Flow of money, a story!

Index:

A primer on payments and settlement system.

How does money move in banks?

More convenience: How do card transactions happen?

Even more convenience: How do online transactions happen?

TODOs:

Retail Payment System of 2020: Rupay, UPI, Nach, etc.

NUE(New Umbrella entity) the proposed alternative to the NPCI (which owns UPI and runs the Rupay network)

Types of bank account

What is an overdraft facility, Line of Credit facility, cash credit facility?

What is revolving credit?

What are virtual accounts?

A primer on payment and settlement system.

A payment is a financial obligation that the two constituting parties have to fulfill.

The entire payment process is nothing but simply an accounting operation in which debt is transferred from one person to another in the payment chain. The participants in the payment system can be handling any of the processes involved in the payment system, i.e., clearing and settlement.

What is this clearing process?

It is kind of like a reconciliation between two people when they decide on the amount which they owe to each other, it may be possible that they are netting their transaction done over a period of time, and then decide on the final position of settlement.

Which brings us to the settlement process.

Once the final position of accounts have been determined, it is time for the payer to pay the payee.

How does money move in banks?

Let’s get the basic cleared. When you put money in a bank, you have loaned that money to the bank and the bank owes that money to you, that is why it is marked as credit in your bank statement.

Say you put ₹100 in your bank account, the bank now owes you ₹100.

When you take some of your money out of the bank, the bank now deducts that amount from your account that it owes to you. If you take ₹20 out from your account, the bank now owes you ₹100 — ₹20 = ₹80.

Let’s start with a simple transaction between two persons. Say Ankur wants to transfer ₹30 to Binod and both have accounts in the SBI bank. What would a bank do in this case?

It is simple, SBI updates the account books of both Ankur and Binod. SBI now owes ₹30 less to Ankur and owes ₹30 more to Binod.

Now let’s include another bank in the picture. This time Ankur who has an SBI account wants to transfer ₹30 to Binod who has a PNB account. How would a transaction happen between these two banks?

Like we did before, SBI can deduct ₹30 that it owes to Ankur and SBI can ask PNB to increase ₹30 that it owes to Binod. Simple? But why will PNB owe Binod ₹30 more?

What If SBI and PNB have also accounts with each other. This time SBI can increase the amout if to PNB by the same value that it has decreased the amount that it owes to Ankur. Since PNB is owed by SBI by ₹30 more, it can now owe Binod by ₹30 more, which complete the whole transaction.

This arrangement of banks maintaining accounts with each other is called a correspondent banking arrangement.

But can all banks have accounts with one another?

It may not be possible for every bank to have an account with every other bank, but it possible any two banks are connected with some number of intermediary banks in between. To understand this imagine the banks to be cities if there is a direct road between two cities mean the corresponding banks have accounts with each other, now all cities may not have direct roads between them, but we can go from any city to any other city by passing through any number different cities.

That is amazing we can make all the transactions happen by simply updating the owed amount through the chain of banks between the two transacting parties.

This setup creates a few problems.

1. Whenever money moves there is a cost associated with it. Therefore in bigger chains, even small valued transactions would become costly, not to mention, the complexity of a transaction also increases.

2. Imagine SBI and Aryavarta bank have accounts with each other and many transactions are happening from Aryavarta to SBI. In SBI books it will be owed by Aryavarta bank by a substantial amount. Wouldn’t it be worrisome for SBI if Aryavarta bank were to go bust, SBI would not get the money back from Aryavarta bank. This is a real and legit worry for banks in this arrangement. Though this problem can if slightly mitigated if instead of increasing the amount owed by Ayravarta to SBI we rather decrease the amount owed by SBI to Aryavarta, this way we have prevented the building up of large inter-bank balances.

There are some other big issues intrinsic to the correspondent banking model:

1. Liquidity and Cost

In our case, PNB and SBI both have to maintain sizeable balances in each other’s accounts so that when their customers are transacting the two can adjust the amount they owe to each other to complete the transaction. Extrapolating this since banks have to maintain an account with many other banks these interbank balances will significantly increase the amount of money these banks have to park aside just to make the transactions among their customers happen, leaving each bank with lesser money which could otherwise have been put to better use in investments and loans.

Does it make sense that the likelihood of a transaction happening from one bank to the other equals the likelihood of a transaction happening the other way round?

Well if it does, we have significantly reduced the amount that needs to be parked aside by each back using the deferred net settlement system. This system keeps track of all the payments, and then, on some schedule, calculates the net amount owed by each bank to each other

Now the two banks can settle by transferring money to/from the accounts they hold with each other, or, can they?

Yes, they surely can, but it still doesn’t solve the earlier problem we discussed. What if before the settlement the bank which owes money goes bust? This arrangement exposes the banks to their counterpart owing banks, which brings us to the last problem.

2. Settlement Finality

All receiving banks need absolute assurance that their payments would go through even if the sending bank goes bust.

It seems that the solution lies in creating a safety net, or in other words, creating a bank that cannot go bust.

The last piece of the puzzle is the presence of a central bank whose customers are all the banks in the system. And if this bank cannot go bust our problem trivializes to the first simple case where Ankur was sending money to Binod with SBI. Now the sending and receiving banks would be like Ankur and Binod both having account in the central bank. The central bank can simply debit the sending bank’s account and credit the receiving bank’s account. And this would be a real-time gross settlement (RTGS) as it happens instantly and there is no netting of the amount because netting payments introduce delay and the settlement has finality, that is, it can’t be reversed.

But for making transactions you don’t always have to go to a bank. There should be a more convenient way to make transactions. The answer is the payment cards, which could be your debit/credit card or other cards like a Starbucks card.

More convenience: How do card transactions happen?

Imagine yourself going to a shopping mall and inserting your debit or credit card into the POS machine and you are waiting for your slip without caring a bit about how the money parked in your account gets transferred to some other account. If you are curious to know how this magic happens in a couple of seconds, please read on.

Let us observe some pieces involved in the transaction.

Cardholder, which is yourself.

Merchant, the store/business where you went shopping.

Payments card and the POS machine.

Issuer, the cardholder’s bank which has issued the payments card,

Acquirer, the merchant’s bank

Do the issuer and acquirer banks talk to each other and transfers the money?

Not really, it is the network that communicates with the participating banks for handling the entire transaction.

Since Visa is the largest and popular open network that exists right now, we shall exhibit how that functions, though other networks work similarly.

So what exactly does Visa do?

Visa Inc. is a public traded company that works with both issuers and acquirers. The issuer is allowed to issue visa payment cards and the acquirer is allowed to accept payments made through the visa payment cards.

How does Visa do what it does?

Visa Inc. created VisaNet which is their payment system for electronic retail transactions.

VisaNet has 3 major components:

1. Authorization

2. Clearing

3. Settlement

Simply put, the authorization layer validates whether the issuer can approve the transaction or not. There could be situations where the card may not be authorized, like lack of sufficient funds or if the card is flagged as stolen, etc.

Now if authorization is successful, the next step would be for the acquirer to send the transaction detail to the issuer which is called clearing.

Finally, the real exchange of funds takes place and all the payments are settled.

First step is the authorization of customer’s account :

cardholder — (swipes) → merchant’s pos — (sends transaction info to) → acquirer — (sends authorisation request to) → VisaNet — (passes request to) → issuer — (sends authorisation response back to) → VisaNet — (forwards authorisation response to) → acquirer — (forwards authorisation response to) → merchant’s pos

Once authorization is complete then happens the Clearing and Settlement :

merchant — (deposits transaction slip to) → acquirer — (credits the merchant’s acc and then submits the transaction info to) → VisaNet — (pays the acquirer and obtains settlement from) → issuer — (posts the transaction to) → cardholder’s account

Now, this a huge service, and services cost money, so who pays for this service?

It the merchant who has to pay for this entire service. The cost to the merchant is termed as Merchant Discount Rate (MDR), which lingers between nil to 2%, and is collected by the merchant’s bank which is then split with the bank that issued the credit card, the payment network (Visa, Mastercard, etc.), and the bank that provided the POS terminal or device.

Now you don’t even want to use a card and go to a shopping mall for making transactions. You can buy stuff from the comfort of your home.

Still more convenience: How do online transactions happen?

You do not get a pos machine online, so how do online shopping transactions happen?

When you click on ‘submit order’ on your favorite shopping site, you are taken from the merchant’s webserver to the payment gateway/payment aggregator (there is a difference between the two but that will not be expounded now), which takes the information to merchant’s bank. You already know the flow of information after this.

Merchants have to pay commission for using the payment gateway services and there are a plethora of services to choose from viz. Razorpay, PayU, CCAvenue, etc.