Online Payments for Developers - Part 2 - Clearing House Based Networks

(this is a continuation of my previous post on Online Payments for Developers - Part 1)

Clearing House Based Network (a.k.a ACH)

A Clearing House simply is a central collection place where banks and other financial institutions exchange checks or drafts and settle accounts. In other words, it’s a common ground for all banks and financial institutions to transact with each other. ACH (Automated Clearing House) is an electronic network for the Clearing House, which was introduced in late 1960s as a result of the first “Paper-less Cache” initiative lead by several banks and Govt. The Federal Govt. wanted to reduce the cost involved in printing and mailing the Social Security, Tax returns, and Payroll checks, and the fraud in stolen checks from peoples mail boxes. The banks wanted to reduce the manual effort required in handling the checks submitted by the people. And last but not least, people wanted quicker access to the funds in their accounts, which otherwise takes a long time for the checks to be processed by the banks manually. Over time several other big corporations started using ACH for direct Payroll processing, and several insurance and utility companies started using ACH for direct debits for their service payments.

The ACH is usually called 4 Participants Model, as there are 4 participants in addition to the Clearing House itself.

1. The Originator – that initiates the payments transactions into the ACH (company that’s processing payroll funds, or the utility/insurance company collecting payments or more recently online and telemarketing companies to debit consumer accounts for purchase of goods and services).
2. ODFI (Originator Depositor Financial Institution) – a national/state charter bank, financial institution or a credit union or an insurance company that consolidates many transactions from many Originators and submits them to the Clearing House for processing. The ODFI makes sure the transactions are valid and confirm to the ACH standards.
3. RDFI (Received Depositor Financial Institution) – a national/start charter bank, a credit union or a loan and savings institution that participates in ACH. The RDFI holds the receivers deposit account and is responsible for accurately processing the transactions by debiting/credits the right accounts and for timely returning information to the ODFI for any transactions that cannot be processed.
4. The Receiver – that receives the transaction. The transaction can be a credit or a debit request, which means money, may be added or subtracted from the receivers account. The Receiver holds a depository bank account with the RDFI. The receivers can be consumers or businesses or some other form of a corporate entity.

Connecting the ODFIs and RDFIs is the Clearing House that processes all the transactions submitted by the ODFIs and delivers them to the RDFIs. As you can imagine the Clearing House processes gigantic volumes of transactions between the ODFIs and RDFIs. There are 2 Clearing Houses in US – the first one is a public Clearing House operated by Federal Reserve bank, where as the second one is a private Clearing House operated by a consortium of financial institutes and is called Electronic Payments Network.

Most financial institutions connect directly to the ACH with an exception of a few smaller institutes that connect indirectly to the ACH through another larger financial institution. Both Clearing Houses operate on the same set of rules defined by the National Automated Clearing House Association (NACHA). NACHA is a non-profit association of member banks, and participants that oversee the ACH network. There are obviously several other regulations that control how the ACH must operate, which you don’t really need to know or worry about unless you are building a system for a financial institution that wants to participate in ACH. J

Also as you can guess, most of the financial institutions act as both ODFIs and RDFIs (with varying volumes based on the businesses they cater to – for example a bank processing Payroll sends more transactions as an ODFI than a consumer bank providing checking/saving accounts to end consumers that handles more transactions as an RDFI), although for a given transaction they can only act as one or the other (all the transactions across different accounts with-in the same financial institution are handled by the financial institutions itself and not sent through the Clearing House).

I know you must be as confused as me when I first read about it J - it helps to understand how this 4 Participants Model work by looking at a sample use case scenario. Let’s walk through a scenario where an employee signs up for direct deposit of paycheck into his personal bank account.

As indicated in the diagram above, an ACH transaction starts when a receiver (employee in example) authorizes the originator to credit/debit money into their accounts (say Bank of America checking account) for any goods or services they have received, by providing his bank’s routing and account information to the Originator (the employer on our example) for direct deposit of paycheck into his account. Once or several times of a day (depending on the business – in case of payroll it would be biweekly or once a month), the Originator (Employer) sends all of it’s transactions (Paycheck information) in a file to it’s ODFI (say Wells Fargo Bank). Once the ODFI processes the files, it debits the money from the Originator’s account for the net value of all the transactions listed in the file.

Similar to the Originator, once a day the ODFI (Wells Fargo Bank in our example) consolidates all the files coming from all of it’s Originators into a single file (format defined by NACHA) and sends it to the Clearing House. The Clearing House processes the ODFI files, sorts the transactions by ABA-RTN numbers and calculates the net position for each financial institution including the transaction fee that the Clearing House charges the ODFI and RDFI for processing the transactions. The Clearing House groups the transactions based on the bank routing numbers, and then send the files to the corresponding RDFIs (in our example Bank of America will receive one).

It must be noted that even though these files contain millions of transactions, the net value for each RDFI might still be zero, or negative in some cases, since almost all the banks and financial institutions act as both ODFI and RDFI for it’s customers sending and receiving money on behalf of them.

Each day after it processes these files, the Clearing House also tells the ODFI and RDFI Financial Institutes whether they (in our example, Wells Fargo Bank and Bank of America) owes money to the Clearing House or the Clearing House owes the money to the financial institution. All the Settlements between the Financial Institutions are done using the accounts that each one of them holds with the Federal Reserve Bank (in case of public Clearing House) or the corresponding Bank of the Bankers (in case of a private Clearing House). Let’s say in our example, the Wells Fargo owes $3M to the Clearing House to provide Salaries to all the employees, out of which say $1M goes to the Bank Of America for all the employees that use accounts in Bank of America and the rest goes to other banks that the employees hold accounts at.

As indicated in the diagram above, the Originator pays the ODFI a negotiated transaction fee varying based on it’s transaction volumes, and it’s negotiating power and relationship with ODFI. There are additional fee for the files that are processed, transaction reports generated, and the process to bank account, etc. The ODFI and RDFI also pay a processing fee to the Clearing House. There are additional fees associated with services (fraud detection, etc.) provided by the Clearing House operator (NACHA). Similar to the ODFI, the RDFI charges it’s consumers a transaction fee based on the type of account (personal or business).

Alright that's it for the Clearing House Based Networks - next up is Card Based Networks, which I am sure is more interesting than the Clearing House Based Networks. :-)