How do instant payment systems work?

An explanation of how instant payment schemes work and how they compare to existing payment methods

Instant payment systems are a recent trend in payments and are increasingly available as a convenient option to make payments in many countries. At present, more than 50 countries have real-time payment rails available and many are looking to build one. They are frequently built and operated by central banks or by organizations that provide national payments infrastructure. The defining feature of these systems is that they provide a continuous service that allows immediate and irrevocable transfer of money between accounts from different banks.

The near ubiquity of mobile phones and increasing expectations of consumers in terms of service quality have been the most important factors driving the investment in these systems. More recently, concerns that cryptocurrencies might compete with sovereign fiat currencies gave regulators an extra push to go ahead and implement them.

The architecture of instant payment systems

The general architecture of current systems is based on a centralized infrastructure responsible for processing payment orders sent by customers of banks. The system is intermediated on two levels. At the first level, customers have accounts at their banks where they keep their money and can send and receive payments. On a second level, banks connect to a central system operated by a trusted third party. This central system allows them to communicate with other banks with messages and to settle financial obligations they create with each other as the payments are processed.

When a customer Amy, who has an account at bank Alpha, wants to send $100 to Brian at bank Beta, Amy instructs her bank with an amount and information identifying Brian’s account. Upon receiving the payment instruction and that Amy has sufficient funds, bank Alpha sends a message with the details of the order to the instant payment system. The system will validate the message and check with bank Beta if there is indeed an active account there belonging to Brian.

What happens next depends on the settlement method. One possibility is for the system to record an entry saying that bank Alpha now owes bank Beta an additional $100 to be settled some time later, possibly in another system. This delay allows the offsetting of incoming and outgoing payments and is known as deferred net settlement. Alternatively, it can settle the value immediately, debiting bank Alpha and crediting bank Beta on accounts they hold within the system. This is known as real-time gross settlement.

After processing the payment order, the system notifies both banks if it was either accepted or rejected. If accepted, bank Alpha will debit Amy’s account and bank Beta will credit Brian’s. The ordering of events might have some variations in different implementations, but this is roughly the outline of the process.

Clearing, posting and settlement

In the context of retail payments, clearing is the process of transmitting, validating and notifying parties of the result of a payment order. It makes sure, for example, that the destination account is valid and that all necessary details are present. Clearing might also include the offsetting of values for payments sent and received by a party (netting of payments). Posting is the debiting and crediting of the involved customers accounts, taking funds from the payer and making them available to the payee. Settlement is the process that terminates obligations that banks create to one another while processing inter-bank payments.

To allow rapid final funds transfer between two accounts, instant payment systems must provide fast clearing and posting of payments while settlement can be immediate or can happen at a later time. In contrast, card schemes do not provide fast posting of payments. When a customer swipes a credit card, what the receiver gets is an authorized transaction, which is a promise that funds will be deposited in their account within a few days (or a month, as used to be the practice in Brazil), after settlement between banks occur.

Settlement is mainly a concern of banks, since customers only really care that funds move from the payer account and are made available to the payee. It is important to highlight that banks use their own funds, often kept at the central bank, to make inter-bank transfers possible. Banks act as intermediaries for their customers. They use their ability to settle with other banks to provide customers a funds transfer service between accounts at different banks.

Dealing with failures

Like many high-stakes man-made systems, a major element of the design of settlement systems is how they deal with failure. In particular, how they deal with the possibility that a bank might go bust (credit risk) or be temporarily out of funds (liquidity risk) and thus unable to meet its obligations in a timely way. These risks are important because the failure of one bank can cascade into multiple other bank failures. In dealing with these risks, payment systems have two main methods of settlement between banks: real-time or deferred net settlement.

Real-time settlement systems settle payments one by one. With this design, credit risk is eliminated. A bank can only transfer funds to another bank, settling the payment, if it has funds in its account. The downside is that this requires banks to have more funds (liquidity) locked-up for this purpose when compared to a deferred net settlement system. This greater need for funds has costs, since banks could be using them for other purposes.

In deferred net settlement, a batch of payments is accumulated and periodically settled. Batching allows payments to be netted, so if a bank owes a total of $1000 to other banks but is owed $900, it only needs $100 to settle the payments. This reduces the need for funds. It introduces, however, the possibility that a bank can’t pay the amount it owes other banks when settling. This is know as credit risk and some arrangements are put in place to mitigate it. Limits on the maximum amount a bank can owe others, collateral posted as guarantees in case of failure and loss-sharing among surviving banks are examples of such mitigations.

Instant payments and existing payment methods

Being the new kid on the block, instant payments are inevitably compared to existing systems. Here is a summary of how instant payment system fit into the existing payments ecosystem.

Cash

Cash is a great piece of technology. It is a simple, user friendly, accessible, decentralized, privacy preserving and resilient payment system. It does not require batteries or internet connectivity. It allows immediate settlement of obligations between parties without any central infrastructure. Moreover, local currency is universally accepted within a geography, frequently by force of law.

Cash, however, has some drawbacks. It requires distribution, which is costly, and it can only be used for in-person transactions. In Brazil, organized crime uses dynamite to explode ATMs at bank branches. As a consequence, security costs increases and that makes servicing small cities in the countryside unattractive to banks. This leads them to close branches and people having to travel to other cities to be able to withdraw cash.

Instant payments are bound to take a significant share of payments done today with cash. Since funds availability are confirmed within seconds to the payee, it is a good substitute for cash in many situations. However, as much as neophiles like to herald the demise of old-fashioned cash, it will probably continue to be demanded as a payment instrument. In fact, from 2000 to 2016, cash in circulation as a proportion of GDP, a proxy for cash use in payments, has increased in many countries. In short, cash is lindy.

Wire transfers and batch payment systems

Electronic funds-transfer systems have been available since the 70s. While a great improvement over alternatives at the time, operating windows limited to business hours and delays on the order of days to process a payment are anachronistic in today’s world of mobile phones, instant messaging and e-commerce.

Instant payments leapfrog these legacy systems across many dimensions such as availability, capacity, speed and data richness. Updating those older systems to meet new requirements would be practically impossible, given the enormous web of dependent systems and procedures from banks, corporations and governments. This complexity means they will probably be around for quite a while. Payment methods are sticky and don’t die easily. Interestingly, it was only in 2018 that the number of ACH debit transfers surpassed the number of check payments in United States.

Cards

The card payment network has extensive coverage around the world and is used mostly for payments in retail (consumer to business). Card payments have consistently increased in use over the years and have been the preferred payment method in the booming e-commerce space.

Recently, card networks started offering person-to-person push payments services. When Facebook rolled-out payments through WhatsApp in Brazil last year (moving so fast that the BCB applied breaks to avoid breaking things), they partnered with Mastercard, using their push-payment offering.

Instant payment systems bring competition and innovation to the electronic retail payments market, which is currently dominated by two huge global card networks (Visa and Mastercard) and regionally by oligopolies of acquirers and issuers. The great market power those providers have allow them charge handsome fees for processing payments. The high costs for credit and debit card transactions led regulators in some countries to even impose caps on fees.

Since many instant payment systems are run like public utilities, on a cost-recovery basis, it is expected that making payments through them will cost much less. In Brazil, for instance, the recently launched instant payment system named Pix will charge only a tenth of a cent (equivalent to 0,00019 USD in Jan/2021) for each transaction. This fee is charged on scheme participants by the central bank to recover costs in the operation of the infrastructure. Participants, however, are free to set fees on person-to-business transfers while person-to-person transfers are free. The price merchants will end up paying depends on how competition among payment service providers will evolve.