ately we've been hearing a lot about the phenomenal growth of automated clearing house (ACH) payments. The growth numbers are quite impressive and not matched in any other area of payments:

• According to NACHA - The Electronic Payments Association, the ACH network increased 18% in the second quarter of 2005 over the same period last year. In that quarter, the network handled more than 2.63 billion ACH transactions (not including those referred to as "on-us") worth nearly $6 trillion.

• In 2004, more than 12 billion transactions worth $28.6 trillion were cleared and settled through the ACH.

• A fairly new type of transaction, a check conversion product called accounts receivable entry, or ARC, has proven to be the most successful ACH transaction type ever. In two years, ARC transactions have increased from 20 million to 1.3 billion. In 2004, ARC grew almost 500%, according to a report by research and analysis firm Financial Insights. The world of ACH is complex, defined by acronyms and guided by a thick book of rules. ACH payments have existed for more than 30 years, but only recently have their explosive growth rates made them a force to be reckoned with.

You probably have at least a basic idea of what ACH is. But do you really understand how ACH works?

The Network

The ACH network is the nationwide system of electronic funds transfers governed by the National Automated Clearing House Association, best known as NACHA, a federation of more than 12,000 financial institutions as well as regional clearing houses around the country. NACHA is not a government agency.

Two of NACHA's main functions are to oversee the ACH network by establishing operating rules and to encourage electronic solutions to improve the payments system.

NACHA is also involved in developing risk management initiatives; education efforts, such as sponsoring conferences and a professional credentialing program; quality control throughout the system; marketing; member relations; and responding to government and regulatory issues.

Everyone who participates in ACH transactions must abide by the NACHA Operating Rules, which are really contractual agreements with the financial institutions.

ACH payments include direct deposit of payroll, Social Security, other government benefits and tax refunds; direct payment of consumer bills such as mortgages, loans, utility bills and insurance premiums; business-to-business (B2B) payments; e-checks; e-commerce payments; and federal, state and local tax payments.

There is only one ACH network, but financial institutions send or receive ACH transactions through two central clearing systems, or operators. The Federal Reserve Banks' system is known as FedACH; it is the country's largest ACH operator. The Fed handles all the incoming government transactions and about two-thirds of all commercial transactions.

FedACH cleared 8.1 billion commercial and nearly 1 billion government ACH transactions across the network in 2004, according to Susan Robertson, Officer of the Federal Reserve Bank Retail Payment Office.

The Electronic Payments Network (EPN) is the private sector network operated by The Clearing House Payments Co. LLC, the company formed in August 2004 following the merger of several separate entities.

EPN processes about 25 million items on an average day; on a peak day, that number can reach as many as 36 million, according to Rossana Salaris, EPN's Senior Vice President.

Third-party ACH providers offer their financial institution or merchant customers a range of services to help them send and accept ACH payments. These providers work by the same rules and standards as the operators, financial institutions and regional associations, but they cannot be NACHA members.

The Operators and Their Operation

Salaris said many intricacies are involved in ACH processing, but simply put, one bank originates something into the network and another one receives it; these are the Originating Depository Financial Institutions (ODFIs) and Receiving Depository Financial Institutions (RDFIs), respectively.

ODFIs originate transactions on behalf of customers (a consumer, merchant or business), and RDFIs post them to their customer accounts for credit.

"The primary role of EPN is to be the switch, or the railroad tracks," Salaris said. "We take files from the ODFI and deliver them to the RDFI."

As a quasi-governmental agency, the Fed is not mandated to provide ACH services, but Robertson said it does because it's a responsibility as a provider of payments services.

FedACH serves the same role for its customers. "Typically there is not a difference in what the Fed does with the transactions versus what EPN does," Robertson said.

"Our very basic general obligations are to receive and distribute the payments out to the receiver. In doing so, we both look at a file the same way and check the fields we're supposed to check, and the integrity of the file and so forth. Where it gets different is in value-added services. Each of us has our own set of extra services that we provide our originating and receiving banks," Robertson said.

Those extra services can include risk management, fraud prevention and reporting. Every commercial bank, savings and loan, credit union, and community bank, whether through FedACH or EPN, can receive ACH payments and post them to their consumer or corporate accounts.

For example, Robertson said EPN's role in a government ACH payment is mainly on the RDFI end. However, not all financial institutions can originate ACH transactions. Salaris said this is where the risk lies in ACH.

"Origination is a business that an institution decides to get into, and there's a lot for them to consider," Salaris said. "There are operational concerns, credit and fraud risk.

"The originating institution warrants that all transactions it originates into the network are authorized. If there's a problem with a debit that an ODFI originated, and the RDFI says the debit is fraudulent, the ODFI has to show proof of authorization. If they can't, the ODFI is liable for that." All ACH transactions are transmitted in a standardized file format set by NACHA. ACH payments are categorized by type of transaction as defined, described and categorized by NACHA. Each transaction receives one of 23 consumer or corporate single-entry class, or SEC, codes based on its purpose.

"Every item that comes through has requirements that we have to check for and validate are there," Salaris said.

SEC codes cover four major applications: direct deposit, check conversion, electronic bill payment and B2B payments. ARC, point-of-purchase check conversion (POP) and prearranged payment or deposit entry (PPD) are a few of those. Some financial institutions transmit to EPN and FedACH through direct connections. Transactions arrive in batch mode and are processed in real time throughout the day. Salaris said processing in the ACH world can be a little complicated; the type of item will change when and how it's processed.

"As a file comes in, we process it right away," she said. "We have different times of operations and deadlines to meet in order to get transactions into different windows and processing cycles that can help customers meet settlement time requirements."

How secure is all this information being transmitted between ODFIs and RDFIs? "There are security protocols in place," Salaris said.

"Many large banks are connected to us over a private line and those communications lines are encrypted at both ends. If tampering occurs, the line is dropped. We don't maintain anything, and we don't store any information like account numbers on databases. As files come in we sort them and distribute the information out," she said.

Voting for the Rules to Operate By

NACHA defines all the procedures and protocols of ACH. The organization is currently comprised of 19 regional associations and 19 direct financial institutions. How do NACHA members decide on the policies and standards that will encompass all ACH transactions?

The Southwestern Automated Clearing House Association, known as SWACHA - The Electronic Payments Resource, is NACHA's fourth largest regional association with nearly 1,000 financial institution members, including banks, credit unions and thrift institutions.

Based in Dallas, it covers the geographical region including Texas, Louisiana and New Mexico.

Dennis Simmons, SWACHA's President and Chief Executive Officer, said that when it comes to electing board members and making changes to bylaws, each association and each direct financial institution member has one member, one vote. Opinions are weighted evenly between banks and associations.

When it comes to changing NACHA's Operating Rules, however, formulas based on a regional association's number of members and a financial institution's volume of ACH transactions determine the number of votes each gets to cast.

Operating directly by NACHA rules, SWACHA's primary function is to provide its members with information and education through publications such as newsletters and alerts, its Web site and by conducting trainings.

SWACHA also provides Answerline, through which callers receive answers to their perplexing ACH dilemmas from the organization's knowledgeable staff members.

Simmons said that membership in SWACHA or another regional association is voluntary for financial institutions, even if they are processing on the ACH network. "But I strongly encourage it," he said. "If you don't, the risks are very high."

Members also get help translating the NACHA Rules Book, a common request according to Simmons.

Where the Growth Will Take ACH

ACH, thanks to more companies such as utilities and other lockbox environments adopting ARC, is growing very robustly, Robertson said. What does that mean for other payment methods?

"ACH will not replace paper checks because there are some unique uses of checks that I don't see being applicable to the way the ACH works; think about grandmothers writing checks for birthday gifts," Robertson said.

"And in the corporate realm, B2B transactions are more complex, requiring invoicing and documentation, and currently, ACH isn't suited for that."

Salaris believes ACH will continue to evolve even further. "ACH has moved from traditional direct deposit/direct debit applications (payroll), to some more spontaneous, non-traditional ones where there is 'no relationship,' and you don't know who your trading partners and customers are," she said. "It's not like a mortgage or car loan company debiting an account every month.

"The environment has been changing, and we as an ACH operator have had to change with it to make sure we help our financial institutions mitigate risk. "We've put some tools in place to help our originating and receiving banks understand the practices of their customers through things like pattern recognition, and providing reports to the RDFI," Salaris said.

Simmons remembers ACH processing before it incorporated electronic capabilities.

"ACH transactions consisted of paper advices from the Fed, saying an account had been credited for direct deposits," he said.

"They had to be manually keyed in to a data processing system at a terminal or we had to encode them with MICR ink and run them through the proof machine. Now it's fully electronic end to end, from origination to posting.

"I keep saying we're not going to see the triple-digit growth every year, but each year I've been wrong," Simmons said.

He predicts ACH will continue to grow. "As more people who have enjoyed direct deposit of their paychecks begin to retire, we'll see more people signing up for direct deposit of Social Security or retirement benefits," he said.