What Is a Payment?
A payment is the transfer of monetary value from one party to another, either in cash or noncash form.
Cash payments are made through the exchange of physical currency, while noncash payments usually involve transferring value between bank accounts via payment systems. Banks facilitate these transfers for their customers through multiple electronic and paper-based systems, such as Fedwire and ACH. Newer noncash payment methods, like mobile payments, transfer value between virtual accounts held by the payment service provider, which is typically not a bank.
PART 1
Payment Process
While the actual participants vary depending on the nature of the payment, in general, there are four key participants involved in the most basic payments scenario:
- The payer initiates the payment and sees their account debited by their bank.
- The payer's bank facilitates the transfer of funds on behalf of the payer.
- The payee or beneficiary receives the payment, and their account is credited by their bank.
- The payee's bank processes the transaction for the payee and typically holds the transferred value in an account.
The payment process itself involves four steps:
- Payment Instruction Submission. The payer provides payment instructions, typically through electronic means such as wire transfers, ACH transactions or payment card transactions. These instructions direct the paying bank to transfer funds to the payee via the receiving bank. In the case of a debit transaction, the instructions come from the payee.
- Payment Generation. The payment instructions are entered into the payment system, initiating the payment process.
- Clearing. Banks use the payment information provided to transfer funds between themselves on behalf of the payer and payee; this may happen directly between banks or through an external network.
- Settlement. The final step involves the actual transfer of funds. The payee's bank account is credited with the payment amount, while the payer's bank account is debited, completing the payment process.
Payments are facilitated through payment rails — the systems that enable transactions between payer and the payee. Each country has different types of payment rails, including those for cash, cards or digital transactions. Some rails directly link the bank accounts of both parties. One example of this is the Single Euro Payments Area (SEPA), which enables the transfer of euros from one bank account to another. Other rails, such as those used for cryptocurrencies or peer-to-peer payments (e.g., Venmo), are managed by nonbank providers with whom each party has an account.
PART 2
Types of Payment Systems
Understanding the diverse array of payment systems is crucial for successfully navigating the financial landscape. From traditional paper-based methods to cutting-edge digital innovations, the spectrum of payment systems encompasses a wide range of mechanisms tailored to meet varying needs and preferences.
Cash Payments
Cash payments — those involving physical currency notes and coins — are commonly used by consumers for small transactions and remain significant for various businesses, including retailers, grocers and restaurants. Despite its prevalence, cash transactions do not require additional settlement infrastructure or bank networks, as the physical transfer of cash itself serves as the clearing mechanism.
Contrary to popular belief, cash payments can be expensive for businesses due to the security risks and associated costs. Safeguarding cash receipts, transportation and bank processing fees contribute to the high cost of cash transactions, making it a less favorable payment method for many companies.
Paper-Based Payments
Although the overall use of checks is declining, they remain a significant payment method for B2B transactions in the United States and are also utilized in various other countries globally, though at a significantly lesser rate. Check payments typically provide funds to depositors within one to two days, but final settlement can be delayed for several weeks due to factors such as stop payment orders and overdraft returns.
The check-clearing process in the U.S. involves six stages, including deposit, electronic conversion, clearing, exchange, deduction of value from the paying bank and paying bank review. While different countries have similar check processing rules, local variations exist regarding processing times and return requirements. Treasury professionals must familiarize themselves with these regulations to effectively manage check transactions, with local banks serving as valuable sources of information.
Electronic Funds Transfer (EFT)
In most countries, there exists at least one system for clearing and settling electronic funds transfers (EFTs), which are primarily designed to facilitate interbank transfers and administer monetary policy. While some countries rely on a single payment system for processing all EFTs, the majority have multiple systems, including ACH and real-time/instant payment systems.
EFT systems are comprised of two components: clearing, which involves transferring and confirming information between the payer's bank and the payee's bank, and settlement, which entails the actual transfer of funds between relevant banks, discharging the payer's obligation to the payee. Clearing and settlement processes can occur immediately and in real-time, on a same-day or next-day basis, or over an extended period, depending on the specific system in place.
Wire Transfers vs. Real-Time Payments
Within the EFT system of payments exist two popular methods: wire transfers and real-time payments.
Wire transfers electronically transmit payment instructions, typically settling in real-time or within a few hours. This instantaneous transfer of funds makes wire transfers ideal for urgent or time-sensitive transactions, such as large business payments or international remittances. Users initiate wire transfers by providing their bank with recipient details, including the recipient's bank account information and the amount to be transferred. Once initiated, the funds are debited from the sender's account and credited to the recipient's account, creating seamless financial transactions, even across geographical boundaries.
Real-time payments (RTPs) offer immediate settlement of transactions between participating banks or financial institutions. Unlike traditional payment methods, where transactions may take days to clear, real-time payment systems process transactions instantly, often within seconds. RTPs are particularly helpful for businesses requiring fast and secure transactions, such as payroll processing or urgent supplier payments.
Low-Value Electronic Payments
Mainly serving businesses and consumers for low-value electronic payments, additional EFT systems support banks in transferring less crucial payment instructions. In the U.S., there is the Automated Clearing House (ACH). ACH transactions, either credits or debits, involve originators and receivers.
For example, payroll or supplier payments are ACH credits initiated by the payer (originator), while mortgage or loan payments are ACH debits initiated by the payee (receiver). ACH transactions offer more detailed payment information than paper-based or wire transfers. In the U.S., the Federal Reserve and EPN manage the system, with the originating bank choosing the operator for each transaction.
In the U.S., there is also the Clearing House Interbank Payments System (CHIPS), a privately owned wire transfer system that settles its transactions through the Fed. CHIPS is one of the main EFT systems for processing international USD funds transfers made among international banks in the United States.
Other examples of low-value transfer systems include Bacs in the United Kingdom and Electronic Clearing (ECG) in Hong Kong, as well as STEP2, which was set up in SEPA to process SEPA payment schemes, including the SEPA credit transfer.
Card-Based Payments
There are various types of cards used for payment:
- A credit card is issued against a line of credit that the institution or merchant has extended.
- A charge card is a special type of credit card in which the outstanding balance must be paid off each month.
- A debit card is issued against a deposit account belonging to the cardholder.
- A prepaid (or stored-value) card is loaded with funds beforehand and is only usable if a sufficient balance remains.
- A virtual card is a digital card with the features of a credit, charge, debit or prepaid card.
Credit Card vs. Debit Card
Credit cards are primarily issued by banks and financial service companies. These are known as open-loop cards due to the fact that they are accepted anywhere the logo is displayed. A number of major retailers and oil and fuel-service companies also issue cards. These are considered closed-loop cards as they are only accepted by the issuing company.
Debit cards, frequently issued by credit card companies, closely resemble credit cards; however, unlike credit cards, which involve borrowing, a debit card is directly linked to a bank account. This means that spending is restricted by the available funds in the account rather than a predetermined credit limit. Transactions made with debit cards immediately deduct funds from the associated account, providing a real-time reflection of financial standing.
Digital Payments
Digital payments utilize various technologies and platforms, including mobile applications, online banking systems and digital wallets, to facilitate the exchange of funds between individuals, businesses and organizations. Unlike traditional payment methods, such as cash or checks, digital payments occur electronically — via credit cards, debit cards, bank transfers and virtual currencies — and often process in real-time or near-real-time.
Digital payments offer numerous advantages, including convenience, efficiency and accessibility, allowing users to make purchases, transfer money and manage finances with ease from virtually anywhere with an internet connection.
PART 3
Payment Trends
There are three overarching trends in payment system development:
- A shift away from traditional paper-based methods toward electronic and digital channels. This shift is primarily driven by the higher costs and risks associated with paper methods, such as checks.
- A notable reduction in retail payment settlement cycles, which is the result of the emergence of real-time or near real-time settlement systems. This includes initiatives like same-day ACH settlement and the introduction of low-cost, rapid settlement systems, which are expected to reduce reliance on more expensive wire payments.
- Increased adoption of digital payment instruments, including cryptocurrencies and exploration into central bank digital currencies. These innovations have the potential to markedly disrupt traditional payment systems, reshaping the landscape of financial transactions.
PART 4
Settlement vs. Finality
Settlement, also known as availability, involves transferring funds from the payer's account to the payee's, allowing the payee to access the funds. Finality occurs when the transferred funds cannot be reversed or retracted by the payer or their bank, at which point a payment becomes unconditional and irrevocable.
Finality depends on the payment system used and the parties involved. Real-time payment systems have been introduced by many countries as an alternative to ACH-type systems, providing cost savings, nearly instant processing and irrevocable payments. In contrast, check or card-based systems offer immediate information but may delay the actual transfer of funds. In these systems, there is a risk of the payer or their bank retracting the payment, which could take several months to resolve, depending on the system.
In domestic transfers, banks often settle using common accounts held at the central bank. Alternatively, they can use correspondent accounts, where two banks hold accounts with each other for the purpose of clearing and settling payments. These are most often used by smaller banks and in international funds transfers. When payments are processed outside the banking network by a payment service provider, finality and settlement depend on the specific scheme's rules, dictating when funds can be accessed from the company's account with the provider.
Knowing when final settlement occurs for each payment method and system is crucial to devising an effective payment strategy.
PART 5
Learn More About Payments
- AFP Real-Time Payments Survey, underwritten by The Clearing House
- AFP Digital Payments Survey, underwritten by J.P. Morgan
- AFP Mini-Course: Global Payments (AFP member resource)