I- Introduction to fundamental concepts in payments
If you are starting in the payment industry and want to learn the basic concepts, where should you begin? In today’s article, we look at fundamental concepts in payments: payment instruments, payment systems and their modeling. What we will see applies to all kinds of payment instruments. So follow me till the end. If you want to watch the video version of this article, you can do it right here.
I have over 17 years of experience in the payment industry, and I am still in love. But things have not always been that easy and lovely for me. It took me about 4 years to really understand domestic payments. So, the information that I am going to share with you is precious. If you follow me until the end, you will be able to understand fundamental concepts, and that will enable you to grow your skills faster.
II– What is a payment?
Let’s begin with the definition of payment. What is a payment?
According to the Bank of International Settlement, a payment is the payer’s transfer of a monetary claim on a party acceptable to the payee. Typically, claims take the form of cash or deposit balances held at a financial institution or at a central bank. Put simply, a payment is a transfer of value from one party to another. The value transferred can be monetary like 10 units of currency. Or it can be of digital form like a cryptocurrency.
A payment transaction involves two end parties: On one side, the debtor or payer who sends the funds, and on the other side, the creditor or payee who receives the funds.
An end party can be the sender or receiver of the payment. It is a party involved in any side of a payment transaction. Payments are generally made in exchange for the provision of goods or services between end parties, or to meet legal obligations.
III- What is a payment instrument?
Closely related to payments is the concept of payment instrument. In the expression “payment instruments”, the word instrument is added to the payment. Let’s look at its definition and see how it combines with payment. An instrument is defined as a means whereby something is achieved, performed, or furthered. It can be compared to a tool that facilitates the execution of a task. Tools make things very easy. You can do gardening or cooking without tools. You would spend a huge amount of time and energy to eventually achieve pretty limited results.
But how easy things are when you have the proper tools. That is why humans are tool builders. Likewise, payment instruments facilitate payments and make fund transfers easy between the end parties involved. Payments instruments are tools to move value or money fast.
Without payment instruments, paying would be very cumbersome. We learn in economic history that before creating payment instruments, people relied on barter to exchange value. But barter has many disadvantages and is not practical at all. Without payment instruments, e-commerce would not be possible. Many things that we take for granted today would simply not exist. Payments instruments are without a doubt a great invention. Cash payment instruments are Banknotes and coins. Non-cash payment instruments are Cheques, Cards, Credit Transfers, Cryptocurrencies, and so on.
IV- What is a payment system?
Payment instruments are the raw materials of payment systems. A payment system consists of a set of instruments, banking procedures, and typically, interbank funds transfer systems that ensure the circulation of monetary or numeric value. A payment system requires four things:
One. A payment instrument, like cash, cheque, credit transfer, or a debit card.
Two. The scheme rules that define the procedures, practices, and standards agreed upon between the payment services providers that join the system.
Three. A transfer mechanism to move the funds from one party to another.
And finally Four. A legal framework to guarantee irrevocable and unconditional finality, that is the discharge of the obligation between the debtor and the creditor.
V- The two models of payments systems
Payments systems operate essentially on two types of models: Open loop models and Closed loop models. In open-loop models, there are intermediaries between the end parties and the payments system. So, in open loop models, the End parties access the payment system through intermediaries. Things are different in closed-loop models. Because in closed-loop models, there are no intermediaries between the end parties and the payments system. So, in closed-loop models, the End parties access the payments system directly.
Let us consider closed-loop models first:
This is what a closed-loop model looks like. A closed loop system is directly connected to end parties, the senders and receivers of funds.
As we can see, there is no intermediary between the end users and the payments system. End parties establish a direct connection to the payments system. And it is not possible to join the payments system as an intermediary. This is the major difference between open and closed-loop systems.
In open-loop systems, end parties access the payment systems through intermediaries. In closed-loop systems, the end parties have a business relationship and transact directly with the payments system.
End parties are companies, merchants, and individuals that join the system either as buyers or sellers of goods and services. Examples of closed-loop systems are the traditional network of American Express, Paypal and Bitcoin. Merchants and consumers join these systems directly. And they don’t need to go through an intermediary to transact with each other.
Things are different for open-loop models. Here you see what an open loop model looks like:
An open-loop system is usually compared to a hub-and-spoke model.
The system is connected to Banks, Payments Services Providers, or similar institutions which act as intermediaries. Banks are one type of Payments Services Providers. In many regions of the world, it is possible for non-bank entities to provide payment services.
As we see in this model, the banks or Payment Service Providers are connected to end parties, the senders and receivers of funds. Only the intermediaries, Banks and other Payments Services Providers, can become members or participants of the payment systems. Open loop models yield the great advantage of allowing banks to transact with each other without direct relationships.
When a new intermediary joins the system, it can exchange transactions with all the banks that are already in the system and vice versa. This allows open-loop systems to scale rapidly. All end parties are in a way connected to each other through the payments system and the intermediary banks.
VI- The anatomy of a payment system
Now you may wonder what is inside the payments system. Here you see the generic model of a payment system at the level of a country:
Payment systems are composed of many interbank systems and central bank systems in the middle.
Central bank systems are at the heart of the system and play a key role. The interbank systems are connected to the central bank systems.
Payments Services Providers, generally banks, can become participants of one or many interbank exchange systems. It is not mandatory for a bank to join all the interbank systems. They may not become members of certain interbank exchange systems.
But Banks must have an account with the central bank and join interbank systems or central bank systems as direct or indirect participants.
A payment transaction begins and ends with end parties and the funds transfer happens through banks and other intermediaries which are connected through interbank and central bank systems.
So, at the country level, payment systems are generally modeled as a network composed of banks and similar financial institutions, of interbank clearing systems, that are generally called ACH or Automated Clearing House, and of the central bank systems.
Interbank transfer systems usually implement a clearing mechanism and are connected to the central bank systems. They are referred to as ancillary systems in contrary to central systems operated by the central bank.
Central bank systems implement the settlement mechanism. Now, why do we need clearing and settlement systems? For cost reduction, effectiveness and risk management.
To understand what clearing and settlement mechanisms are, I refer you to the Paymerix channel. There you will find videos where we explain these key concepts in a very simple manner.
VII- Payments systems in the USA
Now let’s consider core non-cash payments systems in one country to illustrate what we just said.
We will look at the payment market infrastructures for the US Dollar, so the payment systems in the United States:
The overall structure looks like the generic model we consider before. Isn’t that interesting?
In the middle, we see Fedwire, the system operated by the central bank in the USA that is called the Federal reserve bank or simply the Fed. Around Fedwire, we see the interbank clearing systems in the United States. There are called ancillary systems while Fedwire is called Central System. All interbank systems must use Fedwire to settle their transactions.
There are two high-value payment systems in the USA: Fedwire, the RTGS system and CHIPS. CHIPS is a large value payment system that implements continuous net settlement. CHIPS stands for Clearing House Interbank Payments System. It is owned by the financial institutions that use it.
The Federal Reserve bank also operates the National Settlement Service which is used for the settlement of ACH transactions after netting in the different regional systems. ACH stands for Automated Clearing House. It is a generic name for clearing systems used for low-value or retail payments.
There is another ACH system called EPN or Electronic Payments Network. It is operated by a private-sector operator, the Clearing House Payments Company.
Other market infrastructures in the USA are the Cheques Clearing system and the card networks.
The cheque-clearing systems are used for the interbank transmission and clearing of cheques, bills of exchange, and promissory notes. These instruments are all settled in Fedwire through the National Settlement Service system. The card networks are of multiple types. We have not represented all of them so as not to make the diagram more cumbersome. There are Visa and MasterCard for debit and credit cards and there are closed-loop networks like Discovery and American Express. Closed loop networks are not connected directly to central systems. They rely on settlement banks, which are participants in Fedwire, for the settlement of their transactions.
Finally, we see the CLS system that is used to process Dollar-leg of Foreign Exchange transactions.
The Continuous Linked Settlement system is used for the settlement of FX transactions in central bank money. CLS was created to eliminate the risk associated with foreign exchange settlement across time zones.
Cross-border payments go through SWIFT or the card networks. With such a model, isn’t it simple to understand and study payment systems? Please post a comment below and tell me what you think about it. The great thing is you can use this model to easily identify the key market infrastructures in any country in the world.
VIII- Payments systems in France
Here is a similar model for France:
We have Central Bank systems in the middle TARGET2 and TIPS, that are operated by the European central bank. TARGET2 is used for Large value and urgent Transfers between Banks. And TIPS is used for the settlement of instant payments.
Around the central bank systems, we see the interbank clearing systems used for the clearing of domestic payment instruments like cheques, credit transfers and direct debit. It is the same structure, and this shows that this model is really powerful.
Let’s again consider the generic model of payment systems at the level of country level:
This is really a powerful model that you can use to identify and study the payment market infrastructures of any country. Why not begin with the country where you live? With the help of this model, can you describe your country’s payments market infrastructures? Please do so and tell us how it was by posting a comment below.
In the next article, you will get a secret, a very powerful tool that can help you to study any domestic payment system, anywhere in the world.
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See you in the next article.