The Road to Faster Payments: A Banker's Guide

Picture a line of dump trucks outside a gravel yard, engines running as the drivers wait for payments to clear from their employers so they can load up their cargo.

Now imagine the trucks stuck in the exact same place, hours later.

This real-life scenario — relayed to Daniel Gonzalez, vice president of industry engagement at the Federal Reserve Bank of Chicago — is just one example of how slow-to-clear payments can hamstring commerce. An accounts receivable manager at a gravel yard told Gonzalez that she has to hold off releasing the gravel until she can be sure the company's been paid, delaying transport of goods.

Slow payments can also wreak havoc on the everyday lives of working people who don't have direct deposit. A delayed paycheck can destabilize workers who lack financial cushions, forcing them to bounce checks, rely on credit or fall behind on bills. People who need to make last-minute bill payments face uncertainty about whether the payees will receive their money before late fees kick in.

Such issues have plagued the U.S. for years even as nations like the United Kingdom, Australia, Singapore, Brazil and Mexico implemented state-of-the-art networks that allow transactions to clear in minutes or even seconds. At long last, with the financial crisis fading into the rearview mirror and the U.S. payment system in danger of falling behind on a global scale, the government and the financial industry have agreed that it's time to overhaul the way we pay.

Now comes the hard part.

"The challenge in the U.S. is that we have so many banks compared to other countries," said payments consultant Elizabeth McQuerry. "Whatever solution we come up with has to meet the needs of banks of very different sizes and technological capabilities."

To that end, a number of institutional efforts to transform the U.S. payment system are underway. The Federal Reserve in January released its long-awaited plans for shepherding the financial industry toward ubiquitous real-time payments. A few months earlier, big-bank trade group and payments company the Clearing House announced a "multi-year effort" to build such a system. And Nacha, the industry group that sets rules for the automated clearing house network, is taking a fresh crack at a proposal to speed up ACH payments after big banks voted down an earlier plan in 2012. At the same time, proprietary systems including clearXChange, FIS's PayNet and Fiserv's Popmoney have been forging ahead with real-time payment networks of their own.

The Fed, the Clearing House and Nacha emphasize that their endeavors are complementary rather than competing. The lines of communication are open between all three groups. And each organization acknowledges that the success of any effort relies on the ubiquitous adoption of faster payment systems.

"In many ways it's like the vaccination issue," said Andy Schmidt, a research director at CEB TowerGroup. "If certain parties elect not to participate, it creates ripples of inefficiency that can throw systems off."

But achieving ubiquity is no easy job in a financial system as large and diverse as that of the U.S. — particularly since the interests of big and small banks don't always align. The divide was evident in the split over Nacha's original same-day ACH proposal: the Independent Community Bankers of America was for it, while big banks shot the plan down largely because they wanted a way to make the change to same-day ACH profitable. This history suggests that the Fed has taken on a difficult mission in attempting to foster industrywide consensus about the best course of action for faster payments in coming months.

While the road to real-time payments in the U.S. is looking lengthy and tortuous, businesses and consumers are pressing for speedier transactions sooner rather than later. The Fed's research suggests that consumers are eager for faster debit payment processing, while businesses want funds to be available faster. Both groups express a strong preference for payments that clear instantly or within the hour.

"I think it's already happening that people are migrating to options outside the banking system" in search of faster payments, said Bob Steen, chief executive of Bridge Community Bank in Mount Vernon, Iowa. "It's pretty hard to argue that PayPal hasn't had a significant impact, on at least online sales and other transfers between people. And frankly they may be the easiest way to move money internationally there is, and the most cost-effective."

Small banks are well aware that their survival is dependent on their ability to keep up with customers' evolving preferences, said Steen, whose bank has $83 million in assets. "We know for sure there's an important segment that's making payments without us, and we can't just acquiesce to that," he said. "Every time they do that, that's one step removed from their community bank and we can't just be bystanders."

The Fed's January road map lays out four possible options for enabling real-time payments, whittled down by the central bank in consultation with industry participants from an original nine. The first possibility is to revamp the country's PIN debit-card infrastructure. The second is to adopt a common protocol to clear transactions over the Internet. A third option is to build a new payments infrastructure on top of existing technology for limited uses. And the last is to create an entirely new payments infrastructure that would pave the way for the eventual phase-out of checks, wire transfers and ACH transactions.

A task force convened by the Fed and composed of industry participants will be charged with deciding which of these options to pursue. (A separate task force will focus on improving payments security.) Fed officials say that while various segments of the industry have a vested business interest in promoting one option over another, the most popular solution appears to be starting from scratch.

"In general, [most players] are more inclined to suggest that building something new makes more sense," said Sean Rodriguez, the Fed's senior vice president of payments industry outreach. The Clearing House's plan to create a new infrastructure suggests the idea has already taken root among the country's largest financial institutions, he said.

Fed officials hope the task forces, which are now in the process of being assembled, will settle on which avenue to pursue by the end of 2016. The implementation of the new system will be a "multi-year" process, according to Rodriguez.

"There's been a lot of discussion about 'should we be more prescriptive?'" on the timeline for speeding up payments, Rodriguez said. "But you can't until you know what you're going to do. Once we understand what [the chosen system] is, we can start to think about how soon can you get there."

Many bankers have expressed relief that the Fed plans to hold back from issuing a mandate or acting as an operator, instead serving as "the convener-in-chief of meetings," in the words of Stephen Kenneally, vice president of payments and cybersecurity at the American Bankers Association. But some members of the financial industry are skeptical about whether the private sector can move from talk to cohesive action on its own.

"We certainly think you're not going to get to ubiquity without someone that can link the banks of all sizes," said Cary Whaley, vice president of payments and technology policy for Independent Community Bankers of America. "In the past, with checks, ACH and wire transfers, that's been the Federal Reserve."

That sentiment was echoed by Stephen Lange Ranzini, president and CEO of University Bank in Ann Arbor, Mich.

"The ideal scenario is that the Fed steps up to build [a system] that's proper," he said. "But I don't know if they're actually going to do that."

Ranzini fears that if the Fed relies on big banks to figure out a solution, the megabanks may drag their heels. A fast, secure and ubiquitous new system could create more competition for the big banks, lowering the cost of electronic transactions and thereby curbing their payments revenue. "If they lose revenue from electronic payments, their business model collapses," he said.

Banks also theoretically have a disincentive to pursue faster payments because they would miss out on float income — the interest income banks make between debiting the sender of a payment and crediting the receiver. But payments industry analyst Beth Robertson points out that they've already lost a big chunk of it.

"A great deal of float has already been removed from the check system, with many items now clearing via Check 21 or ACH conversion," Robertson said, referring to options that allow banks to process checks electronically rather than physically transporting them between institutions.

This leadership issue is unique to the U.S., according to Paul Stoddart, who serves as managing director of strategy and business development for VocaLink — the company that built the real-time payment infrastructure for the U.K. and other countries. Most nations that have constructed or shifted to a real-time system have had the government take the reins.

"At some point, someone needs to make a decision and that needs to be implemented," Stoddart continued. "Strong leadership to move the debate from discussion and deliberation to implementation is critical."

While the Fed is working to ensure that a wide range of voices have their say before the task forces settle on a plan, it's aware that complete consensus may not be possible, according to David Sapenaro, first vice president and chief operating officer at the St. Louis Fed.

"No individual firm or segment of firms is going to get everything they would want if they were doing it on their own," Sapenaro said. "But we're hoping they come with a broad perspective, and with the public interest perspective that they need to meet."

Kenneally suspects that some organizations will be eager to bypass committee meetings. "You know there's going to be one or two bold players out there who will leap to the forefront and say, 'Here's my solution, follow me,'" he said.

The Clearing House appears to be angling to be such a player. Although the group helped kill Nacha's 2012 proposal for enabling same-day payments and responded warily at first to the Fed's plans for a payment system overhaul, it has since decided to take a leading role in overhauling U.S. payments.

"The Fed did specifically reference the work we're doing in real-time payments" in the report, said Steve Ledford, senior vice president of product and strategy at The Clearing House. "They did also mention in the white paper that they were looking to the private sector to provide solutions. That's what we intend to do."

The Clearing House plans to focus on building a real-time payments system as well as accompanying messaging and tokenization features, according to Ledford. The group does not yet know exactly how it will build the system. But the organization will ensure that the system is profitable for financial institutions, he said.

"One can generate revenue if one is creating additional value for customers," Ledford said. Features like messaging options that notify senders and receivers when payments are initiated and completed, and that allow users to make requests for payments or add additional information "should provide opportunities for financial institutions to get a return on investment."

The Clearing House represents 24 of the nation's largest commercial banks. But the organization is aware that the system will only function if financial institutions of all sizes and their technology providers are on board, according to Ledford.

Community bankers will be keeping a close eye on the group's outreach efforts. The ICBA's Whaley says that while community lenders are "favorable" to The Clearing House plan, "the trick for them is developing relationships that can reach the smaller institutions."

As the Fed and The Clearing House attempt to develop plans that will unify the fragmented financial industry, Nacha's same-day ACH proposal has successfully garnered broad industry support. But no plan pleases everyone. In recent weeks, the Federal Reserve Board has raised concerns about a key component of the scheme.

Nacha's proposal, the details of which were made public late last year, would expand the number of windows during which ACH transactions can be cleared and settled each day from one to three. That includes a period later in the day — a key addition for financial institutions on the West Coast.

The proposal's popularity among banks large and small can be attributed to the very provision with which the Fed takes issue. The new plan requires all payment-originating banks to pay receiving institutions a fee of 8.2 cents per transaction. Nacha said the fee would help receiving banks offset the costs of making mandatory technological upgrades and recover other "opportunity costs" such as lost wire transfer revenue to boot. But the Fed argued in a comment letter that banks would presumably pass the costs of the fee onto customers, who might in turn be dissuaded from using same-day ACH.

It's unclear if Nacha will rejigger the proposal in response to the Fed's concerns. But the organization still plans to put the rule ballot to a vote in the second quarter. If members approve the rule, Nacha would begin phasing in same-day payments as soon as 2016.

"Same-day ACH is really an action we can take now that's meeting needs today," said Nacha president and chief executive Jan Estep, noting that not all payments need to be cleared in real time. "But it's also a set of building blocks for the future." The changes to the ACH system would allow improved security features and other enhancements to be added later on, she explained.

There are alternative ways to address the economic inefficiencies of slow-to-clear transactions, according to CEB TowerGroup's Schmidt.

A system that guarantees funds are available and lets recipients know that a payment is on its way could be a good near-term substitute for real-time payments, Schmidt said. Credit and debit cards already follow this model.

"The guarantee of receipt allows you to move forward with the transaction," Schmidt said. Banks could even use that guarantee to allow payment recipients to access funds immediately, he suggested.

Dwolla, an Iowa-based digital payments startup that announced a high-profile partnership with BBVA Compass last fall, is also advancing the availability of immediate payments, according to Schmidt.

"They've done some fantastic work in creating their own real-time payment network for astonishingly low cost to users," he said.

Federal Reserve officials noted that there are a number of effective proprietary real-time or near-real-time systems, including Dwolla, clearXchange, Fiserv and FIS. But the systems are not currently compatible with one another.

"One of the concerns the task force will have to deal with, in terms of ubiquity, is that the problem we have with a number of solutions is, we don't have interoperability between FIS, Fiserv and clearXchange," said the Fed's Rodriguez. "The question is: can we leverage some of these capabilities without building a new infrastructure? That remains to be seen."

Another small but important player in the faster-payments space is Ripple Labs, an alternative payments company that uses a distributed ledger technology to settle transactions in real time. Although the Fed's paper does not specifically mention Ripple's protocol as the platform that would be used to settle payments over the Internet under option 2, it is the most prominent of such options.

Ripple executives say that the central bank could use its technology to shift away from processing financial institution's transactions in batches during five different periods during the day. Instead, the Fed could allow banks to make payments to one another in real time using the Ripple ledger and later reconcile and record the payment transfers.

Any broad-scale attempt to revamp the payments system will require venturing into unchartered territory. But McQuerry urges the financial industry to take heart.

"There is a lot of disappointment that we don't have a clearer road map, but more of a series of desired destinations," she said. "But this is also a positive moment."

"We've all been having these parallel conversations," McQuerry continued. "There was not an industry dialogue going on. We've now started a national conversation about where we want the payments system to move to. We didn't have that before."