he Federal Reserve Bank has long been a serious observer of the intrusion of third parties into the payments territory-especially nonbanks. This updated research report summarizes perceived risks associated with emerging methods of payment created by the growing participation of nonbanks in our country's payment network.

Early in my career, I was responsible for R&D at Visa. In one of my assignments there, I prepared supporting evidence for Visa's position (typically against the Federal Reserve) in lobbying Congress for guidelines within the original Electronic Funds Transfer Act.

Through this experience, I gained appreciation for the Federal Reserve's power to virtually "darken the skies" with planeloads of PhD's in order to overwhelm the legislative process with evidence supporting the central bank's position.

For this reason, I have always found it important to understand the Federal Reserve's areas of concern. This report does a very good job of setting forth these concerns relative to the role of nonbanks in our payments system.

Executive Summary

This research report systematically describes the various retail payment transaction types, the leading nonbank participants, where they enter the transaction settlement process and the various risk factors they represent to the funds transfer activity occurring in our country.

While this report deserves your download and review, the remainder of this document will serve to summarize three major activities through which each payment transaction moves, the components of risk a federal regulator is concerned about and the extent to which nonbanks participate in 28 retail payment types.

Nonbank Payment Activities

The report lists and defines three different activities (authorization, processing and instrument provision) and the major nonbanks that dominate these activities today:

Authorization

• Check Authorization Vendors - eFunds, TeleCheck
• Fraud System Vendors - Thomson Financial, Bridger Systems
• Online Transaction Security - Baltimore Technologies
• Certificate Authorities - VeriSign, iTrust, Identrus
• Authorization ISOs - Heartland Payment Systems, Cardservice International

• Hardware Providers - Diebold, Hypercom, NCR, Oberthur
• Software Providers - Fiserv, S1 Corp.
• Core Data Processors - Fiserv, Alltel, Jack Henry & Assoc.
• Check Outsourcers - Fiserv, Electronic Data Systems (EDS), Metavante
• In-House Remittance Processors - GE Capital, American Express, State Farm
• Remittance/Lockbox Processors - Regulus, Remitco
• Check Clearing Houses - WesPay, The Clearing House/SVPCo
• Check Archive Services - ViewPointe
• Payroll Service Providers - Automatic Data Processing (ADP), Ceridian, Paychex
• ACH Outsourcers - Fiserv, EDS, Metavante, CheckFree
• ACH Operators - Electronic Payments Network (EPN), Visa
• Card Issuer Processors - First Data, TSYS
• Card Merchant Processors - First Data, Concord EFS
• Credit Card Networks - Visa, MasterCard, American Express
• EFT Networks - Concord EFS/STAR, First Data/NYCE, Visa, MasterCard
• ATM ISOs - eFunds, E*TRADE, American Express
• EBT Service Providers - eFunds, Lockheed Martin
• EDI VANs - Sterling Commerce, Harbringer Corp.
• EIPP Service Providers - Bottomline Technologies
• Internet Banking Platform Providers - Digital Insight, Metavante
• EBPP Service Providers - CheckFree, Metavante, Princeton eCom
• P2P Internet Payment Providers - PayPal, Western Union
• Retail Wire Services - Western Union, Travelers Express/MoneyGram
• Check Cashing Services - ACE Cash Express, Pay-O-Matic Instrument Provision
• General Purpose Credit Card Issuers - American Express, Discover, Diners Club
• Private Label Credit Card Issuers - Sears, Chevron, GE Capital
• Debit Card Issuers - ExxonMobil
• Stored Value Card Issuers - Stored Value Systems
• Money Orders - U.S. Postal Service, Travelers Express/MoneyGram

Below I have summarized and defined the different categories of risk with which the Federal Reserve is most concerned. Many of these risks are interrelated and problematic in their degree and severity.

The Federal Reserve Bank is responsible for monitoring and minimizing the amount of risk and its potential for disrupting commerce in the United States through its regulation of the banks; the banks own the right to effect funds transfer settlement between the buyer and seller-no matter which payment option is in use for any single transaction.

Systemic Risk

Failure by one party in a payment system will lead to failure of other parties in the system; this will have a domino effect that may be transmitted to other parts of the economy. The primary sources of this risk category lie in large dollar transfer networks such as the Fedwire and CHIPS. Globally, the Bank for International Settlements monitors this category of risk.

System-Wide Risk In the event of a shock or disaster, situations in which the amounts transferred through a payment system are too small to have repercussions throughout other parts of the financial network but could be very disruptive to an individual payment category.

For example, the 9/11 terrorist attacks resulted in airports closing, which threatened check clearing nationally.

Settlement Risk

Final settlement fails to occur, leading to financial loss for other members of the payment stream. If settlement failures are widespread, systemic or system-wide losses can arise.

The unwinding of financial obligations can occur if there is a settlement failure in a net settlement system. This risk applies to netting systems in which only the net financial difference after all offsetting transactions has been deducted.

A party to a transaction is unable to meet its financial obligations either when due or at any time in the future.

A party will have insufficient funds to meet its obligations when due, although it may be able to do so at some time in the future.

The risk that hardware or software problems, human error or fraud will cause a malfunction that leads to financial exposure and possible loss. The complexity and rapid expansion of new payment methods have brought increasing numbers of nonbank participants into the payments infrastructure of the United States. Consequently, operational risk has become a growing concern to the Federal Reserve.

By taking a closer look at this risk category, we can identify two sub-categories:

Bilateral Risk

What banks (and nonbanks) take on when they decide to outsource functions to a third party. The dependence on this entity translates into a point of vulnerability for an expanding numbers of payment entities.

Legal Risk

Represents another variation of operational risk caused by poor contract language; or uncertainties that provide the basis for delayed settlement between trading partners. The number of entities and their blurred roles lead to a condition in which liability uncertainty arises.

Major Retail Transaction Types

The report more closely examines the different levels of operational risk exposure that exist in various retail payments. The authors classify 28 different payment types into five broad categories: Check, ACH, Credit Card, Debit Card and Retail Wire Services.

By using color-coding in diagrams, the authors isolate functions typically carried out by nonbanks. If you are not familiar with the sequence of steps leading up to settlement for any of the following payment transaction types, I recommend you download the source document.

Nonbank Roles in Traditional Payment Types

• Check
  »POS (with or without Truncation)
  »Lockbox (Bank or Nonbank as Processor)
• ACH
• Credit Card/Off-line Debit Card
  »Card Present (Visa/MC or First Data Networks)
  »Card Not Present
• Online Debit Card (PIN-based)
• Retail Wire Services (Western Union) Nonbank Roles in Emerging Payment Type
• Check Conversion
  »POS (ACH or EFT)
  »Visa (In Network or Out of Network)
  »Lockbox (Bank or Nonbank as Processor)
• EBPP
  »Biller Direct
  »Consolidator
  »Lockbox
• EIPP
  »Consolidator
• P2P
  »PayPal (Sending or Receiving)
  »Western Union MoneyZap
• Stored Value
  »Single Purpose (Sale or Redemption)
  »Multipurpose
  » »ACH Infrastructure - EBT
  » »Credit Card Infrastructure (Visa Buxx/Payroll Card)