Electronic Fund Transfers Using Automated Clearing House (ACH)

In this video, we'll continue our

examination of existing payment practices by looking at the modern equivalent

of the paper-based checking system. The Automated Clearing House,

ACH for short, has by and large replaced the checking system

as the dominant form of high value non time-critical payments

in the United States and in most countries, as a recent study

by the Federal Reserve has shown. Similar to a bank wire it's a secure

electronic messaging system and similar to checks, it allows transactions

to be initiated by either the sender or the receiver. Even if you haven't heard about ACH,

chances are that you have used it. Every time you have used direct deposit of

your paycheck, every time you used a bank account to pay your utility bills online,

and critically for this course, every time you used a new payment apps,

such as the PayPal and Venmo. And that's the reason we

need to talk about it, because despite being

a quote-unquote legacy system, it is really the bedrock upon which a lot

of the new pay tech Innovations are built. So let's take a look at its

technical underpinnings and then connect them to the new Innovations

in the next couple of videos. Let's start with the five party graph that

we used to illustrate the checking system. I make a few modifications. First, let's get rid of the paper check. I replace it with the computer. Then we'll give some proper

terminology to the banks. The sender's bank is called originating

depository financial institution, or ODFI for short, and

the receiver's bank is called the receiving depository

financial institution, or RDFI. Finally, the paper check writing

system is replaced by an electronic communications network. Think about the postal mail replaced

by email and you get the picture. The ACH network is usually operated

by central banks and in the US Is run by both the Federal Reserve and by a

private company called the Clearing House. Again, think about the ACH network

as something like a messaging app to exchange secure payment-related

messages between banks. Now, let's do a quick transaction and

transfer some money. If you have used the system, you'll see something similar to

this form on your bank's website. You'll need to fill in some basic

information, like how much you're paying, and the receiver's bank information,

their routing and account numbers, and this information is then gathered

into a payment request and transmitted to your bank's server. Remember, this request can go both ways. So if you have used online bill pay, for

example with your credit card company to pay off your credit card every month,

you're sending your bank information to the receiver and give them

the authorization to generate the payment request on your behalf, and

they transmit the request to your bank. Either way,

the request ends up in the ODFI server. After the OFDI gets the request, you will conduct some standard intermediation

tasks, like authenticating the account, making sure the request is authorized, and

there's enough money to make the transfer. After this, the bank will use

the payment request information to generate a standard text message file,

like this. This is the ACH file consisting of all

the relevant identifiers and amounts. It's in a standardized format so

all banks computers can easily read them. This text file is the information that

will be transmitted over the ACH network to the receiver's bank, the RDFI. The bank will then identify the receiving

account, and that's when as a receiver you'll get a notification that

you have some money coming. This completes the information

flow of this transaction and it happens fairly quickly. As you'll see shortly,

it's not instantaneous, but is usually done within the same day. And because everything is electronic,

there's no paper checks to be routed, so settlement, the actual money flow, can also occur much quicker, either on

the same day or within a couple of days. Now, let's think about the primary

advantages of the ACH system compared to the checking system. The most obvious advantage is that it really cuts down the time lag between

the information flow and the money flow. In the paper checking system, the information flow is limited by the

physical speed that the checks can move. In the ACH network,

the information flows digitally. This would both significantly

increase the settlement speed and cut down potential fraud. The other advantage is cost. The system is really cheap to use. The average cost per transaction

is a fraction of a penny. And this low cost is due to the fact

that communications in the system is not done in real-time but in a batch process. Think about it, there are millions and millions of transactions every day between

a vast number of different parties. If every transaction has to

be sent through right away, the demand on the communications

infrastructure will be really high and the cost would consequently

be much higher. A bank wire is like an ACH but

a real-time messaging system and that's why it costs so

much more money to send wire. By contrast, the banks would not send each

ACH message through as they receive them. Instead, they would put

them in a queue and only send them twice a day

at predetermined times. For example, at 10:30 a.m and

2:45 p.m all text files in the queue gets compressed into one zipped file and

sent all at once. Because of this, instead of hundreds

of millions of unpredictable messages over the entire day, the network only

transmits hundreds of thousands of messages at predictable times each day. This really cuts down the infrastructure

requirement for the network and that's why so cheap to use. The low cost of ACH will

be a primary reason why most fintech innovators

choose to build upon this system. Now, let's think about it's limitations. Let me ask you this question. When is the last time you remembered

somebody's bank routing and account numbers? Exactly. Despite the good infrastructure

at the back end, the main drawback of the ACH is

that it's not very easy to use. The user identifiers, these numbers, take

a long time to retrieve and each bank and each receiving merchant usually have

their own different user interface, and some of them are not very intuitive and

user-friendly. All of this add-on to the learning curve

of the end-user thereby discouraging them from using it frequently

in the first place, and that's precisely the market positioning

of most PayTech innovators in this space. They're taking this good but

not user-friendly infrastructure, like ACH, built their own user-friendly

interface on top of it, so that the users would tap into the ACH more frequently

without even realizing they're using it. Therefore, the main value proposition of

the PayTech innovators is that instead of spending all that money to build

an alternative communications infrastructure and taking all the risks of converting enough

people to it, let's do what we do best. We're tech companies, so naturally, we have a lot more experience

designing apps and good user interfaces than banks who are better at building

the actual payment infrastructure. So let's build an easy-to-use

interface that the consumers like and just plug it in to the existing

payment infrastructure. Essentially, a lot of the paycheck

innovations involve building good wrappers around existing solutions, like the ACH,

to make them easier to use. That is the connection between PayTech and

existing tech. So what kind of wrappers? As an example, how about user identifiers? Because no one would remember a hundred

routing and account numbers of their friends, let's replace those with

something that they already have on their phones, their friend's

phone numbers and email addresses. Another example, because it's often cumbersome to use

bank-level authentication methods, like micro deposits, let's replace

that with biometric authentication that we can already access with

the fingertip on our phone. The end user fills in information

using these easier identifiers and authentication methods, the PayTech

app would take these information, convert them back into a format that's

compatible with the existing solutions, like a standard ACH payment request, and then just forward it along

the existing payment rails. And these wrappers are often

called digital wallets. There are three main flavors

that we'll discuss sequentially over the next three videos. The first flavor,

the pure digital wallet, does just that. It rides on the ACH payment

rail to send and receive money. The second variant is the more hybrid

version that does more than just payments. They also use existing payment rails but to channel money between different

types of accounts, like loans and Investments, therefore enable users to do

more than just payments in a single app. In the last variant,

the wrapper is the social network. User identifiers are their names and

handles on the social network and payments enable an additional dimension of

communication between the network users.