White Paper-Research Report: Check Electronification at the Beginning of the 21st Century

A uthor: STAR Systems, Inc. (Concord EFS) Date: December 2000 Relevance Rating: High Web Address: http://www.star-systems.com/newstar_Final.pdf

Eric Thomson's career spans more than 25 years of successfully applying financial systems technology to expand profit margins for his clients. His experience includes managerial positions in international banking (ANZ Bank), research and development (Visa International), consulting (Ernst & Young) and major account financial institution sales (NCR). He was a founder and President of Valutech - a successful systems integrator that delivered cash management systems into such clients as ARCO, Blue Cross/Blue Shield, Colgate and McLane Companies. Currently, he is performing consulting assignments that create new revenue streams for his clients that represent non-traditional vertical market applications for the ISO distribution channel.

Executive Summary While more than a year old, this White Paper is very timely in the sense that it provides a clear overview of the various ways check electronification is performed today and is likely to evolve toward in the near future.

STAR, recently acquired by Concord EFS, is part of the nation's largest ATM and POS debit network. STAR's heritage grew out of the gradual nationwide ATM exchanges that banks formed to enable their debit cardholders the convenience of cash withdrawal virtually anywhere across the country. Consequently, the document, and all of the case studies, are written from the banker's perspective.

Check electronification is a compelling application for online debit processors such as STAR in that it represents massive potential for incremental revenue off its fixed capital investments - investments long justified for processing of ATM and online debit card transactions at the point-of-sale. The prospect of collecting revenues on an estimated POS paper check base of 18 billion transactions is compelling on a number of levels, as described in this report.

First off, the number of checks is six times larger than the 3 billion POS electronic card transactions in the U.S. There are a series of transaction fees to be shared between the acquirer and check writer sides of the transactions on top of an estimated $2-4 billion in check fraud losses that can be greatly reduced through online check truncation.

According to the report, retailers stand to gain from paying less than the estimated $10 billion they now spend annually for bank and other check-handling fees. These online checking systems also offer merchants the promise of greatly reducing the estimated $10 billion in check fraud they experience annually.

The White Paper does a good job of describing the evolution of electronic check conversion (ECC) under the direction of the rules-making organization, the National Automated Clearinghouse Association (NACHA). STAR proposes that a more efficient approach to check electronification lies in exploiting the online links it has built between ATMs/retailer POS terminals and the debit card-holder banks.

Under its "real-time check electronification" model, each time a consumer presents a check for payment, the item will be MICR read/possibly imaged and sent through a switch that will go directly to the check writer's bank for either verification or warranty. If the check writer's bank isn't a part of the debit network, then the transaction will be authorized and, if approved, will be settled via ACH.

Real-time check conversion transactions are anticipated to result in accelerated funds availability for the retailer - by as much as a day or two relative to ACH and even more time than a paper check.

Under this model, verification is defined as assuring the retailer that the check writer's account is open and contains sufficient funds to cover the check - but the funds are NOT placed on hold and settled. This is what occurs when the transaction is approved under a "warranty" contract between the banker and the retailer.

Not surprisingly, the pricing for these two services is anticipated to be very similar to those charged today under check verification and check guarantee, the first on a per-transaction fee basis and the latter on a percent of face value of the funds being transferred. In addition to faster funds availability, warranty also eliminates retailer losses for fraud, NSF and administrative returns.

The challenge for debit network processors like STAR is to facilitate their member banks to make the necessary upgrades that enable these check transactions to look like an ATM transaction across their network. That is not a small change. The ATM card numbers are in different formats as compared to the MICR numbers found on the bottom of checks.

ATMs also use Personal Identifier Numbers (PINs) to provide cardholder identification and authorization -- security missing from personal check writers, who, for whatever reason, have long decided they will not clutter their minds trying to remember PINs. Consequently, the check electronification services provided by debit card processors will evolve slowly over the next few years as more and more banks upgrade their checking account systems to make way for these new sources of revenue.

Visa estimates that I have read suggest that the most online debit could hope to penetrate would be 70% of the checking accounts currently in use across America. The remaining 30% are checks drawn on small credit unions and savings/mutual banks that can't justify the upgrades needed to provide real-time check truncation. These transactions will be converted via ACH.

While the report includes a brief mention of "electronic check imaging," it leaves it as an optional feature of the settlement process. This isn't surprising, given the author of the document. STAR's heritage is as a bank membership organization that enforced strict guidelines on how to qualify cardholders and control the distribution and updating of cards/PIN security systems. Opening a checking account is a much more relaxed process and explains why there are so many more people carrying checkbooks than there are carrying debit cards.

Companies with the most real world experience in check truncation, such as CrossCheck and TeleCheck, are convinced that capturing the check image before returning the canceled check back to the consumer is not only prudent, it makes the business case for providing the service. The image not only provides vital name and address information in the collection of NSF returns, it has proved critical in the repair and re-submission process needed to collect administrative returns for MICR misreads.

There is also a wealth of valuable consumer information on the check when you consider that the name and address can be extracted, linked to a unique number (MICR line) and back to the original transaction detail containing the individual items purchased. As you think about it, these are all the components a retailer needs to identify high-value customers and execute a successful loyalty program.

Maybe even more important than any other retailer value-add, the check image showing the consumer's intention, as shown in his or her own handwriting, represents the logical method of resolving consumer disputes without jeopardizing the long-term relationship.

Highlights of Findings "While predictions may vary, given consumers' allegiance to checks, a more realistic solution is to make checks easier and less expensive for retailers and financial institutions to handle. And the best way to do that is to make check transactions as paperless - as electronic - as possible."

"The term 'check electronification' applies to a wide variety of payment processes along a continuum between traditional paper checks and the complete reliance on paperless, totally electronic payment methods."

"Electronic check imaging: digitally capturing a photo of a check and either storing it for future reference or transmitting it to facilitate settlement."

"Today, two models of check electronification are popular and growing: electronic check presentment (ECP) and electronic check conversion (ECC) to an ACH payment."

"Unlike many other payment forms, ACH conversion does not generate revenue for financial institutions. First Union realized that the growing popularity of ACH conversion could significantly decrease the number of paper checks retailers were depositing with the bank - along with the revenue it derived from processing those deposits."

"... Faulty data in a negative database can mean false declines. Retailers could be losing perfectly good sales because of bad data - and sometimes they're losing the goodwill of their customers, too." -- Woody Tyner, SVP at BB&T.

"Depending upon the level of sophistication required, retailers generally pay a per-check fee ranging from $.02 to $.20 for verification services. In 1999, retailers paid a total of $86 million for verification of checks totaling $152 billion."

"Check warranty (guarantee) fees run between 0.4 and 5.0 percent of the value of a check. In 1999, retailers paid a total of $200 million to warranty checks totaling $50 billion."

"One national retailer estimates that 25% of the checks that it accepts at POS are tied to a shared financial institution - both the consumer and the retailer have accounts at the same institution. As a result, the funds from these checks are made available to the retailer the same night. Approximately 50% of all checks have a 'one-day float.' The remaining 25% have a 'two-day float.' "

"STAR believes that - within a clear and consistent regulatory landscape - financial institutions, retailers and consumers will embrace real-time check electronification as an important component in the evolving electronic payments system."