment] rail, connecting this bank to that bank through a central network,” said Matt Friend, vice president of global faster payments strategy at Visa. “The hard part is how do you have brand trust and secure acceptance and payment initiation infrastructure that makes it easy for people to access those rails in a way that they know they’re going to be protected, they have rights, there’s security. You’re dealing with people’s money, so it’s always extremely sensitive.”
The bottom line
The U.S. faces some unique challenges when it comes to modernizing and speeding up an aging payments system. However, there has already been much innovation around faster payments, and as these initiatives continue to gain traction, they will help provide consumers and businesses with undeniable benefits.
Stay tuned! This is part one of a three-part series on faster payments. In part two, Grow Wire will take a closer look at existing real-time payments solutions and the benefits of those.