Two powerful forces are pulling the U.S. banking system toward real-time payments through the nationwide automated clearing house system: banks' regulators and the evolution of digital technology.
Already, consumers, businesses and governments expect the delivery of everything – information, goods and services, and money – in real time wherever they happen to be. However, banks are deeply rooted in processing transactions in batches, which slows down payment speeds. They've built their payments operations and technology infrastructures around delayed clearing and old-school settlement of transactions.
In order to understand how to update their technology to offer real-time payments through the ACH system, banks first need to demystify a complicated topic that has led to rampant confusion.
Banks across the country and of all sizes are struggling with the concept because they handle a wide variety of payments – from paper checks to wire transfers – that require different policies and procedures. In the case of traditional ACH payments today, a bank will settle funds with another bank first, which can take some time to complete. Then, the funds are cleared to the recipient's account. The total process usually takes one to three days from the file delivery date.
[Get recognized: Applications for the 2016 FinTech Forward rankings are now open until July 25, 2016. Each year, FinTech Forward – a strategic alliance of American Banker and BAI – identifies the top 100 financial technology vendors (by revenues from financial services clients), the top 25 enterprise companies in the space, and 20 companies to watch. Apply here]
In simple terms, real-time payments models work effectively when settlement occurs more frequently throughout the day, or better yet, when settlement occurs in real time. For example, in the United Kingdom, settlement occurs four times a day for same-day payments. If a payment is initiated at 9am in the U.K., settlement occurs at 9:30am. That means the money is available to the end customer at 9:30am. In Australia, settlement occurs in near real time.
To instantly clear transactions through a centralized real-time payments system, banks will have to immediately approve payment upon receiving instructions for a transfer. For a debit transfer from a consumer checking account, the sender's bank must: Authenticate the sender, check that the sender has the funds for the transfer available in the specified account, and send a payment message to the real-time system for clearing.
That payment message will trigger the payments system to validate the payment message. The system then routes the payment to the recipient's financial institution and debits the sender's financial institution for the transferred funds in systems that offer real-time settlement. The receiving bank then validates the account number and sends a message back to the payments system to accept or reject the payment. If the payment is accepted, the receiving bank credits the funds to the recipient's account to make them available immediately. In systems with real-time settlement, the system credits the funds to the recipient's financial institution once payment is accepted, and the funds are then cleared instantly to the recipient.
This real-time payments system scenario is what The Clearing House and FIS are planning to test next year and is a proposal they have already submitted to the Federal Reserve. In this vision, The Clearing House has said banks will have to, among other things, offer 24/7 customer support in case any problems arise with a transaction and offer continuous fraud monitoring and sanction screenings. Banks may have to examine their compliance processes (such as those around anti-money-laundering) and documents (like customer agreements) to update them for real time.
However, it's not the only way banks could clear and settle payments in real time. Banks could also use blockchain-like distributed ledger technology – technology that uses distributed networks of servers to process and validate transactions, which enables cheaper processing costs than centralized mechanisms.
The most famous distributed ledger is the blockchain behind bitcoin; however, financial institutions and fintech providers are exploring how to leverage distributed ledgers for instant clearing and settlement of payments and capital markets transactions. Dwolla and Ripple – young companies that have both submitted real-time payments proposals to the Fed – leverage distributed ledgers to process transactions in real time, for instance.
Transaction processing in a distributed ledger-based system differs from systems based on central clearing mechanisms. In a distributed ledger, transactions are submitted to the network for validation before they can be added to the ledger – the official record of all previously settled transactions in the network. The entire ledger can be viewed by all participants in the network at any time, vastly improving transparency compared to a centralized clearing mechanism. In the case of a nationwide real-time payments system, the participants would likely be financial institutions, their regulators and their third-party technology partners.
In order to be submitted, a transaction would have to be cryptographically signed by the account owner. How transactions are validated once submitted differs by individual systems. Some distributed ledgers, including bitcoin's blockchain, turn the transaction messages into cryptographic hash functions – algorithms that have to be solved in order for the message to be validated by the network.
Ripple's ledger, for instance, validates transactions by sharing information about the transactions among the validating servers on its network. The servers then must agree on which transactions should be submitted to the updated ledger through a consensus process, and then compute a new ledger. Once a new version of the ledger is created, all of the validated transactions included in the new ledger are cleared and settled. Ripple estimates that new versions of the ledger are created about every five seconds.
To implement a nationwide real-time payments system based on a distributed ledger, banks and regulators would need to agree on how transactions would be validated and who would validate them. Banks would also have to determine what information about individual transactions they want to share in the transaction message that gets sent for validation and how that data will be stored securely. Whether banks and their regulators can come to a consensus on these issues will determine the feasibility of a real-time payments system in the U.S. based on distributed ledger technology.