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«July 2012 THE WORLD BANK Acknowledgements The preparation of this paper was led by the Financial Inclusion Practice of the World Bank. Lead author is ...»

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Acceptance: In general, the payee would want to accept those payment instruments that a significant proportion of the payers like to use (i.e., ―payer‘s choice‖). Some payment instruments will require the payee to have some type of deposit account with a bank or another payment service provider. In addition, for some instruments the payee will need to deploy certain infrastructure, like POS terminals and the associated telecommunications means.

Safety and reliability: The payer needs to trust that the payment instrument he has accepted will be processed as expected and the payment due to him will be honored.

This includes aspects like assured processing timelines, system uptime, non-repudiation of payment, and settlement finality.

Payment reconciliation and audit trails: A payee needs payment reconciliation information to enable proper bookkeeping. Payment audit trails are also crucial, for example when defending repudiation related claims.

How these aspects play out in the case of direct debit is discussed in the Box 2.

Box 2: The Role of Mandates in Direct Debit How characteristics of a payment instrument impact its choice – the case of direct debit.

Direct debits, usually require the payer to pre-authorize debit from his account, only after which can the payee initiated a direct debit request. This pre-authorization is commonly referred to as a ―mandate.‖ The issuance, processing, and presentment of this mandate vary across systems.

In some cases, the payer provides the mandate to the payee, and the payee, based on this, authorizes his financial institution to process a direct debit to the payers account. In many other cases, the payer and payee have to register the mandate with their respective financial institutions and the mandate is verified during every subsequent direct debit instructions issued by the payee. The requirement of mandates for direct debits makes them difficult to use for unplanned remote payments, such as for e-commerce. This limitation is also strongly influenced by the rules related to dispute resolution related to repudiation of a transaction by the payer. The proof to be produced by the payee in such situations strongly influences whether the payee will accept a direct debit payment. In addition, the lack of guarantee that the direct debit would be processed successfully, due to reasons such as lack of sufficient balance, erroneous account number, or other related reasons also could make direct debits unsuitable for e-commerce. This has been addressed successfully in some systems by moving the process of providing a mandate online and at the time of the transaction. In these systems, the payer, while transacting at the Payee‘s website, chooses to provide the mandate for the payment online at his bank‘s Internet banking website by authenticating himself using his Internet banking password. The successful recording of the mandate is also conveyed electronically to the payee including an authorization for the underlying amount. The payee then subsequently initiates a direct debit instruction.

Each of the payment instruments described earlier has its own specific set of value propositions for payers and payees. Table 1 shows the respective benefits and risks to both the payer and the payee from the use of these instruments.

The general features depicted in Table 1 may vary from country to country, especially with regard to costs. Moreover, some instruments may not be widely available or widely accepted, due, for example, to the lack of the necessary infrastructure like POS terminals.

There are many examples of this worldwide, notably in Germany, the Netherlands, Malaysia, and recently in the U.S. See Box 3.

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§ Notes: This often limits the usage for payments between trusted parties.

 This is however addressed in the systems referred to in Box 3.

 While this risk exists for other payment products as well, it is heightened in the case of innovative products, mainly because of their novelty and insufficient maturity and also because many of the issuers are non-banking institutions. This risk can however be effectively managed by instituting mechanisms like having escrow accounts.

Box 3: Enhancements to the ACH to Support Authenticated e-Commerce Transactions In the recent past, in many countries the clearing and settlement features of the ACH have been leveraged to support online e-commerce transactions as well. ACH by design are deferred settlement systems with no means for online authentication and authorization of the payer. This has generally resulted in ACH being limited to certain types of transactions like bulk payments, person-to-person transfers, and recurring payments.

The increasing popularity of Internet banking and mobile banking, has, however, been leveraged in some countries to add on an authentication and online authorization capability to traditional ACHs. A typical transaction sequence in such an arrangement is described below.

1. The payer is ready to checkout his purchases of goods/services at the payee‘s website and clicks on the available payment options.

2. One of the options could be the new payment option—ACH enabled payment.

3. The payer chooses this option and is asked to enter his bank account number and other ACH specific routing information like bank routing identification.

4. This information along with the purchase information is passed onto the additional component added to the ACH, which uses this information to re-direct the payer to the website of the payer‘s bank where he can authenticate himself and the payer responds back to the ACH component with the results of the authentication. At this stage, the rules of the ACH are modified to bind the payers‘ bank to the transaction when a successful response.

5. Based on the assurance that the payers‘ bank has verified and committed to accepting the transaction when presented for settlement, the payee completes the transaction.

6. There are two options for processing the settlement—either the payee can request his bank to process a direct debit to the payer‘s account based on the assurance received in Step 4, or the payer‘s bank can be obligated to process a credit transfer to the payee‘s bank within a specified period of time.

7. The standard ACH clearing and settlement process then kicks in.

There could be other variations where Step 4 can be concluded on a mobile phone by exchange of SMS messages, or by entering a PIN at a POS terminal etc.

Successful examples of this include the iDeal in Netherlands and proprietary bilateral arrangements of companies like Bill Desk in India. In the USA, NACHA partnered with eWise systems to provide a similar mechanism, Secure Vault Payments.

NACHA‘s ―Secure Vault Payments‖, Javelin Strategy and Research, October 2008.

This mechanism has a number of advantages: the payer can use his existing bank account and does not need a payment card; all transactions are authenticated; there are significant economies of scale as existing ACH infrastructure can be used; and this can help in spurring adoption of Internet banking as well.

II.4 Clearing and Settlement Processes in Retail Payment Systems Clearing and settlement processes are a vital component in the processing of any noncash payment instrument, either paper-based or electronic. This section describes the typical clearing and settlement models for the various payment instrument groups described earlier. While the clearing and settlement process and the flow of funds and information may be different for each payment instrument, in general terms there is a common set of participants. The payer is typically a consumer but can also be a business or a government entity. The payee is typically a merchant but can also be another consumer, a business entity or a government entity. Both the payer and the payee are represented by their financial institutions and the payment networks, and the clearinghouse plays a role in routing transactions between various parties and in determining settlement positions at specific intervals (normally daily).

Figure 2 below shows a generic clearing and settlement process for retail payments using a standard four-party model.

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Clearing and settlement process for retail payments using the standard four corner model – relevant for  cheque clearing systems (both electronic and paper), ACH networks, ATM/payment card networks.

 The flow of funds and information is different for each payment instrument, solid lines represent flow of goods/services and funds; dashed line represents flow of information.

Cheque Clearing and Settlement The typical flow starts with the payee (e.g. an individual or a business) using a cheque to pay for goods and services. The payee (e.g. another individual or a merchant) that accepted the cheque as a means of payment may opt for cashing the cheque at a branch of the payer‘s financial institution, in which case the transaction is settled with finality at that point.30 Alternatively, the payee may opt for depositing the cheque with its own financial institution for collection. For deposited cheques drawn on other financial institutions, the payee‘s financial institution sends an electronic presentment file with the required cheque data or sends the physical cheque to the clearinghouse.31 Based on the information received from or through the clearinghouse, the payer‘s financial institution sends back information to the clearinghouse on the cheques it will honor and those it will not (so-called ―return items‖) for reasons such as insufficient funds, a closed account, a stop-payment order, fraudulent signature, or failure of the paying financial institution.

All the participants of the clearinghouse send this same information to the clearinghouse, on the basis of which the clearinghouse calculates the amounts financial institutions owe to each other. Normally, these amounts will be subject to some form of netting in order to reduce the gross amounts to be exchanged through offsetting of amounts owed by/due to other financial institutions. In cases where multilateral netting is used, each financial position ends up with a single position (credit or debit) vis-à-vis all other participants in the clearinghouse.

Once all clearinghouse participants know their positions, the corresponding transfer of funds takes place. In most cases, this is done through a central settlement agent, normally the central bank.32 In a multilateral net environment, the settlement agent first debits the account of each of the clearinghouse participants with a multilateral net debit position, and then credits the account of each of the participants with a multilateral net credit position. Once the clearinghouse cycle is completed, the financial institution of the payee will make the funds available to the latter.

There are of course many variants to this basic scheme. Some of the most relevant include tiered clearinghouse participation, the cheque clearinghouse system being based on regional clearinghouses rather than on a single nationwide clearinghouse, mechanisms by which the financial institution of the payee makes the funds available to the latter before the clearing and settlement cycle is completed, etcetera.

Clearing and Settlement for EFT-based Products EFT based products use the electronic network or automated clearinghouses (ACH) for the exchange of payment instructions among financial institutions, typically on behalf of Assuming there are enough funds in the account of the payer to cover the amount of the cheque.

With electronic presentment files, financial institutions exchange the physical cheques at a later stage or do not exchange them at all (that is, the cheque is truncated at the point of deposit).

One hundred one of the 106 cheque clearing houses reported in the World Bank Global Payment Systems Survey settled in central bank money.

customers. They are typically batch-processed, value-dated electronic funds transfers between the payer‘s and payee‘s financial institutions.

The flow of an EFT debit transaction is very similar to that of a cheque cleared by means of electronic presentment files. Instead of depositing a cheque, the payee, based on a mandate received from the payer, instructs its financial institution to debit the account of the payer.33 The payee‘s financial institution routes this and other transactions in batches to the EFT network (or the ACH operator). The latter separates the transactions corresponding to each of the other participating financial institutions and re-routes them also in batches. As in the case of cheques, the financial institution of the payer sends back information on the transactions it will honor, and the rest of the clearing and settlement cycle is also similar to that of cheques.34 The clearing of a settlement of an EFT direct credit transaction is also similar, with the exception that the flow within the system is initiated by the payer. The payer submits the payment instruction to its financial institution, which verifies the availability of funds for each of the requested transactions and submits transaction data files to the EFT network or ACH operator. The transaction is then re-routed to the payee‘s financial institution, which confirms that the relevant account can be credited (e.g. account number is correct, account has not been closed, etc.). The clearing and settlement process takes place and then the funds are made available to the payee by crediting his account.

There are also several variants for this basic scheme. If both the payer and the payee hold an account at the same financial institution, then the corresponding EFT transaction will not need to undergo the interbank clearing and settlement mechanism earlier described. Moreover, in many countries electronic direct credits can also be executed through a real-time gross settlement system, in which case the funds are transferred directly from the financial institutions of the payer to that of the payee.

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