Check 21 – Check based payments in transition in the U.S.

December 2006

Mark Gazaleh

WBS / Electronic Business

Check 21 – Check based payments in transition in the U.S.

Technological advances have facilitated the rapid electronic delivery of data and as such provide an important tool for process reengineering and competitive advantage. Some of these advantages of these technologies manifest themselves through advanced electronic imaging, processing and communications technologies. This paper examines a recent legislative change to the United States (U.S.) paper cheque clearingsystem. Cheques,[1]as negotiable instruments, were established in the 17th century in the United Kingdom. Their popularity steadily increased in the past three centuries as they provided secure disbursement of high value sums over (long) distances. With the advent of electronic payment systems and credit/debit cards, the popularity of cheques has peaked. Nevertheless, with over 40 billion cheques written every year, it remains a crucial payment solution in the U.S. economy.

Thelegislative change reviewed in this paper concerns theCheck Clearing for the 21stCentury Act[2](Check 21) of 28 October 2004. This Act has had a significant impact on the workings of the U.S banking sector in that it allows the conversion of paper bank chequesin and out of electronic form. By establishing the legitimacy of the converted cheques, it allows banks to transmit cheques rather that having to transport and process their paper form through the U.S. banking system.[3] These changes provide a huge saving potential to the industry and clients.

This initiative was an unexpected result of the “9-11” terror attacks on the U.S. The ensuing grounding of all aircraft after the attacks ledto a severeliquidity crisis in the U.S. economy. Cheque movements between banks were blocked until aircraft were allowed to fly again overU.S. airspace. The consequences were so severe that the U.S. Federal Reserve Bank had to pump $47 billion (100 times higher than normal) into the economy in order to maintain its banking sector’s liquidity.[4]

The consequences of the Act are likely to be considerable as the check payment market in the U.S., though in decline,remains huge. Approximately 42 billion cheques with a value of $40 trillion are written in the U.S.every year. Chequescontinue to be very popular as they provide convenient and cheap documentary proof of payment. The U.S.’s extended geographical area, the large number of (15,000 local) banks, as well as a lack of a national electronic payment system[5] have continued to makecheques an important mainstay of the U.S. payment system.[6]

Payment services can make up as much as 40% of bank revenues and 30% of costs.[7] It has been estimatedthat a paper cheque costs between US$ 0.07-0.17 to process.[8] Electronic check clearing is expected to lower these costs by 75%.[9] McKinsey & Company estimates that by the end of this decade 80% of these transactions will be completed electronically.[10] Conservative projections show Check 21 processes could yield approximately $2 billion of savings, though requiring an investment of $10 billion over the next 5 years.[11]

The Check 21 Act’s potential to transform current paper-based chequeprocessing has been through its reduction of the legal impediments tocheque truncation. Cheque truncationprovidesthe means by which the data of a particular cheque is carried forward in the cheque collection process while its paper carrier is eliminated from the payment process. The Check 21 Act does not mandate mandatory changes for the financial industry, but it doescreate a new negotiable instrument called asubstitute cheque (a paper print of an electronic image) which has the same legal validity as the original cheque.[12]

It is important to note that Check 21only requires banks to accept substitute cheques presented to them and it does not require them to accept cheques in electronic format or to create substitute cheques.[13]The Act has an intentionally light regulatory touch in order not to swamp banks with new regulations.[14] Banks unprepared for the changes involved by imaged cheque presentment would be accommodated by the fact they would not be forced to send or receive their cheques electronically. However, the Act’s eventual goal is to facilitate an industry-wide shift to electronic cheque exchange without forcing the pace on any particular player in the sector.

Prior to Check 21, a paper cheque would be first deposited at the bank of first deposit (BOFD). This bank then forwards that paper cheque through the collection process in order to receive the funds from the paying bank. The cheque is usually transported by ground and air directly to the paying bank. Check 21 does not fundamental alter this process.

The Check 21’s substitute check process relies muchless heavily on the processing and transportation of the original cheque. For instance, the original cheque could again be deposited at the BOFD, where thechequeis left as is, or is converted to an electronic image. Thereafter thebank would have a choice of sending the physical original, or itssubstitute cheque image for presentment to the paying bank.[15] Thus the transport process envisioned by Check 21, allows for considerable reduction of clearing times. It should be noted that the Act’s establishment of the legitimacy of the substitute cheque is the mean by which it was felt that the whole industry could move to full cheque image exchange. It which case most, if not all, paper cheques could be eliminated from the clearing process.[16]

It is important to note that the Act finds application in almost all contexts of the cheque as a negotiable instrument as many different types of cheques may be processed electronically. As such, Check 21 allows the rapid presentment and clearing of the following:

  • consumer, business and corporatecheques,
  • government warrants and U.S. Treasury cheques,
  • money orders,
  • controlled disbursementcheques, payable through drafts
  • Traveller’scheques.[17]

The advantages of Check 21

The Check 21 system offers considerable advantages to banks and their customers. By processing cheques electronically, substantial costs of handling, sorting and physically transporting chequesmay be minimised. The banks’ cheque clearing process will benefit from fewer touch points[18] (points of mechanical or human interaction with the cheque) which according to studies result in fewer errors, with lower labour and transport costs.[19] Furthermore, a number of geographic issues (distances, terrain, road and air infrastructure) are less of a barrier as clients can connect electronically over long distances.

As theCheck 21 process is completely electronic,an extended business day nowbecomes possible. This offers customers wider deposit windows, earlier deposit times and therefore maximized value on each cheque. Furthermore, banks can gain closer ‘client proximity’ as remote imaging equipment can be located at their client offices.[20] The technology allows banks to provide their customers competitive advantage by increasing revenue value while lowering costs (transport and labour) while literally getting closer to valued clients. Remote access also increases reach as it greatly reduces the cost of maintaining and servicing unmanned bank branches. It is important to note that although banks should receive the depositors’ money faster under Check 21, theywill not be required to deposit this money in their clients’ accounts any faster. Consumer protection groups have argued that the banks could gain additional interest by holding back the future deposits. However, it has been suggested that competitive forces are so fierce in the industry that banks are unlikely to delay the arrival of their clients’ deposits.

Many banks have become aware of the competitive consequences of adapting to the Check 21 initiative. Banks which are unable or unwilling to accept electronic files will have to pay higher costs for substitute cheques and their associated physical transportation. Their competitive position will be further eroded as chequesnumbers decline and their average cost of transportation increases.[21] The non-adopters are likely to be the community banks that lack the resources and expertise to implement Check 21 methodologies. Nevertheless, these smaller players do have the option of outsourcing their requirements to third party solution providers.[22]

Businesses in turn gain advantages from Check 21as the faster clearing of cheque helps optimise cash flow through faster settlement. Companies benefit through faster access to funds and account information. This offers an improvement in risk management with the earlier notification of returned (bounced) cheques. As mentioned earlier, maximum value can be gained from an extended ‘deposit window’. This is when cheques may be deposited as soon as they are available and not when the next scheduled batch is couriered to the bank. There is no need to be located near a bank branch or to incur the risks and cost of transporting the cheques to a bank teller for deposit. [23] Moreover, maximising deposit value has been so compelling for certain businesses that cheque imaging capabilities are now being installed directly at points of sale.[24]

Consumers will benefit from having faster access to deposited funds as well as deposit and account information. They should nevertheless remain wary that the informal “float” (the period between when the cheque is written and paid) will drop from four to two days or even in some cases even to a few hours. They will need to ensure that they have the required funds available in the account before writing a cheque.[25] By comparison, overdraft protectionis currently not as common in the U.S. as it is in the United Kingdom.

The Act leaves much Check 21creation, implementation, interpretation, and up to the industry. For example, there are no predefined substitute cheque / electronic image quality requirements, no specific requirements on how substitute cheques are to be scanned or transmitted, no regulations about when and how to dispose of the original cheques, as well as no guidance on how long to retain the cheque images.[26]

The definition of a Substitute Cheque

The Act sets forth a statutory framework by which the substitute cheque is the legal equivalent of its original paper cheque. Section 3 of the Act states defines the substitute cheque as a paper reproduction of the original chequeif it

  • contains a true imaged copy of the front and back of the original cheque
  • bears a “magnetic ink character recognition line”[27] (MICR) identical to that of the original
  • conforms in paper stock in size and dimension to that industry standard for substitute cheques
  • is suitable for automatic processing just as the original cheque
  • bears the text of “this is a legal copy of your cheque. You can use it in the same way you would use the original cheque.”[28]

Section 3 also defines cheque truncation as one where the original paper cheque is removed from the cheque collection process and it is replaced by the electronic image of the cheque or its substitute cheque.[29] Under prior Uniform Commercial Code[30] and Federal Reserve Regulations – banks wanting to send images of cheques instead of the paper original would have had to agree formally to the exchange agreement. Under the Check 21 Act, these agreements will no longer be necessary.

Implementation – consumer protection

Section 4 of the Act provides guidelines regarding bank endorsements and identification of the reconverting bank, the applicability of Federal and State law, the code of federal regulations and the Uniform Commercial Code, cheque warrantees, indemnity procedures, expedited recredit for improper charges and recredit reversals.[31]

The consumer receives increased protection as the Act establishes expedited recredit procedures for customer accounts in the event of a substitute chequebeing incorrectly charged to an account. A claim may be made for expedited re-crediting within forty days from either the post date of the statement or the date when the substitute cheque was made available, which ever is later.[32] The bank then has ten business days to investigate and resolve a claim for expeditedre-credit. If it cannot be done by the end of the tenth business day, then the amount of the cheque or $2,500 (which ever is less) must be re-credited to the account holder. Any outstanding amount (over the $2,500 amount and with interest) must also be settled within 45 days.[33]

Warranty and indemnification provisions

Section 8sets out procedures against an indemnifying bank for expedited recredit. It specifies exceptions allowed due to emergency conditions, a measure of damages for breach of warranty, a one year statute of limitationand consumer education regarding substitute cheques.[34] The Check 21 Act establishes a warranty structure to protect depository institutions against losses associated with the use of substitute cheques. The warrantee assures recipients that the substitute cheque is as good as the original[35] and no duplicate will be presented for payment or returned.[36]

The depository institution that creates a substitute cheque and each depository bank that subsequently handles it, whether in paper or in electronic form, provide this warrantee. Once a substitute cheque is created, these warranties flow to subsequent parties regardless of whether the substitute cheque remains in substitute cheque form or is converted back to and forth from its electronic form. In brief, any institution that creates or transfers a substitute cheque provides subsequent transferees with indemnification against any losses incurred due to the receipt of a substitute cheque rather than the original cheque.[37]

Customer Notice

The Act requires that depository institutions provide a specific notice about substitute cheques to consumers who may request a copy of a substitute cheque, or receive paid or unpaid substitute cheques in their monthly account statements.[38] The notice must explain that the substitute cheque is the legal equivalent of the original paper chequeand must describe the expedited recredit process.[39]

Other provisions

Section 14 states that any provisions regarding expedited recredit may be varied via agreement between the banks themselves. Sections 16-18 concern reports to be made to Congress regarding developments in the cheque clearing sector and costs attributed to the transport of cheques from the Federal Reserve Bank.[40]

Risks

The changes introduced by theCheck 21 Act brings changes that arenot risk free. The most likely risk is the possibility of cheque forgery and counterfeitingthat remain undetectable in the new cheque-imaged environment. As mentioned earlier, the speed of Check 21 processing will no doubt assist in prevention of some fraud. Banks will know more quickly if a cheque is the result of identity theft or if it is written on a closed account.

Nevertheless, the fraud implications due the poor image quality of the substitute cheque continue to be a matter of concern.[41] Much emphasis has been placed on image quality assurance (IQA). Many in the sector believe that IQA has been over engineered to the point that the issue is now a non-factor. Fraud experts remain unconvinced pointing out thateven domestic laser printers may print higher definition counterfeits (for example, at 600dpi resolution) than the current generation of check scanners could recognise (at 240dpi resolution).[42] Imaging cheques in grey scale or black and white will always be very different than handling its paper equivalent. Given the high volume of cheques in the U.S., increasing the image quality of substitute cheques will considerably stress bandwidth and storage resources. Furthermore,unless image-based fraud becomes a major material issue, increases in image resolution remains unlikely.

Therefore, at least for the time being, banks will no longer be able to rely on the look, feel and smell of the cheques(watermarks, encrypted keys and other cheque marks) to cheque its legitimacy. It is also notable that under the Act the banks are no longer required to keep the original document. In most cases it is destroyed as soon as it is imaged and therefore would not be available should a dispute arise. Additional concerns have been raised about the possibility of fraudsters gaining account access (including access to stored cheque images)for counterfeit purposes and the fact that banks typically only review a small subset of all cheque.[43] For example, many current fraudulent items are written for small amounts as they are more likely to be overlooked by the banks.[44]

In this light, new technology is being implemented on cheques to assist cheque security. These “image survivable technologies” include encrypted machine readable barcodes, digital seals and micro printing. Other design improvements of secure chequesmainly target recognition of cheque copying and tampering. These are listed in greater detail in Annex A. There have also been announcements regarding new fraud detection technologies for the imaged chequeenvironment. A diagram showing the data that is verified on a cheque has been included in Annex C. Some propose a “self authenticating solution”which through data encoding and encryption technology effectively ‘reads’ the surface of the cheque and point out abnormalities (exception) items.[45]

These solutions use pattern matching and recognition technologies to cheque signatures, dates, common cheque stock and payees.[46] Results suggest that these technologies are capable of yielding far lower false positives rates. However, it has been suggested that despite these recent technological advancements, they are still only likely to be deployed on a small subset of overall cheques passing through the system.[47]