Naughty by Nacha: the ABCs of ACH
Issue 10 |11 March 2024
The start of the Industrial Revolution introduced many changes to our society, including the rise of capitalism, urbanization, innovation and even permutations in the way payments worked.
During the Industrial Revolution, employers would provide workers with wage packets, which were envelopes with paper dollars and coins. In the mid-19th century, the term “paycheck” was introduced to refer to a printed order that workers would take to the bank to receive the stated amount from their employer’s account. Post World War II, many middle-class employees opened up bank accounts and banks created technology that made the processing and clearing of paper checks easier.
In 1972, the Federal Reserve Bank of San Francisco set up the first Automated Clearing House (ACH), which enabled electronic payments. Throughout the 1970s and 1980s, US companies encouraged their workers to have their wages deposited electronically into bank accounts. Today, according to Nacha, there are 8.3B ACH direct deposit (paychecks) transactions, making it one of the largest ACH transaction use cases.
In this post, we will look into what an ACH payment is, how it works and how ACH’s same day settlement network (Same Day ACH) came about.
What is an ACH payment?
Payroll direct deposits are safely and conveniently received using ACH payments. Essentially, ACH payments are electronic transfer of funds between bank accounts at different financial institutions using the ACH network.
The ACH network is administered by the National Automated Clearing House (Nacha), which is an independent organization that is owned by a large group of banks, credit unions and payment processing companies. The ACH Network is a same day, batch processing, store-and-forward system. Transactions are stored by financial institutions throughout the day and processed at specified times in a batch mode.
History of ACH payments
Before the launch of the ACH network, funds were primarily transferred manually using cash or checks. These processes were time consuming and prone to errors especially given the growing volume of checks. Bankers began looking into ways to move beyond checks and improve the country’s payment systems.
Clearing houses were already in use to facilitate the exchange and settlement of various payment types. Automated clearing houses became an extension of that concept by applying electronic mechanisms. The Federal Reserve Bank of San Francisco along with a number of California banks developed an automated clearing house (ACH) system and began operating the first ACH system in 1972 to handle electronic payments. Other regional ACH systems were subsequently formed, and in 1974 Nacha was created to administer the ACH network.
Initially, the volume of ACH payments was relatively low. The biggest barriers to private sector adoption of ACH payments were the challenges of incorporating ACH payments into corporate accounting systems and the preference for checks given the “float” as corporates continued to earn interest on funds in their accounts until the check payment settlement was complete.
Over time ACH payments have grown to be deeply rooted in the US payment ecosystem with volumes reaching 31.5B transactions in 2023 (per Nacha) and have become the preferred payment method for recurring payments such as payroll and consumer bill payment.
Types of ACH transactions
To understand how ACH transactions works, it is important to distinguish that there are 2 types. ACH transactions are either categorized as ACH credit or ACH debit transfers, depending on which way the money moves.
🤜 ACH credit (push): An ACH credit transaction means that money is being “pushed” from one account to another. The payer authorizes funds to move from their account into the payee’s account.
Common examples of ACH credit transfers: Payroll transfers (e.g., direct deposit of paychecks), peer-to-peer (P2P) transactions using Zelle or Venmo
🤛 ACH debit (pull): An ACH debit transaction means money is being “pulled” from one account and sent to another. ACH debits can be authorized manually or set up as recurring payments.
Common examples of ACH debit transfers: Consumer bill pay (e.g., mortgage, utility, internet), credit card or loan payments
How do ACH payments work?
In the case of all ACH payments, the following institutions are involved in the transaction:
National Automated Clearing House (Nacha), which is an independent organization that is responsible for operating the ACH network
The ACH Operator which is the clearing house for ACH transactions that are sent in by financial institutions. There are two ACH operators in the US:
(1) the Electronic Payments Network (owned by The Clearing House (TCH)) and (2) the Federal Reserve Bank
Originating Depository Financial Institution (ODFI), which is the banking institution that issues the ACH transfer request on behalf of the ACH originator
Receiving Depository Financial Institution (RDFI), which is the banking institution that receives the ACH request
Let’s take the example of payroll (ACH credit transfers):
1️⃣ Company ABC or their processing partner (e.g., payroll processors such as ADP) send the payroll ACH files to their financial institution (ODFI in the case of ACH transactions). The ACH files will include employee’s account information, the amount to be sent, a categorization code, and a target settlement date.
2️⃣ The ODFI transmits the files to the ACH operator in periodic batches.
3️⃣ Four times each business day, the ACH operator breaks down the incoming file batches with individual message (transactions) and rebundles them into new batches for immediate delivery to each RDFI that holds the employee’s account.
4️⃣ Each RDFI incorporates incoming files into their system, and executes those transactions based on the processing window requested.
For example, if Company ABC has requested same day processing on any ACH transactions, the RDFI processes the requests and settles with the ODFI within an hour.
5️⃣ If there are any error codes, the RDFI will send them back to the ACH operator with the next regular batch. If there are no error codes (or ACH return codes) received by the requested settlement time, the ODFI and RDFI settle the transaction using their balances at the Federal Reserve.
6️⃣ Once the funds are settled, they are made available in the employee’s account and the funds are pulled from the employer’s account.
Note: Confused about the payments terms? Check out the payments glossary to understand what they mean
Same Day ACH
Starting in 2016, Nacha introduced same-day ACH with the goal of moving ACH from a multi-day settlement window to same day settlement window. Since its inception, same-day ACH has seen lots of growth with volumes reaching 853M with $2.4T transferred in 2023 per Nacha.
The main difference between regular ACH and same-day ACH is that when financial institutions submit their ACH files to the ACH operators, the same-day ACH transactions are expedited in batch for processing that day.
How long do ACH transfers take?
Since ACH files are processed in batch and not in real-time, the ACH transactions need more time to transfer between accounts. ACH transactions can take anywhere from a few hours to three business days, depending on the time of day the payment is initiated and whether same-day processing has been requested. ACH debits, such as bill pay or withdrawals typically take 1-3 days to process, whiles ACH credits, such as payroll, generally take 1 day to process.
Note: If you want an overview of the various payments rails as well as the different processing times, check out this post.
What’s next for ACH?
A large portion of the American economy uses ACH: from paying payroll/ receiving paychecks to recurring bill payments to enabling business-to-business (B2B) transactions. ACH transactions continued to grow through the 2000s, as fintech started to leverage the ACH payment rails to enable online transactions (e.g., PayPal) and peer-to-peer transactions (e.g., Venmo).
Note: To learn more about fintechs and the evolution in this space, check out this post
During the pandemic, electronic payments using ACH continued to grow as people shied away from physical payments, such as cash and check. And recently there’s been an emerging trend around account-to-account (A2A) payments (also known as Pay by Bank). A2A payments are payments made directly between bank accounts without an intermediary like a credit card network or a third-party processor. A2A payments have existed for a long time, but with the advent of open banking, they have gained popularity and most A2A transactions in the U.S. use the ACH network. Given the ubiquity and reach of the ACH network, it is feasible that A2A payments will continue to gain traction in the U.S., offering yet another innovation for ACH in the digital payments landscape.