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May 10, 2010

Going all digital with the check: Check 21, ACH, or an electronic payment order?

Today's continued decline in paper check volumes can be explained in part by the expanding diversification of electronic payment instruments. As part of this transition over the past five years, the Federal Reserve Banks (FRB) reduced their number of paper check processing operations from 45 to one in response to declining paper check volumes. The diminished significance of paper checks and technological advances in the payments arena have given rise to the idea of a new type of check: an all-digital check, i.e., one never having taken paper form.

A concept paper published by a payments research group at the Federal Reserve Bank of Chicago was the first to espouse this idea. The paper advances the idea that this new kind of check could help complete the transformation of the check from paper to electronic form altogether by doing away with the need to write the paper check in the first place. The new check-like payment, termed electronic payment order (EPO), is designed to allow consumers to write a check digitally on a smart phone or other computer device and then send that digital check to the payee who, in turn, sends the image on electronically to his or her bank for deposit. The EPO would clear and settle through the same electronic check processing channels that all other imaged checks do.

The appeal of an all-digital check
In recent months, the EPO paper has received considerable attention. One example is a recent article in the American Banker that portrays the EPO as an efficient and innovative payment product. Although the EPO may function like and contain the same information as a traditional check, the EPO may have benefits beyond those fully explored in the paper.

A possible benefit is the EPO's potential to replace remotely created checks. Since the EPO requires a digital signature signifying intent and authentication—two elements that remotely created checks lack—it may be less subject to fraud because the digital signature establishes more trust and predictability than does a remotely created check. On the other hand, the payee of an EPO transaction is still subject to the possibility that the payer has insufficient funds to cover the EPO.

Fundamental legal and regulatory issues
New electronic payments mechanisms typically raise numerous legal and regulatory issues, such as acceptable methods of payment authorization, information protection, and methods for settling disputes. The all-digital check concept is no different. While it has been reported that the FRB has endorsed the EPO practice, it actually has not, particularly because the specific body of laws and regulations that govern an EPO are uncertain and remain to be addressed.

By being entirely electronic, the EPO achieves the goal of eliminating the paper check, and it therefore makes check law literally inapplicable. Conceptually, the authors of the paper foresee the EPO existing under current check law through agreement while using traditional electronic check clearing channels. Some opine that to the extent that check law may be made to apply by agreement, then an EPO, as a matter of law, would not be subject to the Electronic Funds Transfer Act (EFTA) and Regulation E, as checks are precluded from coverage under EFTA. Others contend, however, that Regulation E should apply, since it regulates all electronically initiated transactions. But no known official determination to that effect exists.

The Chicago Fed's EPO paper acknowledges this paradigm and ultimately rests its legal standing on an agreement-based approach (i.e., where existing law would otherwise have addressed these legal and regulatory issues, parties agreeing to exchange EPOs will privately agree to a set of specific terms and conditions tailored to the new product). Whether an agreement-based approach can provide sufficient "legal" framework and do all that is necessary to make an EPO function as a traditional check but in all-digital form remains to be seen.

An alternative to the all-digital proposal: Credit-push transaction
The check clearing system operates on a debit-pull basis; that is, the payee has to deposit the check as an order to pull funds from the payer's checking account. An alternative proposal to the all-digital check could be a mechanism under which a check no longer operates as a debit pull but instead as a credit-push electronic payment. In this scenario, and in its simplest form, the accountholder would instruct the bank to transfer funds electronically from his or her account to the payee's bank account, thereby limiting the payee’s involvement and reducing the chain of transfers that otherwise occurs with traditional checks.

This alternative approach functions fundamentally like a cashier's check and mirrors payment rails available today from most home banking systems that can be accessed from a smart phone or home PC. Furthermore, the legal and regulatory framework for credit-push transactions is far more certain. For business EFTs, Uniform Commercial Code Article 4A would apply, and EFTA and Regulation E would apply for consumer EFTs. In addition, because the payer’s bank transmits the transaction, the payee can be certain that funds are good upon receipt.

The payments system as established provides an infrastructure for transferring money from one entity in the economy to another. An efficient payments system is one that allows instant confirmation of a transaction and does so in a secure environment. In the months ahead, key payments system participants will determine whether the concept of the EPO will ever be implemented or whether a different approach to traveling the "last mile" of check electronification is best. In any case, challenges remain, and streamlining and simplifying the transaction while addressing the legal and regulatory implications will be big factors in determining the outcome.

By Rich Oliver, executive vice president, and Ana Cavazos-Wright, payments risk analyst, both in the Retail Payments Risk Forum at the Atlanta Fed

May 10, 2010 in remotely created checks | Permalink


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Dave, thanks for the comment. As we research the idea of a credit push electronic check, we will have to consider how to get the payee's information in the ACH payment, clearly a key. Stay tuned as we may write a paper on this idea since it does have some attractive tradeoffs in terms of certainty of payment to the merchant or company and can flow through check rules since it is not drawn on a consumer checking account. Could this be a reverse UPIC transaction?

Posted by: richard oliver | May 24, 2010 at 02:24 PM

Rich, the credit-push transaction exists today through online bill payment systems. One issue with it is there is no universal payee database -- if the payee is large enough, it will likely be in the bank's (or the bank's service provider's) payee database; but for smaller payees the payer would need to know R/T and account number information in order for the payment to be electronic. This is a disadvantage vs. a cashier's check.

There was an early FSTC project on e-check (1993 timeframe) -- it was an entirely digital check -- very interesting technology. I'm not sure why it never took off, maybe the rise of consumer debit cards in that same timeframe was part of it.

Posted by: dave fortney | May 12, 2010 at 03:23 PM

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