Chapter 4: Payment Instruments and Systems

Put the four elements of the payment process in order from first step to last step. 1. Clearing 2. Payment instructions 3. Settlement 4. Payment generation

1.Payment instructions 2.Payment generation 3.Clearing 4.Settlement From a systems standpoint, there are four elements in the payment process: Payment instructions consist of the information contained in an electronic transfer (e.g., a wire or ACH transaction), a payment card transaction, or a check. These instructions are from the payor and tell the paying bank to transfer value to the payee through the receiving bank (or, in the case of a debit, these instructions are from the payee and request the paying bank to transfer value). Payment generation occurs when the payment instructions are entered into the payment system. Clearing is the process in which banks use the payment information to transfer money between themselves on behalf of the payor and the payee, either directly or through some external network. Settlement is the last step in the process and occurs when the payee's bank account is credited and the payor's bank account is charged.

Which of the following are TRUE for a small-value transfer system, but NOT TRUE for checks? 1. Use terms payor and payee 2. Can be either a debit or a credit transaction 3. Capable of transferring payment and additional payment-related information 4. It is a Real-Time Gross Settlement (RTGS) transfer system

2. Can be either a debit or a credit transaction 3. Capable of transferring payment and Checks (or cheques) are the traditional method that payors, also referred to as makers or drawers (because they "make" or "draw" the check), have used to access their bank accounts. The payee will deposit ("pay in") the check—drawn on a domestic bank in local currency—at the payee's bank (i.e., bank of first deposit, depository bank, or collecting bank) either as a physical check or (in the United States) by converting the check to an electronic transaction using a process referred to as remote deposit capture (RDC). EFT systems usually allow transactions to be originated as either credits or debits, and therefore the terms originator and receiver are often used to identify the parties to the transaction, as shown in the ACH credit transaction in Exhibit 4.4. Similarly, the banks may be called the originating depository financial institution (ODFI) and the receiving depository financial institution (RDFI). ACH credits (also called credit mandates), such as payroll or supplier payments, are originated by the account holder who is sending funds (the payor). ACH debits (also called debit mandates), such as mortgage or loan payments, are originated by the account holder who is receiving funds (payee). A debit originator must usually obtain pre-authorization to initiate a debit: depending on local regulation and system rules, one-time or ongoing authorization is available. An additional feature is that these types of transactions can transfer more payment-related information than can normally be transmitted via paper-based instruments or wire transfers.

What is a demand for payment that is payable upon presentment, if accompanied by documents verifying that terms of the transaction have been met, called? a. A payable through draft (PTD) b. A sight draft c. A banker's acceptance (BA) d. A negotiable order of withdrawal

A sight draft is usually presented in combination with other documents that verify the terms of a transaction have been met. If all the documentation is in order, then the draft is payable upon presentment (i.e., at sight).

Purchasing cards are typically used by companies for all of the following types of transactions EXCEPT _________. a. Debt service payments b. Supplies c. Service contracts d. Equipment

Debt service payments Purchasing cards (also known as procurement cards or p-cards) are credit cards used by businesses for the purchase of supplies, inventory, equipment, and service contracts.

Capital cheese is debating between sending a wire and an ACH for a payment to a new vendor. Regardless of which option they choose, both are classified as which of the following type of payment method? a. Card-based payments b. Digital payments c. Electronic funds transfers (EFT) d. Business-to-business

Electronic funds transfers (EFTs) are payments that are cleared and settled electronically. Broadly speaking, there are two categories of EFTs: individual transfers and batch payments There are two forms of individual electronic transfers that are processed through banks: 1. Wire transfers are also referred to as RTGS (real-time gross settlement) or high-value electronic payments, or by the name of the settlement system (e.g., CHATS payments in Hong Kong or CHAPS payments in the United Kingdom). Wires are typically processed individually and in real time with immediate and irrevocable settlement. Wires have existed since the late 1800s with the invention of the telegraph, but did not become widely used until the early 1900s. This payment method is typically more expensive due to the higher costs associated with managing immediate gross settlement. 2. Instant, or real-time, payments have been introduced in many countries as a lower-cost alternative to wire transfers. Because they are generally irrevocable, instant payments reduce the settlement risk associated with batch payments. Low-value, electronic batch payments were introduced in the early 1970s as a means to replace checks. They are also often referred to by the name of the domestic clearing systems, so, for example, in the United States, these payments are called automated clearinghouse (ACH) payments and, in the United Kingdom, they are called Bacs payments. ACH-style payments are value-dated and processed in batches, and typically take one to two days to settle. Same-day ACH is available in the United States for domestic payments of $1 million or less. Originally ACH payments were intended for "small" payments, such as payroll and consumer transactions. Today, however, the lower cost and faster processing of ACH transactions has motivated many companies

Innovation Sales just got notified that they are $25,000 past due with a very important domestic vendor. To ensure that the product continues to be shipped, they must guarantee payment will be received by the vendor today. Which of the following payment methods would be both cost effective for this size of a transfer and meet the requirement of being received today? a. ACH b. Same Day ACH c. Check d. Wire Transfer

Same-day ACH is available in the United States for domestic payments of $1 million or less. Originally ACH payments were intended for "small" payments, such as payroll and consumer transactions. Today, however, the lower cost and faster processing of ACH transactions has motivated many companies to replace wires and other payment types with ACH transactions.

The Trans-European Automated Real-Time Gross Settlement Express Transfer System TARGET2 provides which of the following? a. Central banks a way to move real-time gross settlements through the Euro system b. A payment mechanism for low-value payments within individual countries c. A local real-time gross settlement system for payments within individual countries d. Both intra- and inter-company transfers

a. Central banks a way to move real-time gross settlements through the Euro system TARGET2 is based on a common operating platform developed and operated by Banca d'Italia, Banque de France, and Deutsche Bundesbank on behalf of the Eurosystem. The Eurosystem is comprised of the European Central Bank (ECB) and the central banks of countries using the euro, and is the monetary authority for the euro area. TARGET2 became operational in November 2007 and was introduced to support eurozone monetary policy and facilitate cross-border payments in euros. TARGET2 consists of the core platform, together with national components in all participating countries.

In which of the following ways has the Check 21 legislation facilitated the use of electronic checks? a. Created a legal substitute for a check b. Created the Electronic Payments Network (EPN) to facilitate electronic check exchange c. Gave digital signatures the same legal standing as paper signatures d. Allows businesses to capture a check's account information from the MICR line at the point-of-sale (POS)

a. Created a legal substitute for a check The Check Clearing for the 21st Century Act provided the basis for electronic clearing of checks by allowing the substitution of a copy or image of a check for the original document in the clearing process. The act was intended to speed and facilitate the clearing of checks—by eliminating the need to exchange physical paper—and improve the overall efficiency of the payment system.

How do "self-settling" cash payment systems compare to other types of payments? a. Higher process costs b. Greater reliance on external networks c. More delay in final settlement s. Greater net revenue

a. Higher process costs - Cash payments are typically self-settling, meaning that the physical transfer of cash provides the clearing network leading to final settlement (i.e., no banking network is used). Thus, no additional settlement infrastructure or bank network is needed for cash transactions. - A popular misconception is that cash payments are less expensive than other types of payments. Cash represents a security risk. Cash receipts must be safeguarded at the collection point until they can be transported to a bank and deposited into the company's bank account. This requires items such as locked cash drawers, dual-control procedures, specialized safes, and armored cars. Additionally, banks typically charge their corporate customers a fee to receive, count, and verify cash deposits. As a result, cash is a high-cost payment method for most companies.

Which of the following actions would help a wire transfer comply with Uniform Commercial Code Article 4A? a. Providing message authentication services for electronic transfers b. Requiring the response of the receiving financial institution for prenotes c. Notifying the bank within 24 hours of any unauthorized ACH debit transactions d. Limiting the wire transfer pricing charges to the sending institution only

a. Providing message authentication A bank must make such procedures available to the customer. Further, the bank and the customer must agree that the procedures are commercially reasonable for verifying payment. Some common security measures include the use of personal identification numbers (PINs), callbacks, encryption, and message authentication.

Which of the following is NOT a clearing system in the United States? a. SWIFT b. Fedwire c. ACH d. CHIPS

a. SWIFT

What is the typical speed for check processing finality in the US assuming use of image processing and electronic presentment? a. Several weeks b. Four business days c. Many same day and rest in one day d. Always same day

a. Several weeks As a result of image processing and electronic presentment of checks in the United States, many checks now clear the same day, with the remainder settling in one day. Finality, however, can still take several weeks due to the potential for returned items. Similar options are typically available in most countries.

Which of the following statements is TRUE of the Society for Worldwide Interbank Financial Telecommunication (SWIFT)? a. Utilizes a payment format for funds up to $99,999,999.99 b. Conveys standardized payment related information only c. Transfers value between parties d. Allows for real-time netting

b. Conveys standardized payment related information only SWIFT (Society for Worldwide Interbank Financial Telecommunication) is a communication system used by most of the banks in the world to transmit payment instructions, among other things, and is therefore often thought of, incorrectly, as an international wire transfer or funds transfer system. SWIFT is an industry-owned, cooperative, interbank telecommunication network that enables banks, nonbank financial institutions, and some corporations to send authenticated electronic messages in standard formats. The information that moves through SWIFT ultimately results in value being transferred from one party to another, generally through correspondent banks.

Which of the following is an example of an interest-bearing instrument? a. Government paper b. Eurodollar deposits c. Commercial paper d. Banker's acceptances (BAs)

b. Eurodollar deposits Eurodollars are USD-denominated deposits held in financial institutions outside the United States. Eurodollars may be issued as negotiable Eurodollar CDs or as nonnegotiable Eurodollar time deposits, both of which are interest-bearing. Government paper, CP and BAs are discounted instruments. They do not pay interest; rather, they are issued at less than par value (the discount) and pay par value at maturity.

The 1980 Depository Institutions Deregulation and Monetary Control Act (DIDMCA) was designed to facilitate which of the following aims? a. Facilitate all electronic funds transfers except wire transfers b. Reduce and/or price payment system float c. Fully remove all Regulation Q interest rate ceilings d. Allow some deposit-taking institutions to avoid maintaining reserves at the Fed

b. Reduce and/or price payment system float The Depository Institutions Deregulation and Monetary Control Act impacts both FIs and firms. For the financial services industry, this legislation: - Requires all deposit-taking institutions to maintain reserves at the Fed - Makes Fed services such as the discount window and check clearing available to all deposit-taking institutions - Mandates the Fed to reduce and/or price payment system float, and price previously free Fed services, according to the standards of a tax-paying vendor

The obligation of a bank and its customers to agree on the procedures to verify funds transfer payments is codified in which of the following document? a. Regulation E b. UCC Article 4A c. The Federal Reserve Payments System Risk Policy d. The Electronic Funds Transfer Act

b. UCC Article 4A Article 4A provides a legal framework that outlines the risks, rights, and obligations of parties in connection with electronic funds transfers. Two primary provisions of Article 4A impact: - Security procedures. A bank must make such procedures available to the customer. Further, the bank and the customer must agree that the procedures are commercially reasonable for verifying payment. Some common security measures include the use of personal identification numbers (PINs), callbacks, encryption, and message authentication. - Consequential damages. Banks generally are not responsible for consequential damages, which are losses resulting from an action or error made by the bank beyond the actual loss. However, a bank that incorrectly executes a payment order remains liable for interest losses or incidental expenses. A bank is liable for consequential damages only when it agrees to assume this liability in a written agreement with the customer.

A bank customer makes a deposit of $10,000 on Monday morning in an account with a balance of $5,000. The bank has one-day availability. What is the deposit float on Monday and what is the ledger balance on Monday? a. $0 and $5,000 b. $0 and $15,000 c. $10,000 and $15,000 d. $10,000 and $5,000

c. $10,000 and $15,000 Balance measurements and float calculations are determined by the relationship of the time that a check is deposited to the deadlines set by the depository institution (in contrast, electronic payments are typically available when posted - Ledger balances are bank balances that reflect all entries to a bank account, regardless of whether the deposited items have been collected and are available for withdrawal. Ledger balances are important for accounting purposes, but not for funds availability or bank compensation purposes. A negative ledger balance results in a ledger overdraft, for which charges can be assessed. - Deposit float represents deposited items that are listed on the ledger, but that are not available for withdrawal. The ledger balance at the end of business on Monday is the prior balance of $5,000 plus the deposit made on Monday morning of $10,000, totaling $15,000. With a one-day availability on deposits, the float is $10,000 (the amount of the deposit made on Monday morning).

Which of the following is a common method of foreign check clearing? a. Giro system b. Continuous Linked Settlement (CLS) c. Correspondent bank accounts d. Shared service center (SSC)

c. Correspondent bank accounts Foreign checks are checks deposited at a bank in one country that are drawn on a bank in another country. Foreign checks may also be drawn in a foreign currency (e.g., a check in British pounds deposited with a US bank for credit to a US dollar bank account). These checks are normally treated as collection items and processed outside of the normal check-clearing systems. This implies that the depository bank will send the foreign check to a correspondent bank (or a foreign branch of the depository bank, if it has one) in the country in which the foreign check is payable. The correspondent bank will, in turn, process the foreign check locally and eventually remit the proceeds to the depository bank. Because these checks are subject to both foreign exchange (FX) transaction costs and extra processing fees, the bank of first deposit typically will not credit the payee's account until it receives and converts the proceeds of the check to its base currency. As a result, foreign checks can take days or weeks to clear and normally clear for significantly less than the face amount of the check. Due to the complicated nature of clearing these items, some banks do not accept foreign checks for deposit.

A net settlement system between financial institutions bears which of the following risks? a. Electronic credits may be reversible b. Individual transactions may not have c. proper bookkeeping accounting c. Electronic debits may be reversible d. Individual transactions may not have proper individual value transfers

c. Electronic debits may be reversible Net settlement occurs when many transactions are combined and then sorted by sending and receiving banks. At day's end (or at another agreed-upon point in time), the net amount either owed by or owed to each bank is determined and only the net amount of value is actually transferred. At this point, electronic credit transactions are considered to be final. Electronic debits may be reversible under certain, specified circumstances. All of the individual transactions are accounted for on a bookkeeping basis, with each bank making the necessary debits and credits to individual accounts. As an example, most checks and card payments are settled on a net basis.

Which of the following statements is true of Regulation CC? a. It prohibits banks from paying interest on corporate deposits b. It limits the high fees associated with subprime credit cards c. It defines endorsement standards for checks d. It defines responsibilities of parties in electronic funds transfers

c. It defines endorsement standards for checks Regulation CC implements the provisions of the Expedited Funds Availability Act of 1987, which establishes rules designed to speed the collection and return of checks, and mandates banks to return unpaid checks expeditiously. This regulation also imposes the same return procedures to payable-through-drafts that apply to checks, and establishes endorsement standards for banks and companies to follow when depositing and clearing checks. The regulation has been amended to reflect the fact that most check collection is now electronic.

If a U.S.-based firm is considering offering a credit card to its consumers for the first time, which Federal Reserve Regulation would their treasury professionals need to understand as it likely never directly affected them before? a. Regulation J b. Regulation CC c. Regulation Z d. Regulation E

c. Regulation Z Regulation Z applies to the Truth in Lending Act of 1968 (TILA), which is concerned with promoting informed use of credit by consumers. This regulation covers various types of consumer lending (e.g., credit cards, home mortgages, student loans, and installment loans). For treasury professionals, the primary impact of this regulation relates to credit cards offered to their customers; for educational institutions, the impact relates to the use of student loans.

Which of the following statements is true about the payment process? a. Fund availability and finality occur at the same time b. Clearing is when a money transfer becomes final and irrevocable c. Settlement is the actual movement of funds from payor's account to the payee's account d. Settlement occurs when the payor's bank account is credited and the payee's bank account is charged

c. Settlement is the actual movement of funds from payor's account to the payee's account It is important to understand the difference between settlement and finality of payment. Settlement refers to the movement of funds from the payor's account to the payee's account. In other words, the payee can use the money involved at settlement. For this reason, the term availability can also refer to settlement. Finality refers to the point in time at which the funds cannot be taken back or retracted by the payor or the payor's bank. Settlement transitions to finality when a payment is unconditional and irrevocable.

All of the following payment methods are considered "push" payments EXCEPT which? a. Checks b. ACH credit c. Wire payments d. Direct debits

d. Direct debits Payments can be distinguished according to the following key characteristics: 1. Urgency and time sensitivity of payment. The payment processing time and the ability to determine when the payee will receive value vary according to the clearing and settlement process for the selected instrument. Settlement times vary from real-time and near real-time to same-day or next-day, with some instruments settled on a longer cycle. 2. Dollar value of payment. The dollar value of the payment can affect which payment instruments can be used. Some countries have maximum value thresholds for certain payment systems and require payments above that value to be processed via their systemically important EFT system. 3. "Push" versus "pull" payments. Push payments, including checks, ACH credits, and most wire payments, are initiated by the payor. Pull payments, including direct debits and some card payments, are initiated by the payee, using an authority provided by the payor. The authority to collect a pull payment can be a one-time or recurring agreement.

As a result of the Credit Card Accountability Responsibility and Disclosure Act of 2009 (Credit CARD Act), Regulation Z prohibits which of the following? a. Charging fees for transactions that exceed the credit limit b. Issuing a credit card to any consumer under the age of 21 without a cosigner c. Creditors from using any billing method other than the two-cycle billing method d. Increases in a rate that applies to an existing credit card balance

d. Increases in a rate that applies to an existing credit card balance Regulation Z also implements the Credit Card Accountability Responsibility and Disclosure Act of 2009 (Credit CARD Act). As a result, Regulation Z: - Protects consumers from unexpected increases in credit card interest rates by generally prohibiting increases in a rate during the first year after an account is opened, as well as any increases in a rate that applies to an existing credit card balance - Prohibits creditors from issuing a credit card to a consumer who is under the age of 21 unless the consumer can make the required payments or obtains the signature of a parent or other cosigner who is able to do so - Limits the high fees associated with subprime credit cards - Bans creditors from using the two-cycle billing method to impose interest charges - Prohibits creditors from allocating payments in ways that maximize interest charges

Which innovation in payments was one of the catalysts for the development of the second European union payment services directive, know as PSD2? a. Euro denominated cross-border payments b. Physical euro notes and coins c. Mobile banking d. Internet-based payments

d. Internet-based payments The European Union passed a second Payment Services Directive (PSD2), which has applied since January 2018. It updates PSD1 to recognize the growth in mobile and internet payment services. PSD2 also includes rules that limit the interchange fees on consumer credit and debit card transactions, and prohibit the use of surcharges on these transactions.

Which has in part created a demand for low-value ACH systems that settle in same-day or near real time? a. Electronic check presentment b. Payment cards c. Value dating d. Online banking

d. Online banking The growth in acceptance of internet services and mobile banking has created a demand for low-value systems that settle more quickly than the traditional ACH systems. In response to this demand, many countries have introduced, or are planning to introduce, some form of instant or near real-time transaction.

Which of the following types of payment should a seller require if there is a concern about the creditworthiness of the buyer? a. Payable through draft b. Check c. Preauthorized ACH debit d. Real-time gross settlement

d. Real-time gross settlement Settlement transitions to finality when a payment is unconditional and irrevocable. Finality varies depending on the payment system and the parties involved in the transaction. Payment systems that offer immediate and irrevocable value are called real-time gross settlement (RTGS) systems (sometimes referred to as wire transfer systems). Examples of RTGS systems include FedWire in the United States and TARGET2 in the eurozone. A number of countries have developed (or are developing) real-time payment systems as an alternative to ACH-type systems, offering lower cost, near real-time processing, and irrevocable value. Other systems, such as check- or card-based systems, typically provide immediate information, with value following at a later time. But the value is contingent on the payor or the payor's bank not attempting to retract the payment, a right which can exist for several months or more, depending upon the specific payment system. Understanding when final settlement occurs with each payment instrument and system is key to developing an effective payment strategy.

Which of the following statements BEST describes the principal benefit of using a purchasing card over a traditional purchase order process? a. Free source of financing until end of payment cycle b. There are no spending limits c. Freedom to switch vendors without restriction d. Reduction in administrative complication and time for requisition

d. Reduction in administrative complication and time for requisition Purchasing cards (also known as procurement cards or p-cards) are credit cards used by businesses for the purchase of supplies, inventory, equipment, and service contracts. P-cards are typically used for various types of purchases (high- or low-value) with spending limits established on an individual card basis. Purchases can be limited to approved vendors and suppliers, as determined by the merchant category code (MCC) of the vendor or supplier. From the issuing company's perspective, the principal benefit of a p-card is the replacement of the traditional time-consuming, labor-intensive, paper-based requisition process. P-cards can also help to reduce or eliminate the use of petty cash within an organization. Additionally, companies may negotiate a rebate based on charge volume and average transaction size, and they may be able to effectively delay payment since purchased items will not be paid for until the end of the billing cycle. The principal benefit for an employee is that goods and services can be obtained quickly and conveniently without a complicated purchase order process.

A goal of the Single Euro Payments Area (SEPA) initiative was to incentivize which of the following? a.Use of the euro in cash transactions b.Convergence of securities regulations c.Standardization of deposit insurance across member countries d. The use of cross-border electronic payments

d. The use of cross-border electronic payments SEPA focuses on the technical, legal, and commercial barriers to paying and/or receiving euros cross-border within SEPA boundaries, with a view to ensuring that the same rules apply to both domestic and cross-border electronic payments. SEPA establishes minimum standards and common pricing for payments processing within the European Union, and consists of two primary concepts: - Creation of standard credit and debit payment schemes (both high- and low-value) - Creation of a common payment card framework (both debit and credit)

Which of the following correctly describes the function of the magnetic ink character recognition line of a check? a. This line is primarily used to sort cleared checks before returning them to the payor b. This line is used to identify divisions or subsidiaries of national banks c.This line serves only as a verification of the amount placed on the check by the payor d. This line contains all of the information necessary to process the item

d. This line contains all of the information necessary to process the item The magnetic ink character recognition (MICR) line is a specially formatted line of machine-readable information, printed with magnetic ink on the bottom of a check, that contains all the information necessary to process the check through the check-clearing system.