Certification in Payment Systems Part 2

Certificate Program in Payment Systems TCS FTC (A Domain Competency Centre)
Competency V 1.1
Chapter-13 Continuous Linked Settlement

13.1 Introduction
CLS® (Continuous Linked Settlement) is a means of settling foreign exchange
transactions finally and irrevocably. CLS eliminates settlement risk, improves liquidity
management, reduces operational banking costs and improves operational efficiency
and effectiveness. This session introduces you to functioning of CLS.
13.2 Learning Objectives

After reading this session you will come to know about
Ø What give rise to foreign transaction or cross border transaction
Ø How these settlements take place to avoid any risk
Ø CLS – the intermediary of cross border forex transactions
Ø Working and functions of the CLS.
13.3 Topics Covered

Chapter-13 Continuous Linked Settlement .......................................................................................... 3
13.1 Introduction..................................................................................................................................... 3
13.2 Learning Objectives ..................................................................................................................... 3
13.3 Topics Covered............................................................................................................................... 3
13.4 About Continuous Linked Settlement ................................................................................. 5
.................................................................................................................................................................................. 5
Figure 13.1 Objectives of CLS .................................................................................................................... 5
.................................................................................................................................................................................. 5
13.5 Conventional Forex Transaction Settlement..................................................................... 5
............................................................. 6
13.6 Purpose of CLS................................................................................................................................ 6
................................ 7
13.6.1 Herstatt Risk ........................................................................................................................ 7
13.7 An Example of Multilateral Netting Settlement by CLS................................................ 8
.................................................................................................................................................................................. 8
13.8 The CLS shareholders .................................................................................................................. 9
.................................................................................................................................................................................. 9
13.9 The CLS Group of Companies Hierarchy............................................................................. 9
.... 9
Figure 13.5 CLS Group ................................................................................................................................. 9
13.9.1 CLS Group Holdings AG (CLS Group Holdings).................................................... 9
13.9.2 CLS UK Intermediate Holdings Ltd............................................................................ 9
13.9.3 CLS Bank International..................................................................................................10
13.9.4 CLS Services Ltd...............................................................................................................10
13.10 Parties Involved in the CLS Settlement.......................................................................10
................................................................................................................................................................................10
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Figure 13.6 Parties of CLS Bank...............................................................................................................10

13.10.1 Shareholders.....................................................................................................................10
13.10.2 Settlement Members.....................................................................................................11
13.10.3 User Members ..................................................................................................................11
13.10.4 Third parties ......................................................................................................................11
13.10.5 Nostro agents ...................................................................................................................11
13.11 How CLS Works .....................................................................................................................11
................................................................................................................................................................................12
13.12 The concept of Pay-In and Pay-Out..............................................................................12
13.13 A Transaction in a CLS system ........................................................................................12
................................................................................................................................................................................13
13.13.1 Submission of instructions..........................................................................................13
13.13.2 Settlement and Funding..............................................................................................13
13.13.3 Execution of trade...........................................................................................................13
13.14 The mathematics behind the settlement in a CLS system .................................14
................................................................................................................................................................................14
( Source: www.banque-france.fr)...............................................................................................................14
Figure 13.9 Processing in CLS.................................................................................................................15
..15
(Source:www.clsgroups.com) ......................................................................................................................15
Figure 13.10 Sequence of Instructions Flowing .............................................................................15
13.15 Flow of Information and the payments......................................................................16
................................................................................................................................................................................16
(Source:www.cls-groups.com).....................................................................................................................16
13.16 Risk Management in CLS...................................................................................................16
................................................................................................................................................................................18
13.17 Summary..................................................................................................................................19
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13.4 About Continuous Linked Settlement
The CLS system was launched on 9 September 2002. It is a system which is jointly held
by the large banks worldwide which are its shareholders (as of September 2007, there
are 57 member banks and 1846 third party institutions that participate in this system). It
is regulated by Federal Reserve Board of New York. CLS system acts as an intermediate
for the risk-free cross border forex transactions.
Figure 13.1 Objectives of CLS
The CLS bank deals in the following fifteen currencies. (These are banks not currencies)
Figure 13.2 Central Banks in CLS
13.5 Conventional Forex Transaction Settlement

Prior to the formation of CLS bank in 2002 the process of forex transaction would
expose participating banks to the settlement risk. We will see how with the help of an
example. Two parties, Bank A and Bank B, have struck a deal for a forex transaction in
which Bank A would sell Bank B 10 million US dollars at a rate of 1 dollar for 120 yen. To
settle the transaction, Bank A has to deliver 10 million dollars to Bank B (also known as
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Competency V 1.1
the dollar leg) and receive 1200 million yen from Bank B in exchange (also known as the
yen leg). And vice-versa, Bank B has to deliver 1200 million yen and receive 10 million
dollars from Bank A in exchange.
Figure 13.3 Dollar and Yen leg of settlement

The above figure 13.3 shows that the transaction of both legs i.e. the transaction of a
dollar and of a Yen are made through completely different channels that is through
bank A’s and B’s respective corresponding banks and inter-bank payment networks.
Hence the transaction here isn’t simultaneous as the each bank is exposed to a
settlement risk. That is the Bank A will make a final irrevocable payment of Dollar 10
million without knowing that when will it get the same amount of it in yen from the
bank B and vice-versa.
The Allsopp report defines this risk i.e. the settlement risk as “one party to a foreign
exchange transaction will pay the currency it sold but not receive the currency it
bought”.
The Allsopp Report contains analysis based on a survey of 80 banks from G10 countries
conducted in 1994 and 1995. The survey showed that the average exposure to
settlement risk in foreign exchange transactions extended over several days. This defied
the common belief that the risk stemmed solely from time zone differences and only
lasted a few hours at most, as well as the belief that the risk is incurred only by the
counterparty that has the time zone difference working “against” it.
13.6 Purpose of CLS

Ø CLS is a means of settling foreign exchange transactions finally and irrevocably
Ø It eliminates settlement risk, improves liquidity management, improves
operational efficiency and effectiveness
Ø It’s an effective cross-currency settlement process. The average daily turnover in
global FX transactions at almost US$2 trillion. It’s a process of effective risk free
settlement FX market has long needed
Ø The CLS implemented the concept of simultaneous payments by applying
multilateral netting of currencies and acting as the settlement agent
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Competency V 1.1
Ø Before the establishment of CLS, both parties of the trade paid separately. With
taking time-zone differences into consideration, the risk of one party not
meeting its obligation and hence defaulting accentuates manifolds. CLS
eliminates the temporal risk originated out of different time zone and hence
makes possible same day trading with finality
Ø Enhanced customer service by enabling them to deal with trading counter-
parties, reduce costly reconciliation, and exploit the real-time information on
currency cycling and settlement that only CLS can provide.
A QUICK VIEW OF BENEFITS OF CLS:
• Payment costs lowered due to netting of payments.
• Real-time reporting through SWIFT
• Reduced settlement risks on FX trade flows enables Straight

Through Processing of FX trades.
13.6.1 Herstatt Risk

The most well-known example of settlement risk is the failure of a small German bank,
Bankhaus Herstatt in 1974. On 26th June 1974, the firm's banking license was
withdrawn, and it was ordered into liquidation during the banking day; but after the
close of the German interbank payments system (3:30pm local time). Some of Herstatt
Bank's counterparties had irrevocably paid Deutschemarks to the bank during the day
but before the banking license was withdrawn. They had done so in good faith,
believing they would receive US dollars later in the same day in New York. But it was
only 10:30 am in New York when Herstatt's banking business was terminated. Herstatt's
New York correspondent bank suspended all outgoing US dollar payments from
Herstatt's account; leaving its counterparties fully exposed to the value of the
Deutschemarks they had paid the German bank earlier on in the day. This type of
settlement risk, in which one party in a foreign exchange trade pays out the currency it
sold but does not receive the currency it bought, is sometimes called Herstatt risk. It is
however an inappropriate term since it has materialized in other cases and under
differing circumstances. The collapse of US investment bank Drexel Burnham Lambert
in 1990, Bank of Credit and Commerce International the following year and Barings in
1995 are all excellent case study material for 'Herstatt' risk. The more appropriate name
for 'Herstatt' risk is foreign exchange settlement or cross-currency settlement risk. The
amount at risk equals the full amount of currency purchased and lasts from the time
that a payment instruction (for the currency sold) can no longer be cancelled
unilaterally until the time the currency purchased is received with finality (irrevocable
and unconditional).
Hence as it can be read that the Continuous Linked Settlement eliminates the
settlement risk from the forex transaction and hence implements the concept of
multicurrency PvP system that is payment versus payment which states Delivery-
versus-payment means that the final transfer of one asset occurs if, and only if, the final
transfer of an (other) asset(s) occurs. Assets could be monetary assets (such as foreign
exchange), securities or other financial instruments. A multi-currency DVP system
would thus eliminate Herstatt or cross-currency settlement risk.
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13.7 An Example of Multilateral Netting Settlement by CLS
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13.8 The CLS shareholders
Figure 13.4 Shareholders of CLS
13.9 The CLS Group of Companies Hierarchy
Figure 13.5 CLS Group
13.9.1 CLS Group Holdings AG (CLS Group Holdings)

CLS Group Holdings is the group holding company of CLS UK Intermediate Holdings
Ltd, CLS Bank International (CLS Bank) and CLS Services Ltd. CLS Group Holdings is a
company incorporated under the laws of Switzerland and is regulated by the Federal
Reserve as a bank holding company in the United States.
13.9.2 CLS UK Intermediate Holdings Ltd

CLS UK Intermediate Holdings is the intermediate holding company of the CLS Group
and is a limited company incorporated under the laws of England and Wales. CLS UK
Intermediate Holdings is a 'shell' company from a governance perspective and its
principal role is to provide certain corporate services to CLS Bank and its affiliated
companies (i.e. Finance, Human Resources, Audit and Communications).
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Competency V 1.1
13.9.3 CLS Bank International

CLS Bank is a unique, independent financial institution that provides payment versus
payment settlement for payment instructions arising from FX transactions in eligible
currencies. It is a wholly owned subsidiary of CLS UK Intermediate Holdings. CLS Bank is
an Edge corporation organized under the laws of the United States and regulated by
the Federal Reserve Bank of New York.
13.9.4 CLS Services Ltd

CLS Services is a limited company incorporated under laws of England and Wales. The
principal role of CLS Services is to provide effective operational and back-office support
to CLS Bank and its affiliated companies.
13.10 Parties Involved in the CLS Settlement

CLS is only available through the unique and regulated relationship between CLS Bank,
the central banks in whose currencies CLS settles, and members of CLS Bank.
The CLS process involves a number of different parties:
Ø shareholders
Ø Members - either Settlement Members or User Members
Ø Third parties.
Figure 13.6 Parties of CLS Bank
13.10.1 Shareholders
CLS Bank is owned by 71 of the world’s largest financial groups throughout the US,
Europe and Asia Pacific. They are responsible for more than half the value transferred in
the world's FX market. Five CLS shareholders alone represent over 44% of this market.
Shareholders have invested in CLS to develop CLS settlement. Each has purchased an
equal shareholding in the CLS Group of companies. Each shareholder has the exclusive
right to become a CLS Bank Settlement Member with direct access to the CLS system.
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Competency V 1.1
13.10.2 Settlement Members

A Settlement Member must be a shareholder of CLS Group and must show that they
have the financial and operational capability and sufficient liquidity to support their
financial commitments to CLS. They can each submit settlement instructions directly to
CLS Bank and receive information on the status of their instructions. Each Settlement
Member has a multi-currency account with CLS Bank, with the ability to move funds.
Settlement Members have direct access and input deals on their own behalf and on
behalf of their customers. They can provide a branded CLS service to their third-party
customers as part of their agreement with CLS Bank.
13.10.3 User Members

User Members can submit settlement instructions for themselves and their customers.
However, User Members do not have an account with CLS Bank. Instead they are
sponsored by a Settlement Member who acts on their behalf. Each instruction
submitted by a user member must be authorized by a designated Settlement Member.
The instruction is then eligible for settlement through the account Settlement
Member's account.
13.10.4 Third parties

Third parties are customers of settlement and user members and have no direct access
to CLS. Settlement or user members must handle all instructions and financial flows,
which are consolidated in CLS. The terms on which members can act on behalf of third
parties are governed by private arrangement. These do not directly involve CLS Bank
and third parties do not have any relationship with CLS Bank. Members may provide a
trademarked CLS service to their third-party customers.
13.10.5 Nostro agents

Nostro agents:
Ø receive payment instructions from Settlement Members
Ø may have multiple relationships with Settlement Members
Ø must provide time-sensitive fund transfers to Settlement Members' accounts at
CLS Bank
Ø Receive funds from CLS Bank, User Members, third parties and others for credit
to the Settlement Member account.
13.11 How CLS Works

CLS bank has several members or shareholder banks. Every member bank has its
currency account with the CLS bank. The CLS bank also holds the RTGS settlement
accounts with the respective central bank of member bank’s nation. The CLS does all
the settlement on the multilateral netting basis.
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Competency V 1.1
Figure 13.7 CLS bank is multi-currency bank
13.12 The concept of Pay-In and Pay-Out

Pay-In is an amount of a particular currency that a participating bank will supply into its
CLS bank’s multicurrency account. Hence we can say that after making a pay-in to the
CLS bank the participating bank’s position on that currency will get stronger. This
means that participating bank has surplus of the currency, in which the pay-in is made,
in its multicurrency bank account with CLS. For example bank A sells 100 dollars to
bank B in order to buy 4500 Rupees, but it doesn’t have 100 dollars in its dollar account
with the CLS then it will have a negative position of -100 after the transaction hence at a
specified time bank A will make a pay-in into its dollar account into the CLS bank.
In the same way pay-out is when the participant takes out the particular amount of
currency from its CLS account which reduces its position and hence the bank will only
do it when it has a positive position on that currency. The ability of CLS Bank to make
pay-outs in a given currency depends on the funds available in that currency on its
central bank account, which means it depends on the pay-ins received.
DID YOU KNOW?
On 13th November 2007, CLS bank International set a new record for
volume of payment instructions settled in one day. CLS Bank settled
1,140,644 payment instructions with a gross value of US $ 6.5 trillion.
Source : www.clsgroup.com
13.13 A Transaction in a CLS system

Following is an example for the transaction in a CLS system between two banks A and
B.
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Competency V 1.1
Figure 13.8 Transaction in CLS system

The bank A wants to buy 102 euros from the bank B hence for that it has to supply an
amount of 100 dollars to the bank B.
If the bank B accepts the transaction request from the bank A then following will be
entries of the transfer of funds.
Bank A’s multi-currency account:
– Debit: USD 100
– Credit: EUR 102
Bank B’s multi-currency account:
– Debit: EUR 102
– Credit: USD 100
According to figure 13.9 the settlement process works in three phases
Ø Submission of instructions
Ø Settlement and funding
Ø Execution of final trade.
13.13.1 Submission of instructions

Every bank by 06:30 submits its payment instructions to the CLS bank. Payment
instructions to the CLS bank are sent in the message format MT300 specified by the
SWIFT for the forex transactions. At 6:30, the system calculates the theoretical
multilateral net positions in each currency that would result on the participants’
account with CLS Bank after execution of all of the foreign exchange transactions
submitted for settlement on that day. Participants have to make pay-ins for currencies
in which their theoretical multilateral position is negative. For that purpose, CLS Bank
sends each participant its pay-in schedule for the day. The pay-in deadlines are 8:00,
9:00 and 10:00 for Asian Pacific currencies (yen and Australian dollar at present) and
8:00, 9:00, 10:00, 11:00 and 12:00 for the other eligible currency.
13.13.2 Settlement and Funding

Ø Commences at 07.00 CET and is scheduled to complete at 09.00 CET.
Ø Risk Management Tests applied to both Settlement Members and no settlement
is done if the bank fails in the test.
Ø Real-time exchange of currencies i.e. CLS Bank will not settle the trade unless
both parties have the required funds available.
Ø Exchange is effected with finality & irrevocability for Settlement Members over
their accounts with CLS Bank.
13.13.3 Execution of trade

The execution of trade begins as soon as the settlement members start paying their
obligations and at the end of the settlement time frame window of 5 hrs that is from
the 07:00 – 12:00 the pay-in and pay-out schedules are matched. That is the total value
of the money paid should be equivalent to the total value of the money received. CLS
doesn’t allow for the credit cover hence not a single penny will be paid if the account
balance of the participant becomes negative.
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Competency V 1.1
13.14 The mathematics behind the settlement in a CLS system
Table 13.1 Settlement under CLS System
( Source: www.banque-france.fr)
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Competency V 1.1
(Source:www.cls-groups.com)
Figure 13.9 Processing in CLS
( Source:www.clsgroups.com)
Figure 13.10 Sequence of Instructions Flowing
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Competency V 1.1
Haircut (volatility margin) applied to Settlement Member’s currency balances to

minimise credit risk for CLS Bank–
After the submission of instructions the members start paying their respective netted
obligations calculated by CLS bank. As soon as along with the payment of instruction
the execution of settlement also starts.
13.15 Flow of Information and the payments
(Source:www.cls-groups.com)
Figure 13.11 Flow of Information in CLS
The above diagram makes is clear how the payment flows in a forex transaction
through CLS. The bank A wants to have X number of euros from some other settlement
bank B. So the information flows by sending a message through SWIFT networks. The
message type used is MT300 meant for forex transactions. The CLS bank holds account
for both of the banks and hence it will transfer the equivalent amount of dollars to the
accounts of the bank B and puts the equivalent amount of euros to the account of the
bank A.
13.16 Risk Management in CLS

Following are the three risk control measures employed by CLS:
Ø A participant’s overall balance across all its currency sub-accounts must always
be positive or equal to zero.
Ø A participant’s negative position in a given currency must not exceed the limit
called the "short position limit" (SPL),
Ø The sum of a participant’s negative positions must not exceed the limit called
the "aggregate short position limit" (ASPL).
These various balances, aggregates and limits are expressed in dollar equivalents. For
this purpose, CLS updates the dollar rates of the currencies in real time using the
average bid and offered rates of ten of the most active traders in the market. In view of
the potential variations in these rates during the settlement process, a market volatility
haircut is applied to the net positions. Each participant is assigned a specific aggregate
short position limit (ASPL) that depends on its capital and its short-term rating. This
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Competency V 1.1
limit is aimed at managing counterparty risk by making sure that each participant’s
overall obligations are within limits at all times. It completes the system eligibility rules,
which require a minimum rating for participants. The short position limit (SPL) is
calculated for each currency. This limit ensures that the system can provide timely
settlement even if the participant with the largest negative position in the currency
concerned is unable to make all of its pay-ins. CLS Bank has signed contracts with a
number of credit institutions called "liquidity providers" that undertake to provide the
liquidity necessary to cover a shortfall up to the short position limit.
INSIDE / OUTSIDE SWAP service offered by CLS:
An I/O Swap comprises of two equal and opposite FX transactions that are agreed
as an intraday swap. This reduces intraday cash flows while leaving institution’s
overall FX position unchanged. It exploits the likelihood that an institution with a
large-short position in CLS will most certainly have one or more large long
positions in CLS. I/O swaps can reduce these in CLS cash positions as well as
liquidity position outside of CLS. CLS identifies potential I/O swaps notify the
participants and implement I/O swaps effectively through the CLS system
SOURCE: www. Clsgroup.com
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Competency V 1.1
Box 13.1 Failure Management Procedure (Source:www.banquefrance.fr)
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Competency V 1.1
13.17 Summary
• The CLS system was launched on 9 September 2002. It’s a system which is
jointly held by the large banks worldwide which are its shareholders.
• The CLS implemented the concept of simultaneous payments by applying
multilateral netting of currencies and acting as the settlement agent.
• CLS is only available through the unique and regulated relationship between
CLS Bank, the central banks in whose currencies CLS settles, and members of
CLS Bank.
• The CLS process involves a number of different parties:
- shareholders
- Members - either Settlement Members or User Members
- Third parties.
• CLS bank has several members or shareholder banks
• Every member bank has its currency account with the CLS bank
• The CLS bank also holds the RTGS settlement accounts with the respective
central bank of member bank’s nation
• The CLS does all the settlement on the multilateral netting basis
• Pay-In is an amount of a particular currency that a participating bank will supply
into its CLS bank’s multicurrency account
• Pay-out is when the participant takes out the particular amount of currency
from its CLS account which reduces its position and hence the bank will only do
it when it has a positive position on that currency
• Following are the three risk control measures employed by CLS:
- A participant’s overall balance across all its currency sub-accounts must
always be positive or equal to zero.
- A participant’s negative position in a given currency must not exceed the
limit called the "short position limit" (SPL),
- The sum of a participant’s negative positions must not exceed the limit
called the "aggregate short position limit" (ASPL)
• Each participant is assigned a specific aggregate short position limit (ASPL) that
depends on its capital and its short-term rating.
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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy
14.4. Introduction
The world today has turned into a global village, with faster means of communication,
shortening of distances and with increased frequency of international trade, also called
cross border trade.
With a growth rate of almost 100 percent in the past decade the total international
trade has peaked to over $10.5 trillion in the year 2005. Hence, in consideration of a
trade in goods and services rendered, payments need to be made across nations
involving different currencies.
Most cross-border trade payments are handled through correspondent banking
relationships, whereby a series of banks and domestic payment systems are typically
linked together to move funds.
Did you know?
Payments are big business. Revenues from the U.S. payments industry alone have
grown at 6% per year since 1994, topping $207 billion in 2004. In aggregate, the
payments business generates more revenues than do the airline, personal computing,
lodging, or entertainment industries.
In terms of volume, cross-border payments are estimated to represent approximately
8% of total payments. Although it is difficult to size exactly, one can indirectly estimate
the relative magnitude of cross-border payment flows by analyzing the scope of
international trade. During the past ten years, the world trade volume as measured by
total imports has roughly doubled in dollar value from $5.5 trillion in 1996 to $10.6
trillion in 2005. Correspondingly, one can surmise that the cross-border payments
related to international trade have doubled in size.
(Courtesy: Boston Consulting Group)
There are three major challenges that are incidental in implementing the mechanism of
Cross-border payments:
1. Most payment systems are governed by local laws and practices within existing
domestic banking and financial structures of the respective countries.
2. Dearth of a common global standard and variations between systems has diluted the
ability of both bank and corporate treasury/enterprise systems to seamlessly pass data
and communicate with each other.
3. Government regulations are changing how payments are made.
4. Payments are subject to domestic regulations which compound the challenges of
cross-border payments because often rules vary between an originating and receiving
country.
This we will discuss at the end of the session.
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14.5. How Cross Border Payments Work Today

Most of the world’s major banks maintain correspondent banking relationships with
local banks in each of the important financial centres of the world. This two-way link
between banks is one of many inter-bank relationships, such as nostro/vostro accounts
and the selling of cash management and treasury services to other financial institutions.
The institution providing the services is the “correspondent bank or upstream
correspondent”, while the institution buying the service is the “respondent bank or
downstream correspondent”. At least 80% of bank-to-bank cross-border payments
currently take place through traditional correspondent banking arrangements or via
intra-bank transactions.
Often banks do not separate domestic and cross-border payments, blurring the line of
demarcation in a payment flow. Global financial institutions utilize their internal
networks to clear and settle both domestic and cross-border payments. Often many
payments are bundled in a single transfer, with both domestic and international
transactions combined by currency.
Many cross-border payments are actually settled in a specific country’s domestic
settlement system.
For example, a British company making a U.S. dollar payment to a Korean company
transfers the necessary dollar amount from its U.S. correspondent bank to the Korean
company’s U.S. bank account in the U.S. If the Korean company does not maintain an
account at a bank in the U.S., the funds are transferred to the Korean company bank’s
correspondent bank in the U.S.
An example of how cross-border payments work:
Company X in the United States needs to make a payment to Company Y in Japan.
Company X requests its bank in the United States, Bank A, to send a U.S. dollar payment
to Company Y. Since Bank A does not belong to CHIPS, (Clearing House Inter bank
Payment System(CHIPS) is a bank-owned, privately-operated, real-time, multilateral
electronic payments system that transfers funds and settles transactions in U.S. dollars) it
requests its correspondent bank, Bank B, which is a member of CHIPS, to facilitate the
transfer. Bank B sends the funds transfer via CHIPS to Bank C which is also a member.
Bank C is the correspondent bank for Bank D which is where Company Y has an account
to receive funds.
The Figure 14.1 is the diagrammatical representation of the process:
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Figure 14.1 a typical example of cross border payment process

A typical cross border transaction: In the above example we saw the transaction from
the point of view of a corporate customer. Payments tend to be high-volume, lower-
value payments – such as direct deposits of payroll, dividends, annuities, vendor and
tax payments, and direct payment of utilities, loans and insurance premiums. These
types of payments are supported by the national payment systems in many countries
as a safe, reliable, efficient and cost-effective alternative to paper-based payments.
For many years, financial institutions have offered cross-border payment services to
their customers, typically utilizing proprietary correspondent banking relationships.
Over the last several years, there has been a marked increase in the amount of
international trade due in part to the emergence of trading zones such as NAFTA, as
well as the impact of the Internet, which has increased the need for a cost-effective,
highly automated method for moving lower value payments across national borders.
Additionally, the recipients of these payments are becoming increasing mobile -
working, traveling and retiring internationally. The Internet has also fueled the need for
payments to travel across borders due to the increase in investment activities and the
purchase of goods and services without respect to national boundaries. Without a cost-
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effective and efficient payments mechanism, these types of activities may not reach
their full potential.
An example of a typical cross-border consumer transaction would be a pension or
annuity payment from an employer in the United States to a beneficiary who has
relocated to the Canada. The US employer would originate a credit transaction
denominated in US dollars.
This transaction would in turn be sent to the employer’s financial institution in the
United States, which would then forward the transaction to a financial intermediary
(referred to as an Originating Gateway Operator or OGO). The OGO processes the
transaction and forwards it to a Receiving Gateway Operator (RGO) in Canada. The
foreign exchange is performed at this point by either the OGO or the RGO, depending
upon their agreement, and the file is converted to the format of the receiving country.
The RGO then forwards the transaction to the beneficiary’s financial institution, which
gives final credit to the beneficiary in Canadian dollars. If the transaction is going from
Canada to the U.S. the cycle is reversed. A typical corporate cross-border transaction
would be payment for goods or services purchased by a company in the U.S. from a
company in Canada, or vice versa.
Figure 14.2 A Typical cross border payment process
The Originator is a company or individual with the need to make payments to

or collect money from another company or individual. A contractual agreement
or authorization is established between the payer and the payee prior to the first
payment being made.
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The Originator also establishes a contract for sending payment instructions with an
Originating Depository Financial Institution.
An Originating Depository Financial Institution (“ODFI”) is the financial institution
that initiates the payment instructions between financial institutions.
The next party in the transaction flow is the Originating Gateway Operator or OGO. The
OGO is responsible for receiving payment instructions from the ODFI - with whom the
OGO has an existing relationship - and forwarding the instructions in a timely fashion to
the next participant in the payment flow, the Receiving Gateway Operator or RGO. The
format mapping and translation, foreign exchange conversion and inter-gateway
settlement for the entry occur in accordance with the agreement between the OGO and
RGO.
A Receiving Depository Financial Institution (“RDFI”) is the financial institution that
receives the payment instructions from the RGO. The RDFI is responsible for settlement
and posting of the transaction to the Receiver. Its liability is the same for a cross-border
transaction as it is for any other automated clearing house transaction processed within
its national payment systems rules.
The Receiver is a company or individual to whom a transaction has been sent. The
Receiver is bound by the rules and regulations of its national payment system as they
apply to any domestic transaction.
14.6. Cross Border Payments Environment
14.6.1 Agreements
There must be an agreement in place between the gateway operators covering:
1. Adherence to the Cross Border Payment Operating Rules
2. Foreign exchange conversion
3. Technical and operational responsibilities
4. Settlement
5. Definition of a commercially reasonable time frame
Agreements are also required between the Originator and ODFI and the ODFI and the
OGO.
14.6.2 Transmission of Payments

When payments are transmitted from the Originator to the ODFI, and from the ODFI to
the OGO, they are subject to the requirements, rules and regulations of that country’s
national payment system. The foreign exchange conversion, format conversion and
settlement that take place between the OGO and RGO are subject to the Cross Border
Payment Operating Rules and the agreement in place between the two Gateway
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Operators. The RDFI and Receiver are subject to the requirements, rules and
regulations of that country’s national payment system.
14.6.3 Settlement
Settlement takes place between each of the participants in the cross-border payment
transaction and is governed by the national payments system rules of the participating
countries. The Cross Border Payment Operating Rules place additional responsibility on
the gateway operators. The OGO warrants to the RGO that settlement is final and the
RGO warrants to the RDFI (in the receiving country) that settlement from the OGO is
final. Gateway Operators assume additional risk if they transfer payments prior to
settlement finality, as they will be liable for those payments in the event that settlement
is revoked. Settlement is irrevocable between Gateway Operators once funding has
occurred.
14.6.4 Foreign Exchange

The foreign exchange component of cross-border payments is stipulated in the
agreements that are established between the various participants. Three foreign
exchange scenarios exist:
• Fixed to Variable
Fixed origination currency amount to variable receiving currency amount – The
Originator initiates a payment in their country’s currency, the payment undergoes a
foreign exchange conversion, and the Receiver’s payment is in its country’s currency.
• Variable to Fixed
Variable origination currency amount to fixed receiving currency amount – The
Originator initiates a payment based on a specific foreign exchange rate for payment to
the Receiver’s account in their country’s currency.
• Fixed to Fixed
Fixed origination currency amount to fixed receiving currency amount – Both the
payment from the Originator and the payment to the Receiver are in the same currency.
14.6.5 Cross Border Payment Technical Standards

Cross-border payments should be transmitted using certain technical standards so that
cross-border transactions are readily identified by financial institutions so that they may
apply special handling requirements for cross-border payments, as appropriate. These
formats also enable participants to transmit and receive detailed information that is
unique to cross-border payments, such as:
1. Information relating to foreign exchange
2. Origination and destination currencies
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3. Destination country
4. Identifiers for consumer and corporate payments
5. Identification of foreign receiving DFI
6. Foreign payment amount
7. Foreign trace number
8. Foreign Receiver’s account number
14.6.6 Risk Management

Originators and ODFI’s should be aware that the rights and privileges of the RDFI and
Receiver in the receiving (foreign) country are applicable to the transaction. This may
have an impact on authorizations, time frames allowed for returning items and other
handling of exception items such as incorrect account numbers, payments made in
error, etc. The Originator and the ODFI should fully understand the payment system
rules environment of the countries to which they will be sending payments.
Foreign exchange on cross-border payments creates an area of risk not present in
domestic payments. There may be foreign exchange fluctuation on return items,
leading to a return amount that differs from the amount input. There may be items that
are processed in error or duplicate items. The ODFI needs to understand the foreign
exchange risks and should address how they will be handled in its agreement with the
Originator.
The role of Gateway Operator brings a new participant to the typical flow of payments
that stay within a country’s domestic payment system. The Gateway Operator needs to
be aware of the same foreign exchange impacts as the ODFI and should cover the
handling of the associated risk in their agreements with each other and with the
financial institutions for which they are processing.
14.7. Cross Border Payments Models
14.7.1 Origination Model

The Originator must utilize an ODFI for origination of cross-border payments. The ODFI
may also be acting as the OGO. In the processing flow diagrams that follow, the ODFI
and the OGO are shown as two separate entities. In the cases where the ODFI is also the
OGO, items may be transferred cross-border with a reduced cycle time because the
payments need not be submitted through the national payments system of the
Originator’s country.
It is assumed that all items are processed according to the rules, requirements and
timing criteria as dictated by the originating country’s national payments system and
are formatted according to the specifications. Settlement finality for the entries in the
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originating country’s payments system is warranted by the OGO to the RGO upon
funding of the entries to the RGO.
14.7.2 Receiving Model

Cross-border entries destined to a Receiver’s account with an RDFI that is not also
acting as the RGO flow through the receiving country’s national payments system as
depicted in the process flow diagrams. The entries are processed according to the
rules, requirements and timing as dictated by the national payments system of the
receiving country. When the RDFI is also functioning as the RGO, the cycle time for the
processing of the payment may be reduced due to the entries not being submitted
through the receiving country’s national payments system.
14.8. Case Studies
14.8.1 Case Study 1 – Credit Origination with Variable Amount and Return
(Variable to Fixed transaction)
In this case study, a US company is sending weekly payroll entries to its salaried
employees in Canada. The payment amount must always be the same Canadian dollar
value every week, so the US dollar amount will vary depending on the foreign exchange
rate.
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Figure 14.3 Process Flow Diagram

The company has decided to make cross-border payment to:
1) achieve a better foreign exchange rate for their employees by leveraging multiple
payments rather than having each employee encash their checks individually,
2) reduce the delivery timeframe, and
3) eliminate the need for their employees to visit their financial institutions to cash their
paychecks.
The payroll entry is originated as a variable-to-fixed credit transaction of CAD 1000 and
the payment passes through the system. The employee’s Canadian account is credited
with CAD 1000 and the employer’s USD account is debited for USD 670 based on a 0.67
CAD-USD exchange rate.
In this instance, the Canadian employee’s bank account has been closed, and the RDFI
returns the CAD 1000 payment to the Gateway Operator. The Gateway Operator then
converts back to the standard format, performs the foreign exchange, and forwards the
returned payment to the US Gateway Operator as USD 680 (because of exchange rate
fluctuations, the amount actually credited back to the employer’s account may be
different than the original amount). Normally, two transactions will be originated back
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to the employer’s account, one for the exact original dollar amount (for easier
reconciliation with the original payment), and a second entry to offset the foreign
exchange fluctuation (whether credit or debit).
14.8.2 Case Study 2 – Debit Origination for Collections

(Fixed to Variable transaction)
In this example, a US insurance company collecting insurance premiums from Canada
needs to have the funds credited to its US account without the hassle of managing
paper check collections. As the Canadian customers will be paying their premiums in
CAD, this will mean that a variable amount of USD will be credited to the insurance
company’s account.
A fixed-to-variable PBR debit entry is initiated for CAD 120 and passes through the
system. Upon receipt, the RGO issues a domestic Canadian debit for CAD 120 to the
customer’s account, and the insurance company is credited with USD 80.40 – with the
timing of that credit (i.e. before or after the debit is finalized in Canada) dependent
upon the agreements between the various parties.
14.9. The Global Payment System

There is a growing interdependence of national payment systems, arising from the
needs of international trade and finance, and increasingly evident in terms of foreign
participation in domestic payment systems and in domestic financial markets generally.
There is, in effect, a global payment system.
One of the best illustrations of these interdependencies is provided by the foreign
exchange market. Unlike some financial markets, the foreign exchange market has no
single location. Traders operate in different centers around the world, dealing with each
other both within individual centers and between different centers. Settlement of a
foreign exchange deal (two business days after the deal date in the case of a ‘spot’ deal)
will involve two payments, one in each of the currencies being traded. Thus, using the
example in figure above, to settle a US dollar/Yen deal agreed by two banks in London
requires that each of the banks send a message (usually via the SWIFT- an international
telecommunications network) to their correspondent in the country where they have to
deliver the yen or the dollars, instructing those correspondents to arrange delivery of
the relevant currency. The influence of the world-wide foreign market on turnover in
high-value payment systems is substantial: for the most heavily traded currencies,
payments related to foreign exchange settlement can account for as much as 50% by
value of the daily turnover. Large fluctuations in market activity will thus feed through
(after a two-day lag in the case of spot trades) to the relevant payment systems, and are
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Figure 14.4 Global Payment Systems

capable of putting pressure on the operational and liquidity management capabilities
of those systems. By the same token, a serious disruption in a national payment system,
which resulted in the failure of trades in overseas market centers to settle, could have a
serious impact on confidence in those markets.
14.10. Developing the Business Case for Cross-Border Payments

Origination
14.10.1 Major Drivers of Decision

The business case for origination of cross-border payments is driven by the market
demand for the application. On the corporate side the globalization of the economy is
leading to greater foreign trade activity and increasing the need for companies to make
more - or to begin to make more - international corporate payments. On the consumer
side, as more employees and pensioners are located in (or retire to) foreign countries,
they are expecting to receive their payments in an efficient manner and with certainty
of payment.
The primary features a cross-border payment system must have to be an attractive
option to the Originator are:
1) It needs to be less costly than their current method or other available
methods
2) There needs to be certainty and finality of payment
3) It must be easy to use
4) It must be timely.
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14.11. Cross Border Payment Challenges

1) Inadequate domestic infrastructure – For past few decades many nations
have developed their own large and small value funds transfer systems in
accordance with their own nation specific requirements, hence these systems
are very independent and there is a clear lack of standardization and
automation in inter-bank and intra-bank networks. This adversely affects banks
and businesses alike and results often in manual intervention to collect and
repair data. The current methods of funds transfer across the border are very
inefficient and costly in which the funds are transferred bilaterally, the use of
non-standard customer interfaces, incompatible formats between domestic and
foreign banks, and the low degree of automation in banks’ internal systems.
2) No common message standards – Currently the rates of Straight through
Processing (STP) is very high means the manual intervention and the paper
processing is very high in the current systems. For the reduction of that manual
intervention more and more payment instructions and settlement should be
done electronically with common protocols which are internationally
recognized.
3) Impact of regulatory requirements - The complex governance structures of
these disparate payment systems – some public, some private, some operated
as industry associations – only add to the challenge. Achieving coordinated
change at an industry level is nearly impossible without government mandates.
However, when government mandates occur, they tend to focus more on
responding to crises (or preventing crises) than on promoting efficiency.
14.12. Benefits of the Cross-Border Payment System

This system drives access to cross-border e-payments universal and offers several other
advantages:
* Financial institutions of all sizes may offer cross-border payment origination services
to their business customers
* Batches can contain any mixture of domestic and cross-border transactions, allowing
processes to remain streamlined
* Participating companies benefit from the improved reliability, stability and efficiency
of the existing national payments systems that are part of the process.
14.13. Trends in Cross-Border Payments

• Growth of transnational payment systems – Apart from the domestic
payment system now there is a profound growth and newer developments
in the transnational payments systems such as CLS (Continuous Linked
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Settlement) and TARGET. Moreover in the card systems there are giants like
Visa and MasterCard which are global. Another thing that can be observed is
in countries like Switzerland and Hong Kong, new arrangements have been
developed for the settlement of local payments in foreign currency. These
arrangements neither fit perfectly in the traditional category of
“correspondent banking” or in that of “payment systems”. The main
common characteristic of these arrangements or systems is that they do not
settle in central bank money but across accounts held with a commercial
bank and that they are based on clearly defined and transparent rules for
payment activities. There are other transnational systems like Swiss Euro
Clearing Bank (SECB) developed by Swiss financial institutions established as
a cross-border solution in order to facilitate their cash management in
euros. In Hong Kong, the U.S. dollar and Euro clearing systems, USD CHATS
(Clearing House Automated Transfer System) and Euro CHATS, were
introduced in 2000 and 2003, respectively. They enhance the safety and
efficiency of settling these foreign currencies in the local time zone The
growth in transnational systems can improve the efficiency of cross-border
payments by reducing clearing and settlement times, minimizing float.
Better visibility of funds flows supports improved cash forecasting. Finally,
standardized formats will reduce costly errors and repairs.
• Government-led initiatives and mandates are increasing – To prevent
the issues like money laundering and financial terrorism the central banks
and government is taking up new initiatives. One of the initiatives is Single
Euro Payments Area (SEPA). Government-led initiatives are focusing on the
reduction of costs to the end-users, adoption of common payment
standards, and reducing the ability of payment systems to be used for illegal
means. Ultimately, this will translate into higher costs for banks that provide
cross-border services. However, this leads to revenue opportunities for
those banks that provide services to other banks.
• Risk and liquidity usage are being closely managed - More premium is
now being put on striking a balance between the above two. The exposure
to credit risk is increased if payments are delayed but also for the payer its
liquidity costs decrease but on the other hand when the payments are made
immediately with more liquidity in the system the risks are reduces but cost
of making the payment increases for the payer.
• Multinational banks and corporations are expanding – The trend of
consolidation in the banking sector is becoming a great force. Mergers and
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Acquisitions are becoming big headlines. For example, we have witnessed

the emergence of mega banks such as the merging of Bank of America and
Nations Bank, as well as JP Morgan Chase merging with Chase Manhattan
Bank.
• Operational efficiencies are being sought through outsourcing – The
financial institutions like banks are concentrating more on customers and
the marketing functions. Their paradigm is becoming service oriented and
hence the back office tasks are being outsourced now. Banks have
increasing recourse to such entities, allowing banks to specialize in the
“sales function” (covering direct relations with clients, including account
holding) while outsourcing “production function” such as the processing of
payments and securities.
14.14. Summary
• Many cross-border payments are actually settled in a specific country’s
domestic settlement system.
• Cross-border payments should be transmitted using certain technical standards
so that cross-border transactions are readily identified by financial institutions
so that they may apply special handling requirements for cross-border
payments, as appropriate.
• There must be an agreement in place between the gateway operators in cross-
border payment covering:
o Adherence to the Cross Border Payment Operating Rules
o Foreign exchange conversion
o Technical and operational responsibilities
o Settlement
o Definition of a commercially reasonable time frame.
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15.14. SEPA Cards Framework ..................................................................................................... 23

15.14.1 The Deliverables from SEPA Cards Framework (SCF)........................................ 24
15.14.2 Various Roles within the Card Framework ....................................................... 25
15.15. The Single Euro Cash Area Framework (SECA)........................................................ 27
15.16. Roles and Responsibilities for SEPA Implementation .......................................... 28
15.16.1 The Role of the EC (European Commission)..................................................... 28
15.16.2 The Role of the ECB [European Central Bank] and the Eurosystem..... 29
15.16.3 Role of the EPC .............................................................................................................. 29
15.16.4 Role of banks .................................................................................................................. 30
15.16.5 Role of public authorities ......................................................................................... 30
15.16.6 Role of users of payment services ........................................................................ 31
15.16.7 Role of Payment Infrastructure Providers ........................................................ 31
15.16.8 Role of the payments supplier sector................................................................. 31
15.17. Potential Impacts and Opportunities for Banks ..................................................... 32
15.18. Summary ................................................................................................................................. 33
15.4. Introduction
As economies have grown and incomes have increased, consumers and companies
have demanded more convenient electronic ways of paying for goods at the point of
sale as well as settling bills remotely from home. To provide customers with a more
convenient way to make payments, SEPA [Single European Payments Area] has been
introduced where the people will be able to make payments in Euros whether in
Europe or outside the national boundaries under the same basic conditions, rights and
obligations, regardless of their location.
SEPA is currently defined to consist of the EU 25 Member States plus Iceland,
Liechtenstein, Norway and Switzerland. The very essence of SEPA is to eliminate these
borders and create a Single Euro Payments Area.
15.5. Vision of SEPA

SEPA project dates back to 1990 when European Commission published report
“Making Payments in the Internal Market” which outlined a vision of a single payments
area stating “the full benefits of the single market will only be achieved if it is possible
for business and individuals to transfer money as rapidly, reliably and cheaply from one
part of the community to another as now is the case with (in) most Member States”. In
the year 1999, Economic & Monetary Union (EMU) developed the concept of integrated
European markets for goods and services which could be realized through SEPA. The
EPC’s [European Payments Council] vision of SEPA reflects those of the EC [European
Commission} and the ECB {European Central Bank} and is summarized as follows:
“SEPA will be the area where citizens, companies and other economic actors will be able
to make and receive payments in Euro, within Europe, whether between or within
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national boundaries under the same basic conditions, rights and obligations, regardless
of their location.”
SEPA will have following impact
• All electronic payments will be impacted and as a result, credit transfers,
direct Debits and card payments will migrate to common interoperable
formats and process
• The system will be more efficient with tangible benefits for the economy and
society as a whole.
• Impact on the fragmented national payments instruments with the
implementation of new, common business rules and technical standards
• Euro will be systemically strengthened as a currency by being underpinned
with an integrated payments environment
• It will also generate through harmonization more efficient payment systems
with tangible benefits for the economy and society as a whole.
15.6. Scope of SEPA

There is a priority implementation focus on the Euro area, currently 12 countries (13
from January 2007), and the change programmed will radically impact their whole
domestic payments environment. Within Europe, outside the Euro area, there will be
opportunities to participate in Euro Payment Systems, and communities will be able to
adopt SEPA standards and practices to contribute to the Single Market for Payment
Services. The vast majority of banks throughout SEPA active in making and receiving
Euro payments are expected to participate in the SEPA Schemes and issue.
15.7. Payments landscape after SEPA

The following Figure 15.1 shows the difference between present and future after
implementation of SEPA
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Figure 15.1 Future after SEPA (source: European Payment Council)

The Euro area alone currently processes some 50 billion electronic retail transactions
and between two to four times in cash each year. This volume is generated by 310
million citizens, 16 18 million large and small corporate, 7,000 8,000 banks, 4.5
million points of sale and 240,000 ATMs.
Given the size of the market, the costs of bank migration will be very substantial;
however long-term efficiency gains will eventually more than offset the initial outlay.
SEPA will impact euro payments made within its geographic area. Currently there is a
priority implementation focus on euro area (13 countries) and the change will radically
impact the whole domestic payment environment.
15.8. SEPA Programme

The SEPA programme has been initiated by 3 main European bodies – the European
Commission, the European Central Bank, and the European Payment Council.
The three European Bodies as shown in the Figure 15.2, laid down the programme of
SEPA
a) The European Commission (EC): The overall initiative is steered by the European
Commission (EC). European Commission published Payment Services Directive (PSD) in
December 2005 which was designed to harmonise and remove legal barriers for
payments throughout the European Union (not just the Euro area).
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Figure 15.2 Pillars of SEPA (Source: European Payments Council)

The reason was that EC recognized that a single payments market would only be
possible within a common legal framework that would remove the local anomalies and
differences.
b) European Central Bank (ECB): ECB has developed guidance on SEPA requirements
and set the implementation timelines to ensure an efficient and orderly payments
market in the Euro area. The ECB has issued several reports between 1999 and 2003
to guide the creation of a common Euro area payments market. The ECB fully expects
the launch of SEPA instruments in 2008 and considers that most of the SEPA objectives
can be implemented by the (end of) 2010.
c) European Payment Council: EPC founded in 2002 has responsibility for designing
the new SEPA payment instruments. The EPC has the role of designing and specifying
the core common services which will operate within a single European payments
market place. It also provides guidance and co-ordination to enable the development
of SEPA standards; it identifies and synthesizes best practice in the payments industry
and supports and monitors the implementation of SEPA.
15.9. SEPA-Rulebooks, Implementation and Migration

For SEPA development, EPC has covered two different approaches, which are
complementary to each other.
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1. For Electronic Transfer Schemes (ETS) a “replacement” strategy has been chosen with
new common credit transfer and direct debit schemes for the overall SEPA.
2. For the highly complex cards business, the strategy has been that of “adaptation” of
existing schemes to a new set of business and technical standards.
These two approaches have core feature of different infrastructure for the scheme they
follow.
Here the Scheme could be defined as Credit transfer, debit transfer and card strategy
whereas, Infrastructure could be, the layer comprising of different networks, clearing
and settlement houses. Rulebooks for each of the scheme have been defined
comprising of different standards, rules and obligations.
15.9.1 Timeline & Implementation of SEPA

The EPC, working with the ECB, has drawn up a timeline based upon three deliverable
phases:
1. Design and preparation;
2. Implementation and deployment and
3. Co-existence and gradual migration.
From 2008, the three SEPA payment instruments (credit transfers, direct debits
,cards) will operate alongside existing national processes, with full migration achieved
from the end of 2010 onwards. After the evolution of credit transfer, debit transfer
and card framework no national credit or debit or card framework will be used. SEPA
will be successfully implemented on a solid organizational structure within which all
the players and stakeholders know their duties and can execute their responsibilities.
The Implementation of SEPA will be in following phases
Phase 1 – Design and Preparation involves the design of the two new ETS and the
Cards Framework during 2005. 2006 will focus on the development of standards and
the specification of the technical detail and security.
Phase 2 – Implementation and Deployment overlaps standards and specification with
implementation, piloting and launch by the end of 2007 for the two new ETS.
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Figure 15.3 Timeline of Implementation (Source: European Payment Council)
Phase 3 – Co-existence and Migration will be a transitional period in which there will
be a co-existence of national and SEPA schemes and a gradual migration to the latter
from January 2008 to end 2010 and beyond.
15.10. SEPA End -User Experience

SEPA will have an impact on the users who make their payments in Europe or are the
citizen of Europe. Implementation of SEPA involves a set of complex changes to
payments, commercial practices and infrastructures. Its impact on the day to day
lives of consumers, merchants and corporate within SEPA and the EU is discussed
below with practical applications.
15.10.1 Citizen Europe

• All banks will be able to offer accounts that are usable in all SEPA countries.
• When spending in other countries, citizens can feel more secure, carry less cash
and be less reliant on local ATMs.
• Home country payment card will be accepted for payments in any SEPA
country and they will receive full details of any merchant currency conversion
charges across SEPA.
• Sending money within SEPA to family and friends will be simplified with
uniform processes, rules and account codes and transparent fee structures with
no deductions from the transferred amount.
• Harmonization of Direct debits within SEPA and common processes adopted
for mandate set up, first payments and standing data changes, improving the
service for regular bills payment.
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• Salary payments and credits to the current account will have predictable
posting dates.
• New and common legal framework applied for refunds, disputes and
complaints.
The difference experienced by the citizen could be seen in Table 15.1.
15.10.2 European Mobile Citizens

People participate in programs to obtain work experience and to study in other
countries. Usually these people often find it difficult to use a home based bank to
support payments in other country. Same is the case with home country payment
cards. Money transfers direct to family and relatives at home, or to home banks, is
expensive and takes time to reach their destination. The Table 15.2 below describes
the additional benefits SEPA will offer to the “European Mobile Citizen”.
15.10.3 Small and Medium sized European merchant

SEPA will impact small and medium European merchant’s approach to card
acceptance and the services they receive from their banks.
• With the introduction of SEPA, domestic market specific practices will become
more consistent. Card schemes will move to more standardised approaches.
• Card acceptance-net will be widened, which will enable domestic only
payment brands to be supported by all terminals across the EU.
• All SEPA approved cards will be chip based (i.e. the magnetic stripe will not be
SEPA compliant) and will be authenticated using PIN.
• By moving to common standards SEPA will open up the market for acquiring
services leading to increased choice of providers and the development of
many new products and services.
15.10.4 Large European merchants

• Large retailers will experience significant benefits through lower processing
costs as a result of a common Euro area wide cash repositioning strategy.
• Large merchants will see significant savings in terminal costs and POS {Point
of Sale} processes and infrastructures as a result of a single SEPA software
application, the removal of multiple terminals and the introduction of
common terminal to host standards.
• Under SEPA Europe’s largest merchants with multi country operations will
also obtain additional improvements over and above those of smaller players.
• Cross-border business expansion will no longer be constrained.
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Table15.1Today/Tomorrow-SEPACitizenofEurope
( Source: European Payment Council)
Page 11 of 35
Table 15.2 Today/Tomorrow- SEPA Europe Mobile Citizen
(Source: European Payment Council)
15.10.5 Small and medium sized European corporate

• SEPA will also impact small and medium sized corporate enterprises,
particularly those that trade cross border.
• Under SEPA small businesses will have greater confidence when trading cross-
border as a result of the implementation of Payment Services Directive (PSD) as
its consistent legal framework for payments will introduce much improved
certainty and clarity.
• SEPA wide transfers to pay for sales and purchases will become more efficient
through the implementation of a harmonized timeframe, reaching any account
within SEPA.
• A common SEPA wide full reach direct debit service will be introduced with a
common IBAN/BIC account codes and an electronic mandate processing feature
with the potential to dematerialise paper records thus reducing back office
costs.
• SEPA will open up the market for payments, offering smaller enterprises greater
choice of payment products, encourage innovation and new product offerings.
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15.10.6 Large European Corporate and Public Administrations

Large corporations that operate across Europe want business to business (B2B)
payment instruments to collect revenues from customers and to pay suppliers for
goods and services. These companies work closely with their banks to build highly
efficient payments processes in their domestic markets.
• A major benefit will be one single process for all incoming and outgoing
payments, both national and cross border.
• SEPA will offer opportunity for harmonised, guaranteed, and secure remittance
information across Europe will be a major benefit for both invoicing and
reconciliation. Standard, harmonised Scheme Rulebooks for direct debits and
credit transfer, plus consistent PSD legal framework for exception processing,
will improve efficiency and reduce back office reconciliation costs.
• Corporate with operations in several countries will be able to create (and
receive) a single aggregated file for all payments (domestic and cross border)
and submit these to a single institution within standard clearing and settlement
timeframes. There will no longer be a need for multiple files prepared to
different standards. Common file standards will apply to all payments (and the
use of IBAN [International Bank Account number]) resulting in fewer exceptions
and higher STP.
• The number of banking relationships for effecting and receiving payments can
be consolidated. Banks will offer extended reach and support SEPA wide
operations, reducing administration costs and improving efficiency.
• Entities with large volumes of direct debits and credit transfers will be able to
shop around for banks able to clear and settle at best service, and lowest costs,
inclusive of additional bank services, in any country.
• The new standard for pan European direct debits will offer a much-improved
service for corporate wishing to receive payments from customers working or
living across Europe. The new standard for SEPA Euro credit transfers will enable
predictable transfer times throughout SEPA, again improving the service to
corporate customers.
• SEPA will deliver similar benefits to governments and public administrations,
utilities and other organisations that make substantial payments within national
and pan European markets.
• Services to citizens will be enhanced and pensions, social security and other
benefits paid within a clear timeframe to a best practice standard.
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15.10.7 Large European Merchants

Europe’s largest merchants face significant problems in developing common internal
systems and processes for their operations in European markets. Many large super-
market chains have internal systems that are specific to each country and, in addition,
cannot benefit from economies of scale and the pooling of transactions. As shown in
Figure 15.4 largest merchants of Europe with multi-country operations will also
obtain additional improvements over and above those of smaller players under SEPA.
• The most significant is the use of a single internal ePOS [Electronic Point of
Sale]/EftPos [Electronic funds transfer Point of Sale] platform which will
support payments processing for all countries and enable common systems
for features such as mobile top-up (MTU), dynamic currency conversion (DCC)
and bills payment (BP).This will eliminate multiple country specific systems.
• Cross-border business expansion will no longer be constrained. Multiple
acquirers banking relations can be reduced, because SEPA will enable
combined payment card acquiring for Euro transactions.
Figure 15.4 Benefits to Corporate (Source: European Payment Council)
15.10.8 Owning or renting a home in another country

Many European citizens have properties outside their home country, which is let out,
intend for retirement. Similarly, many rent properties in other countries for extended
time periods. However today the transactions associated with renting or buying a home
in another country, paying the agent, solicitor and taxes is time consuming. They have
to open a bank account in the same country as the property because their domestic
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account cannot easily support national transactions in another country. Similarly, there
are currently limited facilities for receiving cross-border direct debits to pay rented or
holiday home utility bills, taxes and other services. Finally, the process of transferring
salaries, pensions and letting and rental fees to either the home country account or the
holiday or rented country account, is complex and subject to delays.
The holiday home owner or renter will benefit from the introduction of SEPA. There will
no longer need for accounts in two countries. The process of making payments for
deposits, legal or agent’s fees, can be rapidly conducted from the existing home
account. Direct debits for rents, utility bills and taxes can be rapidly directed cross-
border to the home account. Credit transfers for letting fees can be similarly processed.
Finally, SEPA may also increase the number of banks offering products and services that
support second home owners or those living in other countries. The choice of banking
services and new banking products will therefore increase.
Table 15.3 SEPA for Non Residential Europeans
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15.11. Designing Components of SEPA

The features and design criteria used in developing two new SEPA Credit Transfer
[SCT] and SEPA Direct Debit [SDD] Electronic Transfer Schemes and the SEPA Cards
and Cash Frameworks are as follows.
The architectural design of the SEPA deliverables is based on different layers of
activity. First there will be the SEPA products and services of banks which the
customer directly experiences, uses and pays for. The second layer is the scheme
layer which defines the basis on which banks co-operate to provide standards, rules,
and interoperability. The third layer is the processing infrastructure between banks
and providers of payment services. The figure 18.5 shows business architecture of
the SEPA deliverables which is based on different layers of activity.
First layer is competitive bank layer {The SEPA products and services of banks will be
defined, delivered and described by individual banking institutions on the basis of
competition}.The second layer is related to the scheme co operation. The third layer
is related to the processing infrastructure.
Key differences between the scheme and infrastructure are given below in Table
15.4.
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Table 15.4 Scheme and Processing Infrastructure
Figure 15.5 Business Architecture of SEPA Source: European Payment Council
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15.12. Designing two new Electronic Transfer Schemes (ETS)

The two new Electronic Transfer Schemes (ETS) viz. SEPA Credit Transfer (SCT) and SEPA
Direct Debit (SDD) are the deliverables of the European Payment Council [EPC] who
developed them from 2004 through to 2006. These schemes are designed to give core
information to customers, banks, and infrastructure based on the data accumulated
from bank’s day to day contact with their customers. A different methodology has been
adopted for the design of these schemes, compared to that used for the cards arena
which is shown in Figure 15.6 below.
It should be noted that some parts (e.g. clearing and settlement functions) of the [Pan-
European-Automated Clearing House/Clearing and Settlement Mechanism] PE-
ACH/CSM infrastructures and card processing infrastructures could be executed by the
same organization and/or infrastructure.
15.12.1 The SCT (SEPA Credit Transfer) and SDD (SEPA Direct Debit)
Three key domains of activity were identified during the design to ensure an optimal
balance between competition and co-operation amongst banks, namely:
1) Enable banks to offer their own products and services on the basis of
competition.
Banks will provide different types of payment services based on the core functionality
of schemes and compete on factors such as pricing, service level, and optional services.
They are free to add advanced features and practices and integrate their payment
services into the broader range of banking services provided to their customer.
Figure 15.6 Two Electronic Transfer Schemes (Source: European Payment Council)
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2) Create common inter-bank schemes.

In the second domain of ‘scheme’ it became clear that it is necessary to undertake a
full scheme replacement strategy because various national schemes need to be
replaced by one common business rulebook, data sets and standards. These
schemes with common business rules and standards will enable banks to compete
for clients and develop market products and services across SEPA, rather than just
within the home markets, as at present.
The following paragraphs provide a summary of what the SEPA Credit Transfer and
SEPA Direct Debit Schemes will enable banks to deliver to users and how they are
structured in terms of the ‘four-corner’ model.
For Credit Transfer
• The originator (payer) completes a credit transfer instruction and
forwards it to the Originator’s (payer’s) bank by any agreed means [2].
• The originator’s bank receives and checks this, and rejects erroneous
instructions, then the originator account is debited and the credit
transfer is sent to the clearing and settlement mechanism (CSM) [3].
• The CSM forwards the credit transfer message to the beneficiary bank
and settles the amount of the transfer [4].
• The beneficiary’s bank receives the credit transfer message, checks the
credit transfer message and credits the account of the beneficiary [5].
Figure 15.7 SEPA Credit Transfer (Source: European Payment Council)
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Figure 15.8 SEPA Direct Debits (Source: European Payment Council)

For direct debits
• A mandate is given by the debtor to authorize the creditor to initiate
direct debit payments (called collections) [1] and allows the debtor bank
to pay those collections. (Debtors are, however, entitled to request banks
not to accept any direct debit collections on their accounts). A mandate
can be a paper document or an electronic document created and signed
in a secured environment. A mandate, after being signed by the debtor,
must be sent to the creditor.
• After receiving the signed mandate, the creditor may start to initiate
collections. Before a collection the creditor must send a pre-notification to
the debtor [2], unless otherwise agreed between the two parties.
• The signed mandate must be stored by the creditor as long as the
mandate is valid. The Mandated data are transmitted in electronic form
along with each collection [3].
• The debtor bank may reject a collection for technical reasons prior to
settlement. On the due date itself, the debtor bank must debit the
debtor’s account if the account status allows this, if not a return is
generated. The debtor is entitled to obtain a refund from the creditor if
he/she disagrees with the collection for reasons covered by the legal
requirements defined in the PSD, for which he must send the request to
the debtor bank within a period of six weeks. This refund does not relieve
the debtor of its responsibility to resolve the disputed collection with the
creditor.
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Banks will provide further information on the detailed operation of services based on
these electronic transfer schemes before the launch of the new SEPA instruments.
3) Competitive processing infrastructure
In SEPA, SCT (SEPA Credit Transfer) and SDD (SEPA Direct Debit) Rulebook, describes
Clearing and Settlement Mechanisms (CSM) as the third domain of processing
infrastructure. In the new SEPA environment the market can elect various optional CSM
models, all of which must be SEPA scheme compliant namely:
PE-ACH- An ACH that is or is part of a Pan-European ACH, a SEPA-wide, country-neutral
clearing organisation, providing reach to all banks in the SEPA Schemes, and which
banks from anywhere within SEPA can elect to use on the basis of price and service.
SEPA Scheme Compliant ACH- An ACH capable of processing SEPA Scheme
transactions within a defined market and which may or may not (yet) be in transition
to a PEACH. See Figure 15.8
Multilateral CSM- A decentralized form of multilateral clearing and settlement (not
an ACH structure) capable of processing SEPA Scheme transactions within a defined
market
Bilateral- A decentralized form of bilateral clearing or settlement (e.g. correspondent
banking).
IntraBank/IntraGroup. An intrabank and/or intragroup clearing and settlement arra
ngement, where both the originator/creditor and beneficiary/debtor have their
accounts within the same bank or group. This is a competitive domain operating
within a set of principles, as between infrastructures within which banks may
cooperate to operate a particular infrastructure that suits their needs.
Table 15.5 Policy Framework of PE-ACH

To summarise, the SCT and SDD principles have enabled the creation of a common set
of core rules and processes for the two new ETS schemes. The new structure has also
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been designed to fit into the three layer model which will ensure competition by banks
for customers and by the processing sector for services and networks. This framework is
summarised in the Figure 15.5.
As discussed the business architecture of the SEPA deliverables is based on several
different layers of activity. First there will be the competitive bank layer in which banks
provide SEPA products and services for customer use. The second layer relates to the
scheme co-operation. This defines the basis on which banks co-operate to provide
standards, rules and interoperability. The third layer relates to the processing
infrastructure. This layer is primarily competitive as between various competing
channels, although communities of banks can and do cooperate to meet common
needs.
Traditionally commercial aspects of the “payment scheme” are entangled within the
rules for the operational company that delivers interbank payment processing. Under
SEPA the new schemes and their rules, will be separated from the operational inter-
bank service provider.
Each common scheme Rulebook details core and basic SCT and SDD services to enable
a common level of service to be delivered to users for all ETS services within SEPA. The
new Rulebooks will be implemented by banks and processors (PE-ACH or other CSM’s)
and services delivered on this basis across Europe. Rulebooks have been designed on
following criteria.
Table 15.6 Design Criteria for SEPA Schemes
15.13. What the New Electronic Transfer Schemes deliver

A summary of the major components and features of the two new schemes is
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provided below.
Table 15.7 New ETS Scheme
15.14. SEPA Cards Framework

The SEPA Cards Framework (SCF) was developed by the EPC, working closely with
banks as issuers and acquirers as well as the international and domestic card
schemes (card schemes mean VISA, MASTERCARD etc).
Given the complexity of the cards business, widely differing approaches adopted in
the national card scheme of each country and the presence of the International Card
Schemes (ICS), EPC decided that it should not for many practical and cost reasons,
build a new common card scheme and Rulebook unlike the new ETS schemes and it
developed a policy document called the “SEPA Cards Framework” which would state
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how issuers and acquirers and card schemes and operators must adapt their current
operations to comply with the SEPA principles for card payments in Euro.
The card experts developed a three layer model to enable competition between all of
Europe’s card schemes, banks, processors and network providers but within a
consistent framework that defined how the parties and players should interact. Thus
international, national and new schemes will compete for members, banks will
compete for customers and sell products and processors/networks will compete to
service banks within a three layer model as shown in Figure 15.9. Three key areas for
card scheme adaptation identified are as follows.
1) Improving Choice.
Each country operates a different national payment card infrastructure and applies
different commercial frameworks standards, formats and protocols, which can
sometimes limit competition and transparency. The SEPA Cards Framework [SCF]
policy will ensure that national schemes adapt their existing commercial frameworks,
standards and processes to “best practice” guidance and would also ensure that
markets are accessible and competition strengthened.
2) Scheme Inter-operability
Through the international standards developed by Visa, MasterCard, American
Express and Diners Club for credit cards, international interoperability is well
advanced and are accepted in many countries worldwide. National payment cards
often lack this interoperability and are not accepted by most of Europe’s merchants
outside their domestic markets hence SCF policy statement had to ensure
interoperability of all cards by merchants in any country within the SEPA zone, as well
as defining the need for new common standards and processes.
3)Competitive Processing Infrastructure
Most of the national payment card and ATM schemes are embedded within the
payment card infrastructure’s operating companies. EPC decided to separate card
and ATM scheme from processing with the objective of increasing both competition
on the card scheme layer and competition on the infrastructure layer.
15.14.1 The Deliverables from SEPA Cards Framework (SCF)

The Framework defines the environment within which payment card transactions are
carried out. A summary of the major policy scope and features described within the SCF
is provided below.
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Figure 15.9 SEPA Cards Framework (Source: European Payment System)

The SCF’s objective is that banks, as owners of each of the national card schemes, will
commit to the SCF’s policy statements and decide how they will adapt to meet the SCF
principles.
The Framework covers the use of “general purpose” cards for payments and cash
acquisition within SEPA. The Framework defines the environment within which
payment card transactions are carried out.
15.14.2 Various Roles within the Card Framework

1. SEPA Acquirer’s role.
A SEPA compliant acquirer is one that acquires or and processes general purpose
SEPA compliant Euro payment card transactions within the SEPA. Under SEPA
acquirers are expected to perform the following:
• Enable a consistent cardholder experience at the POS (Point of Sale) following
the transaction flow defined by the relevant scheme.
• Communicate the benefits of, and offer to, their merchants (from 1st January
2008) the acceptance at their terminals of transactions generated by one or
more SEPA compliant card schemes.
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Table 15.8 SEPA card Framework

• Remove any barriers that may limit their merchants accepting multiple
schemes and co‐branded schemes at their terminals.
• If several payment applications are contained in the same card and are
supported by their terminal, enable cardholder choice of which payment
application they use.
• Promote to their merchants the benefits of migrating to EMV (Europay,
Mastercard, Visa) certified terminals with PIN pads.
• Complete the migration to EMV by the end of 2010 (with the exception of the
environment in the Netherlands, where existing contractual arrangements
with the Dutch merchant community supersede this).
• Implement the SEPA technical standards, including cardholder to terminal
interface, card to terminal (EMV), terminal to acquirer interface, acquirer to
issuer interface.
2. SEPA Card Issuer Roles. A SEPA card issuer is one that issues general-purpose SEPA
compliant cards capable of being used for payments and/or cash acquisition
transactions in Euro. SEPA compliant card issuers are expected to perform the
following:
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• Offer their customers (from 1st January 2008) SEPA compliant payment
cards.
• Complete the migration to EMV by 2010.
• By the end of 2010 enable all their general purpose cards to become SEPA
compliant.
• Communicate to their cardholders the benefits of SEPA compliant cards.
• Implement SEPA technical standards, including cardholder to terminal
interface, card to terminal (EMV), and acquirer to issuer interface.
3. SEPA ATM Owner’s Roles. A SEPA compliant ATM owner is one that acquires (or
otherwise processes) general purpose SEPA compliant Euro cash withdrawal
transactions at ATMs within the SEPA. SEPA compliant ATM owners are expected to
perform the following:
• Enable a consistent cardholder experience at the ATM following the transaction
flow defined by the relevant scheme.
• Ensure their ATMs accept cards of all schemes of which they are participants.
• Complete the migration to EMV by the end of 2010.
• Enable their ATMs to offer, as a minimum, the national language(s) and
English.
• Where several cash withdrawal applications are contained in the same card
and are supported by the ATM, enable cardholder choice of which application
they will use.
• Implement SEPA technical standards, including cardholder to ATM interface;
card to ATM (EMV); ATM owner to issuer interface.
It should be recognised that the acceptance of a card at any given terminal is
ultimately dependent on the decision of a merchant to accept that particular
card.
15.15. The Single Euro Cash Area Framework (SECA)

The Euro system Bank Note Committee, banks and other key players developed the
plans for Single Euro Cash Area. The objective of SECA is to create, with the Euro
system, a level playing field whereby the basic cash functions performed by each of the
National Central Banks (NCB) in the Euro area are interchangeable i.e. there is a
common level of service and common processes are followed by all Euro-area NCB’s.
SECA seeks to ensure the implementation of harmonized costs of distribution within
the SEPA area. The effect will be to create a common infrastructure for cash (banknotes
and coins) in all Euro countries. These changes will have a good impact on NCB’s,
banks, Cash-in-transit [CIT] companies, merchants and corporate. The key design
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principles are summarized below. EPC also has work-plan to develop a framework for
cash repositioning. This strategy will have the objective of encouraging consumers and
merchants to migrate from cash to payment cards and other electronic payment
instruments.
Table 15.9 SECA Design Principles
15.16. Roles and Responsibilities for SEPA Implementation

SEPA will be successfully implemented based on a solid organisational structure within
which all the players and stakeholders understand their roles and can cooperate and
interact.
15.16.1 The Role of the EC (European Commission)

• As the political driver of the SEPA concept, the EC, have the critical role of
providing the foundations for SEPA by ensuring the approval of the PSD by the
European Parliament and European Council.
• The EC holds responsibility for the overall economic integration of the EU
countries.
• The EC is also expected to provide “SEPA thought leadership” and
encouragement to all the parties as the concept is developed and implemented.
Page 28 of 35
15.16.2 The Role of the ECB [European Central Bank] and the Eurosystem
As a co-initiator of SEPA, the ECB and the Eurosystem focus on the Euro-area. The
Eurosystem, coordinated by the ECB, has set the SEPA objectives and the high level
statement of requirements.
• It consults with, and draws on, input from the SEPA stakeholder groups.
• The ECB also has the role of monitoring the EPC’s progress in designing and
specifying SEPA and attends EPC meetings.
• The Eurosystem produces an annual review of progress.
• Through the Eurosystem, the ECB also has the task of stimulating each central
bank’s role in coordinating national implementation of SEPA.
• The ECB also has a responsibility for SEPA leadership with a special focus on
supporting successful standardisation.
• ECB has responsibility for delivery of TARGET2 starting November 2007 (first
window), which will be an essential building block for settlement of SEPA
payments and for other Euro payments (money market, forex, securities).
• In each national market the national central bank is expected to draw together
the banking industry, governments and public authorities and stimulate and
support the start-up of national SEPA implementation plans and organisations.
• The Eurosystem is also expected to promote the proposition that European and
national public authorities (and their agencies) become “early adopters” of the
new payment instruments.
• Each national central bank will also have a pivotal national role in helping
resolve misunderstandings, facilitating the simplification of processes and
orchestrating the comments of banks, merchants and corporate.
15.16.3 Role of the EPC

• The EPC is the third co-owner of the SEPA concept, with the brief to focus on
design, specification and policy relating to SCT, SDD, cards and cash.
• In order to accomplish the ambitious deliverables timetable the four EPC
Payment Instrument Working Groups (PIWGs) each have responsibility.
• The EPC has developed a formal SEPA-level programme management function,
which will monitor the overall programme and interdependencies, provide a
risk and issues management framework and produce consolidated progress
reporting.
• The EPC also has a mandate to support the start-up of national SEPA
implementation programmes in conjunction with the Eurosystem (see below),
national associations and European associations.
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• The EPC has also established a Roll-Out Committee (ROC) with the brief to
prepare, plan and support the specific roll out of the SCT and the SDD schemes.
• The objectives of the ROC are: to provide guidance to ensure consistent
implementation; to build and operate a scheme Rulebook change process; to
define processes for the scheme service providers (i.e. CSM’s and PE-ACH);
resolve any scheme Rulebook or implementation disputes.
• The EPC has developed a communication plan to communicate the SEPA
message and programme, and to help co-ordinate and align decision makers
and implementers across the SEPA zone. However, it must be emphasised the
EPC manages on the principle of self-regulation; it has no brief to be directive.
15.16.4 Role of banks

• Banks are committing to deliver SEPA payment services based on the two new
Scheme Rulebooks and on the Cards Framework.
• Banks are responsible for developing their SEPA value propositions (products
and services). There should be timely decision making by each bank’s executive,
plus the allocation of resources and the appointment of SEPA project directors
and teams to carry out the essential marketing, product, operational and IT
changes.
• Banks will also strongly encourage their national associations and payment
scheme organisations to ensure the creation of an over-arching national SEPA
implementation structure.
• Internally bank staff and relationship managers are already buying into the
SEPA vision and are implementing external communication plans.
• Constructive engagement with customers and lobby groups, governments and
other stakeholders, supported by appropriate communication programmes, will
continue throughout the next four years.
15.16.5 Role of public authorities

Governments and public authorities will have to provide legislative and regulatory
support to SEPA implementation by helping in the removal of blockages and barriers
that may restrict the effectiveness of SEPA or delay implementation.
Also, as ‘buyers’ of payment services, they have a role as “early adopters” by
encouraging the implementation of SEPA payment instruments within the government
departments, revenue, tax benefits and within public utilities.
Page 30 of 35
15.16.6 Role of users of payment services

• Customers must be persuaded that the new SEPA payment instruments bring
value and convenience. Clearly banks must communicate the SEPA message to
their customers to encourage them to migrate to IBAN (International Bank
Account Number) and BIC (Bank Identification Code) usage.
• Public administrations, large corporate and merchants will have to interface to
new systems and for many, build additional infrastructure components. For
SME’s the majority of the change will be prepared by their banks.
• Merchants in all nations will face changes to their terminals, with new card
acceptance applications and protocols.
• There is potential for the creation of partnerships with financial institutions to
promote adoption of the SEPA payment instruments.
15.16.7 Role of Payment Infrastructure Providers

• Both payment (card) schemes and clearing houses (ACHs) and operators will see
their roles change over the next four years and it is clear that they are essential
facilitators to make SEPA a reality.
• For ACH’s, the role will be that of migration from a one country only scheme to a
Euro-area common scheme.
• Many will need to change their strategies and structures and enable the
separation of scheme from the infrastructure.
• Processing operators will see their roles change as they adjust to becoming a
PE-ACH or SEPA scheme compliant CSM and servicing national and European
customers.
• Similarly, payment (card) schemes and inter-bank processors face changes in
their roles, responsibilities and business opportunities.
• These changes can only be effected by working closely with scheme members
and owning banks to ensure the necessary changes are implemented smoothly
and do not disrupt the implementation of SEPA.
15.16.8 Role of the payments supplier sector

• SEPA implementation is likely to cost the banking sector and corporate and
public administrations a very substantial sum in changes to marketing
communication, product development, operational processes and IT systems.
This enormous change program cannot be achieved without the strong support
and involvement of the supplier sector. The EPC expects software vendors,
processors, systems integrators and consultancies to support the development
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of new cost efficient products and services that will facilitate rapid and low risk
conversion and migration to SEPA.
• This will be no easy task for the cards sector in particular, for standards and
specifications will take time to be finalised and implemented.
• For the SEPA ETS Schemes, the UNIFI (ISO 20022) XML standards have been
specified and the implementation guidelines are in preparation.
• However, suppliers can pro-actively assist the process by supporting their
customers, by contributing to the standards-setting process and
communicating the SEPA vision and concept to their product and services
developers.
15.17. Potential Impacts and Opportunities for Banks

SEPA will create many strategic challenges and opportunities for bank to offer products
and services so that it can build new businesses model. SEPA will also deliver benefits to
customers, merchants, public administrations and corporate.
For Banks, SEPA is a strategic opportunity, and not just compliance. Individual banks and
other payment industry players across SEPA will have to grasp the scale of the
opportunity. All banks dealing in retail Euro payments will be impacted whether inside
the Euro-zone or not. It is important that banks see SEPA as a business opportunity.
Banks need to understand SEPA and the PSD, assess the impact on their revenues,
review the impact of competitor’s offers and analyse their strengths and weaknesses in
the future payments market.
Change will bring many strategic opportunities for banks to innovate, to develop new
products, to replace ageing systems and to improve operational efficiencies.
Competition amongst banks is likely to increase. Larger banks can offer high volume
payments processing products. Smaller banks can compete with larger ones, because
one home account can serve customers in multiple countries (private clients, students,
pensioners etc). Large and smaller banks can also specialise and develop and deliver
products that will service niche sectors.
With change comes both threats and opportunities. Innovative market offerings linked
to the benefits of improved efficiencies in service delivery will be essential requirements
if all banks are to compete.
With the introduction of SEPA, geography and national markets will no longer be a
barrier. Even smaller national and regional banks will have the opportunity to compete
on a pan-EU basis – physical presence alone will no longer necessarily be a differentiator.
Banks will have to provide new cross-border products and services to Pan-EU corporate
and retailers to take advantage of the efficiencies delivered by SEPA. Banks will provide
Page 32 of 35
scale processing offers to Europe’s largest corporate. One common account processing
engine can be developed to serve the whole SEPA area, reducing the costs of country
specific platforms and enabling mergers and acquisitions.
Similarly, acquirers can offer large merchants much improved, multiple nation Pan-EU
acquiring services for all payment cards. Common in-house platforms will enable large
processors to develop new pan-EU services at lower cost.
Payment sector software suppliers can innovate and develop new interfaces and
converters to enable SEPA migration. In addition, the costs of products and services will
decline, as vendors develop common EU designs rather than national market specific,
reducing bank’s operational costs.
All banks will have to assess the impact of SEPA and the (PSD) on their revenue streams
and re-evaluate their pricing strategies in the new market context. Increased
transparency will reduce cross subsidisation and as a result, payment product prices can
be more closely linked to cost. Transparency will enable simpler structures, improve
customer clarity, as well as meeting the requirements of regulators and consumer
groups.
15.18. Summary
• “SEPA will be the area where citizens, companies and other economic actors will
be able to make and receive payments in Euro, within Europe, whether between
or within national boundaries under the same basic conditions, rights and
obligations, regardless of their location.”
• There is a priority implementation focus on the Euro area, currently 12
countries (13 from January 2007), and the change programmed will radically
impact their whole domestic payments environment.
• For SEPA development, EPC has covered two different approaches, which are
complementary to each other. 1. For Electronic Transfer Schemes (ETS) a
“replacement” strategy has been chosen with new common credit transfer and
direct debit schemes for the overall SEPA. 2. For the highly complex cards
business, the strategy has been that of “adaptation” of existing schemes to a new
set of business and technical standards.
• The EPC, working with the ECB, has drawn up a timeline based upon three
deliverable phases:
1. Design and preparation;
2. Implementation and deployment and
3. Co-existence and gradual migration.
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• The two new Electronic Transfer Schemes (ETS) viz. SEPA Credit Transfer (SCT)
and SEPA Direct Debit (SDD) are the deliverables of the European Payment
Council [EPC] who developed them from 2004 through to 2006. These schemes
are designed to give core information to customers, banks, and infrastructure
based on the data accumulated from bank’s day to day contact with their
customers.
• The objective of SECA is to create, with the Euro system, a level playing field
whereby the basic cash functions performed by each of the National Central
Banks (NCB) in the Euro area are interchangeable i.e. there is a common level of
service and common processes are followed by all Euro-area NCB’s.
Page 34 of 35
Chapter-16 TARGET
V 2.0, April 2009
for associates
Certification Program in Payment Systems Competency V_2.0
Page 1 of 28
Confidentiality statement
This document should not be carried outside the physical and virtual boundaries of TCS
and its client work locations. The sharing of this document with any person other than
TCSer would tantamount to violation of confidentiality agreement signed by you while
joining TCS.
Page 2 of 28
Chapter-16 TARGET
16.1. Introduction
This session is a peek into upcoming European Union-wide Real Time Gross Payment
systems, which is expected to change the payment scenario for all the participating
European nations. This payment system is christened TARGET. This session also deals
with the core functioning of TARGET, its components, its accounts and various modules.
16.2. Learning Objectives

After completing this session you would know
Ø What is TARGET1& TARGET2?
Ø What are the new features of TARGET2?
Ø Various modules OF TARGET2
Ø Detailed concept of SSP (Single Shared Platform).
16.3. Topics Covered

Chapter-16 TARGET ......................................................................................................................................... 3
16.1. Introduction.............................................................................................................................. 3
16.2. Learning Objectives .............................................................................................................. 3
16.3. Topics Covered........................................................................................................................ 3
16.4. TARGET – An Introduction.................................................................................................. 4
16.5. Purpose of TARGET................................................................................................................ 5
16.6. Principles of TARGET............................................................................................................. 5
16.7. Structure of TARGET.............................................................................................................. 6
16.8. Participants in TARGET......................................................................................................... 8
16.9. Role of SWIFT............................................................................................................................ 9
16.10. Payments in TARGET...........................................................................................................10
16.10.1 Customer Payments......................................................................................................10
16.10.2 Inter-bank Payments ....................................................................................................11
16.10.3 Validation of Customer and inter-bank Payments ..........................................11
16.11. From TARGET1 to TARGET 2 ............................................................................................12
16.12. Concept of TARGET2...........................................................................................................13
16.13. Objectives of TARGET 2: ....................................................................................................14
16.14. Features of TARGET-2 Explained: ..................................................................................14
16.15. Single shared Platform.......................................................................................................17
16.16. Participants of TARGET 2...................................................................................................17
16.17. Directories of the participants ........................................................................................20
16.18. TARGET2 & its Modules......................................................................................................20
16.18.1 Payments Module (PM) ...............................................................................................20
16.18.2 Information and Control Module (ICM)................................................................20
16.18.3 Reserve Management (RM) and Standing Facilities (SF)................................21
16.18.4 Home Accounting Module (HAM) ..........................................................................21
16.18.5 Static Data Management............................................................................................23
16.18.6 Contingency Module....................................................................................................24
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16.19. Summary..................................................................................................................................24
16.4. TARGET – An Introduction

The EU-wide real-time gross settlement (RTGS) system, The Trans-European Automated
Real-time Gross settlement Express Transfer system (TARGET) is one among the leading
three largest wholesale payment systems in the world, which contributes to the smooth
execution of monetary policy and singleness of money market within the EU region.
TARGET came into existence in January 1999, at the same time as the start of European
Monetary Union (EMU). TARGET facilitated the conduct of the single monetary policy
and the creation of a unified money market in the Euro area. TARGET is owned by the
Euro system, which consists of the European Central Bank (ECB) and the 12 national
central banks (NCBs) of the Euro area. TARGET has a decentralized structure linking
together 17 national real-time gross settlement (RTGS) systems (Some RTGS systems are
linked through other RTGS systems) and the ECB payment mechanism. TARGET is an
essential initiative for the implementation of the monetary policy for the Eurosystem,
and has contributed a lot to create a single money market within the Euro area.
Interesting Facts:
In 2002, TARGET held 85 percent of the EEA’s high-value payments market share in
terms of value and 59 percent of the volume. Notably, cross border payment volumes in
TARGET expanded 19 percent 2002 over 2001 due to an increase in commercial
customer payments, which have migrated from correspondent banks to interbank
networks. However, the share of cross border payments relative to domestic payments
declined from 39 percent to 31.3 percent 2002 over 2001, due to faster growth in
domestic payments.
Figure 16.1 Members of TARGET
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16.5. Purpose of TARGET

TARGET has been developed to achieve three main objectives:
• To provide a safe and reliable mechanism for the settlement of cross-border
payments on an RTGS basis;
• To increase the efficiency of intra-EU cross-border payments; and, most
importantly,
• To serve the needs of the ESCB's monetary policy.
The introduction of the Euro enabled internationally-oriented financial and non-
financial enterprises in the EU to centralise their treasury operations, which were spread
over a number of currencies. By using one currency instead of several, it is possible for
all enterprises involved in cross-border activity to make considerable savings.
One pre-condition for optimizing these savings was that the payment systems
themselves must be integrated.
All prevalent national currency areas had an integrated payment system at their
disposal; it was essential for the Euro area to have the same facility. The successful
implementation of the single monetary policy is reflected in a uniform money market
interest rate.
The EMU-wide interbank market required, first, that credit institutions had both the
incentive and the capability to manage their liquidity positions efficiently and, second,
that arbitrage operations can be executed easily and swiftly throughout the Euro area.
This in turn presupposed the existence of an integrated EMU-wide payment system to
ensure that liquidity could be transferred from one participant to another in a safe, easy
and timely fashion within the new monetary area.
16.6. Principles of TARGET

Market Principle
The use of TARGET is only mandatory for payments directly relating to monetary policy
operations (in which the ESCB is involved either on the receiving or on the sending
side). The use of TARGET is not mandatory for either interbank payments or commercial
payments. However, in order to contain the systemic risk inherent in large-value net
settlement systems, all such systems operating in Euro are required to settle through
TARGET. TARGET is mandatory for payments directly relating to monetary policy
operations.
Irrevocability
The national rules of each RTGS system in TARGET stipulate that payment orders are
irrevocable at the latest from the moment when the RTGS account of the sending
participant is debited by the sending NCB/ECB for the amount of the payment order.
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The moment when the RTGS account of the sending participant is debited by the
sending NCB/ECB for the amount of the payment order, the payment becomes
irrevocable.
Finality
TARGET provides a firm foundation for the management of payment system risks. It
gives participants the possibility of settling payments in central bank money with
immediate finality, thus eliminating the settlement risk between participants which is
inherent in other payment mechanisms.
16.7. Structure of TARGET
Figure 16.2 Interlinking of RTGSs
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TARGET is a decentralised payment system, consisting of national RTGS systems and

the ECB payment mechanism (EPM), which are connected to each other by the
Interlinking system. The TARGET system makes use of the infrastructures in place in
the EU Member States. RTGS system participants’ settlement accounts are held at
national central banks (NCBs). Individual payment messages are exchanged
bilaterally and directly between the two central banks concerned, using reciprocal
accounts for debiting and crediting. Only a few overall centralised functions are
undertaken by the ECB (e.g. TARGET coordination and end-of-day procedures).
National RTGS systems have retained their specific features to the extent that they
are compatible with both the singleness of the Eurosystem’s monetary policy and
the level playing-field for credit institutions. In addition, they must comply with the
“Minimum common performance features of RTGS systems within TARGET”, the
“Interlinking Specifications” and the “TARGET Security Requirements”. To enable the
different RTGS systems to process and settle cross-border Euro payments, a number
of common features have been agreed upon and implemented in the TARGET
Interlinking.
Over and above these technical features, harmonisation is concentrated in four key
areas:
Ø the provision of intraday liquidity for euro area RTGS system participants;
Ø operating times;
Ø TARGET cross-border holidays; and
Ø Pricing policies for TARGET payments.
The RTGS system in each country is represented by the NCB concerned.
The TARGET system is composed of:
- One national RTGS system in each of the EU countries that have adopted the euro.
RTGS systems in those EU Member States which were already members of the EU at
the start of Stage Three, but which have not yet adopted the single currency are
allowed to be connected to TARGET, provided that they are able to process the euro
currency alongside the national currency.
- The ECB payment mechanism (EPM).
- The Interlinking system, which interconnects the RTGS systems and the ECB
payment mechanism. It consists of an IT system which provides inter-NCB accounts
for recording mutual claims and liabilities between NCBs stemming from payment
transfers, and a telecommunications network for the real-time transmission of
interlinking data.
Each national RTGS system and the EPM is composed of:
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- An IT system which provides final and irrevocable debiting and crediting functions
along with some optional features such as queue management, gridlock resolution,
provision of debit or credit advice; and
- Telecommunications facilities for the real-time transmission of payment orders
and additional information between RTGS system participants and the NCBs/ECB.
Only NCBs and the ECB – with regard to the EPM – may be members of the TARGET
Interlinking.
16.8. Participants in TARGET

National provisions regulate the relations and operations between NCBs and their
RTGS system participants.
Credit institutions access TARGET via RTGS systems participating in or connected to
TARGET. The interface with credit institutions is determined by the NCB concerned.
In order to send and receive cross-border euro payments, credit institutions must
either be:
• Direct participants in an RTGS system or be represented by a direct participant (in
the latter case the institution is sometimes referred to as an “indirect participant”);
or
• They must be customers of a participant or of an NCB connected to TARGET.
Credit institutions which are direct participants in an RTGS system maintain
settlement accounts at the NCB responsible for this system. There are other
participants in a variety of legal and technical situations where credit institutions
which are not direct participants but which may hold an account at the NCB (albeit
not an RTGS settlement account) can nevertheless access and receive funds from
TARGET. They may choose to participate in their local RTGS system and/ or to
participate as a remote access participant in another RTGS system. All TARGET RTGS
system participants must be identified by a unique published Bank Identifier Code
(BIC).
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TARGET promotes STP. To ensure that validation takes place early on in the
payment process, it was necessary to define a common reference which could
be used by all TARGET RTGS systems and also by banks using TARGET.
For this reason it was decided to use BIC addresses published by S.W.I.F.T. as the
means of identifying the sender bank, receiving bank and, where appropriate,
the intermediary bank. Although the BIC is used to identify banks, it does not
imply that the banks have to use S.W.I.F.T. as their message carrier.
BICs are listed in the widely available “SWIFT BIC Directory” of published codes,
which is available both in electronic and in paper form.
In cooperation with S.W.I.F.T., the ECB has published the TARGET Directory,
which lists those credit institutions which are addressable through TARGET.
They are listed alphabetically by name of institution and are also sorted by BIC
address.
16.9. Role of SWIFT

The logical and physical technical platform for the TARGET Interlinking is based on
the SWIFTNet FIN network. S.W.I.F.T. has been selected as the preliminary network
provider for the TARGET Interlinking. The national RTGS system user interface may
also be SWIFTNet based or may use another network provider.
Figure 16.3 Message flow via SWIFT
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Participant banks send payment instructions using domestically agreed message

formats to their RTGS system. NCBs exchange messages through the Interlinking
using the Common Interlinking Message formats.
Payment messages are mapped to an MT103 – standard or straight-through
processing (STP) – or an MT202 Interlinking specification message. The messages
are enveloped in an MT198 proprietary message format by the sending NCB for
sending via the Interlinking. They are then unwrapped by the receiving NCB and
forwarded to the final beneficiary.
16.10. Payments in TARGET

TARGET processes customer and inter-bank cross-border payments in Euro. Data in
TARGET payments are transmitted without any alteration of the content from end to
end, although the order in which data appear may be altered slightly, because payment
messages are mapped from domestic formats to TARGET Interlinking formats and vice
versa.
If, for any reason, a beneficiary is unable to apply a payment order that it has received
via TARGET, there is a mechanism which provides information so that the payment can
be returned by the receiving RTGS system participant to the TARGET participant which
introduced it into TARGET.
TARGET has been designed to support STP to the greatest possible extent. Thus,
TARGET participants must address cross-border payments directly to the receiving bank
in its RTGS system (the receiving RTGS system). It means payments to be made to
TARGET participants should include the published BIC of the credit institution
concerned in the first credit field of a SWIFT payment message (and not the BIC of the
NCB through the RTGS system of which the participant accesses TARGET).
16.10.1 Customer Payments

Customer payments are defined as payments in the SWIFT MT103 format, standard or
STP, or equivalent national message formats. Customer payments can be transmitted
via TARGET from 07.00 until 17.00. The 17.00 cut-off time applies to both domestic and
cross-border customer payments.
The participants send their payment orders to the Euro RTGS system in which they
participate using the SWIFT MT103 formats (standard or STP), or the equivalent national
message format for TARGET payments, which is converted by the RTGS system into the
common Interlinking message format.
The Interlinking uses SWIFT proprietary MT198 messages as its message framework.
MT198 messages are “envelope” messages which contain free space that can be
formatted by the users (the NCBs/ECB in TARGET) according to rules agreed bilaterally.
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S.W.I.F.T. does not validate the content of the envelope, except to verify that the
characters used belong to the SWIFT character set, that the length of each line does not
exceed 78 characters and that the total number of characters in each message does not
exceed 10,000.
16.10.2 Inter-bank Payments

Interbank payments are defined as payment messages in the SWIFT MT202 format or
equivalent national message formats for TARGET payments. This type of message is
sent by or on behalf of the ordering institution either directly or through any
correspondent(s) to the financial institution of the beneficiary institution.
Interbank payments are payments, such as the payment leg of money market, foreign
exchange and derivatives transactions, which take place between credit institutions or
between NCBs/ ECB and credit institutions. Interbank payments can be transmitted via
TARGET from 07.00 until 18.00.
The MT198 sub 202 General Financial Institution Transfer is used to transmit an
interbank payment message through the Interlinking. The sending and receiving RTGS
systems process interbank payments in the same manner as that outlined for customer
payments.
16.10.3 Validation of Customer and inter-bank Payments

The sending RTGS system checks the syntax of the data according to the appropriate
standard, the value date of the payment order (the only value date for the TARGET
system is “today”) and the availability of the receiving NCB/ECB.
If syntax errors or other grounds for rejection are detected, the sending NCB/ECB
handles the data according to domestic rules and returns the error information in the
agreed domestic format.
The receiving RTGS system checks all those parts which are necessary to successfully
credit the account of the beneficiary institution in line with its own national provisions.
If the crediting of the beneficiary institution in the RTGS system is successfully
completed, the receiving NCB/ECB sends a positive acknowledgement to the sending
NCB/ECB. In the event that an error occurs during the processing and it cannot be
completed, a negative acknowledgement is sent to the sending NCB/ECB stating the
reason.
These reasons can be either the absence of any information by which to identify the
receiving institution or an invalid format. The sending NCB/ECB then handles the data
according to domestic rules.
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Figure 16.4 Cross-border Euro customer payment through TARGET
16.11. From TARGET1 to TARGET 2

TARGET has a number of shortcomings that stem from its heterogeneous technical
design. In view of this, and because of developments such as the future enlargement of
the Euro area, the Eurosystem is currently building the TARGET of tomorrow i.e.
TARGET2. The new system will achieve even higher levels of safety and efficiency
through a harmonized structure based on a common technical platform.
Figure 16.5 From star (TARGET) to wheel and spoke (TARGET2) topology
On 17 June 2005, the Governing Council of the ECB communicated to the market that
the period of extensive user consultation had concluded and that the go-live date for
the first migration window will be 19 November 2007.
The Euro system has agreed to split the migration into four waves (with the last wave
being reserved for contingency purposes only) and has decided on the composition of
the migration groups.
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16.12. Concept of TARGET2

In October 2002, the ECB announced the move to the next generation of TARGET,
TARGET2, which is to be based on the EU’s most efficient RTGS systems. It
declared that any system that does not meet TARGET2’s cost recovery requirements
in 4 years will be closed. TARGET2 is to improve customer needs by offering core
service levels, which will be defined in close cooperation with the user community,
and cost efficiencies that will arise from a less fragmented IT infrastructure. Individual
central banks will be able to offer specific, national services in addition to the core
service levels. TARGET2 will consist of national components and a shared IT
platform component that central banks can use on a voluntary basis. Although plans
are for a single price structure for euro payments, volume based pricing or pricing
based on timing of payments may be also offered. It is estimated that TARGET2 will
be operational in the second half of this decade. A number of user groups meet
regularly and discuss the requirements for the current and future TARGET system.
Thus, TARGET2 is the future real-time gross settlement system of the Euro system. It is
based on a single platform infrastructure, i.e. the entire application is based on an
integrated central technical infrastructure (so-called "Single Shared Platform" (SSP).
Banca d'Italia, Banque de France and Deutsche Bundesbank are co-operating on the
development of the new payment system.
In order to allow for a smooth migration from TARGET to SSP it is foreseen to support
the current Interlinking logic also at SSP level, until the last migration window is closed,
in order to allow a gradual migration of countries in several waves. Thus, Central Banks’
will not have to migrate to the new environment "in one go". After the migration period
is finished the Interlinking functionality will be removed.
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From a user's perspective, TARGET2 offers a broad range of features and services to
meet the requirements of all users (European banking industry, NCBs and ECB).
TARGET-2 has following features (some of them new and some old with improvement):
• Homogenous Technical Design/ A Single Technical Platform
• TARGET-Wide Flexible Liquidity Management Services
• Support For Payments With a Debit Time Indicator
• Pooling of Intraday Liquidity
• Interaction With Ancillary Systems
• Strengthened Business Continuity Measures
• Information & Control Module
• TARGET2 Directory
• Operational Day.
16.13. Objectives of TARGET 2:

With the TARGET2 project the Eurosystem is pursuing the following main objectives:
1. Fulfilling the European banking industry’s user requirements (eg Europe-wide
liquidity management).
2. Compliance with the neutrality principle. TARGET2 should lead to a level playing field
for banks and market infrastructures in the respective countries.
3. Provision of a harmonised level of service on the basis of a common technical
platform.
4. Applying a single price structure that is applicable to both domestic and cross-border
payments.
5. Safeguarding the principle of decentralisation within the ESCB. The participating
central banks will retain responsibility for conducting business with their customers.
6. High degree of flexibility through a modular approach in order to accommodate the
various interests of the participating central banks.
7. High level of standardization.
8. Benchmark-setting provisions for business continuity.
16.14. Features of TARGET-2 Explained:

1. A single technical platform -Probably the most important innovation is the
consolidation of the technical infrastructure. TARGET2 will replace the decentralised
technical structure of the current TARGET system with a single technical platform,
known as the Single Shared Platform (SSP).This was also the overriding user
requirement to emerge from the public consultation on TARGET2 held in early 2003.
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2. TARGET-wide flexible liquidity management services- Payment system users are

increasingly demanding enhanced liquidity management services and liquidity-
efficient systems that combine the advantages of both gross and net settlement
systems. TARGET2 will respond to these demands by offering both state-of-the-art
liquidity management tools and liquidity-saving features.
3. Strengthened business continuity measures- TARGET2 will respond to the new threats
in the post-September 11 world by offering the highest possible level of reliability and
resilience, as well as sophisticated business contingency arrangements which are
commensurate with the systemic importance of the TARGET infrastructure.
4. Integration with ancillary systems-TARGET2 will provide cash settlement services in
central bank money for all kinds of ancillary systems (ASs), including retail payment
systems, large-value payment systems, foreign exchange settlement systems, money
market systems, clearing houses and securities settlement systems (SSSs). The main
advantage of TARGET2 for ASs is that they will be able to access any account on the SSP
via a standardised interface. TARGET2 will offer six generic procedures for the
settlement of ASs (two real-time procedures and four batch procedures),which
represents a substantial harmonisation of current practices.
5. Support for debit time indicator- TARGET2 will take into account the increased time-
criticality of payments, particularly in the context of CLS, by making it possible to
submit transactions with a debit time indicator.
6. Pooling of Intraday Liquidity- Liquidity pooling will be achieved by grouping a
number of accounts.TARGET2 will offer two variants for liquidity pooling: i) the virtual
account; and ii) consolidated information. In the virtual account option, a payment
order submitted by a participant belonging to a group of accounts will be settled if the
payment amount is smaller than or equal to the sum of the liquidity available on all
accounts (including any credit lines) in the group. Otherwise the payment order will be
queued. The consolidated information option is an information tool: it will give
comprehensive information to the participant subscribing to the service about the
liquidity position of all of the entities of the group at any given moment. Such
information will also be provided in the virtual account option. However, payment
amounts will be checked only against the liquidity available on the individual RTGS
account of the sending participant. The liquidity available on other accounts in the
group will not be used to settle the payment. In the event of insufficient liquidity on the
sending bank’s account, money will need to be transferred to that account.
Only credit institutions established in the European Economic Area (EEA) and directly
participating in the system will be able to use the consolidated information option.
Furthermore, owing to business and legal constraints, the virtual account option will
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only be available for accounts of euro area banks held with euro area central banks. It
will only be possible to establish a group of accounts (for the consolidated information
or virtual account options) for credit institutions that belong to the same group.
7. Strengthened Business Continuity measures- TARGET2 will offer the highest possible
level of reliability and resilience, as well as sophisticated business contingency
arrangements commensurate with the systemic importance of the TARGET2
infrastructure.
The business continuity concept of TARGET2 consists of a multi-region/multi-site
architecture. There will be two regions. In each region, there will be two sites some
distance from each other. This will be combined with the principle of region rotation in
order to ensure the presence of experienced staff in both regions.
8. Information and Control Module- TARGET2 users will have access, via the information
and control module (ICM), to comprehensive online information and easy-to-use
liquidity control measures appropriate to their business needs. Users of the ICM will be
able to choose what information they receive and when. Urgent messages (e.g. system
broadcasts from central banks and warnings concerning payments with a debit time
indicator) will be displayed automatically on the screen. Through the ICM, TARGET2
users will have access to the payments module (PM) and the static data (management)
module. Depending on the decision of the relevant central bank with regard to the use
of the optional modules offered by the SSP, participants may also have access to the
home accounting facility of the central banks and the applications for reserve
management and standing facilities.
9. TARGET2 Directory- The TARGET2 directory will contain information on each
institution that can be addressed in the TARGET2 system, and will be updated on a
weekly basis to support system participants in their routing of payment instructions.
The directory will use TARGET2-specific information provided by TARGET users during
the SSP registration process in combination with SWIFT-related information. The
TARGET-2 directory will be an electronic product/service provided to the direct
participants by the Eurosystem.
10. Operational Day- In order to better meet users’ business needs, the operational day
in TARGET2 will be longer than that of the current TARGET system. TARGET2 will start
the new business day on the evening of the previous day. The night-time window2 will
be available from 7.30 p.m. to 6.45 a.m. the next day, with a technical maintenance
period of three hours between 10 p.m. and 1 a.m. The night-time window will facilitate
the night-time settlement of the different ancillary systems in central bank money with
finality, and will also support cross-system settlement during the night. Settlement of
ASs will take place in dedicated accounts. During the night-time window, liquidity
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transfers via the ICM between RTGS accounts and the dedicated sub-accounts will be
possible. Ancillary systems and their participants will be able to choose whether or not
to enable this liquidity transfer functionality, or to limit the functionality. Banks may
alternatively decide not to participate in night-time settlement. The Eurosystem
believes that the night-time window will generally increase the efficiency of night-time
settlement and will favour initiatives such as cross-system delivery versus payment.
16.15. Single shared Platform

The following modules are implemented on SSP:
Ø Contingency Module (CM)
Ø Home Accounting Module (HAM)
Ø Information and Control Module (ICM)
Ø Payments Module (PM, including the interface for ancillary systems)
Ø Reserve Management (Module) (RM)
Ø Standing Facilities (Module) (SF)
Ø Static Data (Management) Module (SM).
We will see functionality of each module in subsequent sections.
Figure 16.6 Single Shared Platform (SSP) depicting modules
16.16. Participants of TARGET 2

Direct participant
Direct participants have
1) direct access to the Payments Module (PM)
2) hold an RTGS account in the PM
3) access to real-time information and control measures.
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The following institutions are eligible to be direct participants in TARGET2:

Ø Supervised credit institutions
Ø Treasury departments
Ø Public sector firms
Ø Investment firms
Ø Organisations providing clearing or settlement services
Ø Central banks.
Indirect participant
Ø are registered in the PM through participants with direct access
Ø are directly linked to one direct participant only (which may be located in
another country)
Ø can be indirectly addressed in the PM
Ø have no own RTGS account within the PM
Ø must have published BIC.
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Table No. 16.1 Direct and Indirect Participants
Multi-addressee access
In the TARGET2 system, direct participants will be able to authorize their branches and
credit institutions belonging to their group, located in EEA (European Economic Area)
countries, to channel payments through the direct participant’s main account without
its involvement by submitting/receiving payments directly to/from the system. This
offers affiliate banks or a group of banks efficient features for liquidity management
and payments business.
The payments will be settled on the main account of the direct participant.
Table No. 16.2 Direct and Multi-addressee Participants
Addressable BIC (Correspondent BIC)

Addressable BICs will always send and receive payment orders to/from the system via a
direct participant. Their payments will be settled in the account of the direct participant
in the PM of the SSP.
Any direct participant’s correspondent or branch that holds a BIC is eligible to be listed
in the TARGET2 directory, irrespective of its place of establishment. Moreover, no
financial or administrative criteria have been established by the Euro system for such
addressable BICs, meaning that it will be up to the direct participant to define a
marketing strategy for offering such status. It will be the responsibility of the direct
participant to forward the relevant information to the respective central bank for
inclusion in the TARGET2 directory
Difference between indirect participant and Correspondent BIC:
Following not available to Correspondent BIC
• Settlement Finality Directive
• Compensation scheme.
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16.17. Directories of the participants

TARGET-2 directory
1. The directory of TARGET2 contains the needed routing information for TARGET2
participants
2. Directory is updated weekly.
3. In the TARGET2 directory , details of BIC to be used in SWIFT header for receiver
is also included
4. All the related Information on non-migrated participants is available in the
directory
5. The routing logic between SSP users and a SSP user to a non-migrated
participant is exactly the same. [ Y- copy ]
6. In case of a non-migrated participant, the TARGET2 directory delivers the SSP
Interlinking BIC, which must be addressed in the SWIFT header instead of the
receiver BIC .
BIC directory
1. BIC directory is updated monthly.
2. The BIC directory shows all global SWIFT participants and the payment system
(s) to which they are connected.
3. For indicating direct and indirect SSP participation worldwide the respective
TARGET service code (TGT or TG+) is mentioned for each SSP participant.
16.18. TARGET2 & its Modules
16.18.1 Payments Module (PM)

The Payments Module (PM) gathers all services related to the processing of payments.
All direct participants (e.g. credit institutions, market infrastructures, other participants
and CBs) have to maintain an account managed within the PM (called as RTGS account).
All transactions submitted to and processed by the PM are settled on these RTGS
accounts.
In addition to the services related to the processing of payments (settlement including
optimization procedures, queue management, etc.), the PM offers advanced services
for liquidity management (limits, reservation of liquidity, etc.), for the communication
with participants (participant interface for credit institutions based on the Y-flow value-
added service) and ancillary systems (ancillary system Interface with six generic
settlement models based on SWIFT Net XML standards).
16.18.2 Information and Control Module (ICM)

The Information and Control Module (ICM) allows participants to access all information
related to their accounts and use control measures through a comprehensive on-line
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information tool. In particular, the participants benefit from a "single window access" to
the Payments Module (PM), Static Data (Management) Module (SD) and depending
upon whether the relevant central bank has decided to use optional services, to the
Home Accounting Module (HAM), the Reserve Management (Module) (RM) and
Standing Facilities (Module) (SF).
The ICM enables direct participants to control and manage actively their liquidity and
payment flows (visibility of incoming and outgoing payment queue).
The ICM allows access to data of the current business day only, which are available
through "pull mode". This mode gives each user the flexibility to decide what
information should be updated and at what time.
Finally, the ICM can be accessed either through application-to-application (A2A) mode
or user-to-application (U2A) mode.
16.18.3 Reserve Management (RM) and Standing Facilities (SF)

With regard to Reserve Management (RM) and Standing Facilities (SF), the choice to
adopt standardised SSP modules or to manage them locally is up to the individual CB.
For the local management, specific applications have to be in place at CB level. CBs who
opt for these standardised SSP modules can offer the following services to their
users:
16.18.4 Home Accounting Module (HAM)

Need for Home Accounting
Direct TARGET2 participants will have to maintain an RTGS account in the Payments
Module (PM). Nevertheless, each CB is free to maintain so-called additional "home
accounts". This "home accounting" functionality could be used for the following
reasons:
Ø Some banks may not be interested to participate directly in the RTGS system,
but are nevertheless subject to minimum reserve requirement. In addition, they
may wish to directly manage cash withdrawals etc. Therefore, they need an
account with the CB outside the RTGS system.
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Ø In some cases, depending on the specific situation in each country, it may be

preferable to have a second set of accounts. This could be used to specific
operations of direct participants, which already have an RTGS account. Some
ancillary systems might, for example, decide not to migrate from the start to the
SSP, but maintain - for the time being - a local infrastructure.
Each CB is fully responsible for the execution of its home accounting business.
In this context, each CB is also free to choose:
Ø Either to offer proprietary home accounting services or to rely only on
TARGET2, if there is a need to offer such services.
Ø For what type of business the home accounting application is used.
Proprietary Home Accounting Module-
In this case, the service offered to its banks contains a limited number of well-defined
transactions, but never fully-fledged payment services.
Home Accounting Module
The SSP also offers a standardised Home Accounting Module (HAM). This module is not
intended to offer real payment services. These activities must be performed through a
direct PM participant.
This is to accommodate the needs of those central banks wishing to use commonly
shared resources to a larger extent. The HAM allows to manage accounts for financial
institutions as well as accounts for CB customers not allowed, according to the TARGET
Guideline, to open accounts in the PM (hereafter referred to as "CB customer’s
accounts“).
The following standardised account services to its customers may be offered through
the HAM by central banks that opt for the use of this module:
Ø Liquidity holding (e.g. maintaining reserve requirement either through RM or
proprietary application) on an account with the CB
Ø Interbank transfers between accounts in the HAM held by the same CB
Ø Interbank transfers between the HAM accounts and RTGS accounts of direct
participants
Ø Cash withdrawals with the respective CB
Ø Access to standing facilities either through the SF or through a proprietary
application managed by the CB.
There is also the possibility that the HAM account is managed by a PM participant (the
so-called co-manager). The aim of the co-management function is to allow small banks
to manage directly their reserve requirement, but to delegate cash flow management
to other banks.
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The co-management is also available on a cross-border basis. The HAM is technically

integrated in the SSP and can be accessed by customers via SWIFTNet.
16.18.5 Static Data Management

The Static Data Management Module provides the SSP operator, CBs and SSP
participants with a homogeneous set of data thanks to:
Ø A unique point for the creation, modification and deletion of static data.
Ø Daily data transmission for all the SSP modules including the provision of a
coherent procedure according to which the data are synchronously loaded into
all other modules at the same point in time.
Ø Exceptional procedures for urgent updates of all the modules in case of
emergency.
Ø For audit trail purpose the central repository keeps the "tracking" for all data
updates (date and reference).
Ø Static Data module is not meant to manage the past versions of static data.
Ø Possibility to enter changes that become effective at a future date, including
versioning facilities.
Users
Users of the Static Data Module are:
Ø CBs for consultation and updates
Ø Credit institutions for consultation and updates
Ø Ancillary Systems for consultation only
Ø SSP operators for consultation and updates
Controls and responsibilities for data
The entity in charge of data modifications is the one which is responsible for the data:
Ø CBs for all data related to the participant's structure and AS
Ø SSP operator for production data such as opening/closing time, calendar, etc.
Ø Credit institutions for specific credit institution data.
This respective entity is also responsible for the manual controls to be carried out in
context with possible changes. Controls consist of both automated and manual
procedures. Automated controls on the data format have to be strictly applied to the
data before it is used in the production environment.
When information has to be checked against "subjective" elements, manual controls are
carried out. In order to safeguard the integrity of data, manual controls and changes
cannot bypass automated controls.
Four eyes principle can be enforced for any static data creation and updates. Therefore
each entity (in most cases CB) in charge of static data management will be able to
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define which data creation/updates are critical and should therefore be subjected to
four eyes principle.
Critical static data are all data needed for processing payments in the PM and HAM. It
includes participant's public data, participant's private data, ancillary system data,
specific CIs data and SSP data.
Static Data Description
Data managed via ICM are represented by:
• the participant's structure (credit institutions and central banks)
• the AS (Ancillary Systems)
• specific data for SSP, such as TARGET calendar, monitoring data, etc.
• specific credit institution's data, such as default limits, standing orders and
direct debit
According to the general principle regarding responsibilities on data ("The entity in
charge of data modifications is the one which is responsible for the data"), CBs are
responsible for all data related to the participants structure and ASs which are in their
area of competence. They are in charge of the update of data, integrity and controls.
In specific circumstances, SSP operators are able to act on behalf of a CB. That's why SSP
operators have full rights to update all data of the participants’ structure.
Similarly, SSP operators are in charge of the update of production data.
For specific credit institution data, only CIs (Credit institutions) are responsible for their
data, but SSP operators and CBs are able to update those, on behalf of a CI.
16.18.6 Contingency Module

The Contingency Module (CM) is a common mandatory tool for each CB joining the SSP.
The CM runs in the non-active region. It is an independent module which includes all
the functions needed to access the SWIFTNet services. Considering the high level of
resilience provided by the SSP, the use of the CM is only envisaged for the processing of
(very) critical payments in specific situations. These are:
Ø Unavailability or inaccessibility of the SSP components.
Ø The time needed for the activation of the alternate site/region lasts too long.
The CM ensures the processing of a limited number of (very) critical payments. The
concept of (very) critical payments in TARGET2 defines payments which if processed
with a delay could cause systemic risk.
16.19. Summary
• The EU-wide real-time gross settlement (RTGS) system, The Trans-European
Automated Real-time Gross settlement Express Transfer system (TARGET) is one
of the leading among three largest wholesale payment systems in the world
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• TARGET has a decentralized structure linking together 17 national real-time

gross settlement (RTGS) systems (Some RTGS systems are linked through other
RTGS systems) and the ECB payment mechanism.
• The logical and physical technical platform for the TARGET Interlinking is based
on the SWIFTNet FIN network. S.W.I.F.T. has been selected as the preliminary
network provider for the TARGET Interlinking.
• TARGET processes customer and inter-bank cross-border payments in euro.
Data in TARGET payments are transmitted without any alteration of the content
from end to end, although the order in which data appear may be altered
slightly, because payment messages are mapped from domestic formats to
TARGET Interlinking formats and vice versa.
• TARGET2 is the future real-time gross settlement system of the Euro system. It is
based on a single platform infrastructure, i.e. the entire application is based on
an integrated central technical infrastructure (so-called "Single Shared Platform"
(SSP). Banca d'Italia, Banque de France and Deutsche Bundesbank are co-
operating on the development of the new payment system.
• TARGET-2 has following features (some of them new and some old with
improvement):
o Homogenous Technical Design/ A Single Technical Platform
o TARGET-Wide Flexible Liquidity Management Services
o Support For Payments With a Debit Time Indicator
o Pooling of Intraday Liquidity
o Interaction With Ancillary Systems
o Strengthened Business Continuity Measures
o Information & Control Module
o TARGET2 Directory
o Operational Day
• The following modules are implemented on SSP of TARGET2:
o Contingency Module (CM)
o Home Accounting Module (HAM)
o Information and Control Module (ICM)
o Payments Module (PM, including the interface for ancillary systems)
o Reserve Management (Module) (RM)
o Standing Facilities (Module) (SF)
o Static Data (Management) Module (SM)
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1. TARGET is an essential instrument for the implementation of the monetary policy for
the Eurosystem, and has contributed a lot to create a single money market within
the euro area.
2. TARGET has been developed to achieve three main objectives:
• To provide a safe and reliable mechanism for the settlement of cross-border
payments on an RTGS basis;
• To increase the efficiency of intra-EU cross-border payments; and, most
importantly,
• To serve the needs of the ESCB's monetary policy.
4. TARGET is a decentralised payment system, consisting of national RTGS systems and
the ECB payment mechanism (EPM), which are connected to each other by the
Interlinking system.
5. Credit institutions access TARGET via RTGS systems participating in or connected to
TARGET.
Page 26 of 28
Page 27 of 28
Page 28 of 28
Chapter-5 Process of MICR Check-clearing
This session discusses cheque and its clearing process details.
5.1 Learning Objective

• Discusses all the processes the cheque goes through to clear the payments
• Discuss the Importance of the numbers present on the cheque, how are they
written & identified through the various channels.
5.2 Topics Covered

Chapter-5 Process of MICR Check-clearing ........................................................................................... 3
5.1 Learning Objective ....................................................................................................................... 3
5.2 Topics Covered............................................................................................................................... 3
5.3 Introduction.................................................................................................................................... 3
5.4 The Basics of Cheque Clearing Process............................................................................... 4
5.5 Mechanized Cheque Processing based on MICR – an introduction....................... 5
5.5.1 Equipments used in MICR Cheque Processing System’s ............................................ 6
5.5.1.1 MICR Encoder ................................................................................................................ 6
5.5.1.2 Reader/ Sorter ............................................................................................................... 7
5.5.1.3 Image Capture .............................................................................................................. 9
5.6 MICR Standards............................................................................................................................. 9
5.6.1 MICR fonts ................................................................................................................................ 9
5.6.2 Character Specification......................................................................................................10
5.6.3 Print Specification................................................................................................................11
5.7 The Process of check clearing at different levels..........................................................13
5.7.1 Local Clearing .......................................................................................................................13
5.7.2 Outstation Cheque Clearing............................................................................................16
5.8 Main Operators of the Clearing Cycle ...............................................................................16
5.8.1 Service Branch .......................................................................................................................16
5.8.2 Clearing House......................................................................................................................16
5.8.3 Settlement Agent.................................................................................................................17
5.9 Reconciliation of clearing differences ...............................................................................17
5.9.1 Inward clearing differences .............................................................................................17
5.9.2 Outward clearing differences .........................................................................................18
5.10 Summary.........................................................................................................................................19
5.3 Introduction
Paper based instruments like cheques, demand drafts are very important constituents
of a nation’s payment systems. Hence it is very important to know how the paper based
instruments are cleared and settled. With the growth in trade and commerce the
volume of the instruments like cheques and demand drafts have also increased
astronomically over past couple of decades.
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Did you know? For the year 2005 the value of total transactions done by cheques in
US, UK, Japan and Canada were 302, 137, 105 and 269 times, respectively, of the their
respective GDPs (Gross Domestic Product - The market value of all final goods and
services produced within a country in a given period of time, for example GDP of USA in
the year 2005 was 12.98 trillion $). Courtesy www.bis.org
However, with the advent of payment cards, paper-based instruments have seen a
decline but still they are an integral part of the payment system. The introduction of
MICR (Magnetic Ink Character Recognition) technology brought about a revolution in
cheque clearance and settlement during the mid eighties and early nineties. Although
other revolutionary techniques like E-check and Cheque Truncation are now in the
phases of trial and testing, MICR forms the backbone of cheque clearing mechanisms in
India and rest of the world.
This session aims at imparting knowledge about what are the basic concepts behind
the settlement of cheques along with a discussion of MICR technology in Indian
scenario.
5.4 The Basics of Cheque Clearing Process

• The customer (payee or holder) deposits the cheque that he has received from
the Payer drawn in his favor with his Bank.
• The payee’s bank processes the cheque and sends it to the clearing house along
with other cheques that it has received for clearing purposes.
• At the clearing house the cheques are sorted bank-wise and all the banks
(drawee banks) collect the cheques that are drawn on them (the cheques for
which they have to make payment).
• The drawee banks process the cheques and validate them for details like
signature, availability of amount in the customer’s account and so on.
• The Drawee banks communicate the fate, (i.e. if the payer’s account has
sufficient funds to honour the payment or not, if the signatures matching or
not), of the cheques to the clearing house within the time frame as specified by
the clearing house.
• With this information, the payee banks either credit the customer’s account
with the cheque amount or return the unpaid cheque to the customer.
The Diagram below depicts the cheque clearing process:
Page 4 of 20
Figure 5.1 Process of Cheque Clearing
5.5 Mechanized Cheque Processing based on MICR – an introduction

It is defined as the machine recognition of numeric data printed with magnetically
charged ink. It is used on bank cheques and deposit slips. MICR readers detect the
characters and convert them into digital data. This technique is useful to accelerate the
check routing process as also to route the check back to the location where the funds
exist and to settle the transaction in minimum time.
Cheques were processed manually until the rapid increase in their use after the Second
World War necessitated the introduction of a reliable automated method of cheque
processing. This growth was most marked in the USA, and the American Bankers
Association (ABA) in 1956 adopted a process of Magnetic Ink Character Recognition, or
MICR, which was developed jointly by the Stanford Research Institute and General
Electric Computing Laboratory. MICR is standardized by ISO 1004.
The MICR proofing systems have also developed since the early 1960s to incorporate
scanning technology and advanced optical character recognition techniques to
improve the automation of document processing. This technology, known as “Image
Processing”’ provides the means for converting the image of documents into a digitized
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format suitable for electronic processing and storage. The data contained in the MICR
code line is still predominantly captured magnetically.
MICR cheque processing was introduced by the Reserve Bank of India first in Mumbai
and Chennai in 1987 and was implemented in 1988 in Delhi to be followed by Kolkata
in 1989. Following were the factors responsible for the adoption of MICR technology:
• Increasing clearing volumes
• Faster realization of cheques
• Better control over clearing reconciliation
• Use of state-of-the-art technology in cheque clearing
• The availability of cheque-wise data on instruments processed in clearing
• The facility to store, retrieve, and group data on clearing instruments with the
aid of the computer systems used for the MICR processing
• The capability to provide data in a meaningful manner enabling further analysis.
Advantages and disadvantages of MICR
Advantages:
• MICR systems are secure against most common types of defacements like
overprinting, dirt or writing across numbers
• A layer of transparent adhesive tape over the numbers does not prevent
desirable results
• Imprinting with magnetic ink is highly durable and can withstand thousands of
transits across the read-head with no impairment of the signal
• Documents are difficult to forge
• Reduces human errors.
Disadvantages:
• Highly stylized font required to ensure character discrimination
• Limitation to numbers and only about four other characters
• Difficulty in scanning with hand held device
• A very shallow depth of field
• MICR readers and encoders are expensive.
5.5.1 Equipments used in MICR Cheque Processing System’s

Following are the instruments required:
5.5.1.1 MICR Encoder

The encoder is a tabletop machine, which can print the coded particulars of cheques
and other payment instruments in magnetic ink on the 5/8” read band at specified
position. The conventional encoder has a keyboard and a programmable journal
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printer (i.e. lister). It endorses on the reverse of the instrument a fixed or variable stamp.
The encoder has the facility to proof the pay-in-slip amount or control totals
simultaneously by marking off successive amounts of encoded cheques thus arriving at
a zero balance when all the cheques are encoded and bringing out discrepancies, if any,
in the totals or errors during encoding. The figures are cumulated to enable encoding
of the control documents viz., Batch and Block tickets. The encoders are also
programmed to simultaneously affix/print the Clearing Endorsement Stamp on the
reverse of the instrument, in the format prescribed. Encoders with compatibility to PCs
are available, as also are power encoding machines and encoders with limited sorting
facilities. Encoding work could either be decentralized at branches or centralized at the
Service branch depending on the logistic in the bank. Clustering of encoding work at
some branches to take care of smaller branches in the vicinity is another option
available. Following are some images of popular encoders used by banks.
Figure 5.1 Encoders used by Banks
5.5.1.2 Reader/ Sorter

Previously two different methods for check processing were used. They were Sort-A-Matic and
Top Tab Key Sort.
Sort-A-Matic method: It was made up of 100 dividers from 0-99 made up of leather or metal. It
sorted checks through stepped or phased process. After reviewing the first two numbers of the
account the checks were then placed into dividers which were then grouped by second two
numbers and so on to make the check in numerical order of account numbers.
In Top Tab Key Sort holes are being punched at the top of each check indicating the ones, tens
and hundred digits. For sorting the checks, a metal key was inserted into the checks separating
them by the corresponding holes until they get arranged according to the account number.
Both these methods were time consuming and outdated methods which eventually led to the
emergence of the MICR encoding and sorting.
A Reader/Sorter is a device that reads the MICR encoded documents and sorts (direct)
them to one of the many pockets as per the pre-determined sort pattern/program. The
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characters are printed using special magnetic ink which contains iron oxide. As the
document passes into the MICR reader, the ink is magnetized so that the shapes of the
character can be recognized electronically. Documents are fed automatically from an
input, which can handle documents of various sizes simultaneously. The documents
travel past an electronic field, which magnetizes the characters, and symbols in the
MICR read band and generates distinct wave patterns intelligible to the machine.
The physical sorting of cheques on the machine is carried out under the control
of a computer program. This sort program, while directing the documents to the
designated pockets, simultaneously captures and stores the information in the MICR
code line on the cheques. The information captured from the documents is
simultaneously stored on disk/tape, etc. and used for further processing. In case certain
information is not read due to defective printing, encoding, etc., the cheque is directed
to a ‘Reject’ pocket along with the control documents. These are taken out and the
missing information is completed by manually keying in the data.
Following are the photographs of MICR readers one is an older version another is a
current one.
An early MICR machine the "football field-long" machine from Recognition
Equipment was used in the 1970s to process checks and credit card slips. (Image
courtesy of BancTec, Inc.)
A current MICR machine this contemporary machine supports both MICR and OCR
(optical character recognition) processing. (Image courtesy of BancTec, Inc.)
Figure 5.2 New MICR Reader
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Figure 5.3 Old MICR Machine
5.5.1.3 Image Capture

Image capture and image processing technology is a recent development in document
processing by which the image of a payment instrument is captured simultaneously
when it is processed on reader/sorters by adding an image capture module and related
software. The images so captured are stored on magnetic media for retrieval and
processing. The images can be displayed on a screen and copies can be printed. It is
also possible to transfer the image data to banks through magnetic media or through
the communication backbone. The availability of image files enhances the processing
quality and speeds up reject recapture, balancing, etc. The stored images could also be
retrieved at a later date to facilitate quick reconciliation of clearing differences.
5.6 MICR Standards

Following are some character, fonts and printing standards followed.
5.6.1 MICR fonts

MICR fonts are printed at the bottom of every cheque or demand draft now –a-days.
The MICR font looks like as under the following diagram.
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There are two different fonts that appear at the bottom of the checks or financial
documents, which are used according to the established banking standards in the
country. These are E-13B and CMC-7.
The E-13B fonts look like this:
This one is accepted in USA, UK, Japan, Australia, India, Canada, Mexico, Columbia and
Turkey.
And the CMC-7 looks like:
and is accepted in the countries- France, Spain, Israel, South America and
Mediterranean countries. (source: ANSI 9.27 specification)
The ABA (American Bankers Association) accepted the specification for the E-13B font
and use of magnetic ink as a standard in 1958, and then in 1959 the first ABA publication for
MICR was issued. Lithographic printing and impact ribbon were adapted to the process
shortly afterwards. The American National Standard Institute (ANSI) adopted the ABA
specification in 1963 as the American Standards, with local revisions.
In addition to their unique fonts, MICR characters are printed with a magnetic ink or
toner so that, even when they have been overprinted with other marks such as
cancellation stamps.
5.6.2 Character Specification

The character set comprises 10 numerals and 4 special symbols. The ten numerals are:
0123456789
The four special symbols are:
Amount <
Domestic =
BSB ;
Dash >
But there could also be some problem with the MICR characters:
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This way the character printing may lead to fallacies. So printing is the most important
part of MICR enabling.
5.6.3 Print Specification

The instruments passing through clearing are required to be issued in standard format
and defined size of 8” x 3 2/3”. The instruments should be printed on MICR grade
quality paper with a “read band” of 5/8” in width reserved at the bottom on which
essential particulars occur in special MICR ink in the above mentioned E-13B Font.
Approved security printers forming part of a panel, which is maintained by the Indian
Banks’ Association, print cheques. The numeral which we see at the bottom of any
cheque these days is known as the MICR code line structure. This also follows a
particular format, every sequence of number has some importance which depicts some
information.
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Figure 5.4 MICR Code Line Structure

1 - Cheque serial number of six numeric digits preceded and followed by a delimiter.
The alphanumeric prefix to the serial number normally used by banks should be printed
outside the code line in close proximity, just above the read band, in normal ink.
2 - Sort field or the city/bank/branch code number consisting of nine digits followed
by a delimiter. The first three digits represent the city; the next three indicate the bank and
the last three digits signify the branch. The nine-digit sort code is unique for any bank
branch in the country.
The bank code is a three-digit code number allotted to the bank on an all-India basis.
The branch code is the last three digits of the nine-digit sort code and is unique to a
branch in a city. Allotment of branch codes is by the President of the Clearing House of
which the Bank is a member; generally the service branch of a bank is allotted the
branch code of ‘001’.
A sub-member will be treated as if it were a branch of the sponsoring bank. It would
have the bank code number allotted to the sponsor bank to be followed by the branch
code, which would normally commence from 251.
A full list of nine digit code number allotted to each bank/branch along with the three
letter alphabetical abbreviations for the clearing stamp could be obtained from the
President of the concerned Clearing House.
3 - Account number field consisting of six digits followed by a delimiter is an optional
field. In the case of Government Cheques issued by CENTRAL BANK alone (the RBI in
India), the account number is of seven digits. The Government Account number is 10
digits in length – 7 digits occurring in the Account number field and three in the
transaction code field.
4- Transaction code field comprising of two digits in all instruments except
Government cheques drawn on CENTRAL BANK, which have a 3-digit transaction code.
Control documents – batch and block tickets have a three digit representation in the
transaction code field.
5 - The last field represents the amount field and consists of 13 digits bounded on
both sides by a delimiter. The amount is encoded in paise without the decimal point. It
should be noted here that this field is empty while customer has his checkbook with
him. Only after issuing a check to the Payee and when the check enters the clearing
process in the Drawee’s bank, then this amount field will be filled automatically by the
system. Hence this implies that under normal circumstances, customers can never see
this field filled!
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5.7 The Process of check clearing at different levels

Now the in the current cheque clearing process the cheque has to travel through
various levels before getting realized i.e. before the actual transfer of funds into the
payee’s account from the payer’s account. All these steps comprise of the clearing
process of the cheques.
Clearing is an arrangement through which a bank exchanges cheque drawn on other
banks for those drawn on it, and the obligation of each party is determined. In the
absence of such an arrangement, each bank will have to present cheques to each of the
other banks for receiving payment of cheques over which they have a claim. The
cheque clearing system provides a easy, systematic, efficient and cost-effective method
of clearing cheques.
For Example Vinod Shah deposits a cheque into his account, at Dadar Branch of Bank
of Baroda. This cheque has been given to him by Paresh Modi who has an account with
Andheri Branch of Dena Bank. The processing of this cheque deposit transaction
involves the debit of Paresh’s account at Andheri Branch of Dena Bank, and credit
Vinod’s account at Dadar Branch of Bank of Baroda. The activities involved in carrying
out this transaction are as follows:
• The cheque has to be sent to Andheri Branch of Dena Bank, so that they can
carry out the validations, and debit Paresh’s account in their branch.
• Andheri Branch of Dena Bank has to then debit the account in their branch and
send the credit to Dadar Branch of Bank of Baroda.
• On getting the credit from Andheri Branch of Dena Bank, Dadar Branch of Bank
of Baroda will in turn credit Vinod’s account in their branch.
This activity becomes a complex task as every day individuals all over the country are
sending cheques drawn on their account at one bank to people who bank with other
banks. There will be a continual stream into each bank, of cheques drawn on each of
the other banks. Such exchange of cheques therefore takes place in a Clearing House.
We will describe below the stages involved in cheque clearing. This is the process
followed when the cheque that has been deposited is drawn on a bank that is in the
same city. This is referred to as Local Clearing.
5.7.1 Local Clearing

The timings indicated are not uniformly applicable across all branches, but are quoted
for better understanding. The various stages involved in the clearing of cheques are as
follows:
1) Let us say that on any day around 500 cheques are deposited by the customers at
Mahim Branch of Bank of Baroda. The branch would collect the cheques until a fixed
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time say 3.00 p.m. Cheques deposited after 3.00 p.m. will be sent for clearing on the
next working day only.
2) After collecting all the cheques, a clerk in the clearing department would enter the
details of all these cheques in an Outward Clearing Register. The cheque amounts will
then be totaled using an adding machine. The listing from the adding machine will be
attached to the bundle of cheques, and sent to the Service Branch of the bank. The
cheques are collected until 3.00 p.m., and are sent out of the branch to the bank’s
Service Branch at around 4.00 p.m.
3) As per central bank guidelines, each clearing cheque bundle or lot should contain at
most 300 cheques. This activity at Bank of Baroda where the cheques drawn on
different banks that have been deposited by the customers are collected and sent to
Service branch is referred to as Outward clearing.
4) The Service branch of a bank receives cheques from all the branches of that bank in
that city. These cheques would be of different banks. At the Service branch, the
cheques are sorted bank-wise and encoded using the encoding machines. Encoding of
the cheques involves the printing of the cheque amount, city code, bank code and
branch code on the MICR line (at the bottom of the cheque). After encoding, the Service
branch bundles the cheques bank-wise with control information on the number of
cheques and the total amount for each bank.
5) The cheques from the Service Branch are then sent to the Clearing House which is
generally managed by central bank or nominated bank.
6) Once the Clearing House receives the encoded cheques from the various banks
(through their Service Branches), these cheques are processed during the night by the
reader sorter machines. These machines read the encoded information from the MICR
line, which contains details such as the bank branch where the cheque was issued, the
bank branch where the cheque has been sent for clearing, and the cheque amount. The
clearing of cheques involves transfer of funds from one bank to another, i.e. settlement.
At the Clearing House, each bank has to maintain an account with the managing bank.
The inter-bank transfer of funds required in the course of cheque clearing, is affected by
debiting and crediting the accounts of the respective banks’ accounts with central bank
. Each bank in turn will credit or debit the account of the branch with the Head Office.
Simultaneously, the cheques are sorted based on the bank branch where the cheque
was issued.
7) Next day, the personnel from the Service branch of each bank, would collect the
cheques issued from its own branches, from the Clearing House. The Service branch
sorts the cheques branch-wise. Each branch will send a person to the Service branch of
the bank early in the morning, to collect the cheques issued from their branches, which
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have come through clearing. These cheques reach the branch at around 11.00 a.m. If
there are any cheques which are to be returned due to insufficient balance or any other
reason, then these have to be sent out of the branch by 3.00 p.m.
8) In case any cheque is returned, then the cheque is sent by the branch to the Service
branch from where it is forwarded to the Clearing House who will return it to the bank
where the cheque was deposited. If a bank branch does not receive any cheque return
advice, then it treats the cheque as cleared. If a cheque return advice is received, then
the account is debited.
9) Thus the Dena Bank (Andheri Branch) cheques deposited at Bank of Baroda (Mahim
Branch) reaches Dena Bank (Andheri Branch) at around 11.00 a.m. on the following
working day. These Cheques are posted to the respective customer accounts. Incase of
returns that might arise due to insufficient balance, signature mismatch, etc. the
cheque has to be sent back from the branch at around 3.00 p.m. These return cheques
will reach branch Bank of Baroda (Mahim Branch) early in the morning on the 3rd day.
On the 3rd day morning all the cheques except the ones returned will be treated as
cleared.
This activity at Dena Bank branch, where the cheques drawn on Dena Bank that have
been deposited at various other banks are received from the Clearing House and
processed is referred to as Inward clearing.
Following is a representation of the Clearing Cycle. Consider the Cheques of Dena Bank
that has been deposited at Bank of Baroda:
Figure 5.5 showing the Operation Cycle of Cheque Clearing
In this whole cycle the operations performed at the branch Bank of Baroda are referred
to as the Outward Clearing operations, since the cheque is going out of this branch. The
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operations at the branch of Dena Bank are referred to as Inward Clearing Operations. In
the course of the cheque clearing the flow of funds will be as follows:
• The customer who has drawn the cheque gets debited
• Funds are transferred between the two banks involved
• The customer who deposits the cheques gets a credit in his account.
Now a branch can decide to credit the customer’s account by the cheque amount on
the day it was cleared or for the benefit of customer can decide to credit the account on
the day it was deposited. In the latter case, the balance to the extent of cheque amount
will remain uncleared till it gets cleared on the third day.
5.7.2 Outstation Cheque Clearing

If the cheque deposited has been drawn on a bank branch that is not in the same city,
then this cheque is sent for Collection. A cheque of Bank of Baroda Chennai branch is
deposited in Indian Bank at Nariman Point branch. This cheque will not go in the
outward clearing of Indian Bank. Indian Bank – Nariman Point branch will send this
cheque to Indian Bank branch in Chennai. From there it will follow the Local Clearing
process and the Chennai branch of Indian Bank will receive the credit. Chennai branch
will then forward the credit to the Nariman Point branch of Indian Bank.
5.8 Main Operators of the Clearing Cycle
5.8.1 Service Branch

Service Branch is a specialized branch of a bank for handling clearing of cheques,
payment towards Demand Drafts, Pay Orders and collection of outstation cheques. Its
basic objective is to facilitate the clearing process. Generally, banks have one Service
branch in major cities.
Wherever it is not feasible to operate an exclusive service branch, an existing branch
acts as a nodal branch and carries out functions of service branch.
5.8.2 Clearing House

The primary objective of the clearing house is to facilitate the speedy and economic
way of collecting cheques, bills and other documents payable or deliverable at or
through offices of the members and sub-members of the house situated in that town
by a system of clearing.
In general, central bank undertakes the management of the clearing house. In the
absence of this, one of the public sector banks in that centre, which may be specified by
central bank , shall be managing the Clearing house. Clearing houses are established in
all the cities, towns and even large villages where the volume of cheques is large and
number of banks in the area is more than 2. This results in considerable saving of time
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and cost. Clearing houses are autonomous institutions having uniform regulations and
rules regarding the conduct of operations.
5.8.3 Settlement Agent

This is explained with the help of an example.
Central Bank of India presents cheques drawn on other banks which were deposited by
its customers. The instruments are grouped by Central Bank of India bank-wise and the
amount due from each bank is shown therein. The aggregate of these amounts
represents the total amount to be received by Central Bank of India from all other
banks. The instruments are presented to the respective bank along with a memo in a
clearing house. Likewise Central Bank of India also received cheques presented by other
banks. The aggregate of the totals of such instruments delivered by other banks
represents the total amount of cheques drawn on Central Bank of India and payable by
it. The difference between the two amounts is the net debit or credit to Central Bank of
India. The Central Bank of India as well as other member banks keeps an account with
the presiding bank-branch which manages the clearing house, through which these
debits/credits are passed.
5.9 Reconciliation of clearing differences

Generally, there are two types of ‘clearing differences’ that may arise viz.,
• Inward Clearing Differences
• Outward Clearing Differences.
5.9.1 Inward clearing differences

Inward Clearing Differences are of the following types:
• Cheques listed to the bank/branch but not received by it - the Clearing
Receivables
• Cheques received by the bank/branch but not debited to it - the Clearing
Payables;
• Cheques received by the bank/branch with the actual debit not tallying with the
face value of the instrument.
For all the Clearing Receivable differences reported by a branch, the Service Branch
should maintain full data and try to match these with the Clearing Payable differences
reported by the other branches. If no such matching is possible, then the Service Branch
could forward the Clearing Receivable Report to the presenting bank for further action
as per the Clearing House Rules. For Clearing Payable differences too, the same
procedure could be adopted and unresolved Clearing Payable Report sent to the
cheque-processing centre as per the Guidelines. The CPC [Check processing Centre],
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would, on the basis of the MICR data available at their end, find out the bank/branch to
which the actual debit has been raised and inform the same to the bank/branch
reporting the Clearing Payable difference that could issue a Pay order to the affected
branch for settlement of this un-reconciled clearing difference.
In the case of a cheque listed for a value higher than the actual amount of the cheque,
the branch may debit the drawee’s account for the actual amount of the instrument, if it
is otherwise in order, and the excess should be reported to the Service Branch for
onward follow-up with the bank/branch concerned. In the case of a cheque which is
listed i.e. the debit has been raised, for an amount lower than the value of the cheque,
the branch may debit the drawee’s account for the actual value of the instrument, if it is
otherwise in order, and the difference passed on to the Service Branch for onward
transmission to the presenting bank/branch after verifying the position from the
cheque processing centers
5.9.2 Outward clearing differences

Outward Clearing Differences could arise in one of the following ways:
• No credit received in respect of an instrument presented.
• Short credit received in respect of an instrument presented.
• Excess credit received in respect of an instrument presented.
• Credit received in excess of the claim.
In respect of first three above, the differences should be reconciled promptly, if
necessary by obtaining the additional information from the CPC or in consultation with
the drawee bank/branch concerned. As regards to the last one where credit is received
in excess of the claim, the Service Branch should be informed of the position by
reporting the same in the daily Branch Clearing Control Report. The service branch
should attend to such cases promptly and ascertain the reasons therefore by referring
the matter to the CPC. Before making a reference, however, the Service Branch should
verify from the Branch Clearing Statement and the branch wise claim figures whether
the excess credit is adjusted against a corresponding short credit against another
branch. Such inter-branch clearing differences should be reconciled internally without
reporting the same to the CPC.
It must be recognized that reconciliation of clearing differences is an important activity
that assumes greater significance since this is also an area that may give rise to frauds.
The essence of reconciliation is the need for all banks and branches to follow the set
rules and guidelines laid down in this regard. Prompt reporting and solving of the same
should, therefore, be the prime concern of all players in the field. It would also be
desirable that all un-reconciled clearing differences payable are transferred to the
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Chapter-6 Electronic Funds Transfer and Electronic

Clearing Systems
6.1. Introduction
This chapter focuses on electronic fund transfer and electronic clearing process. In this
chapter the Indian scenario for both EFT and ECS has been highlighted to explain the
concepts with better clarity.
6.2. Learning objectives

After reading this session, you will
• Learn about the aspects of electronic transfer of funds
• Basics of the ECS or electronic clearing service
• Know major players and their role in the EFT process.
6.3. Topics Covered

Chapter-6 Electronic Funds Transfer and Electronic Clearing Systems..................................... 3
6.1. Introduction..................................................................................................................................... 3
6.2. Learning objectives...................................................................................................................... 3
6.3. Topics Covered............................................................................................................................... 3
6.4. Electronic Funds Transfer – an introduction ..................................................................... 3
6.5. Advantages of Electronic Funds Transfer ........................................................................... 4
6.6. Payments Made By EFT............................................................................................................... 6
6.7. The RBI EFT system ....................................................................................................................... 6
6.7.1 Process Flow in the RBI EFT................................................................................................ 6
6.7.2 The RBI EFT Network............................................................................................................. 7
6.7.3 Some Applications of EFT.................................................................................................. 8
6.8. Electronic Clearing Services (ECS) – an introduction ..................................................... 9
6.9. Importance of ECS ........................................................................................................................ 9
6.10. Electronic Clearing Services (Credit Clearing)............................................................ 9
6.10.1 Participants of ECS (Credit Clearing)......................................................................10
6.10.2 How ECS Credit clearing works................................................................................10
6.10.3 The ECS Process Cycle..................................................................................................11
6.11. ECS (Debit Clearing) ............................................................................................................13
6.11.1 Participants of ECS Debit clearing ..........................................................................13
6.11.2 The process cycle for the ECS ....................................................................................14
6.12. Proportions of Retail Electronic Transactions in India..........................................14
6.13. Summary..................................................................................................................................14
6.4. Electronic Funds Transfer – an introduction

Electronic Funds Transfer is a method of funds transfer by which the payer, (it could be
an individual or a financial institution,) can give electronic (non-paper) instructions to
the financial institution to debit or credit customer accounts and henceforth making
the funds to move (transfer) from one account to another. The EFT mode of funds
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transfer is faster and comparatively safer than funds transfer with the help of paper
checks. Basically EFT is an alternative channel of payment, both for debit payments like
mortgages, insurance premiums as well as for credit payments like payroll, dividends
and other income. It has become more prevalent with more and more use of personal
computers, arrival of cheap networks, internet, cryptography etc.
The history of Electronic funds transfer originated from the common funds transfer
from the past .Since the 19th century with the help of telegraphic funds transfer were a
usual thing in commercial transactions. Finally with the advent of computers
transactions took place electronically and came to be known as ‘Electronic funds
transfer’
6.5. Advantages of Electronic Funds Transfer

EFT is similar to other direct deposit operations such as paycheck deposits, and it offers
a safe modern alternative to paper checks. Providers who use EFT would realise the
following benefits:
• The main advantage of this technology is time saving, since all transactions are
done automatically and electronically.
• Reduction in paper-based transactions.
• Savings in time and other logistic operational costs normally incurred in
presentation of paper checks and visit to Banks for this purpose.
• Elimination of the risk of paper checks being lost or stolen in the mail or in any
form of transit. Also, the risk of mutilation and damage of checks is eliminated in
this case.
• Faster access to funds as most banks credit direct deposits faster than paper
checks (which go through the clearing process)
• Easier reconciliation of payments with bank statements.
DID YOU KNOW?

In 1996, in the USA, the IRS introduced its free e-payment service, the
Electronic Federal Tax Payment System. In 2004, 1.75 million people paid
their taxes electronically. To sign up, all you need is your Social Security
Number and checking account information. In addition to paying your tax
bill online, you can access your payment history and schedule tax payments
for next year
SOURCE: EFTPS ( Electronic Federal Tax and Payment system)
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Traditionally, the primary modes for Funds transfer are Demand Draft, Mail transfer and
Telegraphic Transfer. The demand draft facility is paper based. The remitter, after
purchasing demand draft from a bank branch, dispatches the same by post/courier to
the beneficiary. The beneficiary, in turn, lodges the draft to his/her bank for collection
and clearing. The time taken for completing the process is about 10 days. In the case of
telegraphic transfer, fund reaches the beneficiary either on the same day or the next;
but both the remitter and the beneficiary would have to be account holders of the
same bank. If they are customers of different banks, a good deal of paper processing is
required. On the other hand, the EFT system is an inter-bank payment system. The
Central Bank of the nation acts as an intermediary between the Remitting bank and the
Receiving bank and effects inter-bank funds transfer. The customers of these banks (i.e.
the Payer or Remitter and the Payee or Beneficiary) can request their respective
branches to remit funds to the designated customers’ accounts irrespective of bank
affiliation of the remitter and beneficiary. This makes the task of message reaching to
the banks easier and quicker.
A recent survey and statistical analysis by First Annapolis came up with the results:
Here, it can be seen that the electronic transactions increased from 33% to 43% in last 5
years and there is a phenomenal drop down of the percentage of paper transaction
occurrences. The check transactions significantly declined with time whereas those of
electronic are showing a northwards move.
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6.6. Payments Made By EFT

The Electronic Fund Transfer or EFT is deployed in several payment scenario. For
example, when a company which is public i.e. has shares floated in the nation’s stock
exchange announces a dividend uses EFT, rather than sending the check of dividend to
each shareholder. When you transfer funds from an account to another with the help of
online banking is also known as EFT (rather it is NEFT- “N” for National). Other
applications include payment of taxes and payment of salaries to the employees.
Payroll disbursement is a very important usage of the EFT system. Hence, EFT is mainly
employed for the bulk (high volume) but low value retail payment transactions.
6.7. The RBI EFT system

In this section of the session, we will learn about the Electronic fund transfer initiative of
our nation’s central bank, Reserve Bank of India. It is again a scheme initiated by the
central bank so as to enable customers to transfer funds electronically.
The EFT system of RBI started its transactions on the BANKNET network. Where
BANKNET was X.25 based packet switching network jointly owned by the Reserve Bank
and the public sector banks. The computer system resources of the four IBM
Mainframes (installed at the four metros for cheque processing operations) are used
during the day time by BANKNET for data communication with additional equipment.
This later evolved into the INFINET network.
The major applications and usage of INFINET are:
• Inter-bank fund transfers on banks' own account and on customers' account;
• Inter-branch funds transfers on banks' own account and on customers' account;
• Government transactions;
• Facilitates automated clearing services (similar to BACS);
Funds Settlement Time Frame in RBI EFT
• Till year 2001 from the time of its establishment in 1996 the RBI EFT used to
settle funds on T+1 basis across other cities and on same day for metros
• Subsequent to year 2001 , RBI EFT makes settlement throughout the country on
a same day basis.
6.7.1 Process Flow in the RBI EFT

Step 1 – The customer fills up the EFT Application form in duplicate (similar to the
draft application form) which contains the beneficiary’s account information viz. A/c
name, A/c no, A/c type, Bank /branch name and City
Step 2 - On receipt of the application from a Remitter, the branch checks Beneficiary
details and Applicant details and sends it to its Service Branch along with following
documents.
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– EFT Scroll
– EFT application forms
Step 3 - At the Service Branch, the Beneficiary particulars are verified and ensured that
all the details are correctly filled in.
Step 4 - The data is entered in an application which has a well defined template for all
the fields.
Step 5 - Officer level user verifies the transactions and freezes them
Step 6 - At the cut-off time for settlement at RBI, the file is generated containing all the
transactions for the day (incl. Acknowledgement of inward transactions).
Step 7 - RBI office merges files from various banks and generates centre-wise files. It
transfers the files to other centers over the INFINET as per the pre-defined time
schedules 12 noon, 2 pm and 4 pm.
Step 8 - At each of the RBI centers, files from all the centers are processed and uploaded
to the respective service branches of the destination banks. Service branches process
the file and print branch level report containing beneficiary details.
Step 9 - Destination branches credit the account to the beneficiary’s account.
The following figure 6.1 shows the process.
Figure 6.1 EFT Process flow
6.7.2 The RBI EFT Network

The EFT system presently covers all the branches of the 27 public sector banks and 55
scheduled commercial banks at the 15 centres (viz., Ahmedabad, Bangalore,
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Bhubaneswar, Kolkata, Chandigarh, Chennai, Guwahati, Hyderabad, Jaipur, Kanpur,

Mumbai, Nagpur, New Delhi, Patna and Thiruvananthpuram). Funds transfer is possible
from any branch of these banks at these centres to other branch of any bank at these
centres both inter-city and intra-city. The following diagram shows the total network.
Centres which are connected with larger arrows are the centres where the mainframes
are located and together they form the communication backbone.
Figure 6.2 RBI EFT Network
6.7.3 Some Applications of EFT

• E- Cheque of ICICI Bank, Corporation Bank. Similar products of Bank of
Punjab, Vysya Bank. Companies (including LIC) can pass on credits from
their account after settling the case, from their office itself!!
• EFT for crediting merchant establishments of Credit Cards, Point of Sale,
Smart Cards.
• Corporate crediting Suppliers through EFT. Railways and Defense
Suppliers credits.
• Routing Foreign credits to beneficiaries in India.
• EFT interface on internet allows customers freedom to credit
beneficiaries in other banks without visiting their bank.
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• Banks having EDI interface with Govt. Departments say for example
Customs, can credit payments like duty drawback etc., into accounts of
other banks instead of giving pay orders.
6.8. Electronic Clearing Services (ECS) – an introduction

The above term, Electronic Clearing Service as the name clearly implies goes in tandem
with the Electronic Fund Transfer. The objective behind its origination was to eliminate
the paper based instruments for the bulk payments like payment of interest, dividend,
refund, etc. which usually are disbursed by companies through paper-based
instruments. This in turn will help immensely the banks and
Companies/Corporations/Government Departments effecting the payments and hence
resulting in faster and efficient customer service.
ECS is a mode of electronic funds transfer which uses the services of a Clearing house to
enable transfers from one bank account to another account. This is normally used for
bulk transfers. This can be used for both distribution and collection of amounts.
6.9. Importance of ECS

• Saves cost in bulk payments
• Paper based instruments put a lot of stress on the clearing and settlement
systems.
• Moreover, studies done by RBI shows that volume wise paper checks arising
from the periodic payments may be very high but value wise they are quite low.
ECS scheme helps organizations such as Unit Trust of India, Life Insurance
Corporation, banks and mutual funds and utility companies for their respective
receipts and payments so that the ever increasing volume of paper instruments
flowing to banks and clearing houses could be arrested.
• Chances of the paper based instruments getting lost in transit and exposure to
fraud are very high
• In case of loss, instrument has to be re-issued which takes additional time
• To prevent fraud the validation procedures involves procedural delay
• The payment cycles become very long in paper based instruments.
6.10. Electronic Clearing Services (Credit Clearing)

In the case of ECS Credit, a series of electronic payment instructions are generated to
replace paper-based instruments. The system works on the basis of one single debit
transaction triggering a large number of credit entries. These credits or electronic
payment instructions which possess details of the beneficiary's account number,
amount and bank branch, are then communicated to the bank branches through their
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respective service branches for crediting the accounts of the beneficiaries either
through magnetic media duly encrypted or through hard copy.
e. g dividend, interest or salary payment come under ECS(credit clearing)
6.10.1 Participants of ECS (Credit Clearing)

• User
These are the companies/corporations/Government Departments or any other
institutions effecting bulk payments to a large number of beneficiaries (For example a
dividend paying firm or the firm making payroll payment).
• Sponsor Bank
It is the bank which would act as the agent of the User to submit the payment
instructions prepared by the User to the National Clearing Cell (NCC) and which would
give a mandate to Reserve Bank of India / Clearing Agency designated by RBI to debit
its account.
• National Clearing Cell (NCC)
This is a functional unit of the local Bankers’ Clearing House or such other agencies
created by RBI which process the payment instructions received from the Sponsor Bank
and generate relevant clearing reports for settlement of accounts of banks at RBI. The
institutional arrangements made by RBI shall be final.
• Destination Account Holder
It refers to the beneficiaries who opt to receiving payments from the User directly by
way of credit to bank accounts.
• Destination Bank Branches
It refers to the bank branches where the Destination Account Holders maintain their
bank accounts into which ECS payments are credited.
6.10.2 How ECS Credit clearing works

The figure below (10.3) explains the working of the ECS Credit Clearing process. A
payment is initiated by the corporate institution generating the payment instruction
which will debit its (the corporate institution’s) account and credit multiple user
accounts. The corporate institution’s bank will then submit the payment instructions on
its behalf to the clearing house, which in turn clear the payments and credits the
destination accounts of the beneficiaries.
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Figure 6.3 Working of ECS (credit clearing)
6.10.3 The ECS Process Cycle

Table 6.1 ECS Process Cycle
Corporate Institution submits payment
details on a data storage device to the
Day-1 Clearing House through its banker
(Sponsor Bank)
Clearing House sends the credit reports
Day-2 (on data storage device) to the Service
Branches of the investors’ banks
(Destination Banks)
Service Branches send the credit reports
Day-3 (mostly on paper) to investors’ branches
(Destination Branches)
Destination Branches credit the investors’
Day-4 accounts on the due date of payment
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Figure 6.4 ECS Process
Figure 6.5 ECS Process Flow

The above figure 6.5 explains the same process of clearing in a schematic manner
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6.11. ECS (Debit Clearing)

As opposed to the ECS credit clearing, the ECS debit clearing service is used when
multiple debit entries from different accounts are required to be initiated and credited
to a single account. The objective is to provide an alternative method of effecting
payment transactions in respect of the utility-bill-payments such as telephone bills,
electricity bills, insurance premium and loan repayments, etc. which would obviate the
need for issuing and handling paper-based instruments and thereby facilitate improved
customer service by the banks/companies/corporations government departments
collecting / receiving the payments.
6.11.1 Participants of ECS Debit clearing

• User
User refer to the utility-companies, insurance/corporations and government
departments or any other institution receiving / collecting repetitive payments from a
large number of customers/beneficiaries, under the scheme. The individual transaction
limit under the scheme is generally fixed at a certain amount.
• Sponsor Bank
It refers to the bank which has agreed to act as the agent of the user company and to
submit the data storage device containing debit instructions prepared by the user to
the RBI National Clearing Cell (NCC) (to be referred to as RBI hereinafter).
The Sponsor Bank also submits an undertaking to the effect that the standing
instruction mandates to debit the accounts of the concerned users mentioned in the
media device have been duly collected from the utility-users (consumers etc.) and have
been forwarded to the respective destination bank branches for credit to the account of
the Sponsor Bank with the sum mentioned therein.
This mandate will also authorize RBI to debit Sponsor Bank's current account
maintained with them to the tune of un-debited returns.
• National Clearing Cell (NCC)
This is a functional unit of the local Bankers' Clearing House or such other agency
created by RBI which processes instructions for debit payment received on magnetic
media from the Sponsor Bank. The data is validated and then the NCC generates
relevant ECS-Debit clearing settlement reports for debit/credit of the current account
maintained at RBI. The instructional arrangements made by RBI is final.
• Destination Account Holders
This refer to the utility-consumers such as telephone and electricity users, insurance
policy holders, debtors etc., under the ECS Debit Clearing scheme who opt for making
payments to the User company directly by way of debit to their bank accounts as
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indicated by them in the individual ECS mandate submitted by them to the utility
company and also to their bank/branch.
• Destination Bank Branches
This refers to the bank branches where the Destination Account Holders maintain their
bank accounts from which ECS utility payments are debited.
6.11.2 The process cycle for the ECS

The process cycle for the ECS debit is same as that of ECS credit with only difference
that in the ECS Debit the initiators of the payment instructions being the beneficiaries
of the ECS credit services.
6.12. Proportions of Retail Electronic Transactions in India
Figure 6.6 Retail electronic transactions (By value and volume)
6.13. Summary
• Electronic Funds Transfer is a method of funds transfer by a Payer who could be
either an individual or a financial institution.
• Basically EFT is as an alternative channel for payments - both debit payments
like mortgages, insurance premiums as well as for credit payments like payroll,
dividend and other income disbursement.
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7.4. Check 21 – an overview

In the year 2000, Federal Reserve Board (FRB) started working on improvement of the
processing of checks in U.S in accordance with the changed scenario (to suit the needs
of the 21st century). Fed mainly focused on promotion of check truncation, and
electronic check presentation.
The final outcome of their endeavour was “Check clearing for the 21st Century Act”
(popularly known as Check 21). The main idea was to come up with a machine readable
copy of a check (a substitute check) for traditional check for forward collection or
return. Substitute checks that meet the requirements of this act would be legal and
practical equivalent of the original check. During this entire process, the FRB worked
with the industry partners and other stake holders during the different versions of this
Act.
On December 21, 2001 FRB sent a proposal to the members of the senate and House
Banking Committees. Both the House and senate introduced a Bill in 107th congress.
Many banking organizations monitored the legislative process and provided inputs. All
sectors of the banking industry like small banks, large banks, credit unions, technology
companies, FRB worked closely and supported the act in its passage strongly. Check 21
is short for “Check Clearing for the 21st Century Act”. Check 21 was signed into law on
October 28, 2003 and became effective October 28, 2004. Check 21 allows banks to
create and process a substitute check, also known as an Image Replacement
Document (IRD) in lieu of an original check. Its purpose is to improve the speed and
reliability of the check-clearing process by taking as much of the paper out of the
process as possible.
It helped develop the Substitute Check that is the legal equivalent of the original check
and it is the electronic copy or image of the original check.
Finally, the Accredited Standards committee focused on the development of industry
standards for the financial services industry and developed the technical specifications
for the substitute checks.
7.5. Why was Check 21 created?

While the current paper check clearing system in the U.S. is well established, the
logistics of moving physical paper checks across America for processing and clearing
has long been an impediment to further efficiencies. The check clearing for 21st century
act was enacted into law on October 28th 2003 by 108th congress and is a United States
Federal Law.
The Check 21 Act was enacted primarily in response to the September 11th, 2001
terrorists' attacks that grounded virtually all check payments and forced the U.S.
Page 4 of 21
government to rethink how paper checks are processed. This new law will eliminate
much of the risk associated with moving billions of checks, such as: transportation
breakdowns (labor and mechanical), weather delays, fraud, theft and terrorism.
7.6. Highlights of the Check 21 act

Main purposes of Check 21 are
• To facilitate check truncation
• To develop innovation in the check payment without mandating the payment
of check in electronic format
• Overall improvement of the payment system.
This act created a new negotiable instrument called “substitute check”
• If this substitutable check meets the criteria of the act then it is legally
substitutable to the paper-written traditional check
• This substitute check can be processed similar to the paper check
• Involved Parties cannot refuse to accept these substitute checks if they follow
all the requirements by the act “Parties” involve all the banks, Federal Reserve,
consumers, customers and other financial services institutions.
The act provides legal equivalence only for substitute checks.
• The act provides check truncation and electronic image/ exchanges but does
not provide legal equivalence for electronic check or image presentment
• Check clearing services where electronic checks are used, require the
agreement of the parties who are accepting the electronic form of the
instrument for value
• This act encourages the use of electronics to the empowering banks to truncate
the original checks, and give paper checks where necessary.
All checks except foreign checks are eligible to become substitute checks, some of the
following which can act as substitutable checks are
i. Consumer checks
ii. Business checks
iii. Corporate checks
iv. Government warrants
v. U.S treasury checks
vi. Money Orders
vii. Control disbursement checks
viii. Payable through drafts
ix. Traveler’s checks.
Page 5 of 21
• Usually the bank providing the substitute check to the subsequent parties
should provide warranties and an indemnity to the subsequent parties
involved in collection and return process
• Warranty involves that the substitute check meets the Act’s legal
requirements
• No party will be asked to make payment for the check which it has already
paid (No double debit)
• The indemnity relates to the losses that incurred due to accepting this
substitute check instead of the original check
• In the instance of warranty breach, the indemnity includes the damages
proximately caused
• In the absence of warranty breach, the indemnity is for the amount of the
substitute check and interest
• The indemnity bank may limit its liability if it can produce the original copy of
the check.
Even this Act has an expedited re-credit facility for those who receive the substitute
check.
• Consumer may claim expedited re-credit if the substitute check is improperly
charged to the consumer account and even the consumer has the warranty
claim if the consumer suffered any loss
• Banks are required to provide consumer awareness notices to the consumers
whom they give substitute checks
• This will be applicable to both the existing as well as new customers.
7.7. What is Check Truncation?

Truncation is stopping the flow of the physical check issued by the issuer to the issuer’s
branch. Actually some where in the route the physical check is stopped from further
travel and electronic image of the same is generated using some scanning device which
will make sure that the front and back images of the physical check are captured
properly with details like MICR and the content written on it, payee bank details, etc are
added to the image.
Then this captured image is sent across the electronic channel that is then used for the
further processing. This truncation is basically done to reduce the time required for the
payment of checks and associated cost of transit and delay in processing.This process
helps in speeding up the process of collection or realization of checks. Once a check has
been truncated, banks, businesses can either work with the check’s digital image or a
print reproduction of it.
Page 6 of 21
Substitute Check
A substitute check is an electronic or paper reproduction of the original check that
contains the front and back information of the original check. The substitute check is in
compliance with ANSI standard X9.100-140. All substitute checks are required to
include the following statement, “This is a LEGAL COPY of your check. It can be used the
same way you would use the original check.”
Check 21 improves check processing without requiring customers to change the way
they write checks. Check 21 allows the financial institution to make a decision to
truncate all paper checks without agreement with any other parties. Check 21
authorizes the creation of the substitute check from an electronic record (image) of the
check for those banks who have not agreed nor have the capability to accept the
electronic record.
Substitute check is a paper reproduction of the original check.
• Contains the front and back images of the original check in electronic form
• Is suitable for the automated processing as the original check
• Conforms, in paper stock, dimensions as it is generally applicable to industry
standards for substitute checks
• Contains a MICR line as the entire information that was available is printed in
order for processing of the substitute checks, as accepted in the industry.
• Usually in the places where we find original check is found, a photocopy or
image
• Bank customers may find substitute check with their periodic statement, when
viewing checking images via online banking. Customers may request the copy
of the paid check from the bank, or when a deposited check is returned unpaid.
Once a check is truncated, businesses, and banks can work with either the digital image
or a print reproduction of it. Images can be exchanged between member banks, Saving
& Loans institutions, credit unions, clearinghouses, and the Federal Reserve.
The figure 7.1 is the example of substitute check.
7.8. Uniqueness of the Image

The Images captured at the presenting bank level would be transferred to the clearing
house then onto the drawee branches with the digital signatory of the presenting
bank. Each image would have a digital signature apart from the endorsement from the
presenting bank. In order to ensure that the images of the requisite quality reach the
drawee bank, there will be quality check at the level of the Image capturing and the
clearing house. In the entire process clearing house plays an important role of the
interface and even the proper quality images with the presenting bank’s signatory will
Page 7 of 21
only sent to the drawee bank. Even the drawee bank may consider using the barcodes
or holograms to maintain the uniqueness of the image.
DID YOU KNOW?

Research indicates that image exchange and other Check 21-driven
changes can save the US bankingindustry about $2 billion a year.
Source:www.carreker.com
Figure 7.1 Substitute check
7.9. Check-21 Processing Cycle (Fig. 11.2)

Basically, the process of Check 21 starts with user or an account holder giving a check
to a retailer in exchange for some service or some goods. Once the check changes
Page 8 of 21
hands, retailer submits the check to his branch, and deposits in his account. This
branch which receives the check sends the check for processing to the Bank service
department, where the check is truncated and the image of substitute check is
generated (usually after the substitute check is developed the original check is
destroyed) and transmitted further for clearing to the Clearing house. The role of the
clearing house is to process the check and transfer it to the Account holder’s Bank. The
account holder’s bank deducts the amount of money from the account holder’s
Figure 7.2 Post-Check 21 Image Check Processing Cycle

account and this particular image is saved for record purpose or same can be used for
further payment and collection systems. And, usually this image of the check is sent to
the payee or account holder who issued the check in his descriptive statement.
7.10. Check Conversion and Check 21

On March 16, 2007, a new standard for converting checks into electronic form for
processing through the Automated Clearing House (ACH) system went into effect for
U.S. businesses. Referred to as Back Office Conversion (BOC), this latest development
represents one more step in the inexorable movement towards a paperless e-conomy.
The migration towards electronic payment began in the early 1970s with the
introduction of direct deposit payroll and Social Security benefits via local private and
government Automated Clearing House (ACH) networks. In 1978, these local ACH
networks were linked into a nationwide system through the efforts of the Federal
Reserve and NACHA (the National Automated Clearing House Association). Since the
Page 9 of 21
mid-1990s the volume of paper checks has been gradually declining in favor of
electronic payments.
The development of electronic payments was driven by the desire of government,
businesses and consumers to make payment processes more secure and efficient. The
advent of digital technology provided the means to achieve these goals. And, as they
say, the rest is history. According to NACHA, the ACH network volume has doubled in
the last five years to nearly 14 billion ACH payments in 2005. Much of this growth was
due to check conversion applications.
Check conversion, sometimes called “electronic checks” or “e-checks”, is a process of
converting paper checks into electronic debits. It was introduced in 1999 to utilize the
same ACH network that had been used for direct deposit and direct payment
transactions for more than 25 years.
As of March this year (2007), there are three types of ACH check conversion
applications:
POP – Point of Purchase, available in September 2000
ARC – Accounts Receivable Entries, introduced in March 2002
BOC – Back Office Conversion, in effect as of March 16, 2007
All three were developed:
• To reduce handling and transport required for paper check processing
• To reduce the costs of processing payments
• To accelerate payment processing time
• To lessen the opportunity for loss and fraud.
All three check conversion systems apply to checks for less than $25,000. All three are
governed by provisions of the Electronic Fund Transfer Act of 1978 (implemented by
the Federal Reserve’s Regulation E). Some of the consumer protection clauses include:
1. Payers must be notified, before issuing the check, that it will be
converted into a one-time electronic debit
2. Payers can “opt out” of the check conversion
3. Payers have 60 days from the posting date to dispute the transaction.
(Under check law, a bank or credit union has only until midnight of the
business day following receipt of the check to return it through the
system)
4. Bank statements listing converted checks must provide transaction
details that include the check number, date, amount and payee’s name.
(With paper checks, the payee’s name is not provided on the bank
statement, although customers usually do have the option of receiving
copies of their cancelled checks.)
Page 10 of 21
The differences among the applications are primarily:

(1) How the check is accepted by the business payee; and,
(2) What is done with the paper check after conversion?
Two of the applications – POP and BOC – primarily relate to merchant sales to
consumers. ARC has application for both consumer and B2B organizations.
7.11.1 POP (Point of Purchase) Check Conversion

POP is used for checks written at the point of sale, which are converted to a one-time
electronic debit “at the register”, then voided and immediately returned to the
customer. POP’s popularity was not as widespread as was hoped due to: Cost of the
technology - scanning equipment had to be available at every payment station; and
Training Issues – each checkout clerk had to be able to properly explain the transaction
to the customer.
7.11.2 BOC (Back Office Conversion)

As with POP, Back Office Conversion relates to checks written either at the point of sale
or at a manned payment location. However, with BOC, the seller retains the checks and
converts them in a centralized “back office” location.
BOC can be considered an improvement over POP for a number of reasons:
(1) Sellers only require equipment in their back office, not at every register;
(2) Individual cashier’s do not require any special training, only the back-office
personnel; and
(3) the experience is more transparent to the customer, as no voided checks are
returned to him at the point of sale.
7.11.3 ARC (Accounts Receivable Entries) Check Conversion

With ARC, checks are received by the biller through the mail, at a central location or
drop box, and are converted into one-time electronic debits, which are batched and
sent through the ACH network. The biller retains the check until the payment has been
processed, at which time the check is destroyed.
Steps in the ARC Process:
• The biller mails a statement to its customer. (As customers must be notified that
their checks will be converted and offered the option to “opt out”, the billing
statement itself is a good format for notification)
• The payer pays the statement by check mailed either directly to a centralized
billing location, or to a drop box.
• The payment check is processed
• The check MICR code is scanned
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• It is determined if the check is eligible for conversion. It must be written for less
than $25,000 with no values in the auxiliary on-us line of the MICR. (“on-us” is a
line of code sometimes utilized for routing information)
• One or more batches of ARC entries are electronically transmitted to the bank
that then routes them through the ACH network
• The biller must ensure that the paper checks are securely stored so that there is
no opportunity for double submission: once as the electronic debit, and again
as a paper check. Once the payment has been processed, the checks are
destroyed.
Any organization (business, not-for-profit, utility, etc) receiving volumes of check
payments can take advantage of ARC.
Benefits include:
• Reduced processing times
• Reduced errors caused by manual processing
• Streamlined A/R reporting
• Decreased costs.
Interestingly, B2B companies are lagging behind B2C in utilization of e-checks.
According to NACHA, in its March 5, 2007 “Check Conversion White Paper” in 2004, 80%
of business-to-business transactions were [still] completed by paper check.
Source: www.firstdata.com
Page 12 of 21
7.11.4 Difference between Check Conversion and “Check 21”

Both check conversion and “Check 21” were developed for the same purposes: to
increase the speed and efficiency of payment processing while decreasing the cost.
Check conversion and the Check Clearing for the 21st Century Act (called Check 21),
however, should not be confused, as the two are very different processes governed by
entirely different rules and regulations.
With POP, ARC and BOC, the MICR code on the paper check is read by a piece of
equipment and the data is used to create an electronic debit transaction which is then
batch-processed and passed through the ACH system. With Check 21, scanners take
pictures of the front and back of the check, and this digital image is used to create a
substitute check that has the same legal weight as the original paper check. The
substitute check is processed through the check clearing system, which has an entirely
different set of regulations.
7.11.5 Impact of Check Conversion

Overall, Check 21, check conversion, and ACH processing have a positive impact on
buyers, sellers and the U.S. economy as a whole. According to NACHA’s “White Paper”
“the use of ACH in 2000 saved consumers, businesses, and the government
approximately $8.4 billion.”
There is, though, one drawback of check conversion that affects what is probably a
good portion of consumers and business purchasers. That is the loss of the “float”.
While check conversion does not result in an immediate draw from the payer’s account,
as does, for instance, use of a debit card, converted checks will clear by the day after
they are written. So … the days of writing checks against future funds are rapidly
waning. If a consumer writes a check, he should be sure that the cash is already in his
account.
7.11.6 The Future of Check Conversion

The conversion of paper checks into electronic format, whether by conversion or Check
21, is definitely a growing business trend in the United States. A Federal Reserve
Payment Study confirmed that electronic payment transactions in the United States
exceeded check payments for the first time in 2004. The international consultancy firm
for financial institutions, Celent, has projected that paper check processing will nearly
disappear in the US by the end of the decade.
7.11. What is the difference between E-Check and Check Truncation?

An E-Check (Electronic check) is when a paper check is converted into an electronic
debit at the point of sale. E-Checks are routed through the automated clearing house
Page 13 of 21
(ACH) network. An E-Check is processed when a retailer scans check for financial
information, and takes consumer’s authorization before initiating the process of
electronic transfer. Once the transaction is authorized the check is voided and is
handed back to the consumer. A Substitute check is different from the E-Check in the
way that it will appear as a check in consumer’s statement not an ACH item.
7.12. Impact on Customers

By converting the original checks to the substitute checks banks can move the checks
electronically through the payment systems. This will increase efficiency as well as
reduce fraud in check collection and payment system.
Substitute checks usually take very less time to clear compared to traditional paper
checks, meaning consumers have less float time. Once the substitute check is created
the original check will be destroyed. It is assumed that over a period of time these
substitute checks will replace the traditional paper checks.
7.13. Bank’s Response to Check 21

There are many banking benefits of Check 21 system. First, it allows financial
institutions to process checks faster, theoretically within minutes, thereby reducing
account holder float. Secondly, it reduces the dependence on the transportation
networks needed to move checks, including the associated costs and potential
disruptions. The savings accrue from archiving checks (10%), electronic image
exchange (65%) and distributed and fraud reductions (25%).
The legislation does not require institutions to present and receive electronic images
for payment. The industry experts predict that mid-sized banks, those with assets of $5
billion and more, are expected to follow suit and become image-capable by 2008. Half
of the nation’s small banks, with assets of $100 million or less, are expected to use check
truncation and become image-enabled by 2008.
7.14. Domino Effects of Check 21

• Image Exchange: Banks will have to invest in Image Exchanging infrastructure
and software. With emergence of Image sharing and Image exchanges, it would
still require the process in place to manage the transmission of check images
and accept the returned ones.
Most of the US banks already have imaging capabilities for capturing and
storing images. Today US banks spend approximately $8 billion a year just on
check processing and transportation. But with the adoption of check 21 roughly
one quarter of these costs could be avoided
Page 14 of 21
• Image Application Cascade: Once an image is captured and made available,

the number of valuable uses to which it can be put is virtually unlimited.
Application developers and product vendors are falling over themselves to
make use of this huge opportunity.
Some of the uses like image statement delivery and positive pay have been in
use for some time but applications like image lockbox and image self
processing are still in nascent stage.
• Distributed Capture: The quicker the check is captured, the lower the expenses
in terms of transportation, data entry and errors and frauds. Image capture at a
branch is no longer a novelty, image capture at the ATMs and Point of Sale
would soon be reality. Banks will have to be ready with applications to deal with
the data and images coming in from ‘n’ different sources. By pushing capture
out to its earliest point, banks can reduce their deposit processing expenses,
achieve faster funds availability and share these benefits with the customers.
• Payment Guarantee: It refers to ability to guaranty check payments at the time
the check is captured and imaged. With the wider acceptance of check
imaging, banks will be in a better position to implement the much awaited
shared utility and industry database that would enable them the guarantee of
payments at the point of capture. It would go a long way in reducing the $8
billion that the banks lose to check frauds annually. It could also lead to other
types of frauds, like image tampering for which there would products required
for validation, monitoring and fraud reporting.
• Emergence of New players: It’s an opportunity for banks to enhance their
market share through enhanced products and services to the customers. Banks
who have missed out in the last race, especially the new ones, now have a
renewed opportunity to define their niche and come out top. The same can be
said about the technology vendors. Third party outsourcing providers are
hugely benefited from the confusion in the market regarding the future of the
check. It could be beneficial to company like ours which has completely missed
out the last wave of check processing development. The current situation
promises a huge opportunity for us to help banks reduce their investments.
• Increased Outsourcing Potential: The main back-office functions of
exceptions, research, adjustments, and return items have been costly
consumers of human resources. Image enablement of these back-office
functions will remove the physical constraints and remove the dependence on
local labor giving access to global labor supply. Outsourcing the back office
payment processing would only be the first step in inviting the large third party
Page 15 of 21
IT outsourcers to provide a comprehensive solution encompassing IT

Development, Maintenance and Back office check processing.
DID YOU KNOW?
Carreker research indicates that, on average, U.S. banks

can reduce approximately 10 percent of their of CIPC (CASH
ITEMS IN PROCESS OF COLLECTION) as a result of Check 21
and image exchange initiatives.
7.15. Glossary of Terms for Check-21 and Check Conversion

Accounts Receivable Conversion (ARC): The conversion of consumer payments from
checks to ACH transactions. For example, Wells Fargo Home Mortgage converts
monthly payments received as checks to ACH, and destroys the original check. This
creates a gap in the check sequence and means that the check would not be returned
to customers in their monthly statement. ARC transactions currently appear in the
"Other Withdrawals" section of the statement, along with other ACH payments.
Automated Clearing House (ACH): A nationwide electronic funds transfer system that
provides for interbank clearing of electronic payments for participating financial
institutions. Payroll direct deposit, Social Security and tax refunds, and direct payment
of mortgages and utility bills are all examples of ACH payments.
Binary Image: A black and white image of a check where each pixel can be stored in
memory by one bit of information since it is binary - either black or white.
Black and White Image: The print of the image of an original check or substitute check
is only in black and white tones.
Bank of First Deposit: The bank where a customer deposits a check.
Check Conversion: The process by which a payment originating as a consumer check is
turned into an electronic ACH debit.
Check Image: An electronic or digital image of an original check that is created by a
bank or other participant in the check collection process. Check images can be
exchanged electronically by banks through image exchange agreements, printed for
customer statement purposes, displayed on Internet banking websites, and used to
create substitute checks.
Check 21: The Check Clearing for the 21st Century Act —which was signed into law on
October 28, 2003, and went into effect a year later — makes substitute checks the legal
equivalent of original checks. A substitute check is a paper reproduction of an
Page 16 of 21
electronic image of an original paper check. Under Check 21, the bank of first deposit
(where the check is deposited) may present substitute checks instead of original checks
to the paying bank (where the check is drawn). The law applies to virtually all check
types. Check 21 seeks to:
• Increase the efficiency of check clearing in the United States
• Lower check processing costs
• Reduce the vulnerability of the check processing system to disruptions in air
and ground transportation.
Check 21 does not require that banks send or receive checks electronically, it simply
makes substitute checks the legal equivalent of original paper checks and requires that
banks accept and process them.
Check Return: The service by which customers receive cancelled checks with their
statements. Most customers choose the convenience of check safekeeping, where bank
stores checks, and makes copies available on request. Many customers prefer to
research and view their checks via, for example in case of Well Fargo bank, “WellsImage
CD”, or online using the “Stops-Images-Search” service.
Check Truncation: The process, by which an original paper check is removed from the
payment-processing stream, is archived as an image and replaced by a substitute
check. The original check is usually destroyed after a short time.
Capture: Reading and storing data from the check MICR line to enable the funds
represented by the check to move between banks and their customers.
Cash Letter: A group of checks packaged and sent by a Bank to another Bank,
clearinghouse, or a Federal Reserve office. A cash letter is accompanied by a list
containing the dollar amount of each check, the total amount of the checks and the
number of checks in the cash letter.
Electronic Check Presentment (ECP): An electronic record governed by check law,
created from the entire MICR line on a check and suitable for posting to a customer’s
account. ECP transmissions may stand alone or may be followed by or accompanied by
check images or paper checks. ECP transmissions are governed by check law.
Electronic Check (e-check): Used to refer to several types of electronic transactions
that debit a checking account. An electronic check is not a substitute check.
Forward Collection: The transfer of a check by a Bank to a Paying Bank for payment.
That is, the Bank forwards the check to another Bank directly or through an
intermediary.
Float: The time elapsed between the time a check is deposited in a bank and the time
the bank receives the funds.
Page 17 of 21
Gray Scale Image: The print of the image of the original check or substitute check is in
black or shades of gray.
Image: A digital representation of all or part of an original check or substitute check.
Image Exchange: An exchange of some or all of a digitized image (or images) of a check.
Image Capture: The act of reading or digitally recording a check or other document so
it can be reproduced as an exact replication when needed. To create a substitute check,
a bank first must image capture it.
Image Exchange: The electronic transfer of the MICR data and the front and back of an
image-captured check between financial institutions for the purpose of clearing the
check. Image exchange agreements must be in place between the exchanging parties.
Image Quality: The visual characteristics and readability of a check image, including
the MICR line.
Image Statement: A statement that contains images of cancelled checks rather than
the original cancelled paper checks.
Image Replacement Document (IRD): Another term for substitute check. The term
under Check 21 is substitute check.
Magnetic Ink Character Recognition (MICR) Line: Numbers printed in magnetic ink
near the bottom of the front of the check to facilitate automated processing. These
numbers identify the bank the check is drawn on (the paying bank), the account
number, the check number, and other information. The position and content of the
MICR line are governed by industry standards.
Point of Purchase (POP) Conversion: This occurs when consumer check payments are
converted to ACH transactions at the point of sale. For example, a cashier receives a
check, then scans it through a MICR machine, creating an ACH or electronic transaction
to directly debit the customer's checking account. The cashier voids the check, asks the
customer to sign an authorization, and hands the check back to the customer. This
process creates a gap in the check sequence, and such transactions have appeared in
the "Other Withdrawals" section of the statement. Customers now see a clearer
description of POP transactions on their statements.
Position 44: The legislation states that substitute checks will use position 44 of the
MICR line to identify an item as a substitute check. A “4” in that position labels it as a
substitute check for forward presentment; a “5” designates it as a returned item in the
form of a substitute check.
Reconverting Bank: The bank that creates a substitute check; or if a substitute check is
created by an entity other than a bank, the first bank that transfers, presents or returns
that substitute check.
Page 18 of 21
Chapter- 8 e-Check
8.1. Introduction
Electronic check is a technological innovation in the financial space. We shall try to
understand the technology behind it, its structure and different operational models of
e-check.
8.2. Learning objectives

After reading this session you will be conversant with
• Concept of e-checks
• Structure of e-check
• Flow of e-check
• Application of PKI in e-check.
8.3. Topics covered

Chapter- 8 e-Check .......................................................................................................................................... 3
8.1. Introduction..................................................................................................................................... 3
8.2. Learning objectives...................................................................................................................... 3
8.3. Topics covered ............................................................................................................................... 3
8.4. E-check – An Introduction ......................................................................................................... 3
8.5. Benefits of an e-Check................................................................................................................. 5
8.6. Architectural Specifications for e-checks..........................................................................13
8.6.1 Financial Services Markup Language (FSML) – The language to define e-
checks 13
8.6.2 Check Block............................................................................................................................14
8.6.3 Account Block.......................................................................................................................16
8.7. Cryptographic Signatures in E-checks ...............................................................................17
8.8. Electronic Checkbooks..............................................................................................................19
8.9. Flow of E-checks ..........................................................................................................................24
8.10. Alternative Operational Models.....................................................................................26
8.11. Summary..................................................................................................................................28
8.4. E-check – An Introduction

Checks are a very important part of the non-cash retail transactions. For many of the
daily payments we need to write checks. But the processing of checks takes
considerable amount of time. It is ironic that our own money gets trapped in the
banking system as float due to considerable time taken for the clearing and settlement
of these payment instruments.
With the advent of information technology and its profound impact on almost every
business area today, the form of checks has undergone a transformation.
Page 3 of 29
Electronic check is a payment instrument which comes with a two fold advantage, that
it amalgamates the advantages of electronic transactions like speed, security and
efficiency with the already existing legal infrastructure and business processes in place
for the paper based checks. It is the first and the only electronic transaction mechanism
chosen by the United States Treasury to make High Value Payments over public
network.
E-check is an all electronic end-to-end payment instrument which works just like a
normal paper check (electronic equivalent of paper check) and has the same legal
treatment. It is a new payment instrument which combines speed and efficiency in
processing of all electronic transactions. The e-check was developed as an initiative of
the Financial Services Technology Consortium (FSTC). The FSTC is comprised of about
100 members, including most of the major banks, suppliers of technology to the
financial industry, universities and research laboratories. The technical work of the
Electronic Check Project was carried out in a number of phases: generating the original
concepts, performing preliminary research, building and demonstrating a prototype,
formulating specifications for a pilot system, and implementing the pilot system.
The vision behind the development of e-check is to substitute the paper based
document with the electronic document by replacing the handwritten signatures with
public key cryptographic signatures.
• The payer writes an e-check by structuring an electronic document with the
information legally required to be present in a check and cryptographically
signs it
• The e-check is received by the payee, he then verifies the payer's signature, the
e-check is then endorsed by him, writes out a deposit, and signs the deposit
• The payee's bank verifies both payer's and payee's signatures, credits the
payee's account and forwards the check for clearing and settlement
• The payer's bank verifies the payer's signature and debits the payer's account.
DID YOU KNOW?
According to NACHA ( the electronic payments association)- More

than 200 million e-check payments were made during first half of
2002, an increase of over 300 percent over the same period of
2001.
A recent study by Federal Reserve shows that check use in US is
declining. But with billions of checks still being written every year
at the point of sale and for bill payments, e-checks are poised for
substantial growth and will contribute to the decline of paper
check processing.
Page 4 of 29
Here is a flow of e-check:
Figure 8.1 Flow of an e-check

Note: The advantage of e-checks is that the cryptographic signatures can be verified on
every e-check, while handwritten signatures have no provision to be verified because it
is very tedious.
8.5. Benefits of an e-Check

The obvious questions arises here is that why do we need e-checks and what are its
benefits. Following is a list of some important reasons for use of e-checks:
Ø e-check saves cost – A very surprising finding by the Federal Reserve says that
currently the total costs of handling paper checks to the US economy is approx. $44 bn
per annum. While some other estimates also claim that it could be as much as 2 percent
of the total GDP!
Electronic check will have a major benefit to drive this cost down. Certain elaborations
below will explain this.
Ø Time Savings with e-check: Various time lags at various stages of paper check
processing increases the total time for the clearing and settlement of checks. However
the following are the times savings payer, payee and the financial institutions will have
with e-checks.
• Waiting time while the paper checks are picked up from one bank to the
clearing house for verification and further procedure by the transportation
services or the postal services is totally eradicated with e-checks.
• Reduced/ eliminated mail float or lead time for bill payment instructions
• No paper envelopes to stuff or open. This may sound funny but the various
support accessories like envelopes become mandatory while we transfer checks
from one place to another. Hence this also wastes time but with the case of e-
check this is also eliminated
Page 5 of 29
• In the smaller cities checks are totalled manually hence with e-checks this
additional step of counting manually is eliminated, which again saves number
of man-hours
• Additional requisites like printing check deposit slips are also eliminated
• E-check facilitate improved document tracking and it’s very easy to retrieve
stored information too
• Strong auditing and in the case of errors it’s easy to track and rectify them
Ø E-checks are well suited for clearing micro payments, the conventional
cryptography makes processing easier as compared to systems based on public key
cryptography.
Ø Electronic check technology connects the public networks to the financial
payments and bank clearing networks and hence leverages the accessibility of public
networks with the existing financial payment infrastructure
Ø Staff steps eliminated with e checks with all payer, payee and financial
institution’s perspective. With the change of business process some steps taken by staff
to process checks will change and hence it is found that man hours will be saved
resulting into substantial saving.
Table 8.1 Steps saved by the business payer
Steps saved by the Business Payer
Step e-check
Management of the check stock for

example order, storage, control, retrieval Eliminates
and destruction of checks.
Management of envelopes (order, store,

Eliminates
retrieve, destroy)
Managing signature plates or font (order, Reduces; requires holder control of

lock up, retrieve) Electronic Checkbook
Loading checks in printer to print

Eliminates
information.
Stuffing envelopes with checks and

Eliminates
remittances.
Cash forecasting, the management of cash Reduces and becomes easy; e checks will
Page 6 of 29
Steps saved by the Business Payer
Step e-check
of working capital in the banks. clear more consistently and have the
better predictability for the cash
requirements at the bank.
Reduces; fewer remain outstanding for

Reconciliation for outstanding checks.
long periods
Record keeping and filing Reduces; no paper checks to keep on file
Reduces; records on computer, no need

Researching payments
for paper copies
Page 7 of 29
Table 8.2 Steps saved by Business Payee
Steps saved by Business Payee
Step e-check
Mailroom (Receive envelopes in mail, sort

Eliminates
envelopes by department, deliver)
Retrieve payments (retrieve mail, open Eliminates; system performs these functions
envelopes) manually or automatically
Verify payment information (match

Reduces; will eliminate with EDI {Electronic
remittance, payment amount, conditions
Data Interchange}
against accounts receivable)
Verify check (appears legitimate, properly

signed, paid to right party, right amount, Eliminates
dated, no hidden conditions, etc.)
Create payment record and file

Reduce/Eliminate; records stored
(photocopy check, store in paper
automatically on computer
company files)
Prepare deposit (endorse checks, bundle, Reduce/Eliminate; system automatically

prepare deposit ticket, total) performs all steps except endorse
Make deposit (go to bank or night deposit Eliminates; system automatically sends
box, give to teller, get receipt) deposit to bank
Reduced. More descriptive statement

Statement Review
information available
Table 8.3 Steps reduced by Financial Institutions
Steps reduced by Financial Institutions
Step e-Check
Receive check deposits in branch or night

deposit (teller inspection, deposit ticket Eliminates
proofing, bundling, balancing, bagging)
Branch pickup Eliminates
Item Preparation and Proof and Transit

(delivery, unbagging, power encoding, Eliminates
balancing, error correction, batching,
Page 8 of 29
Steps reduced by Financial Institutions
Step e-Check
pickup)
Suspicious item inspection (outsorting, Eliminates manual effort. Every eCheck is

delivery, manual inspection, signature card automatically validated for signatures,
lookup, paper tests, etc., pickup) dates, etc.
MICR Capture (may include image capture) Eliminates
Eliminates; e-checks never need be

Reject repair
"repaired"
Eliminates physical sorter passes. All

Automated Sorting sorting done electronically. Fine sorts can
be done in a single pass.
Eliminates manual steps. Cash letters

Bundling, cash letter preparation, bagging
automatically prepared for both.
Clearing (bag pickup, handoff to

transportation company/group, delivery to Eliminates manual effort. All clearing is
clearing house, Fed, or other Financial electronic.
Institution)
Inclearing (bag delivery, MICR capture, etc. Eliminates manual effort. All in clearing is
as above) electronic.
Returns (item pull, storage, bundling, cash

Eliminates manual effort. All returns are
lettering, etc., transportation to returns
electronically processed.
clearing house or collecting bank)
Reduces; all items available online through

Filing (item filing, microfilming, statement
data base inquiry. No physical check to
retrieval)
include in statement.
Statement Rendering (retrieve checks, fine

sort, insert checks into statements, re-
Reduces; no physical items to handle
image for image statements, stuff
envelopes, etc.)
Research (item pull, finding on microfiche,

Reduces
photocopying, deciphering the back, etc.)
Page 9 of 29
Ø The reduction of Risks and Frauds by e-check- The table below shows various
risks or frauds and parties exposed to them and how they can be eliminated by the e-
check.
Table 8.4 Risk and Fraud Reduction by E-Check
Parties with greatest

Risk Description e-check impact
exposure to loss
Primarily banks and Reduced through PIN-

Check to be stolen
payee protected hardware
Reduced through personal

Unauthorized issuing of assignment of signing tokens.
Payer
Checks Also reduced through support
for dual signatures.
Virtually eliminated through

digital signatures, automatic
Forgery Payee, Paying Bank
verification, and PIN-protected
hardware signing keys.
Forgery where Facsimile

signatures are used on Payee, Account owner Eliminated
account
Virtually eliminated through

digital signatures, automatic
Counterfeiting Paying Bank, Payee
verification, and PIN protected
hardware signing keys.
Reduced through rigorous

Innocent Payees,
duplicate detection
Depositing bank for
Duplication functionality, use of payee
fraudulent payee,
public key in addition to name
Paying bank
in pay to field.
Fraudulent unsigned demand Payee, Depositing

Eliminated.
draft Bank, Paying bank
Depositing bank,
Alteration of payee name fraudulent payee, Effectively Eliminated
payer
Alteration of amount (no Depositing bank, Effectively Eliminated
Page 10 of 29
Parties with greatest

Risk Description e-check impact
exposure to loss
positive pay) payee
Alteration of amount (with Depositing bank,

Effectively Eliminated
positive pay) payee
Depositing bank,
payee inconvenience,
Amount encoding error Eliminated
small errors often
written off by banks
Non-sufficient funds, account Reduced due to faster, more

Payee
closed consistent clearing times.
Stop Payment Payee Reduced due to faster clearing.
Eliminated due to digital

Check drawn on non-existent
Payee certificates issued by banks to
bank or account
account holders
Other Handling Costs saved: While there are some obvious costs which will be saved
by the implementation of e-checks. The following table shows the costs saved in dollar
terms for the paper check handling.
Table 8.5 Paper check handling cost and saving by e-check
Item Typical Cost Saved by
Paper check stock $.02 -$ .25 Payer
Paper remittance forms $.02 -$.15 Payee
Envelopes $.02 - .10 Payer or Payee
Postage $.22 - $.33 Payer, Bank on statement
Photocopies of checks $.02 -$ .05 Payee, Bank on research items
Filing cabinets, storage space Varies Payee, Payer, Bank
While the above savings may seem small, the total cost per check turns out to be $.5
which is significant savings if e-checks are used.
Ø Enhancement in Customer Service: With e-checks banks can save their costs and
as well enhance their customer service manifold.
Page 11 of 29
Table 8.6 Customer Service Enhancement
eCheck enables financial institutions to provide their customers

an increased array of cost-effective electronic payment
Wider Choice alternatives. Its design, which provides true end-to-end security,
makes it suitable for use by any bank customer, even in insecure
environments like the Internet.
eChecks provide better, more accessible, information about the

transaction than paper checks. For example, on the payer's bank
Better Information
account statement, eCheck transactions will show the payee
name in addition to the check number, date, and amount.
eChecks are designed to allow payment between any two

parties, for most types of transactions. Anyone with a bank
Pay Anyone account can receive e-checks. As with paper checks, we expect
services to be developed to enable anyone to receive an
eCheck, even if they don't have a bank account.
eChecks are designed to enable the same payment instrument

to be used for both paying and receiving payments. Many other
Pay and Receive instruments, such as debit cards, are designed primarily as retail
payment vehicles, and can therefore be used by consumers only
to make payments.
eChecks are designed for direct exchange between transacting

parties, rather than requiring an intermediary in the middle of
Do business directly
the transaction. They support direct exchange of transaction
information, and payment over the Internet.
Since e-checks are modeled after paper checks, they are

Familiarity familiar, and don't require a significant effort to learn new
terminology or processes.
eChecks build on the most familiar payments legal

infrastructure in the US today, check law. Banks and customers
Accepted Legal Basis understand the risks of this system, and know which risks are
acceptable on a daily basis. Users of the system can be assured
the system is stable and relatively unchanging.
Through the use of strong digital signatures, e-checks enable

Payer Control only authorized transactions to be posted to a bank account,
and the authorization is checked every time. Payer's control and
Page 12 of 29
banks can enforce who can make payments from their account,
and how much they can do. Business practices, such as dual
signatures and transaction limits, are part of the system design,
and automatically enforced.
Payees can receive e-checks directly, or can use electronic

lockbox services to simplify their processing. In addition, payees
have control over which payments to accept or reject, which
Payee Control account to deposit into, how much risk they are willing to take,
and the timing of depositing the transaction (which is
particularly important for cash basis businesses managing
quarterly results).
eChecks are designed to coexist with paper, reducing the

Co-exist with paper. confusion and complexity of accepting eCheck transactions into
Helps transition to businesses that currently receive paper checks. They help
electronics businesses migrate in a cost-effective, non-disruptive manner
from paper to electronic payments.
8.6. Architectural Specifications for e-checks

In this section we will look into the various technological aspects defining the format of
an e-check and the work process flow of e-checks. Paper based checks have information
both handwritten and printed on it. Amongst all of them payer’s signatures is one of
the most important information. It clearly is the mode to validate the check, but in
electronic checks this issue of certification and generation of unique identification such
as a signature is resolved differently. An alternative of checkbook in the e check systems
is discussed. The markup language used to specify body of check and other issues are
handled below.
8.6.1 Financial Services Markup Language (FSML) – The language to define e-checks
FSML is a mark up language designed to allow the creation of electronic financial
documents An e-check must have cryptographic information for its unique
identification and other fields like MICR numbers, amount etc need to be stored in a
check.
Hence an e-check is written in FSML. It’s a markup language defined in SGML (Standard
Generalized Markup Language). The document structure and data items for e-checks
are delimited by “tags” similar to those used in HTML (HyperText Markup Language),
another language defined using SGML. FSML is designed in a manner to support the
Page 13 of 29
data structures and the cryptographic information required in an e-check. The e-check
written in FSML will contain all of the information that is normally found in paper
checks, including that which is handwritten, preprinted and in the magnetic ink
character line at the bottom of the check.
• FSML includes signature blocks designed to support the addition and deletion
of FSML document blocks and to support rich signature semantics to enable
signing, co-signing, and endorsing of e-checks by the several parties who may
sequentially process an e-check. FSML also provides the ability to encapsulate
and cryptographically attach other documents, such as an advice of payment,
invoice, or remittance information to enable the payee to correctly post the
payment in accounts receivable.
• To ensure the widest possible compatibility with electronic mail, HTTP
(HyperText Transport Protocol) and other types of transport, FSML specifies a
limited line length and a restricted ASCII character set for encoding all e-check
data.
• Each FSML Document is a sequence of blocks. The start and end of a block is
specified by a start and end tag. The start tag and end tags identify the type,
and hence the contents, of each block. Each block starts with block name tag,
criticality and version tag. We shall see contents of check block and account
block.
8.6.2 Check Block

In check block , the first part of the block content will be a sequence of data items
which are logged by the electronic checkbook (will be discussed later). This gives
the signer a secure, portable record of the most important items which have been
signed by the private signing key in the electronic checkbook.
The number of the electronic checkbook and the check number are automatically
inserted by the electronic checkbook to ensure uniqueness of each e-check. The
check block requires the date that the e-check becomes valid and the date that the
e-check was issued. The writer may enter the country that the e-check was written
in order to comply with local laws. The writer must specify the amount and type of
currency, and the “pay to the order of” data item must be present. However, in
order to unambiguously identify the payee, the payer may specify the payer’s bank
and account or customer number at the bank. Alternatively the payer may specify
the payee’s public key. A payer may place restrictions on the e-check, such as to
Table 8.7 Check Block
Page 14 of 29
distinguish between writing an e-check to “John and Mary Smith”, which both must
endorse, or an e-check to “John or Mary Smith” which either can endorse. Just as on
paper checks, the payer may enter memo information as a reminder of the purpose of
the e-check. A specific memo field is provided which the payer may use to enter the
payer’s account number at the payee’s business to assist the payee in correctly posting
the payment in the payee’s accounts receivables. Lastly, the check block carries a legal
notice that the e-check is subject to check law.
Table 8.8 The FSML Account Block
Page 15 of 29
8.6.3 Account Block

The account block shown in Table 12.8 contains the bank code and account number
that corresponds to the bank code and account number that would be found on the
MICR line of a check, and it contains a reference by issuer and serial number to a
certificate containing a public key that can be used to verify signatures on e-checks
drawn against the account. It may also contain restrictions on the value, the maximum
time interval before the e-check becomes stale, and requirements on the number of
signatures required for e-checks above certain values. A bank customer may have more
than one account block corresponding to the several accounts over which the
customer has signature authority. There also will be multiple account blocks issued on a
single account when the account is held jointly or in the case of commercial accounts
where several persons have signature privileges.
Page 16 of 29
The following Table 8.9 gives a comprehensive overview of the total number of blocks
defined for an e-check.
8.7. Cryptographic Signatures in E-checks

Till now we discussed about FSML, about the various blocks an e-check has and how it
carries information. Now we shall see how the digital signatures of a payer are made
and put on an e-check.
Figure 8.2 which follows this description will help you to understand the process. The
figure explains the process of creating a digital signature and putting up that signature
on the e-check. The hash code generated will be the unique identification of the payer.
For the transmission purposes it will be encrypted with the private key of the sender
and public key of the recipient. At the receiving end the private key of the recipient and
the public key of the sender will come into use to decrypt the document.
The signature block in FSML is shown in Table 8.10
When an e-check is originated, a minimum set of information is written and signed. As it
is processed, more information and more signatures will be added as it is passed from
party to party. For example, an e-check may be:
• originated by a payer,
• co-signed by a co-payer,
• certified by a bank,
• endorsed by a payee,
• co-endorsed by a co-payee,
• deposited, and
• paid.
This requires a flexible document structure and signature mechanism. The principle
characteristics of the FSML signature mechanisms are:
• The document consists of a sequence of blocks, and blocks may be nested.
• Signatures implement cryptographic signatures and/or hashes on other blocks
referred to by name.
• Signatures may sign other signature blocks.
• Signature blocks refer by block name or by issuer and serial number to the
certificate block which contains the corresponding public signature verification
key.
These characteristics provide enough flexibility to handle the signature requirements of
electronic checks and the signature requirements of a broad range of financial
documents.
Page 17 of 29
The signature block contains the names of the other blocks being signed, and the
corresponding hashes computed on those blocks. The <blockref> and <hash> data
elements are repeated in pairs (as shaded) when multiple blocks are being signed. The
random nonce is generated by the electronic checkbook prior to hashing any of the
blocks, it is prepended to each block, and it is also included in the scope of the hash
calculation on the signature block itself. This defeats attacks where the attacker
fabricates two messages that have the same hash value, persuades the victim to sign
one, and then substitutes the other.
The signature block also contains a reference to the public key to be used in verifying
the signature, either by naming another FSML block or by referencing the X.509
certificate by the Certificate Authority’s distinguished name and the certificate serial
number.
The signer can choose to include other personal data, such as name, address, phone
number, email address, etc. These data items are stored in the electronic checkbook
when it is initialized by the bank, and are changeable only after the electronic
checkbook has been unlocked using the bank's administrative PIN. This method of
providing personal information is not as secure as including the information in the
X.509 certificate or the account block. However, it is expected to be secure enough for
purposes such as analysis and decision making by check guarantee services, while
providing the bank’s customer with complete control over which personal information
is released to which payee.
The electronic checkbook signature is actually a signature on a hash of hashes. The
advantage of this design is that the signature can be verified for any subset of the
blocks which were originally signed. However, it also implies that if any blocks are
absent, the application can determine whether the subset of blocks still present
constitute a valid e-check. For example, attachments which might contain remittance or
other business information are deemed not to affect the validity of the e-check, and
attachment blocks can be removed by the payee or discarded by the bank of first
deposit with impunity.
Figure 8.2 shows how signatures are applied to the e-checks. The right hand set of
blocks are the check as made out by the payer. The payer's signature signs the action,
check, account, attachment and invoice blocks. The payer's signature block references
the payer's account block which references the payer's certificate. The payer's certificate
contains the payer's public key, which verifiers use to verify the payer's signature. The
payer's bank has signed both the payer's account and certificate blocks, and the payer's
bank's certificate contains the public key needed to verify the bank's signature.
Page 18 of 29
The endorser has signed the action and endorsement blocks of the endorsement, plus
the check and the payer's signature on the e-check being endorsed.
The depositor has signed the action and deposit blocks of the deposit, plus the
endorsement and endorser's signature of the e-check being deposited. Note that since
Figure 8.2 E-check signature and endorsement

the payer's signature block only contains the hashes of the attachment and invoice
blocks, when these blocks are removed by the depositor, the payer's signature can still
be verified on the remaining check blocks by the paying bank.
8.8. Electronic Checkbooks

A handwritten signature captures the reflexive movement of the signer's muscles and is
partly a biometric characteristic of the signer. This makes it difficult for a forger to create
a perfect forgery, even if the forger has a sample of a handwritten signature.
However, a perfect forgery of a cryptographic signature can be made by anyone who
has the signer's private signature key.
Therefore, it is critical to establishing an e-check system based on public key signatures
that payees and banks are able to trust that payers can maintain possession and control
over their private signing keys at all times. Electronic checkbook smart cards or other
cryptographic hardware are used to help ensure that signatures are made only by
legitimate signers, so that check forgery is made difficult. Electronic checkbook cards
also standardize and simplify key generation, distribution and use, so that a high and
uniform level of trust can be established without depending on the skill and diligence
of every e-check customer .
Page 19 of 29
Source: www.e-check.org
Fig 8.3: Public Key Signature Security Fundamentals
Verifiers must believe three types of things about the signer and the signer's private
and public signing keys:
1. Private key possession and control -- The signature verifier must believe that the
signer has exclusive possession of his signing key. If an attacker can get possession of
the signer's private key, then the attacker can forge signatures using his own system
from any location on the network. If the attacker can gain control of the signer’s
computer, then the attacker can forge signatures without the signer’s knowledge.
Page 20 of 29
Table 8.9 The Blocks defined for the E-check
Page 21 of 29
Figure 8.4 Signing a e-check (source : www.entrust.com)

The electronic checkbook, in the form of a PIN-activated tamper-resistant smart card or
similar cryptographic hardware, performs the signing algorithm so that the private
signing key is always kept inside the trusted hardware and is never read into the
signer's much more vulnerable networked personal computer or server. The electronic
checkbook is aware of e-check syntax and logs critical data from e-checks to provide
the signer with a trusted log of signing actions.
Page 22 of 29
2. Key pair generation -- The signature verifier must believe that the private/public key
pair was generated such that the private key cannot be calculated or guessed by an
attacker based on knowledge of the public key.
The electronic checkbook performs key generation within the tamper-resistant
hardware using algorithms that have been properly tested and certified by the
Table 8.10 Signature Block
manufacturer. Only the public key is exported from the hardware, and the private key is
never revealed to anyone.
3. Public key infrastructure -- The signature verifier must be able to trust that the
public key provided for use in verifying the signature really belongs to the signer and is
the other half of the signer's public key pair.
The electronic checkbook is initialized using procedures based on bank card issuing
processes. The public key exported from the card is included in an X.509 certificate
Page 23 of 29
signed by the bank's Certification Authority, and associated with an account block also
signed by the bank's Certification Authority. The bank e-check servers also keep an
independent database of the bank's signer's public keys, such that they always know
the most current relationships of keys to accounts and signers.
Besides key management and logging functions just described, electronic checkbooks
also:
1. Include the checkbook's unique number (manufacturer, model and serial number) in
each e-check,
2. Consecutively number each e-check as it is signed, in order to ensure that each e-
check is unique,
3. Generate random numbers that are prefixed to blocks to increase security of the
hashing functions,
4. Contain signer personal data which the signer can selectively apply to e-checks,
5. Separately unlock e-check writing, checkbook administration and bank
administration functions using PINs,
6. Deactivate if PIN hacking is detected.
Furthermore, the design of the electronic checkbook must be such that the private
signing key cannot be extracted via its electrical connector and any successful attempt
to extract the private key will visibly damage the electronic checkbook and render it
inoperable. The security concern with the e-check is that whoever has the private key of
the signer can forge perfectly the cryptographic signature of the signer. For the
prevention of these attacks the tasks of key generation and management, logging
important information is done by a PIN protected and tamper resistant smart card
known as an electronic checkbook.
8.9. Flow of E-checks

The following figure 8.5 shows the flow of e-check in the system
Page 24 of 29
Figure 8.5 Flow of e-check source: www.e-check.org.
e-checks are currently cleared and settled between the banks using the ANSI X9.46 and
X9.37 standards.
The Electronic Check Clearing House Organization (ECCHO) has adopted rules for inter-
bank clearing of electronic checks which consider the e-check to have the status of a
"negotiable instrument" for the purposes of the Uniform Commercial Code and a
"check" for purposes of Regulation CC. This is reinforced by including a legal notice
within the e-check which states "This instrument subject to check law", as well as by
uniform customer agreements for use between the banks and their customers, which
agree that e-checks are subject to check law. If a consumer, rather than a business,
writes the electronic check, then Regulation E also applies. Regulation E provides
consumers with additional rights and protections, and it supersedes Regulation CC
where they overlap.
In the normal check flow described here, the banks providing e-checking accounts
must be members of ECCHO, members of an equivalent organization or clearing house
providing clearing and settlement rules, or they can agree to clear and settle e-checks
bilaterally. An exception to this is the alternative e-check flow described in Figure 8.5,
8.6, and 8.7 below.
The business transaction begins with the payee sending an invoice or bill to the payer,
which is processed by the payer's accounts payable system. When the time comes to
pay the invoice, the invoice information is retrieved from the accounts payable system,
and the invoice data is used to create an e-check. The e-check includes familiar check
information such as the payee's name, the amount, and the date and the account
information. To sign the e-check, the payer enters a PIN to unlock an electronic
checkbook card in the form of a smart card. This card is a secure container for the
Page 25 of 29
payer’s private signature key, and assures a degree of non-repudiation. The signature
on the e-check may also cryptographically bind a copy of the invoice to the e-check, so
that an attacker cannot substitute a different invoice in order to commit fraud. The
invoice format is not fixed, but it can be flexible with respect to length, format and data
content, so that the payer can return the document received from the payee. This
provides the payee with the complete information needed to correctly post the
payment.
The signed e-check and invoice is sent to the payee by email or a web transaction. The
payee verifies the payer's signature on the e-check and invoice, detaches the invoice
information, and posts the payment to accounts receivable. The payee enters his PIN to
unlock his electronic checkbook and uses the electronic checkbook to endorse the e-
check and to sign an electronic deposit slip to deposit a batch of e-checks.
The endorsed e-check is forwarded to the payee’s bank for deposit and subsequent
clearing. The clearing process can be done by integrating e-check into existing
Electronic Check Presentment systems or other clearing and settlement systems. Both
the payee’s bank and payer’s bank verify all signatures on the e-check and
endorsement using a two layer certificate system which links the signature verification
keys to the signer and signer's bank account. The paying bank verifies that this
transmission of the e-check is not a duplicate, that the payer's certificate and account
are currently valid, and posts the e-check to the payer's Demand Deposit Account
(DDA).
Finally, the payer receives a line item on his statement, which may now carry a full
description of the transaction, since the entire contents of the e-check are machine-
readable.
8.10. Alternative Operational Models

The e-check flow shown in Figure 8.5 is typical, but e-checks can be used in other ways,
just like paper checks.
Figure 8.6 shows how a lockbox operator can process an e-check on behalf of the
payee. In this case the lockbox operator does the cryptographic processing to verify the
payer's signature. The invoice or advice of payment information can be converted by
the lockbox operator to the same format used for paper checks. This allows the payee,
typically a biller, to receive e-check payments without implementing new, e-check-
specific software and hardware. The lockbox operator endorses and deposits the e-
check on behalf of the payee. If the lockbox is operated by the payee's bank, then the
lockbox functions can be interfaced directly to the bank's e-check server, saving the
separate endorsement and deposit signing steps.
Page 26 of 29
Figure 8.6 E-check lockbox flows
Figure 8.7 shows how a payee can endorse and cash the e-check at the payer's bank.
The payer's bank transfers the proceeds to the payee's bank by electronic funds
transfer. This flow is particularly useful if a payer wishes to pay payees whose bank does
not yet offer e-check accounts. The payer's bank can provide the payee with a "check
cashing" electronic checkbook valid for cashing the payer's checks. The electronic funds
transfer can be done over a variety of networks, including international networks. In this
case the payer could write the e-check in the payee's currency, and the payer's bank
could implement the funds conversion from the payer's currency to the payee’s
currency when making the electronic funds transfer.
Figure 8.7 E-check cash and transfer flow

Figure 8.8 shows a certified electronic check flow. In this case, the payer sends the e-
check to the payer's bank. The payer's bank verifies the payer's signature, determines
that there are funds available in the payer's account, and places a hold on the funds.
The payer's bank then countersigns the check to certify it, and send the check back to
the payer. Alternatively, the bank can send the certified check directly to the payee,
possibly over an encrypted channel to provide the payee with the greatest degree of
security and confidentiality.
Page 27 of 29
Figure 8.8 Certified e-check flow
8.11. Summary
• Electronic check is a payment instrument which comes with a two fold
advantage - it amalgamates the advantages of electronic transactions like
speed, security and efficiency with the pre-existing legal infrastructure and
business processes in place for paper based checks
• The e-check was developed as an initiative of the Financial Services Technology
Consortium (FSTC)
• The vision behind the development of e-check is to substitute the electronic
document with the paper based document by replacing the handwritten
signatures with public key cryptographic signatures
• With e-checks banks can save their costs and as well enhance their customer
service manifold.
• An e-check must have cryptographic information for its unique identification
from others.
• It’s a markup language defined in SGML (Standard Generalized Markup
Language).
Page 28 of 29

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Certificate Program in Payment Systems TCS FTC (A Domain Competency Centre)

Chapter-13 Continuous Linked Settlement

13.2 Learning Objectives

13.3 Topics Covered

Figure 13.6 Parties of CLS Bank...............................................................................................................10

13.4 About Continuous Linked Settlement

Figure 13.1 Objectives of CLS

Figure 13.2 Central Banks in CLS

13.5 Conventional Forex Transaction Settlement

Figure 13.3 Dollar and Yen leg of settlement

13.6 Purpose of CLS

A QUICK VIEW OF BENEFITS OF CLS:

• Payment costs lowered due to netting of payments.

• Real-time reporting through SWIFT

• Reduced settlement risks on FX trade flows enables Straight

13.6.1 Herstatt Risk

13.7 An Example of Multilateral Netting Settlement by CLS

13.8 The CLS shareholders

Figure 13.4 Shareholders of CLS

13.9 The CLS Group of Companies Hierarchy

Figure 13.5 CLS Group

13.9.1 CLS Group Holdings AG (CLS Group Holdings)

13.9.2 CLS UK Intermediate Holdings Ltd

13.9.3 CLS Bank International

13.9.4 CLS Services Ltd

13.10 Parties Involved in the CLS Settlement

Figure 13.6 Parties of CLS Bank

13.10.2 Settlement Members

13.10.3 User Members

13.10.4 Third parties

13.10.5 Nostro agents

13.11 How CLS Works

Figure 13.7 CLS bank is multi-currency bank

13.12 The concept of Pay-In and Pay-Out

DID YOU KNOW?

13.13 A Transaction in a CLS system

Figure 13.8 Transaction in CLS system

13.13.1 Submission of instructions

13.13.2 Settlement and Funding

13.13.3 Execution of trade

13.14 The mathematics behind the settlement in a CLS system

Table 13.1 Settlement under CLS System

Figure 13.9 Processing in CLS

Figure 13.10 Sequence of Instructions Flowing

Haircut (volatility margin) applied to Settlement Member’s currency balances to

13.15 Flow of Information and the payments

13.16 Risk Management in CLS

INSIDE / OUTSIDE SWAP service offered by CLS:

SOURCE: www. Clsgroup.com

Box 13.1 Failure Management Procedure (Source:www.banquefrance.fr)

14.5. How Cross Border Payments Work Today

Figure 14.1 a typical example of cross border payment process

Figure 14.2 A Typical cross border payment process

The Originator is a company or individual with the need to make payments to

14.6. Cross Border Payments Environment

14.6.2 Transmission of Payments

14.6.4 Foreign Exchange

14.6.5 Cross Border Payment Technical Standards