The US interbank payments ecosystem

Interbank payments ecosystem is extremely complex and involves a lot of moving parts that most of us (even those in payments), never encounter.
By the end of this article you will better understand how banks communicate with one another, what do those communication channel look like and how do funds get settled depending on the channel.

Definitions and terms.

This is the 3rd draft and after failing the first 2, I have realized that we have to start with making sure you understand all parties involved. Trust me, each piece is important.

ACH - Automated Clearing House is a payment processing network that’s used to send money electronically between banks in the United States. It is ultimately a payment rail that is processed by FedACH and TCH (technically by EPN).
A payment rail means that it carries a message to an operator (you’ll learn about them in just a second) containing information on the payment: how much, who is the sender, who is the receiver, which banks are involved etc.

TCH - The Clearing House is a banking association and privately held payments company. It is owned by 20 of the world’s largest commercial banks. It is an association that processes payments for a number of rails like ACH, RTP and Wire.

EPN - Electronic Payment Network. This network belongs to TCH and is the only private operator of ACH, being the one of the two operators processing ACH transactions. This means that almost half of the ACH transactions are routed through EPN.

FedACH - aka the Federal Reserve is the second operator of ACH transactions, processing the rest of ACH transactions. I’ll go into the difference between EPN and FedACH later in this article.

RTP - is a payment processing network that allow participants to send funds between US banks instantaneously. All RTP transactions are processed through TCH.

CHIPS - The Clearing House Interbank Payments System, it is the largest private USD clearing system for wire transfers. And yes it is also held by the TCH.

FedWire - public sector counterpart to CHIPS. The main difference between FedWire and CHIPS is that FedWire is not a netting engine. This means that it doesn’t batch transactions like CHIPS does, which in turn means faster settlement but more transactions and at a higher cost. This also means that FedWire uses RTGS which I’ll cover in a second.

FedNow - same as RTP, it is a network that allows participants to send instant payments. It is owned and operated by the public sector in the form of the Federal Reserve. It is the newest instant payment rail added in the US, going live in 2023.

RTGS - Real-Time Gross Settlement is a system for inter-bank payments where transactions are processed and settled near-instantly rather than in the batching format (like CHIPS). This is NOT a payment rail like RTP or Zelle or ACH - it is a settlement system.

DNS - Deferred Net Settlement is a system that is the direct opposite of RTGS from above. It settles payments on the backend in batches which are frequently netted.
For example, CHIPS is using DNS system which means that it aggregates multiple payments into one. If bank XYZ sends $10 to bank BIT and the same day, bank BIT sends bank XYZ $5, there will be just one transaction though DNS: from bank XYZ to bank BIT totaling $5.

Here is a duck to show you my appreciation for making it this far!

This is chaos and this is exactly why I have sat down to sort this all down and write it in (hopefully) simple terms. If I can explain it well, it means I understand it well so good fingers crossed!

Summary of all the above.

All of the above are a mixture of individual payment rails, operators and settlement systems. Let’s organize them in the buckets.

Payment rails: ACH, RTP, FedNow, Wire. These are the customer-facing inter-bank (bank to bank) payment rails that actually see the touch of a live human being. If you are sending a payment to your landlord through your bank - most likely you are using an ACH. Receiving an instant payment to your bank account from your employer - most likely you’re using RTP or push to card. Payment rails define how payments are initiated (RTGS or DNS) who clears them (which operator below) and how they get settled (FedWire or CHIPS).

Operators: FedACH, EPN, TCH, Federal Reserve. These are the controllers, the rule-setters, the bookkeepers, the watchers.
In less dramatic words, they pass instructions regarding payments initiated by one of the rails above and make sure the money ends up where it’s supposed to.
You encounter these operators almost every time you send a payment but you will not be reaching out to their customer support if your payment doesn’t arrive on time. The bank or another Financial Institution might, but that is none of your concern. Just think of them as shadowy figures sitting behind any bank transaction you initiate and making sure your money arrives where intended.

Settlement systems: Fedwire, CHIPS, RTGS and DNS. These are the systems that make sure that banks pay each other at the end of the day (DNS) or right away (RTGS). Using the directions from the payment rails that are enforced by the Operators, they make the final push of funds to the correct bank after all the front end has been handled.

Here is the flow of these three buckets.

 

Three layers involved into any inter-bank transaction. This is still ugly but the diagram was made by ChatGPT. I do still hate AI in creative spaces but give me a break I hate making diagrams.

Full Fund Flow Example.

You, just like most Americans (myself included) are about to pay rent. You most likely have the autopay enabled that takes money from your bank account and makes them disappear into ether. Here is where your hard-earned money goes at each step.

Step 1: the landlord initiates the pull of $3,000 from your connected bank account.
It’s time to choose the payment rail to be used. Since it’s a pull transaction, they can’t use an instant rail so the transaction goes through ACH. Payment rail has been selected.

Step 2: the funds are being drawn from your bank account. The system identifies the correct operator to utilize for the transaction. Since it’s an ACH, the choices of the operator are FedACH or EPN. Since you bank with JPM Chase and your landlord banks with Bank of America, the system chooses EPN. Operator has been selected.

Step 3: JPM Chase and BofA update their ledgers. Chase’s core, using the information passed via ACH, records that you now have $3,000 less in your account (debit) and BofA, using the same information from the ACH transaction, records that your landlord has an extra $3,000 in their account (credit).

Step 4: operator (in this case EPN) performs their magic. They route the transaction from your account to the landlord. In the system, it is marked that Chase owes BofA that $3,000. This is clearing that is necessary for settlement.

Step 5: settlement. The settlement system used will be DNS since ACH is operating through batches. This means that millions of other ACH payments will be bundled and netted.
The final count of which banks owes which bank how much will be performed by the operators. In this case, it will be EPN. At the end of the day, Chase might owe BofA a total of $3 billion while BofA owes Chase a total of $5 billion.
CHIPS will net it out and push the difference of $2 billion to Chase. Below is the visual of how it looks like.

 

How DNS (Deferred Net Settlement) system works in practice. By the quality of the visual you can tell I put it together myself.

Step 6: ah damn you’ve been duped. Your money never left your bank and yet you paid that $2 charge for the ACH that was pulled. Magic of the banking system. At least now you and I better understand the inner-workings of this system.

Hopefully this all makes some sense now. But to add some more clarity, I’ve decided to further break down some rails, clearing houses and settling systems.

RTGS VS DNS.

In simple terms, RTGS is a system of processing transactions instantly while DNS is processing them in batches and netting the end results. You can read more about batching here.
DNS: slow, reducing total volume of settling by netting the transactions and therefore it is cheaper to operate.

RTGS: instant processing and near instant settlements, no batching, fast and therefore more expensive to operate.

An important thing to remember here is that both RTGS and DNS are just the settlement mechanisms that covers multiple customer facing rails like RTP and FedWire and ACH.

EPN VS FedACH

There is virtually no difference between these operators except that one (EPN) is privately held by a banking association through TCH. The consumer does not care one bit which operator will process their transaction. There is no difference in speed of funds clearing or the transaction cost.

The routing to each operator’s clearing house is made based on the banks involved in the ACH transaction. If the transaction is performed by one of the US major banks, chances are, it’s routed through EPN. If smaller banks or local credit unions are involved, FedACH picks it up.

This really doesn’t make much of a difference in anyone’s day to day operations, but I think this is interesting information to know.

RTP VS FedNow

First of all, these are both instant payment rails that are, in fact, rails. They both are operating 24/7 364 days and both settle nearly instantly. They only differ in that RTP is operated by TCH and has far greater adoption rate (~83% of DDAs) opposed to FedNow (~30% of DDAs) that is operated by the Fed.
The other difference is per-transaction limit imposed by each rail: RTP’s limit is $10,000,000 per transaction and FedNow is limited to $500,000. They are also priced at almost the same rate.

Both of these are customer-facing unlike FedACH, EPN, TCH or FedWire. They sit in your bank, your investment app, your savings app, your early pay app etc. Even though frequently you won’t know which rail is used, you will still actively interact with it.

Wrap Up.

I have tried to go further in some of the explanations but this is becoming a bit too crowded and adds confusion rather than clarifies the subject. I am also tired of writing about interbank payments ecosystem.
Therefore, this is as good of a place as any to wrap it all up. Hope you enjoyed this article!

This article has been originally created for my SubStack that you can follow for all my writing about payments here: https://aftfinance.substack.com/

Documentation.

First and foremost, I have to give a massive shoutout to Modern Treasury. They have a massive number of extremely well-written documentation and remain to be amongst my primary learning sources.
Of course, not as well-written as some of my articles but credit where credit is due. You can check out their learning materials here.

Here is a very useful course issued by FedNow on instant payments. You can access it completely for free and it’s provided by the Federal Reserve so it’s obviously skewed towards FedNow but provides useful information nonetheless.

You can find the list of all the participating financial institutions in the RTP network here.