March 2023 - Payment Topics

How is the ISO 20022 standard defined?

The financial industry uses different terms and different message formats across to describe payment processes. This leads to barriers in facilitating payment integration. ISO 20022 aims to define common payment business processes and consistent message standards to ensure financial institutions have a common understanding of payment information exchanged. The ISO 20022 standard is defined as individual 3 layers:

Business Concepts
Logical models
Syntax

Business Concepts

The ISO 20022 standard is defined using a business model which describes the roles, actors and processes that make up the flow of payment information. This business model will define concepts such as debtor, creditor, debtor agent, creditor agent, credit transfer and direct debit.

Logical Models

The logical model describes all of the parts needed to perform a business activity such as a credit transfer. Its independent of syntax. The following diagram shows a simplified data model for a subset of the CreditTransferTransactionInformation.

Syntax

To generate the physical syntax, we use the logical model. The physical syntax of ISO 20022 is XML. An example of XML syntax within ISO 20022 is the pain.001 XML message.

The dictionary defines all the terms used in ISO 20022. This removes any ambiguity to the different terms used in the payments industry.

What are High and Low Value Payment Systems?

Overview

Banks generally separate their payment systems into high and low value streams:

High value payments (inter-bank payments)
Low value payments (retail payments).

High value payments are settled instantly. Low value payments are batched and settled generally at end of day.

High Value Payment Systems (HVPS)

HVPS transfer large value inter-bank transactions. Transactions settle in real-time and instantly. HVPS are Real Time Gross Settlement Systems (RTGS).

Generally HVPS do not have an upper limit on the monetary value of transactions allowed. Central banks will have oversight of the HPVS in individual countries ensuring stability and reliability. They also will use robust security to guard against fraud, hacking and other malicious behavour.

Examples

Fedwire (United States)`

RTGS (India)

RITS (Australia)

MEPS+(Singapore)

TARGET2 (EU)

CHAPS (UK)

Low Value Payment Systems (LVPS)

LVPS are deferred settlement systems. Payments are batched and settled at a certain point in the day. Transaction amounts are on average low in comparison to high value payments.

Low value payments constitute the vast majority of payments. Individually they pose no systemic risk and it is inefficient and expensive to process them in a real time basis. They settle in batches at the end of the day.

LVPS are also known Batch EFT (Electronic funds transfer) or ACH (Automated Clearing House) payment systems.

SWIFT supports over 25 low-value payment systems.

Examples

CHIPS (United States)

NEFT (United States

BECS (Australia)

SEPA (EU)

What is CHAPS?

CHAPS is acronym for Clearing House Automated Payment System. It is a high-value payment systems, operated by the Bank of England, providing efficient, settlement risk-free and irrevocable payments in Sterling. It was first introduced in 1984.

CHAPS is an RTGS where settlement is risk-free, i.e. because each payment is settled individually, in real-time. It is primarily used for the same-day settlement of high-value wholesale payments as well as time-critical, high value retail payments like house purchases.

In 2019 it processed over 35 millions high value payments with a total monetary value on 75 trillion GBP.

Who uses CHAPS?

There are over 35 financial institutions, known as direct participants, who make payments over CHAPS. Direct participants include high street banks, financial market infrastructures and challenger banks.

Several thousand other banks make payments through direct participants (correspondent banking).

How does CHAPS work?

What are the benefits?

Supports secure high value, same day payments from payment service providers to their customers.
Payments are highly secure using the SWIFT payment infrastructure together with the Bank Of England’s RTGS system. There is no upper/lower payment limits.
Among direct participants, the liquidity requirements eliminate settlement risk.
The system processes and settles transactions on the same day, thus ensuring that the beneficiary receives payments on the same day as the payment initiation.
Allows the direct transfers between direct participants and financial institutions eliminating the need for intermediaries.

What is TARGET2?

TARGET2 (Trans-European Automated Real-time Gross Settlement Express Transfer System) is the RTGS owned and operated by the Eurosystem. The Eurosystem is the monetary authority of the Eurozone; it consists of the European Central Bank (ECB) and the national central banks of the Eurozone countries.

TARGET2 is used by central banks and commercial banks to process euro payments in real-time enabling the free flow of money across the Eurozone. It is a payment system that enables EU banks to transfer money between each other in real time.

It’s mandatory to use TARGET2 when settling euro payments that involve the Eurosystem. It was introduced in 2007 replacing the older TARGET (Trans-European Automated Real-time Gross Settlement System) system. In 2020, it processed over 92 billion transactions with a total value of approximately €152 trillion

How does it work?

Who uses TARGET2?

It is used by central banks and commercial banks.

Central banks will use it to manage liquidity and facilitate the flow of funds between financial institutions.
Commercial banks within the eurozone will use it to settle large value transactions. A full list of participants can be found here

What is FedWire?

FedWire (Fedwire Funds Service) is a RTGS high value payment system run by federal reserve banks in the United States.

As Fedwire is an RTGS, payments are settled immediately and are irrevocable. Fedwrite transfers trillions of dollars daily. This is advantage over its nearest competitor, CHIPS, which uses an end-of-day net settlement process.

Fedwire is used banks, businesses, and government agencies for large, same-day transactions. It is a credit transfer service, so transfers are always a payment from a sender to a receiver. It does not have a direct debit facility so a financial institution cannot pull funds from another financial institution.

In order to be eligible to participate in Fedwire a financial institution must have an account with one of the 12 federal reserve banks. If a financial institution does not have an account with the federal reserve, it must partner with one that does. This is known as a correspondent relationship.

How does Fedwire work?

A sender bank initiates a funds transfer by instructing its Federal Reserve Bank, to debit funds from its own master account and credit funds to the master account of another recipient bank.

The federal reserve bank will holds account for both sender and recipient and settles transactions individually and immediately.

What is Net Settlement?

In net settlement, a bank nets transactions at the end of the day, whereas in gross settlement, it happens instantaneously

It allows for efficient settlement by simplifying the reconciliation and reducing the overall volume of transactions, leading to increased operational efficiency and risk reduction.

Banks will collect transaction information throughout the day. At the end of the day, the bank commonly shares this information with a clearing house and calculate the net difference

Two types of settlement systems exist in payments; net and gross settlement.

Types of Netting Systems

Bilateral Net Settlement

A combination of two banks settles payments. Net Settlement is value of all the transactions a participant has received during a certain period of time less the value of the transactions made by that participant to all other participants.

The ECB defines bilateral netting as A settlement system in which every individual bilateral combination of participants settles its net settlement position on a bilateral basis

Multilateral Net Settlement (MNS)

Banks submit their transactions to a clearinghouse or a central bank. The clearing house/central bank then calculates the net positions or net obligations of each participant based on the transactions submitted. The calculation involves offsetting the payable amounts against the receivable amounts to determine the net amount owed or payable by each participant.

The clearing house or central bank facilitates the settlement process by transferring the net amounts between the participants once they determine the net positions.

The reduction in the number of transactions that need to be settled reduces risk. It also enhances operational efficiencies in the financial system.

MNS streamline the settling process, improve liquidity management, and reduce credit and liquidity risks associated with individual transactions. MNS is commonly used in securities trading, derivatives markets, and interbank payment systems.

What are the differences between Net and Gross Settlement?

Who are The Clearing House?

The Clearing House (TCH) , www.theclearinghouse.org, are a US financial institution that clear and settle over $2 trillion dollars of ACH, wire, real-time payments and checks every day. It owns and operates the RTP platform.

TCH also operates one half of the ACH network, while the Federal Reserve operates the other half. It is owned by a collective of 24 large banks. These are both domestic US and international banks.

TCH runs a number of payments systems such as:

CHIPS (Clearing House Interbank Payments System):
RTP (Real-Time Payments)
ACH (Automated Clearing House)

What is CHIPS?

CHIPS is an acronym for Clearing House Interbank Payments System and is the largest clearing system for wire transfers in US dollars. It settles approximately 1.8 trillion dollars daily.

CHIPS is not an RTGS and does not settle payments in real-time. It is a netting engine and aggregates payments over the course of the day.

What is RTP?

RTP is a real-time payments platform that allows banks insured by the US government to clear and settle payments in real time. An RTP payment resembles an instant wire transfer.

Real-time payments over the RTP network provide financial institutions with the capability to send payments directly from their accounts 24/7, and to receive and access funds sent to them over the RTP network immediately.

What is the ACH Network?

What is Open Banking?

Open Banking allows banks and registered third party vendors access consumers financial data as long as they have the consumers explicit consent. By doing so, it allows non-banks offer banking functionality.

A customer authorises apps to access their bank data. Those apps are run by third party organisations known as TPPs. These apps must have the consent of customers before they can access a customer’s data and they must do it in a secure and standardised manner. Customer’s data is accessed via secure Application Programming Interfaces (APIs).

Examples of third party vendor who may wish to access your financial data could be budgeting or cash flow management apps.

Why do we need Open Banking?

Banks hold the most valuable data a person has, i.e. where and how they spend their money. Banks know how much we spend, where we spend it and on what.

Open Banking makes it easier for registered third parties access this data and provide services on this data.

What are the benefits of Open Banking?

Better understanding and management of your finances. Lets you see all of your financial information in one location.
By accessing a customers financial data, TPP apps could recommend better products and services as they become available.
Lets customers pay online instantly. Most customers pay online with debit or credit cards which can fail and take a number of days to clear. Open Banking allows payments to be made instantly.
Funds can moved instantly to apps used for things such as investing or betting.

What is PSD2?

Payment Services Directive, PSD2 is EU law which compels banks to allow registered third parties access consumer accounts. This facilitates innovation.

PSD2 also seeks to protect consumers by mandating stronger security through multi-factor authentication for user login.

PSD2 is integral to the growth of Open Banking within the EU as it mandates banks to make their customers financial data available via APIs to registered third party vendors. You can read more about PSD2 here

What is PSD2?

PSD2 (Payment Service Directive (derived)) is an EU law which regulates access to your financial data by organisations other than your bank.

It is critical to the growth of Open Banking within the EU as it mandates banks to make their customers financial data available via APIs to registered third party vendors.

What is the purpose of PSD2?

The purpose of PSD2 is to:

Encourage innovation and competition in retail payments
Improved security for payment transactions
Protect customer data.

How does PSD2 work?

Basically Open Banking lets approved companies access bank accounts with the account holders’ permission.

Third party financial service providers need an account information service provider (AISP) license and/or a payment initiation service provider (PISP) license before they can offer Open Banking Services.

PSD2 facilitates the migration of banking applications to an open innovative ecosystem.

Technical Terms

PSD2 introduces a number of technical terms. The diagram below shows where these terms are applicable within Open Banking

PISP – Payment Information Service Provider. Third Party PISPs can initiate payments directly from customers payments account assuming they have the customers consent.

AISP – Account Information Service Provider. AISPs can access a customers data from different banks to give an overall overview of their financial position.

TPP – Third Party Payment Service Providers

PSU – Payment Service Users

ASPSP – Account Servicing Payments Service Provider. Financial institution holding a customer account, i.e. Bank.

XS2A – Access to account

PSD2 Services

PSD2 regulates two popular services available already:

Payment Initiation Services (PIS)

Account Information Services (AIS).

PIS allow customers to make online purchases without a credit card. This means that you can use a bank transfer to make a purchase without any delay.

AIS allows the collection of a customers financial information from different bank accounts into one location.