In this video, we'll continue our examination of existing payment practices by looking at the modern equivalent of the paper-based checking system. The Automated Clearing House, ACH for short, has by and large replaced the checking system as the dominant form of high value non time-critical payments in the United States and in most countries, as a recent study by the Federal Reserve has shown. Similar to a bank wire it's a secure electronic messaging system and similar to checks, it allows transactions to be initiated by either the sender or the receiver. Even if you haven't heard about ACH, chances are that you have used it. Every time you have used direct deposit of your paycheck, every time you used a bank account to pay your utility bills online, and critically for this course, every time you used a new payment apps, such as the PayPal and Venmo. And that's the reason we need to talk about it, because despite being a quote-unquote legacy system, it is really the bedrock upon which a lot of the new pay tech Innovations are built. So let's take a look at its technical underpinnings and then connect them to the new Innovations in the next couple of videos. Let's start with the five party graph that we used to illustrate the checking system. I make a few modifications. First, let's get rid of the paper check. I replace it with the computer. Then we'll give some proper terminology to the banks. The sender's bank is called originating depository financial institution, or ODFI for short, and the receiver's bank is called the receiving depository financial institution, or RDFI. Finally, the paper check writing system is replaced by an electronic communications network. Think about the postal mail replaced by email and you get the picture. The ACH network is usually operated by central banks and in the US Is run by both the Federal Reserve and by a private company called the Clearing House. Again, think about the ACH network as something like a messaging app to exchange secure payment-related messages between banks. Now, let's do a quick transaction and transfer some money. If you have used the system, you'll see something similar to this form on your bank's website. You'll need to fill in some basic information, like how much you're paying, and the receiver's bank information, their routing and account numbers, and this information is then gathered into a payment request and transmitted to your bank's server. Remember, this request can go both ways. So if you have used online bill pay, for example with your credit card company to pay off your credit card every month, you're sending your bank information to the receiver and give them the authorization to generate the payment request on your behalf, and they transmit the request to your bank. Either way, the request ends up in the ODFI server. After the OFDI gets the request, you will conduct some standard intermediation tasks, like authenticating the account, making sure the request is authorized, and there's enough money to make the transfer. After this, the bank will use the payment request information to generate a standard text message file, like this. This is the ACH file consisting of all the relevant identifiers and amounts. It's in a standardized format so all banks computers can easily read them. This text file is the information that will be transmitted over the ACH network to the receiver's bank, the RDFI. The bank will then identify the receiving account, and that's when as a receiver you'll get a notification that you have some money coming. This completes the information flow of this transaction and it happens fairly quickly. As you'll see shortly, it's not instantaneous, but is usually done within the same day. And because everything is electronic, there's no paper checks to be routed, so settlement, the actual money flow, can also occur much quicker, either on the same day or within a couple of days. Now, let's think about the primary advantages of the ACH system compared to the checking system. The most obvious advantage is that it really cuts down the time lag between the information flow and the money flow. In the paper checking system, the information flow is limited by the physical speed that the checks can move. In the ACH network, the information flows digitally. This would both significantly increase the settlement speed and cut down potential fraud. The other advantage is cost. The system is really cheap to use. The average cost per transaction is a fraction of a penny. And this low cost is due to the fact that communications in the system is not done in real-time but in a batch process. Think about it, there are millions and millions of transactions every day between a vast number of different parties. If every transaction has to be sent through right away, the demand on the communications infrastructure will be really high and the cost would consequently be much higher. A bank wire is like an ACH but a real-time messaging system and that's why it costs so much more money to send wire. By contrast, the banks would not send each ACH message through as they receive them. Instead, they would put them in a queue and only send them twice a day at predetermined times. For example, at 10:30 a.m and 2:45 p.m all text files in the queue gets compressed into one zipped file and sent all at once. Because of this, instead of hundreds of millions of unpredictable messages over the entire day, the network only transmits hundreds of thousands of messages at predictable times each day. This really cuts down the infrastructure requirement for the network and that's why so cheap to use. The low cost of ACH will be a primary reason why most fintech innovators choose to build upon this system. Now, let's think about it's limitations. Let me ask you this question. When is the last time you remembered somebody's bank routing and account numbers? Exactly. Despite the good infrastructure at the back end, the main drawback of the ACH is that it's not very easy to use. The user identifiers, these numbers, take a long time to retrieve and each bank and each receiving merchant usually have their own different user interface, and some of them are not very intuitive and user-friendly. All of this add-on to the learning curve of the end-user thereby discouraging them from using it frequently in the first place, and that's precisely the market positioning of most PayTech innovators in this space. They're taking this good but not user-friendly infrastructure, like ACH, built their own user-friendly interface on top of it, so that the users would tap into the ACH more frequently without even realizing they're using it. Therefore, the main value proposition of the PayTech innovators is that instead of spending all that money to build an alternative communications infrastructure and taking all the risks of converting enough people to it, let's do what we do best. We're tech companies, so naturally, we have a lot more experience designing apps and good user interfaces than banks who are better at building the actual payment infrastructure. So let's build an easy-to-use interface that the consumers like and just plug it in to the existing payment infrastructure. Essentially, a lot of the paycheck innovations involve building good wrappers around existing solutions, like the ACH, to make them easier to use. That is the connection between PayTech and existing tech. So what kind of wrappers? As an example, how about user identifiers? Because no one would remember a hundred routing and account numbers of their friends, let's replace those with something that they already have on their phones, their friend's phone numbers and email addresses. Another example, because it's often cumbersome to use bank-level authentication methods, like micro deposits, let's replace that with biometric authentication that we can already access with the fingertip on our phone. The end user fills in information using these easier identifiers and authentication methods, the PayTech app would take these information, convert them back into a format that's compatible with the existing solutions, like a standard ACH payment request, and then just forward it along the existing payment rails. And these wrappers are often called digital wallets. There are three main flavors that we'll discuss sequentially over the next three videos. The first flavor, the pure digital wallet, does just that. It rides on the ACH payment rail to send and receive money. The second variant is the more hybrid version that does more than just payments. They also use existing payment rails but to channel money between different types of accounts, like loans and Investments, therefore enable users to do more than just payments in a single app. In the last variant, the wrapper is the social network. User identifiers are their names and handles on the social network and payments enable an additional dimension of communication between the network users.
