All aboard: payments rails and electronic payments
Issue 7 | 15 December 2023
In this age of digital payments, customers are able to tap, swipe or click a button and they expect money to be transferred. In fact, according to McKinsey, 9 out of 10 American use some form of digital payments (as of 2022). These forms of digital payments include browser-based or in-app online purchases, in-store checkout using a mobile and/or QR codes and person-to-person (P2P) transfers.
But how does money move when one of these customer actions are initiated? Let’s peel back the layers in this post and learn about payment rails - the underlying plumbing that enables payments to move from point A to point B. Similar to the way that rail tracks guide trains to move from one destination to another, payment rails enable money to move between parties (individuals or businesses).
Payments rails are one of the most important aspects of how money moves, but they are so integrated into payments that customers barely notice them.
What are payment rails?
A payment rail is a platform or network infrastructure that allows electronic payments to be transferred between individuals, businesses and financial institutions. Each payment rail differs in how electronic payments occur based on the payment process, speed, availability, enabling technology or geographic location.
To understand how payment rails enable payments, imagine the following scenarios:
Peer-to-peer (P2P) payments: When friends split a restaurant bill or a person sends money to family members via a P2P app, the payment rails facilitate the instantaneous transfer of funds.
Customer-to-Business (C2B) payments: When customers pay their utility bill online or buy the latest shopping gadget from an e-commerce website, the payment rails ensure the secure transfer of funds between the customer’s bank account or credit card and the company or merchant’s account.
Business-to-Consumer (B2C) payments: When companies directly deposit their employees’ paychecks via direct deposit, it’s the payment rails that handle the movement of money behind the scenes, so that employees can have access to their hard-earned funds.
Business-to-Business (B2B) payments: As the world becomes more interconnected, global trade grows and digital marketplaces (e.g., Amazon) become prevalent, the payment rails facilitate the transfer of funds so that businesses can pay their suppliers and partners.
Government consumer payments: Payments to the government (e.g., traffic tickets, tax payments) and payments received from the government (e.g., stimulus payments, tax refunds) have increasingly become digital, and are enabled by the payment rails.
Note: The scenarios listed above are examples of payment use cases that are assisted by payment rails, and are not meant to be inclusive
Now that we have a sense of how mission critical payment rails are for money movement, let’s understand how they work.
How payment rails work
Each payment rails varies slightly in how they work, but the general steps for a payment flow through the rails in examined below.
💸 Payment initiation: Each payment transaction has a party that initiates the payment (payer) and a party that receives the payment (payee). When a payment is initiated, payment instructions are routed to the appropriate payment rail to start the payment process. The payment instructions include the payer’s financial information (e.g., bank account number, credit card information), amount to be paid and any additional data.
For example, when a customer swipes and taps a credit card at a merchant’s point-of-sale (POS) terminal, the payment instructions are sent to the card network to initiate a payment.
🧾 Payment authorization: Once the payment instructions are submitted, it may trigger a payment authorization process, where the payer or their financial instruction authorizes the payment via the payment rails. Depending on the payment rail, the payment authorization may not happen in real-time.
For example, when a customer sets up recurring bill payments using their bank account, they authorize their utility company or cable company to collect payments from their bank account via the electronic payment rail, known as the Automated Clearing House (ACH)
✅ Payment approval: One the payment is authorized; the payer’s financial institution verifies that the payer has sufficient funds or credit necessary to the complete the transaction. If the payer has insufficient funds or unavailable credit, the payment transaction is rejected. Some payment rails, such as card network provide payment approval in real-time, while other such as ACH may provide approval after the payment has been processed.
🗒️ Payment clearing: Payment clearing is the process by which the payer’s financial institution passes payments instructions and notifications through a clearing house, which then send the instructions and other related information to the payee’s financial institution. Some payment rail operators (e.g., card networks) use an interbank clearing house, while other payment rail operators (e.g., The Clearing House (TCH) for ACH) acts as the clearing house.
💱 Payment settlement: After payment clearing take place, the payer’s financial institution and the payee’s financial institution settle funds between each other as the final step in the payment transaction. Typically, at this point, funds are deposited in the payee’s account and withdrawn from the payer’s account. Payment settlement is facilitated by a settlement network, and similar to payment clearing, some payment rail operators facilitate payment settlement (e.g., card networks), while other payment rail operators use a settlement network (e.g., the Federal Reserve is the settlement network for ACH).
Payment rails are designed to make settlement times fast and straightforward, helping the payers, payees and their corresponding financial institutions complete payment transactions quickly and painlessly.
Popular payment rails in the US today
Payment rails in the US have facilitated the rise of digital payments and global connectivity. The most popular payment rails today are ACH, card networks and wires. Fintechs and payment processors, such as PayPal and Venmo leverage existing bank rails (e.g., ACH) to move money for their customers.
Note: The term payment rails typically refer to underlying infrastructure to allow for electronic payments, and don’t cover non-electronic payment types such as cash and check
Automated Clearing House (ACH)
The ACH payment rail was introduced in the 1970s to handle electronic payments and has morphed into the backbones of electronic bank-to-bank payments in the US. The ACH payment rail is regulated by Nacha, which is the governing body that sets the rules and regulations for the network. In the US, there are 2 payment rail operators for ACH transactions - the privately owned TCH and the Federal Reserve that manages FedACH.
ACH transitions have become so embedded in the US payment ecosystem with $76.7T dollar in payment value in 2022. ACH transactions facilitate direct deposit of salaries and wages, electronic bill payments, peer-to-peer (P2P) transfers, business-to-business (B2B) transactions as wells as variety of other electronic funds transfers.
ACH transactions typically take 2-3 days for payment completion, though Same Day ACH transactions transfers funds within the day (if the specified business-day time windows are met). Nacha regulations allow some ACH transactions to be reversible, meaning that the transactions can be reversed even after payment settlement, if certain circumstances are met.
Card Networks
Credit and debit card transactions rely on card networks, such as Visa, Mastercard, American Express and Discover. These card networks came into existence starting in the 1970s due to technological advances (e.g., card’s magnetics stripes) and data improvements (e.g., ability to authorize payment transactions over the telecommunication networks).
These card networks connect the merchants, customers and their respective financial institutions (card issuers which is the customer’s bank, and the acquirer which is the merchant’s bank) across the globe to facilitate swift and secure payments transactions. For example, in 2023, Visa reported $15T in total card volume across 200+ countries.
Card transactions are authorized within seconds, and merchants who accept card transaction are generally funded with 24 to 48 hours. Each card networks creates the rules, standards and procedures for card transactions, including outlining the liability criteria in the event of a chargeback (i.e., the ability for customers to dispute card transactions, and get the charge reversed by the merchant).
To learn more about how card networks operate, check out the post on the evolution of credit cards. If you want to learn more about the evolution of Visa (the predominant card network), I highly recommend that you check out this Acquired podcast episode.
Wires
Wires transfers are typically large value transactions directly transferred electronically between people or institutions, both domestically and internationally. International wires can be sent to the receiving party in the local currency.
Wire transfers can be facilitated by a financial institution (sometimes called a “bank wires) or a nonbank money transfer provider, such as Western Union. Wires are generally non-reversible, and funds are guaranteed, so the wire payment rails are considered reliable. In the US, there are 2 wire payment rails operators or settlement systems, just like there are for ACH transactions. The privately owned TCH operates the Clearing House Interbank Payment System (CHIPS) and the Federal Reserve operates FedWire.
Wires tend to be more expensive than other payment types and are used mostly for large value transactions. Domestic wire transfers generally cost up to $35 for the sender and $20 for the receiver. International transfers run between $25 to $65 for the sender and up to $30 for the recipient (but can cost more depending on the provider). The arrival of funds varies depending on whether the wires is domestic or international, but domestic wires typically settle on the same day. International wires take longer, since the money has to move through a number of intermediaries and has to meet sanctions screening requirements.
The Society of Worldwide Interbank Financial Telecommunications (SWIFT) plays a role in international wire transfers. SWIFT is often assumed to be a payment rail, but it is not. In fact, it is primarily a messaging system that transmit instructions and information via a standardized protocol and it plays an important role in international wire transfer.
Emerging payment rails in the US
In the recent years, new payment rails have emerged in the US to allow people and businesses to send money with greater transaction speeds. These emerging payment rails have leveraged advances in technology to be faster, available 24/7 and transparent. Instant payments have gained popularity around the world and were first introduced in the US in 2017 via TCH’s Real-Time payments (RTP) rail. Blockchain-powered transactions, such as cryptocurrency payments offer an alternative way to move money via a more decentralized financial mechanism.
Instant Payments (RTP and FedNow)
TCH introduced the RTP payment rail in 2017, allowing parties to send payments instantly, irreversibly and 24/7. Financial institutions have to be part of the RTP network to send instant payments, and the network currently reaches 65% of the US deposit accounts.
The Federal Reserve introduced their own instant payment rail, called FedNow in July 2023. Following the tradition in the US of having 2 payment rails for a payment types (e.g., TCH and the Federal Reserve both offer payment rails for ACH and wires), RTP and FedNow operate in a similar manner. Unlike TCH ACH and FedACH transactions however, RTP and FedNow are not yet interoperable - this means that the payer and their financial institution have to pick the instant payment rail upfront.
Common use cases for instant payments are B2C payments, particularly digital wallet defunding and insurance payouts (or disbursements), gig economy payments and same day payroll (or instant wage access).
What is unique about the instant payment networks (RTP and FedNow), is that payment clearing and settlement happens simultaneously and in near real-time. Unlike the traditional payment rails (e.g., ACH, card networks and wires), where payment settlement happens either later in the day or within a few days after payment initiation, instant payments settlement happens at the (almost) same time as the payment initiation.
Both RTP and FedNow are cheaper payment rails compared to wires, credit cards or Same Day ACH, but not as cheap as ACH payment rails.
Blockchain
Digital currencies such as cryptocurrencies (crypto) have grown in popularity since Bitcoin was first launched in 2009. Crypto generally depends on decentralized control and is not issued by a central authority or within the banking system. As a result, crypto is not considered legal tender, and doesn’t offer any protections for their suers from price volatility.
Unlike crypto, central banks around the world are exploring Central Bank Digital Currencies (CBDCs), which would be digital currencies that would be direct liabilities of the central bank. Various other entities, including commercial banks are issuing stablecoins, which are digital currencies that are backed by fiat currencies (e.g., US dollar). These types of digital currencies (i.e., CBDCs and stablecoins) would be more stable than crypto, since they are issued by a central bank or are backed by a fiat currency.
Digital currencies are powered by blockchain technology, specifically distributed ledger technology for funds transfer. Similar to the instant payment rails, blockchain backed payment rails have instantaneous payment settlement.
Note: In subsequent posts, I will do a deep dive on each of the payment rails, how they operate and their evolution over time.
Understanding the differences between payment rails
Each payment rail offers specific characteristics that are best suited for certain use cases:
Speed: Payment rail speed depends on the average settlement times that each rail can provide. Some payment rails such as RTP/ FedNow offer instant settlement, while other payment rails such as ACH take few days for settlement. International money transfers, typically using the wire payment rail, tend to take a long time to settle due to the large number of intermediaries that are involved in the process and sanctions screening requirements that have to be met.
Availability: The traditional payment rails have specific operating hours and typically don’t operate over the weekend, while the emerging payment rails are available 24/7/365. Payment rail availability impacts when the customers are able to access their funds, and emerging payment rails are better suited for scenarios where urgency and immediacy are key.
Geographic limitations: Some of the payment rails covered in this post, such as ACH transactions and instant payments (RTP/FedNow) are only available within the US. Other countries have their own versions of ACH and instant payments that work with their geographical or regional boundaries. On the other hand, payment rails, such as card networks and wires operate on an international scale.
Transaction fees: There are fees associated with using the payment rails. In some cases, the payment rails are free to use for consumers, but the fees are paid by other entities. For example, most banks will allow consumers to make ACH transactions for free and will cover the payment processing costs. Card network fees are paid by the merchants and there are no card fees for the consumers (though issuers make most of their money from consumers on card interest rates).
Transaction limits: Each payment rails has limits on the amount of funds that can be transferred over the rail. In addition, banks or financial institutions may add additional limits for certain type of payment transactions. For example, the limits on a FedWire is $50M per transaction, but Fidelity will limit wire transfers at $25K per day.
Reversibility: The emerging payment rails are final and irreversible, typically due to instantaneous settlement. ACH and card transactions can be reversed if certain criteria are met.