The way people pay for things is rapidly changing. Fintech start-ups have been quick to identify pain points in traditional payment systems, which, so far, have been interbank clearing and settlement systems, or those run by the various card associations. Here’s a first of a series of quick primers on payment schemes.
What is a payment?
A payment is a message. Unlike your typical WhatsApp message, however, a payment instruction comes with obligations – it obliges (at least) one financial institution to debit one account (a financial instrument) and credit another.
This is what happens if Alice pays Bob, both of whom hold accounts at the same bank. Alice instructs her bank to debit her account and credit Bob’s account. When the bank gets the message, it verifies that Alice and Bob both have accounts with it, that both accounts are active, that Alice has enough funds in her account to do the transaction, and that there are no regulations that may disallow the payment. The bank authenticates the message to make sure that Alice sent it, and not someone else. This last bit is important, because unless the bank can demonstrate that it did all it could to ensure that Alice sent the message, it is liable in case Alice disputes the payment. After this authentication, the bank debits Alice’s account and credits Bob’s account. This means that the money is now available to Bob, and that the payment is complete.
What are Payment Schemes?
When there’s only one financial institution involved, there’s no payment scheme required. That financial institution can choose the form and content of the payment instruction. However, what if Alice and Bob hold accounts in different financial institutions? Here, Alice’s financial institution has to instruct Bob’s financial institution to credit his account. This means that the message format has to be agreed on by the two banks. When there are more than two financial institutions involved, this becomes a payment scheme.
This is, essentially, the function of a payment scheme. Existing payment schemes have either been created by industry associations (Visa, MasterCard, SWIFT) or by standardization bodies like ISO. Some common messaging standards in the banking industry are the SWIFT MT message series (a collection of different message types for different purposes), and the ISO 8583 (for card payments) and ISO 20022 (for bank payments).
A payment scheme standardizes the format of the payment instruction.
There’s more to payment schemes than just standard message formats, however. When multiple financial institutions are involved, they have to have a way of knowing they’ll be paid for the credits they do on behalf of other financial institutions. This is done through settlement systems.
Regulators have their own requirements from payment schemes as well. They need to be assured of systemic stability – what happens if a payment scheme handling a significant volume of the country’s transactions fails? Regulators are also concerned about the qualification criteria for participation in the scheme – who decides, and on what basis, that a financial institution may join the scheme? They care about the governance of payment schemes too – what is the structure of management of the payment scheme and what controls are in place to monitor transactions through the scheme?. There may be compliance concerns – how anti-money laundering and combating financing of terrorism (AML/CFT) processes are implemented by the participants in the scheme.
A payment scheme, therefore, establishes the rules of the payment system, and creates a process of governance, in addition to standardized message formats and processes of reconciliation, settlement and support.
In the payments industry, settlements means the realization of “good funds”, or having the funds transferred to you safely in your control. In most cases, this means having the funds credited to your account.
When the payer and the payee hold accounts with the same bank, this is a fairly easy process, as the bank knows that Alice has the money in her account, and can transfer the money from Alice’s account to Bob’s account. What happens when Alice and Bob have accounts at two different banks? This complicates things significantly. Alice has to instruct her bank (Bank A) to pay Bob’s bank (Bank B) and ask them to deposit the money in Bob’s bank account. At a messaging level, this is still fairly simple. Bank A and Bank B agree in advance on a format for the message and a way to prove that it is an authentic message from Bank A. However, why would Bank B credit Bob’s account until they get funds from Alice’s bank, Bank A? Since no one carries cash between banks as they used to earlier, the ways banks have organized this is by two different ways – using correspondent banking arrangements or using an interbank settlement system.
Correspondent banking arrangements are the equivalent of leaving some money with your friend to make payments on your behalf. Imagine Alice and Bob are in two countries, Alice in India and Bob in the USA. Alice makes frequent purchases online from US companies, and therefore keeps $1000 with Bob. Bob buys frequently from India, and keeps Rs 100,000 with Alice. When either of them wish to make a payment, they tell the other to do it on their behalf, deducting the money from the balance they have with them.
Interbank Settlement Systems
In a country with, say, 50 banks, it would be expensive for each bank to have deposits with every other bank. Instead, what they do is to keep one single deposit with the central bank of the country, and all payments are made using those accounts. This can be in real time, as with RTGS (Real Time Gross Settlement) systems, or with several payments batched together, as with EFT (Electronic Funds Transfer) systems.
In the next post in this series, we’ll look at how payment schemes are established.