Chapter

6 Some Aspects of Debit and Credit Transfers

Author(s):
Omotunde Johnson, Jean-Marc Destresse, Nicholas Roberts, Mark Swinburne, Tonny Lybek, and Richard Abrams
Published Date:
March 1998
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This chapter discusses certain essential characteristics of debit and credit transfers, from a legal vantage point, with examples from a number of countries.

Credit and Debit Transfer Systems Contrasted

Credit transfer systems are normally simpler operationally than debit transfer systems. A credit transfer is similar in structure to a direct transfer of cash from payer to payee, except that it uses the mechanism of bank accounts. A credit transfer begins with the delivery of the payment instruction by the payer to the payer’s bank, and so it is not usually suitable for direct dealings between the payer and the payee. A credit transfer is particularly useful if the payee requires final payment before delivering goods or taking other action. Because the payer and its bank and subsequent banks are transferring funds that they possess, or that they can determine whether or not they possess, there is no need for credit. Also, in comparison with a debit transfer, there is less need for a return mechanism, and final, unconditional payment can occur earlier in the process. For these reasons, credit transfers have become the choice for speedy, secure large-value transfers.

In contrast, a debit transfer such as a check begins with the delivery of the payment instruction by the payer to the payee, but the payment is conditional until after the payment instruction has been transferred by the payee, usually through intermediaries, to the payer’s bank, and the payer’s bank has determined to pay the instruction rather than return it. Despite the delay in final payment and the risk of nonpayment, credit is often given by the payee to the payer based on receipt of the payment instruction. Similarly, the payee’s bank may give credit to the payee (that is, availability) based on receipt of the payment instruction, or it may only make funds available to the payee based on the expected time it takes to learn of nonpayment.

Debit transfer systems usually operate on the principle that “no news is good news”: notice of payment is not given by the payer’s bank to the payee’s bank; only notice of nonpayment is given. Despite the encouragement to take on credit risk and the uncertainty for the payee about when payment has occurred, debit transfers have predominated in certain countries as the means of payment other than cash because of the payer’s and the payee’s desire to exchange something tangible in lieu of cash or legal tender, and because a paper debit transfer instruction is flexible enough to be used anywhere.

Debit Transfers

Paper debit transfers originally were used by merchants primarily for international payments (a “bill of exchange”). Check law developed as checks (a particular form of “bill of exchange”) became widely used in domestic commerce. Electronic debit transfers have some of the legal characteristics of checks.

Differences Among Debit Transfer System Rules

Because of their relative complexity, debit transfer system rules exhibit greater variability than credit transfer system rules. Debit transfer system rules provide rights of recovery against a party transferring a payment instruction in order to encourage acceptance and provide some assurance to the payer or its bank in making ultimate payment. However, the payer or its bank usually retains the ultimate responsibility for authenticating the payment instruction and determining whether payment is proper in a paper debit transfer system. An electronic debit transfer system, in contrast, must provide a guarantee to the payer’s bank that the instruction is authorized, because the payer’s bank has no signature to authenticate.

The allocation of responsibility for authentication of a payment instruction is an example of the choices to be made in framing laws or rules to support a debit transfer system. Placing the responsibility on the payer or its bank in the check system is often justified on the basis that the payer or its bank is in the best position to detect a forgery because it is expected to know the payer’s signature. However, a possible alternative justification is that finality of payment is promoted by such a rule.47 If payment by the payer or its bank is final a short time after receipt of the payment instruction, the payee’s bank may make funds available to the payee earlier and with less risk than would be the case if the payer’s bank were permitted to recover payment and upset a series of commercial transactions at a later date when a forgery is discovered. The advantages of such a rule to the payee and the payee’s bank outweigh the disadvantages to the payer’s bank (which, of course, acts as the payee’s bank with respect to other checks). It is commonly understood that the payer’s bank will not, in fact, attempt or be able to authenticate each and every check, but will assume the risk of payer forgery in many cases. Normally, the payer’s bank may recover final payment of a forged check only directly from the payee, unless the payee took the check in good faith and for value, or from a party that participated in the forgery.

Another example of the choices to be made in supporting a debit transfer system is whether the payer is permitted to prevent final payment, such as by failing to provide sufficient funds or by countermanding payment. If the payer is permitted a change of mind with impunity, the payment instruction becomes more conditional and thereby riskier to those accepting it.

These choices are made differently in different countries. In the United States, for example, the law generally requires the payer’s bank to authenticate a check and determine whether to pay within a strict time limit, and requires the payee’s bank to make funds available to the payee within specified times. This benefits the payee. In contrast, the payer has a generally unrestricted right to stop payment of a check drawn on the payer’s account, and a check may also be returned by the payer’s bank for insufficient funds. The payee cannot enforce payment against the payer’s bank even if there are sufficient funds but may only recover against the payer itself if a check is not paid. As a result, up to 1 percent of checks are returned unpaid, and payees must attempt to limit their risk by obtaining information on payers’ check-writing history and by other means. The rules relating to electronic debit transfers, which are used for preauthorized bill payments, have many similarities to check rules.

The conditional nature of checks introduces risks for payees and their banks, but checks still predominate for noncash payments in the United States. The payer receives a financial advantage from delays associated with payment, which it does not have in a preauthorized electronic debit transfer system or in credit systems. Most other industrial countries impose greater restrictions than the United States on the payer, with respect to checks.

Check law in continental European countries from Norway to Turkey and in Japan, Mexico, and Ecuador is based on the model of the Geneva Convention of 1931, which grew out of the League of Nations.48 That convention reflected the civil law approach of continental legal systems. Under these laws, the payer does not generally have a right to stop payment until after the time limit for presentment, which is generally eight days, and may bear the risk of loss if a check is lost or stolen and the payee’s endorsement is forged.

Some countries have adopted additional restrictions intended to make checks more likely to be paid. For example, in Japan, where checks are used primarily for business payments, banks must suspend transactions for two years with a customer that dishonors checks twice within a six-month period. In France, where checks are widely used, persons writing checks with insufficient funds are prohibited from using checks for up to ten years if the checks are not paid by the payer. A national database reports on prohibited payers and lost and stolen checks. As another example, in Vietnam, which is in the process of adopting a check law based on the Geneva model, a party must verify the identification number of the prior party on a check, and a payee may compel the payer’s bank to pay if the payer’s account has sufficient funds.

The effort to improve efficiency in the check collection system by transmitting check information electronically between the payee and payer banks, instead of transporting checks physically to the payer for payment (a process sometimes called “truncation” of a check), is successful only if an acceptable method is found to reduce or shift to another party the payer bank’s risk that the debit, if made on the basis of an electronic message, is not authorized by the payer. Without a means of reducing this risk to the payer’s bank, truncation has been limited to small-value checks in many countries, such as Germany, Spain, and the United States. However, the Eurocheque system incorporates successful risk reduction procedures that permit these checks to be truncated and sent to the payer’s bank throughout Europe by electronic debit transfer. Authentication responsibility for Eurocheques is placed on the payee. A Eurocheque is guaranteed to be paid by the payer’s bank on the condition that the payee compares the payer’s signature and other information on the check with the signature and other information on the Eurocheque card exhibited by the payer to the payee. Because the guarantee is conditional, the Eurocheque is still a conditional means of payment. Acceptance of a Eurocheque by the payee does not discharge (or finally pay) the underlying obligation of the payer; discharge occurs only when the Eurocheque is finally paid.

An electronic debit transfer system differs from a check system in that the payer’s bank does not in many cases have a means, such as a signature, of authenticating the payer’s electronic instruction. In such cases, the payer’s bank must rely on a guarantee by the payee and its bank that the instruction is authorized by the payer. Usually, to support this guarantee, the payee requires the payer to provide written authorization to initiate the electronic instruction. Because obtaining written authorization is cumbersome for a single transaction, preauthorized electronic debit transfers are used primarily for recurring payments, such as payment of monthly utility bills. Preauthorized electronic debit transfers are also used primarily for small-value payments, because the payer’s bank is reluctant to rely on another person’s guarantee of authenticity to debit the payer’s account for a large-value transfer. As with checks, a preauthorized electronic debit transfer is a conditional payment, and the payer may be able to stop payment or may have insufficient funds to cover payment.

Electronic debit transfer systems may in some cases provide a secure means for the payer’s bank to authenticate electronically the payer’s instruction when received. Examples are debit card systems and systems that use “digital signatures.” A debit card system has attributes of both a debit transfer system and a credit transfer system. Because the payee sends the instruction through its own bank’s system for authentication and settlement by the payer’s bank, it resembles a debit transfer system. Because the payer’s bank may authenticate the instruction before the transaction is processed, it also resembles a credit transfer system. From the point of view of efficiency, an electronic debit card system has many advantages over a check system, but it does not have the flexibility of use of a check system because it generally requires on-line authentication.

Variability of Rules

To the extent that paper debit transfer systems permit transfer of the payment instrument to other parties besides the payer and the payee and their banks, the rules must balance the rights and obligations of many parties whose self-interest often is in conflict. The rules must be widely understood and not subject to rapid change if such a system is to be trusted and widely used. As a result, paper debit transfer system rules are usually found in a statute of general applicability, rather than in agreements among parties or in a regulation of a government authority.

While stability of commercial law is important, particularly for payers and payees, it may also inhibit experimentation and development. Statutes usually are not amended easily or rapidly. To permit experimentation and evolution of payment rules, a statute may permit individual participants to vary the rules by agreement among themselves. For example, clearinghouses—groups of banks that exchange payments among themselves—often adopt agreements (rules) that are binding on the members. If the statute permits, the clearinghouse rules may differ from the statute on matters such as times and means of settlement or other matters.

A controversial issue is whether the statute should permit these private agreements to be binding on other parties and affect their rights. In the United States, for example, the check statute (which is a set of generally uniform statutes adopted by state legislatures) permits variation of its terms by agreement—except that the agreement may not disclaim liability of a party—and permits clearinghouse rules (like regulations) to bind parties other than members of the clearinghouse.

Some industrial countries, particularly where the banking industry is fragmented, have found that statutory check law has not been flexible enough to provide for introduction of new technology and more efficient processing procedures, especially in the area of collection of checks by banks. In these countries, the statutory check law has been supplemented by government or mixed public-private regulation to provide the necessary flexibility. In Canada, for example, the 1890 check statute was supplemented in 1980 by a statute creating the Canadian Payments Association, a mixed public-private entity, the first of its kind in the world, to operate a national payments system. The association has created a highly efficient check clearing system that exchanges checks overnight (most banks operate nationwide) and effects settlement as of the previous day. In the United States, the statutory check law has recently been supplemented by a statute authorizing the Federal Reserve Board to regulate the payments system.49 This authority has been used to introduce automated processing of returned checks in order to reduce the risk to the payee’s bank of requiring that it make funds available quickly to the payee.

Credit Transfers

Credit transfers have been in existence for years for both small-value and large-value payments. Often there are separate systems for small- and large-value payments. For small-value payments, the transfers may be made between banks, or they may be made through a closed system where the payer and the payee deal with the same entity, such as “giro” systems operated by postal and telegraph monopolies in Europe and by Western Union in the United States. For large-value payments, the transfers are usually made through banks, and participation in the system may be limited, as in a clearinghouse.

Differences Among Credit Transfer System Rules

Credit transfer system rules usually characterize the payment order transaction as an assignment or transfer by the payer to the payee of the payer’s bank’s deposit obligation to the payer. If the payee has an account at a bank other than the payer’s bank, the payer’s bank, in order to complete the transfer, must issue another payment order to the payee’s bank assigning to the payee the payee’s bank’s deposit or other obligation to the payer’s bank. The series of payment orders constitutes the credit transfer. Because each bank is responsible for settling with a subsequent bank or the payee to which it transfers a payment order, the bank must first authenticate the payment order it received and determine whether there are sufficient funds or credit in the account of the prior party. If there are not sufficient funds or if the bank cannot authenticate the order, the bank may reject the order. Credit transfer rules do not specify when the payer’s bank or another bank must debit its customer’s account but leave this to the bank’s credit judgment.

Differences in credit transfer system rules exist primarily between large- and small-value systems, rather than between systems of the same type. One example of differences in rules between types of systems is the revocability and reversibility of a payment order after it is issued. The difference results from the importance placed on speed and finality of payment. The business nature of payments in large-value transfer systems (LVTSs) requires speed and certainty of payment. The payee often relies on receipt of payment to make important business decisions, so that finality of payment is very important. Although a bank may have a right to revoke a payment order it has issued in an LVTS electronically, that right usually ceases as a practical matter when a subsequent bank has relied on the payment order it received to pass a payment order on to the payee. In contrast, small-value systems may permit transfers to be revoked within the system because of an error, for example, even after payment would otherwise be considered final. Similarly, the reversibility of a payment order for failure of settlement may differ between large- and small-value systems.

When the payment orders in a credit transfer are irrevocable and irreversible, the transfer is considered final. When the transfer is final, the underlying obligation between the payer and the payee is discharged or paid. Finality of payment relates to the payment system and does not mean that payment cannot be recovered, such as for a mistake, outside of the payment system under general principles of law.

The rules of large-value credit transfer systems often provide that final payment occurs at the time when the payee’s bank accepts the transfer by some overt act, such as by notifying the payee or crediting its account. Upon final payment, the payee’s bank’s debt to the payee is substituted for the payer’s debt to the payee. Final payment does not necessarily mean that the payee has cash or even that the funds are available for use by the payee. The payee’s bank may become insolvent before the funds are withdrawn or used by the payee. The payee relies on the solvency of its bank in agreeing to payment by credit transfer, as it would in accepting a check drawn by a bank as payer, which also usually constitutes final payment of the underlying obligation. Because a credit transfer is not equivalent to cash or legal tender, the payee can refuse to accept it as payment, and if it does so, the underlying obligation is not discharged.

Finality of payment in a large-value credit transfer system often occurs earlier in a gross settlement system (where transfers are settled individually) than in a net settlement system, because a net settlement system’s rules may condition finality on completion of settlement. If the central bank participates in a gross settlement system as an intermediary bank, its settlement is usually considered final. In contrast, in a net settlement system, even if settlement is made on the central bank’s books, the central bank usually does not guarantee settlement, to encourage the participants to adopt their own measures to assure that settlement becomes final.

The differences between gross and net settlement in large-value systems with central bank involvement are exemplified in several countries. In the United States, transfers on the Fedwire system (see the Appendix), which is owned and operated by the Federal Reserve Banks, are settled on a gross basis on the books of the Reserve Banks. A payment order sent by a Reserve Bank is irrevocable (and settlement is final) when the Reserve Bank transfers the payment order to or credits a subsequent bank. If the subsequent bank is not the payee’s bank, payment to the payee is not completed until the payee’s bank receives and accepts the transfer. In the CHIPS system (see also the Appendix), which is owned and operated by the New York Clearing House Association, transfers are settled on a net basis at the end of the day, also on the books of the central bank. Under CHIPS rules, payment orders are irrevocable when made. However, payment is not completely final until the end of the day, because payment orders may be reversed if settlement does not occur. Because of the existence of risk reduction procedures and collateral in the CHIPS system, there is only a very remote possibility that settlement will not occur, but the law permits payment orders and final payment to be reversed in such an event.

In Japan, there exists a gross-settlement system, BOJ-NET (see the Appendix), operated by the Bank of Japan, that provides final payment similar to Fedwire. The net settlement system, the Zengin system, operated by the Tokyo Bankers’ Association, is unusual in that settlements between banks are not final until the day after the transfer is completed but are guaranteed by the Bank of Japan, backed by collateral deposits by the banks as well as by other risk reduction measures. In Switzerland, the gross settlement system, Swiss Interbank Clearing, SIC (see Appendix), operated jointly by the central bank and a service organization owned by Swiss banks, provides final payment similar to Fedwire and BOJ-NET. In France, the Bank of France gross settlement system, TBF, provides final payment; in the Paris Banks’ Clearing House net settlement system, payment is not final until settlement is made at the end of the day.

As regards differences in rules between large- and small-value transfer systems, another example is the time when funds are required to be made available for withdrawal to the payee by the payee’s bank. In large-value systems, the payee’s bank is usually not required to make funds available for withdrawal until after final payment has occurred, for risk reasons. In the United States, for example, a statute requires the payee’s bank to make funds available to the payee only on the day after payment is final (because the statute applies to large- and small-value payments, within and outside organized “systems”).50 However, the business practice in large-value systems is to make funds available on the day payment is final. In contrast, the clearinghouse rules that apply to small-value credit transfers (such as payroll payments) require participating banks to make funds available to payees at the opening of business on the settlement date, for reasons of consumer acceptance, even though the payment orders may be revoked for error after that time, and even though settlement and final payment do not occur until later.

Credit Transfer Rules/Agreements

If payment orders are not generally transferred out of a “system,” the rules need only govern the members of the system (such as by a clearinghouse) and their customers and may be created by those members. If participation is more widespread, it is desirable that the rules be of general applicability, which may require a general regulation or statute. For large-value systems governed by clearinghouse rules, the rules are often supplemented by regulation of the settlement risk aspect of systems. In most developed countries, credit transfers are not governed by any comprehensive rules. For example, in the United States until 1989, credit transfers in large-value “systems” were governed by clearinghouse rules, supplemented by central bank regulation of settlement risk, and credit transfers in the Fedwire system were governed by regulation. Many interbank credit transfers were not governed by any formal rules. In 1990, a comprehensive statute, the first in the world, began to be enacted by state legislatures to govern large-value credit transfers.51

In an effort to create a model law for large-value credit transfers between countries, the United Nations Commission on International Trade Law (UNCITRAL) in 1992 completed a Model Law on International Credit Transfers. Although the United Nations has recommended worldwide enactment, no country has yet enacted it.52 Both the Model Law and the state statutes in the United States permit variation of certain terms by agreement between participants. These laws should prove useful to industrial as well as other countries desiring to adopt generally accepted rules for large-value credit transfers.

In many developing countries, often the first step necessary in regulating electronic credit or debit transfers is to establish by statute the validity of an electronic record and the legal enforceability of an electronic instruction. Until participants in these countries are assured of the enforceability of electronic messages, they may continue to insist on receipt of a paper copy of an electronic transfer before considering a payment final, thus impeding the efficiency of an electronic system.

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