Contemporary Bank Check Alternatives

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Department of Electrical Engineering and Computer Science

Massachusetts Institute of Technology

Cambridge, MA 02139

Contemporary Bank Check Alternatives

An AUP Final Report submitted by:

Adam T Garner


Advanced Undergraduate Project Final Report

May 16, 2003

AUP Supervisor: Professor Amar Gupta

0. Abstract

Traditional bank checks are slow, cumbersome, and expensive for all parties involved. In response, electronic alternatives have gradually emerged, that as a whole, have the capability of completely replacing bank checks. These alternatives have been met with varying levels of success. However, in the long run, bank checks will be phased out by newer, better, and cheaper ways of doing business.

Table of Contents

0. Abstract 2

1. Introduction 5

2. Funds Transfer Systems 6

2.1 ACH 6

2.2 Card-Based Transactions 7

3. Consumer-to-Consumer: Paypal 9

3.1 How It Works 9

3.2 Underlying Processes 11

3.3 Advantages and Disadvantages 12

3.4 Commercial Success Thus Far/Future Prospects 13

3.5 Similar Products 13

4. Consumer-to-Business (Recurring): Checkfree 14

4.1 How It Works 14

4.2 Underlying Technology 15

4.3 Advantages and Disadvantages 15

4.4 Commercial Success Thus Far/Future Prospects 15

4.5 Similar Products 16

5. Consumer-to-Business (one-time): Debit Card 17

5.1 How It Works 17

5.2 Underlying Technology 17

5.3 Advantages and Disadvantages 17

5.4 Commercial Success Thus Far/Future Prospects 18

5.5 Similar Products 18

6. Business-to-Consumer: Direct Deposit 19

6.1 How It Works 19

6.2 Underlying Technology 19

6.3 Advantages and Disadvantages 20

6.4 Commercial Success Thus Far/Future Prospects 20

6.5 Similar Products 20

7. Features Taxonomy 21

8. Foreign Systems 22

8.1 European GIRO 22

8.2 Bank Checks 24

9. Conclusion 26

10. References 29

Table of Figures

Figure 1. Financial Transaction Counterparty Breakdown and Designation 5

Figure 2. ACH Participants [2] 7

Figure 3. On-line Transaction Flowchart 8

Figure 4. Offline Transaction Flowchart 8

Figure 5. Paypal Account Establishment and Payment Flow [10] 10

Figure 6. Pricing for Paypal transfers [4] 11

Figure 7. Direct Deposit payment flow [9] 20

Figure 8. Volume of Funds Transfer Payments [22] 23

Figure 9. Per Capita Cheque Payments for Various Countries [22] 26

Figure 10. Transaction Times for Alternatives vs Standard Bank Checks 27

1. Introduction

Traditional bank checks are an integral part of the modern economy. They are one of the primary mediums by which individuals and organizations transfer money and pay bills. However, bank checks are extremely expensive and time consuming to deal with – both from a behind the scenes processing standpoint as well as a top-level user standpoint. From a processing standpoint, it has been estimated that each check costs society between one and five dollars to administer [25]. End-user costs vary but are significant as well. With roughly fifty billion checks written every year, this amounts to a great deal of money [25]. Efforts to ameliorate the situation have gone in a number of different directions and have focused on different aspects of the problem.

Some, public and private, have attempted to streamline the underlying process. Professors Amar Gupta and Rafael Palacios of the PROFIT Initiative at the Sloan School attempted to do so when they designed the iCheck system. This system utilized the internet as well as custom optical character recognition (OCR) and neural network technology to cut time and costs from the bank check processing procedure [1]. By transmitting digital images of checks rather than the physical checks themselves, the system is potentially able to eliminate the biggest expense associated with check processing: the cost related to physical transport of the physical check during the clearing process [5].

Other efforts, mostly private, have sought to offer commercial alternatives to bank checks. These focus on user costs and convenience but simultaneously reduce or eliminate processing costs to society as well. To this point, there has not emerged a single silver bullet alternative to bank checks in the U.S. However, as a collection, they fulfill many of the roles of traditional bank checks and can be categorized according to their focus, as follows:

  • Consumer-to-Consumer

  • Consumer-to-Business (recurring)

  • Consumer-to-Business (one-time)

  • Business-to-Consumer

  • Business-to-Business

The following sections will discuss the first four of these applications. Business-to-Business alternatives are a topic unto themselves. These encompass Financial Relationship Management (FRM), professional invoicing, and a host of other interconnected tools that are beyond the scope of this paper.

Figure 1. Financial Transaction Counterparty Breakdown and Designation

2. Funds Transfer Systems

Before alternatives for bank check are discussed, the commonly used systems by which funds are transferred will be introduced. These systems are part of the pre-existing financial infrastructure and form the underlying basis of every bank check alternative that will be discussed in this paper.

2.1 ACH

Founded in 1972 by the Special Committee on Paper Entries (SCOPE), ACH is “a processing and delivery system that provides for the distribution and settlement of electronic credit and debits among financial institutions. The ACH Network was developed in response to the astronomical growth of check payments and the many technological advances in the mid-twentieth century and functions as an efficient, electronic alternative to paper checks. Through a nationwide telecommunications network, each ACH Operator is able to communicate with other ACH Operators to exchange entries quickly and efficiently, regardless of geographic distances involved. The ACH Network offers an assortment of technical formats that can be used for a variety of payment applications, products and services. The ACH Network is governed by operating rules and guidelines, which are developed by the actual users of the system, and is administered through a series of agreements among financial institutions, customers, trading partners, and ACH operators.” [2]

In 1980, the Monetary Control Act was enacted stating that the Federal Reserve must charge enough to cover its costs as an ACH Operator. Previously, it had offered its services free of charge. Therefore, the amount that private companies are charged for ACH Network transfers can be used as an accurate gauge of the actual cost of such transfers. This amount can be used as a comparison to the amount that it typically costs for bank check processing.

Every ACH transaction has five participants:
Originator: The entity initiating the transaction. This can include individuals and any type of organization (company, government, etc.).

Originating Depository Financial Institution (ODFI): The financial institution representing the originator. This institution receives payment instructions from the originator and passes these on to the ACH Operator.

Automated Clearing House Operator: Central clearing facility operated by either the Federal Reserve Bank (FRB) or a private organization.

Receiving Depository Financial Institution (RDFI): The financial institution representing the receiver. This institution receives ACH entries from the ACH Operator and then adjusts the receiver’s accounts accordingly.

Receiver: The entity represented by the RDFI. This can include individuals and any type of organization (company, government, etc.).

Figure 2. ACH Participants [2]

Originators initiate transactions with receivers through their ODFI’s. There are two types of transactions: credit and debit. A credit transaction is one in which the originator sends a payments. A debit is a transaction in which the originator requests a payment. Generally debits are pre-authorized transactions, such as payments to an individual’s mortgage company or cable company.

Processing of ACH transactions employs a “batch processing, store-and-forward system.” [2] Thus, transaction time is not instantaneous and may take several days – typically three or four.

2.2 Card-Based Transactions

The information provided in this section is based on a phone interview with Bob Miszkiewicz, a Senior Sales Executive at First Data, a leading data processing firm.

Card-based transactions are the transactions underlying credit card, debit card, and ATM payments. There are two primary, interconnected systems by which these transactions are processed. The first is the network used for processing ATM transactions. The second is the network used for processing credit card transactions.

Debit cards employ both systems, depending on the type of transaction that is occurring. Typically, the customer is given the choice of which type of transaction in which to engage at the point-of-sale (POS). On-line debit card transactions are those that employ the ATM network to directly debit money out of the customer’s bank account. A pin number is entered at the processing terminal of the retailer in order to complete the transaction. The term, “on-line”, is used to signify the active, real-time nature of the transaction. Off-line debit card transactions are those that employ the credit card network to debit money out of the customer’s account. A customer signature is required to complete the transaction. The processing time is far longer with off-line transactions, taking approximately four days as opposed to the single day required for on-line transactions.

A description of the underlying processes is presented in the following paragraphs. First, the on-line process will be described followed by a description of the off-line process. Cumulatively, Miszkiewicz reported the average on-line transaction to cost a net amount of 20 cents while off-line transactions cost a uniform 1.70% of the transaction size.

On-line Processing

1) Customer Accesses Terminal: First, the customer accesses the nationwide card processing network through a terminal at the POS. Such a terminal is operated by a terminal processor, such as BUIPASS, and costs the retailer a base amount of approximately $175 a month to use. The customer swipes his/her debit card through the terminal which reads the information off of the magnetic strip on the back of the card. The retailer is also charged for each transaction. Three cents must be paid to BUIPASS and the retailer is charged an additional 20 cents which is paid to the customer’s bank.

2) Terminal Processor Routes Transaction: The first six digits of the card are known as the bank ID number (BIN). The terminal processor looks this number up in a BIN table in order to determine the customer’s bank. Each bank in the table has a contract with a specific electronic payment company, such as NYCE, to which transactions are routed. For a flat fee of approximately $1000 a month, each terminal processor is allowed access to each of the electronic payment company’s systems.

3) Electronic Payment Company Obtains Authorization: In this step, the electronic payment company acts as a traffic cop. It relays the transaction information to the customer bank. An example of an electronic payment company is the NYCE Corporation. For its services, the electronic payment company receives 4 cents from the retailer and 4 cents from the customer’s bank.

4) Customer Bank Authorizes Payment: The customer bank checks the customer’s account to ensure that there are sufficient funds in the account to cover the transaction. If this is indeed the case, the customer bank relays the authorization to the electronic payment company. Actual processing occurs as a batch job on a daily settlement basis in a type of ACH transaction known as a Fed Funds Wire.

Figure 3. On-line Transaction Flowchart
Off-line Processing

1) Customer Accesses Terminal: Once again, the customer accesses the nationwide card processing network through a terminal at the retail location. Fees and processes are identical except that instead of being charged 20 cents for the transaction, the retailer is charged 1.7% of the transaction size by the customer’s bank.

2) Terminal Processor Routes Transaction: The terminal processor routes the transaction to the appropriate destination – in this case, the customer’s credit card company. There are two primary credit card companies that issue debit cards: MasterCard and Visa. The two companies process transactions in an identical fashion and receive a fraction of the 1.7% service fee that is paid to the customer’s bank.

3) Credit Card Company Processes Transaction: The credit card company processes these transactions like any other transaction. This typically takes several days. However, at the end of this process, instead of the charge being added to the short-term debt of the customer, the payment amount is immediately billed to the customer’s bank account.

4) Customer Bank Executes Transaction: After receiving the transaction, the customer’s bank transfers the money to the bank account of the retailer. This occurs even if the customer does not have sufficient funds in his/her account. In this case, the customer is charged an overdraft fee and a line of credit is extended.

Figure 4. Offline Transaction Flowchart

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