A Changing Payment System: Implications for Utilities

Erik D. KiefelFederal Reserve Board

Utility Payments Conference

October 21, 2008

22

Discussion TopicsDiscussion Topics

Trends in the use of noncash retail payments

Trends in payment fraud

Industry payment initiatives

Legal and regulatory payment-related initiatives

What does it all mean for utilities?

DisclaimerDisclaimer

Views expressed are those of the presenter and do not necessarily reflect those of

the Board of Governors of the Federal Reserve System

44

Trends in Noncash Retail PaymentsTrends in Noncash Retail Payments

The Federal Reserve has conducted surveys on the use of

checks and electronic payments for the years 2000, 2003,

and 2006.

Each survey collected data from: About 1,200-1,500 commercial banks, credit unions, and savings

institutions

Over 100 payment networks, card-issuers, and third-party

processors

The main goals have been to:

Produce accurate national totals

Measure trends

Special focus on

Substitution of electronic payments for checks

Migration of checks from paper-based to electronic processing

Reports are available at: http://www.federalreserve.gov/paymentsystems/paymentsresearch.htm

55

Number of Noncash Retail PaymentsNumber of Noncash Retail Payments

2000 2003 2006

Checks

Checks

Checks

Electronics

Electronics

Electronics

Card

sA

CH

42

37

31

16 19 22

16

9

264

6

2

4

9

Card

sA

CH

Card

sA

CH

Debit

Credit

Credit

Debit

Credit

Debit

Credit

Debit

Credit

Debit

Credit

Debit

5

Note: Transfers over large-value interbank funds transfer systems are not included. Debit card payments include electronic benefits transfers (EBT).

66

Number of Noncash Retail PaymentsNumber of Noncash Retail Payments

Electronic payments are now

double the number of checks.

Electronic payments increased

to over 62 billion

Checks decreased to less than

31 billion

2000 2003 2006

Checks

Electronics

Card payments now more than half of all noncash

payments

Debit card now exceeds credit card.

Cash replacement likely one major reason.

77

Number of Noncash Retail PaymentsNumber of Noncash Retail Payments

0

10

20

30

40

50

60

2000 2003 2006

-3.8% -6.4%

Checks Decline in checks:

Ongoing—due to substitution

with electronic payments

Accelerating—due to growing

use of ACH conversion

Total noncash payments reached

over 93 billion

Rate of increase higher than

previous study

Increases driven by debit card

and ACH debit payments

3.9% 4.6%

2000 2003 2006

Total

88

1

Value of Noncash Retail PaymentsValue of Noncash Retail Payments

2000 2003 2006

Checks Checks Checks

Electronics

Electronics

Electronics

Card

sA

CH

40

42

210

918

12

10

12

13

Card

s

Card

sA

CH

DebitCredit

Credit

Debit

Credit

Debit

CreditDebit

Credit

Debit

CreditDebit

21

AC

H

41

Note: Transfers over large-value interbank funds transfer systems are not included. Debit card payments include electronic benefits transfers (EBT).

99

Value of Noncash Retail PaymentsValue of Noncash Retail Payments

Growth in total value $76 trillion in 2006 – up from $68 trillion in 2003 Electronic payments not yet caught up to check

Cards have smallest share Value of debit cards less than half the value of credit cards

Average value of ACH debits declined Primarily because of the increase in converted checks

2000 2003 2006

Average Value

2003 2006Annual Growth

Rate

Checks Paid 1,104 1,366 7%

ACH Debits 2,849 1,535 -19%

ACH Credits 2,668 2,974 4%

Debit Card 40 39 -1%

Credit Card 89 98 3%

Checks

Electronics

10

Trends in Payment Losses/FraudTrends in Payment Losses/Fraud

Source: Association for Financial Professionals (AFP) Payments Fraud (Risk) Surveys, 2005-2008

Payments-fraud losses are limited < .01% of revenues Banks bear as much

as two-thirds of payment losses

ACH-related fraud losses may be most common

Questions for audience How significant an issue

is payments fraud for your organization?

What are you doing to address it?

What should regulators be doing?

Type of fraud 2004 2005 2006 2007All types 55% 68% 72% 71%

Check 94% 94% 92% 94%ACH 37% 35% 38% 30-40%

Card payments 29% 23% 36% 14-24%Wire transfers N/A 1% 3% 3%

Percentage with losses 2004 2005 2006 2007All fraud types 51% N/A 58% 37%

Check N/A 19% 25% 17%ACH N/A 27% 20% 15-51%

Card payments N/A 54% 72% 33-66%Wire transfers N/A N/A N/A N/A

Type of corporation 2004 2005 2006 2007All corporations 26,600$ N/A 23,300$ 13,900$

Revenues > $1bn 37,600$ N/A 46,300$ 18,200$ Revenues < $1bn 18,100$ N/A 16,800$ 8,200$

Percentage of U.S. corporations reporting attempted or actual fraudTrends in payments-related fraud and losses

Trends in payments-related fraud and lossesMedian actual payments-fraud losses at U.S. corporations

Trends in payments-related fraud and lossesPercentage of U.S. corporations reporting attempted or actual fraud that

experienced payment losses

11

Banks’ check-related losses increased 13 percent to $1 billion between 2004 and 2005, returning to 2003 estimated levels Since 1995 study, losses have increased at a compounded

annual growth rate of 5 percent

Bank Check Losses2004 and 2005

(Comparison of check losses)

8971,018

0

200

400

600

800

1000

1200

2004 2005

$ m

illi

ons

13 percent growth

Source: FRB 2006 Check 21 survey: http://www.federalreserve.gov/pubs/reports_other.htm.

Trends in Payment Losses/Fraud: CheckTrends in Payment Losses/Fraud: Check

12

Questions for Group DiscussionQuestions for Group Discussion

Does your typical payments mix (use and acceptance) reflect these overall trends?What differs and why?

Which payment instruments are most important to your organization and why? Is cash still important?

13

Check Market CompositionCheck Market Composition

*Population is “prime pass” checks processed by nine large commercial banks. Estimates exclude 0.2% of checks that could not be classified.

“B” refers to business or government.Figures may not add due to rounding.

Casual

Income

32%

6%

13%

51%

C2B

16%

5%3%

25%

B2B C2C

7%

B2C

Remittance

Remit/POS

POS

17%

• Representative random sample of over 32,000 checks.

• Sample population is about 40% of “prime pass” checks.

• Consumers write 58% of checks paid.

• Businesses/government receive 76% of checks paid.

2006 distribution of checks by counterparty and purposePercent of sampled population of checks*

1414Note: The graph includes annualized figures from March and April 2007 data. Numbers may not add due to rounding.

Check Processing Increasingly ElectronicCheck Processing Increasingly Electronic

Electronic Check

Presentment30%

Original Check57%

Substitute Check13%

Paper70%

Two trends: “Electronification” of paper checks—Depository institutions

increasingly use electronic methods to process interbank checks.

ACH conversion of paper checks—Billers and merchants convert checks to ACH payments.

Checks by Presentment Method

15

Check 21 is facilitating rapid growth in the use of electronics within the check-collection system

Sources: 2006 Check 21 survey data and industry data

Check Presentments Check Images and Substitute Checks Presented to Paying Banks

0%

5%

10%

15%

20%

25%

30%

35%

March 2006--Allbanks

January 2007--Keyindustry participants

May 2007--Keyindustry participants

June 2008--Keyindustry participants

Perc

ent o

f all

che

cks

paid

Check images

Substitute checks

2%3%

12%8%

18%

9%

29%

10%

Check processing increasingly electronicCheck processing increasingly electronic

1616

Most ACH payments remain recurring bill and other payments Remittance type payments (C2B)

More than half of all ACH payments and about a quarter of total ACH value

Remittance/POS payments (C2B)

About a third of all ACH payments were converted consumer checks or one-time ACH consumer debits that accounted for 5 percent of total ACH value

Corporate payments (B2C/B)

Most of the rest of the ACH payments and accounted for about two-thirds of the total value

ACH market compositionACH market composition

•2007 Electronic Payments Survey

1717

Only about 40 percent of checks are eligible for conversion Business format checks are not eligible

Converted checks now: About 20 percent of total ACH payments

About 8 percent of checks

ACH Market Composition: ACH Market Composition: Check ConversionCheck Conversion

Growth in conversion

activity may be tapering

off

2003-2006 growth –

about doubling each year

2006-2007 growth –

about 30 percent

33.137.6

20062003

Converted to ACH

Checks Written*

37.330.6 Checks Paid

*Includes the use of checks as source documents.

1818

Primarily C2B payments at the POS or for remittances, but with increasing use of purchasing cards for B2B payments

Private label (retailers, oil & gas, or fleet cards)

2.8 billion transactions valued at $253.6 billion, with an average spend of $91.59

Oil company cards (in-house) totaled 191.3 million transactions valued at $7 billion, with an average spend of $36.49

General purpose

19 billion transactions valued at $1.9 trillion, with an average spend of $98.68

Credit card market compositionCredit card market composition

•2007 Electronic Payments Survey

1919

Supports C2B payments, usually POS and some remittances

Signature debit

16 billion transactions valued at $637.2 billion, with an average spend of $39.93

PIN debit

9.4 billion transactions valued at $348.6 billion, with an average spend of $37.20

Prepaid cards

Open loop (subcategory of debit): 321.8 million transactions valued at $13.3 billion, with an average spend of $41.30

Closed loop (separate category): 3.1 billion transactions valued at $36.6 billion, with an average spend of $11.90

Amounts to about 3 percent of all noncash retail payments and less than 1/10th of one percent of the value

Debit card market compositionDebit card market composition

•2007 Electronic Payments Survey

2020

Emerging payments use ACH or cards to complete the payment

Online bill payment: 3.4 billion transactions valued at $1.2 trillion, with an average payment of $345

RFID transponders: 2.1 billion transactions valued at $3.6 billion, with an average payment of $2

Other new payment types: 532.1 million transactions valued at $35.5 billion, with an average payment of $67

Includes person-to-person, proprietary ACH cards, mobile payments, and deferred payment transactions

Put together, these payments account for less than 7 percent of all noncash retail transactions and less than 2 percent of the value of those transactions

Emerging payments market compositionEmerging payments market composition

•2007 Electronic Payments Survey

21

Some potential implicationsSome potential implications

Operational Physical payment

receipt centers Reliance on back-office

and lock-box operations Reliance on more

electronic processes and need to tie to existing paper processes

Risk Data management and

security risks Legal and regulatory

compliance

Technological New technology

investments Multiple platforms Reliance on paper-

based technologies

22

Some potential implicationsSome potential implications

Financial Customer float Bank fees with ACH

transactions Bank fees with CC/DR Opportunities and

challenges for A/R, A/P Effects on cash flow Funding and priority for

payments initiatives Reconcilement needs

within treasury operations

Customer service Payment choices and

means to initiate payments

Touch points with customers/cross-selling

Self-service opportunities (cost reductions)

Opportunities and challenges for quality of service

23

Questions for group discussionQuestions for group discussion

What are the key challenges for your organization in the payments area?

Where is your organization focusing its efforts?

What priority do these payment initiatives have within your organization?

24

Industry initiativesIndustry initiatives

Check Remote deposit

capture (RDC) Reserve Bank check

restructuring Check and ACH

convergence

Cards Decoupled debit Prepaid Mobile and contactless

ACH EBIDS Secure Vault Direct exchanges

Wire transfers (RTGS) Remittance standards

25

Industry initiatives: CheckIndustry initiatives: Check Remote deposit capture (RDC)

Scanning (capturing) check images outside the bank’s back office (may also include ACH check conversion deposits)

Merchant, ATM, Branch, Retail customer level

Issues Merchant/customer selection (KYC) Warranties and liabilities Retention/destruction of original checks Security of check images

FFIEC Examiner guidance on RDC upcoming

Questions for audience Are you using RDC? How are you and your bank addressing these issues?

26

Dallas

Denver

Helena

Chicago

Atlanta

Memphis

Seattle

Baltimore

Charlotte

Cleveland

St. Louis

Cincinnati

Des Moines

Kansas City

Minneapolis

Los Angeles

Philadelphia

Jacksonville

Windsor Locks

San Francisco

Full-service check processing site

Substitute check print site

Check image capture and Substitute check print site

Industry Initiatives: CheckIndustry Initiatives: CheckFederal Reserve Check infrastructure (2010)Federal Reserve Check infrastructure (2010)

See: http://www.federalreserve.gov/newsevents/press/other/20080331a.htm

27

Industry initiatives: CardsIndustry initiatives: Cards

ACH debit cards Merchant issued payment card ultimately linked to DDA but cleared and

settled via ACH

Decoupled debit cards Debit card issued by a bank (or potentially non-bank institution) other than the

bank holding the customer’s demand deposit account (DDA) Capital One’s decoupled debit card (MasterCard branded) Tempo has expanded to decoupled debit as well

Funds ultimately debited via ACH from cardholder’s DDA at another bank Status of Capital One effort: more pilots and testing

Significant challenge to traditional bank account-based debit card relationship Industry concerns have led to NACHA rules changes to require a one-for-one

linkage between ACH debits and decoupled debit card transactions http://www.nacha.org/ACH_Rules/ach_rules.htm

Question for audience What is your company’s position on decoupled debit

28

Industry initiatives: ACHIndustry initiatives: ACH

EBIDS NACHA-sponsored pilot (developed jointly with the Federal Reserve Banks)

that uses the ACH system to present and pay bills and invoices via on-line banking systems

Pilot began in August and will run through December 2009 Handful of bank and corporate participants, including telecommunications

companies, banks, and the Federal Reserve Bank of Cleveland Experience to date of customers appears good

For more information: http://www.nacha.org/ebids/ Secure Vault Payments (SVP)

NACHA-sponsored pilot that uses the ACH to provide an alternative payment authorization and settlement for on-line purchases via on-line banking systems

Pilot began in May but remains limited First use of interchange fees associated with ACH payments

For more information: http://www.securevaultpayments.org/ Question for audience

Is your company considering participation in these pilots?

29

Industry initiativesIndustry initiatives

Check Check and ACH

convergence

Cards Prepaid Mobile and contactless

ACH Direct exchanges

Wire transfers (RTGS) Remittance standards

Questions for audience How important are these

initiatives to your payment strategies?

What concerns or suggestions do you have regarding these or other industry initiatives?

30

Legal and regulatory initiativesLegal and regulatory initiatives

Check Remotely created

checks (RCCs) Funds availability

legislation Regulation CC return rules

Cards Regulation Z proposals Legislation updates

ACH NACHA risk

management initiative International ACH

Transaction (IAT) rule

BSA/AML (FinCEN) Cross-border wires MSB definitions Other recent guidance of

interest

Identity theft FACTA Red Flag

requirements

31

Legal and Regulatory Initiatives: CheckLegal and Regulatory Initiatives: Check Remotely created checks (RCCs)

Consumer provides his/her account information to allow a business to create a check (draft) drawn on the consumer’s account.

The check bears the consumer’s printed name or a statement that it was authorized rather than a signature

Various concerns about potential use of fraudulent RCCs

FRB amendments to Regulation CC help address these concerns without prohibiting the legitimate use of RCCs

Amendments shift liability for unauthorized RCC payments to the depositary bank Regulatory changes appear to be working, with the number of unauthorized RCCs flowing

through the Reserve Banks decreasing http://www.federalreserve.gov/boarddocs/press/bcreg/2005/20051121/default.htm

Reserve Banks do not accept image RCCs that were never a paper check (OC-3 changes)

http://www.frbservices.org/communications/customer_communications.html

Questions for audience To what extent and for what purpose does your company use RCCs? Do you or your customers have any fraud or other concerns with their use?

32

Legal and Regulatory Initiatives: ACH Legal and Regulatory Initiatives: ACH

NACHA risk management initiative NACHA approved a risk management strategy for the

ACH network and is in the process of enacting associated new rules to address those risks

Network rules enforcement Company name identification requirements Risk management and rules compliance audits Prohibitions on use of the ACH for illegal Internet

transactions

NACHA considering new data reporting requirements to support broader risk management and monitoring efforts

For more information: http://www.nacha.org/OtherResources/riskmgmt/riskmgmt.html http://www.nacha.org/ACH_Rules/ach_rules.htm

33

Legal and regulatory initiatives: ACHLegal and regulatory initiatives: ACH

NACHA IAT rule Result of industry concern about OFAC responsibilities for

inbound international ACH transactions Definition of international ACH unclear along with RDFI’s

OFAC responsibilities for inbound transactions

New NACHA rules established to meet OFAC requirements Establishes broader definition of “international ACH

transaction” or IAT An ACH entry that is part of a payment transaction involving a

financial agency’s (an institution authorized by law to accept deposits, issue money orders or transfer funds) office that is not located in U.S. territorial jurisdiction.

Expands IAT format to include “travel rule” information, but ONLY for purposes of complying with OFAC requirements

Effective date extended to September 18, 2009 http://www.nacha.org/IAT_Industry_Information/

34

Legal and regulatory initiatives: Legal and regulatory initiatives: Identity TheftIdentity Theft FACT Act of 2003

Regulation requires 3 things Written ID theft prevention program Address validation for card issuers Verification of consumer address (related to use of

credit reports)

Financial institution must determine whether to cover business accounts

Guidelines How to identify/detect “red flags” for ID theft How to prevent/mitigate ID theft

Implementation date: November 1, 2008

35

Legal and regulatory initiatives

Check Funds availability

legislation Regulation CC return rules

Cards Regulation Z proposals Legislation updates

ACH ACH debit posting times

BSA/AML (FinCEN) Cross-border wires MSB definitions Other recent guidance of

interest

Questions for audience How important are these

initiatives to your company?

What concerns/suggestions do you have regarding these or other initiatives?

36

Questions?Questions?

Erik D. KiefelProject Leader

Board of Governors of the Federal Reserve System

202.721.4559Erik.kiefel@frb.gov