Innovation & Globalization In Retail Payments Systems: Legal & Compliance Issues

Richard M. FraherFederal Reserve Bank of Atlanta

Technology Drives; Law Reacts

• Technical innovation drives the new frontiers in payments– Completely new mechanisms—web, M-banking– Transformation of old mechanisms—e-checks

• Law reacts by balancing competing goals– Promote efficiency, certainty, predictability

• Allocate risks of loss– Prevent abuses

• Fraud• Money laundering/terrorist financing

– Regulate without stifling innovation

• Online • Check Images• ACH• Cards• Emerging

– M-banking

Electronic Payments

Paper to Electronics

U.S. Noncash Retail PaymentsBillions of payments

0

10

20

30

40

50

60

70

80

90

1979 1995 2000 2003

Electronic

Check

Number of non-cash electronic payments exceeded checks for first time in 2003; trend is accelerating

Source: Federal Reserve, 2004

Transformations of Check Processing

• Paper instruments sorted/posted by hand

• Electronic processing—1960-1990– MICR—paper check as “IBM card”– Electronic presentment under UCC 4-110

• Attempted escapes from paper– Image exchange agreements; “e-checks”

• Low adoption rates

The Check 21 Act

• Effective 10/28/2004

• Creates Substitute Check to facilitate image exchange

• Does not define, regulate, or protect image exchange

The Substitute Check

Paper Check Collection/ReturnBank to Bank—UCC 4

Bank of

First Deposit

CHECK

Intermediary Paying Bank

CHECK

CHECK

Bank to Bank Check Collection and Return After C21

CHECK

PAPER

Intermediary Paying BankIMAGE

PAPER

Bank of

First DepositIMAGE

or or

New Deposit Side Services

CHECK

BOFD backroom process

Intermediary or Paying

Bank

IMAGE IMAGEPayee

Remote Deposit

Presentment Side Services

PAPER

Paying BankIMAGE• cash letter

• bulk delivery

or, by agreement:

PAPER

Intermediary IMAGE• cash letter

• bulk delivery

Drawer

Rapid Electronification

• Explosion of image based check collection, 2004-2007 and beyond…

Adoption of Image Exchange

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2004 2005 2006 2007 2008 2009 2010

Two Forecasts:Image Exchange as % of Check Volume

FinancialInsightsCelent

Legal Lessons Learned

• Public lawmaking may be useful to spur adoption of new technologies

• Adapting old laws to new technology led to unanticipated results– Business outcome: remote deposit capture– New legal issues: duplicates; “rejects”– Evolving technical standards developing in

private sector were incorporated in public law

Globalization

• Creating the FedACH international service

FedACH International

Goal: Make international retail payments faster, cheaper– 1990s – “NAFTA ACH” and “WATCH” Discussions – 1998 – Rivlin Committee—Fed support for international

ACH– 2000-2003 Fed discussions with European postal banks

Goal: Support U.S. Treasury move away from paperPractice: Building new channels, one border at a time

– 1999 – Canadian ACH Pilot– 2003 – FedACHi Transatlantic to Five Nations– 2004 – FedACHi to Mexico– 2004 – FedACHi to Panama

FedACH International® Services

• Guiding Principles– Provide services to banks and to Treasury– Develop safe, efficient, inexpensive solutions for government

and commercial payments– Compliance with all laws/regulations– Leverage Fed’s existing ACH network, formats, & application to

create a channel for small value cross-border payments– Develop automated, STP solutions– Support bi-directional flows– Offer end-to-end certainty of clearing & settlement times– Offer competitive FX rate– No fees deducted from principal amount of transaction

Legal Structure

• NACHA Cross-Border Rules + FRB OC4• “Gateway Operator” Agreement for:

– Settlements—a series of bank to bank steps– Editing, format translation, and forwarding into destination

payment system– Establishing exchange/processing timetables to fix date

for receipt of funds

• Payment Rules of Destination Country• DI must have adequate compliance program—BSA,

AML, USA Patriot Act• OFAC compliance regime

US Bank FedACH

Gateway OperatorForeign Bank

Originator

Receiver

FedACH International Process Flow

Lessons Learned• Efficiencies Produced by FedACHi

– Treasury payments moved away from paper– Consumer benefits—safety, reduced costs

• Compliance can be elusive and expensive• Linking payments networks is:

– Complex, technically and legally, to begin– Time consuming and expensive to maintain

• Where are the payments?– US Treasury; remittances; what else?

Conclusions

• In creating a framework of rules for emerging retail payments systems– Public law is difficult to enact quickly enough

• The more detailed and prescriptive the public law is, the harder it is to keep up with change

• Should public law state general principles and leave the specifics to the private sector?

– Private sector agreements creating new payments mechanisms may or may not adequately protect consumers

Conclusions…

• Compliance has become crucial in retail payments– Concentrations of dirty money are a threat– “Everything changed after 9/11”– As retail payments go global, combating

fraud, money laundering, & terrorist financing in retail payments is a global concern

– Non banking mechanisms may be hard to police

Conclusions…

• Legal and technical differences from country to country hamper internationalization of bank based retail payments– This sustains a market for non-bank based, non-

regulated retail payments mechanisms

• Regional or global efforts to break down legal and technical barriers may help to create safe, efficient bank based cross border retail payments systems