ith the near-term passage of the Check 21 Act, the MLS/ISO community will be presented with an unprecedented opportunity to sell, install and maintain check image-capture solutions for more than 40 billion items-four times the current number of credit card transactions in this country. These 40 billion transactions will consist of a mix of consumer, corporate and government checks, which all have different requirements associated with their conversion-from paper to image exchange and settlement.

Merchant Level Salespeople who understand the magnitude of this opportunity will expand their vision from point-of-sale (POS) transactions and start laying the foundation to turn their clients'' payroll checks and vendor and government payments digital. The one industry that has probably given more thought to this transition than any other is the securities industry.

After all, brokers perform their services as agents moving large sums of "other people's money" between investors and investments. In doing so, relative to the dollars transferred, they operate on very thin margins and are forced to manage a wide array of payment risks.

The issues and requirements the securities industry has defined for streamlining funds transfer, which is described in this Securities Industry Association (SIA) white paper, are informative and relevant.

Executive Summary

The document starts with an introduction in the form of a Letter from the Chairperson, Ernest Pittarelli. In the first sentence, it becomes obvious that Pittarelli is addressing a select group because he describes the drivers behind electronic payments for the securities industry as STP/T+1.

For those of you not familiar with this jargon, STP stands for Straight Through Processing, and T+1 is shorthand for an SEC ruling requiring the securities industry to move toward completing stock exchange purchases one business day after the trade is executed. T+1 is pretty straightforward; STP deserves some further explanation.

Imagine a POS transaction where the consumer pockets the change and walks out of the store with the scanned merchandise. When STP comes to your retailer, as the cashier scans the merchandise during checkout, not only does the cash register run a total purchase amount, but the store inventory is reduced for each item sold, and the bar-coded items are aggregated into an electronic purchase order and transmitted to various suppliers for bid.

The retailer's computer uses a set of rules to compare the supplier bids, and generates a purchase order and transmits it to the winner. When the pallets arrive at the loading dock, scanners are used to confirm that the content matches the approved purchase order, inventory is updated, and an electronic payment is authorized for release according to the terms offered by that supplier.

For the securities industry, STP is the execution of a stock transaction without another human being involved past the broker's entry into the order system. With Internet security trades, the broker is taken out of the transaction stream and the trade is taken "straight through" the order, confirmation and settlement stages electronically.

With drivers like STP/T+1, the security industry set forth 10 building blocks, one of which was to "reduce the reliance upon checks and increase the use of alternative means of payment." This white paper was published more than a year ago, before the Check 21 Act was a serious piece of legislation. But even at that stage, the SIA knew that checks weren't going away and that the ACH alternative had serious limitations associated with it. Specifically, this is what Pittarelli referred to in his cover letter as "the NACHA Right of Return Rule."

This is the NACHA regulation that allows a consumer 60 days from the date of authorizing an ACH debit to a checking account to dispute the item and ask the bank to reverse the transaction. This is a major problem for a brokerage house, especially if the stock market slides and the investor takes a serious loss when a bank statement shows the authorization for those 100 shares of K-Mart.

The white paper preceding this version of the Payments Subcommittee report investigated the various advantages and disadvantages of existing forms of retail payment, including ATM debits. The realization surfaced that the paper check was not going away anytime soon and would remain the predominate method of payment for the securities industry into the foreseeable future. The industry concluded that it needed to focus on approaches to improving the security and automation of paper check transactions.

The subcommittee identified the following advantages and disadvantages associated with paper check transactions: Advantages: widely used, familiar, relatively low banking fees, convenient for investors and reliable.

Disadvantages: fraud exposure, uncertainty of funds availability timing, mail delays, inherent manual process that increases risk and costs, along with the extension of credit during the settlement process under T+1 conditions. This white paper also detailed concerns associated with ACH as an alternative to checks. They included the following:

• NACHA's 60 Day Right of Return rule, which was originally intended to protect consumers over unauthorized transactions. This rule represents a major exposure increase for the securities industry relative to the finality of settlement afforded checks under the UCC body of law.
• Credit and debit cards also provide cardholders with similar protections and rights of reversal.
• Appeals by the securities industry to the NACHA rule-making committee for exceptions to the 60 Day Right of Return rule were not successful.
• ACH, ATM and wire transfers represent very small portions of the current security transactions; changing consumer behavior to adopt these methods of payment, even if they were able to overcome the settlement risk issues, were felt to be unrealistic in the near term.

High Value to the Broker/Dealer:

• Finality of payment
• Funds availability by settlement date
• Notification of payment on transaction date
• Guarantee of payment on transaction date

• Ubiquity
• Ease and convenience of executing payment
• Low cost
• Secure and reliable
• Ability to handle large dollar amounts for security transactions

More recent SIA documents1 contain further details on the mix of payments and the Check 21 Act. The significance of this legislation is greatest to the Securities Industry for its ability to satisfy STP/T+1 requirements in a manner that is transparent to the investor community. It now seems clear that finality of funds transfer in a short settlement window will provide the investment ROI needed to deploy check image capture technology at all of the endpoints where checks first enter a broker/dealer's operation. It looks like the starting gun has gone off in the race to build out the infrastructure for converting paper checks into digital images.

Excerpts from this White Paper

• The survey results indicate there has been a small decline in checks in favor of electronic payments such as ACH and wired funds. All of these results are encouraging, but there is still a long way to go. The U.S. needs to catch up with many of its European and Asian counterparts.
• As of 1997, check usage in the United Kingdom amounted to 31% of non-cash payments usage; the respective figure for Japan was a mere 7%. Contrast these figures with the U.S. with a 70% check usage at the same time. While a number of factors accounted for these differences in the level of check usage, we tended to underestimate the size of the hurdles confronting a shift away from checks.
• The most significant disadvantage of using the ATM networks is that the client's financial institution on trade date may not guarantee finality of the ATM Pull Debit transactions, while the other ATM transaction types are considered final. Barriers to implementation of ATM transactions include:
  • Obtaining buy-in from ATM network vendors and financial institutions. A significant majority of financial institutions and networks may choose not to participate or may choose to participate at different times; hence critical mass may not be achieved. There may not be enough network providers electing to participate to cover the U.S.
  • The ATM Network Initiatives working group is still conducting research to understand the rules and regulations that apply to the three SIA transaction types. Additional network rules may need to be developed. All ATM network vendors may not agree on recommended rule changes.
  • Potential costs to implement this product have not been estimated. High potential costs may prohibit adoption of this initiative.

Best Practices for Risk Management of Retail Payments: Ultimately, each broker/dealer must determine which payment method(s) is appropriate based on the level of risk that is acceptable to them. Each payment method is associated with a unique set of risks, and these risks should help determine how that payment method should be developed and managed. Those risk categories include:

• Risk of Fraud: the risk that a wrongful or criminal deception will lead to financial loss for the parties involved
• Operational Risk: the risk that deficiencies in system and internal controls will result in financial loss
• Settlement Risk: a general term used to describe the risk that settlement will not take place as expected
• Liquidity Risk: the uncertainty that a counter party cannot settle its obligations in full by the due date
• Credit Risk: the risk that the counter party will be unable to settle its obligation in full at any time
• Legal Risk: the risk of loss because a contract cannot be enforced

Web Sites for More Information on the Securities Industry Perspective on Electronic Payments

www.sia.com/stp/pdf/paymentsystems.pdf

T+1 Payments Committee White Paper, Version 2.0, May 1, 2000, Securities Industry Association. Projected implications for broker / dealer migration from Trade Date Plus Three (T+3) settlement cycle to T+1 and the required changes in technology (batch vs. real time) as well as client behavior and perspective.

www.sia.com/stpspring03/pdf/Payments.SubPart1.pdf

STP Payments Sub-Committee Presentation, Spring 2003. This slide deck contains an update on the industry understanding of payment mix and new electronic options to checks. The mix of inbound (75% checks) payments and outbound (85% checks) payments further re-enforced the fact that a solution to checks would have to be transparent to the investor, if it was going to come in time for STP/T+1. Closing slides describe the Check Truncation (Check 21 Act) as the best payment alternative available to the industry.

www.financialcounsel.com/News/Economics/SIA/SIA-1002.pdf

Research Reports, Vol. III No. 9, October, 25, 2002, "The Future of Straight Through Processing," Judith Chase, VP and Director Securities Research, page 26.

www.evalucheck.com

A creative mix of technologies that offer immediate advantages over traditional check payments while also containing the features needed to migrate into Check 21 image settlement once this legislation goes into effect. It's also an Internet payment option worth exploring for B2B and C2B transaction categories.

Research Report: Securities Industry Association (SIA) Payments Processing White Paper Update

Authors: SIA STP Payments Processing Sub-Committee

Date: August 2002

Size: 59 pages

Relevance Rating: Medium-High

Web Address: www.sia.com/stp/pdf/Payments_White_Paper_v3.6_082902.PDF

Eric Thomson is Executive Vice President of Profit Source Advisors. He can be reached at eric.thomson@profitsource.us