Technology and Innovation, Vol. 21, pp. 3-9, 2019 ISSN 1949-8241 • E-ISSN 1949-825X Printed in the USA. All rights reserved. http://dx.doi.org/10.21300/21.1.2019.3 Copyright © 2019 National Academy of Inventors. www.technologyandinnovation.org

BLOCKCHAIN PLATFORM FOR REAL-TIME PAYMENTS: A LESS COSTLY AND MORE SECURE ALTERNATIVE TO ACH

Nasser Arshadi College of Business Administration, University of Missouri – St. Louis, St. Louis, MO, USA

This paper examines the historical development of banking and automated house legacy systems and offers blockchain platform for real-time payments as an alternative. Insti- tutions with legacy systems resist disruptive change unless there are demands by businesses and customers and an opportunity for new products at reduced costs and additional revenues. Although the Automated (ACH) in the U.S. has phased in a twice-a-day clear- ing and settlement system, it is still behind real-time models in use in several other countries. ACH uses individual clearance and settlements for large payments and batches for smaller transactions. Using ACH data, this paper calculates the annual opportunity cost of using a real-time model such as blockchain versus ACH’s discrete, twice-a-day clearance and settlement procedure. For 2016, the real-time protocol would have resulted in benefits for businesses and customers of $10 billion.

Key words: Blockchain; Payment systems; ACH; System

INTRODUCTION House (ACH) and handles 16% of the total payment Advances in computation technology have transactions and 82% of the total value of the pay- drastically improved the information processing ments. ACH has adopted a same-day processing capabilities of payment systems. Payment process- system that replaces the old one, which took two to ing institutions have shown interest in the new three days to complete a transaction. In 2016, ACH technologies, but their adoption has been slow. In processed 25 billion transactions for more than $43 the meantime, non-banking technology providers trillion (2). have introduced new protocols that promise to sig- regulatory agencies, especially the Federal nificantly improve the speed and security of data Reserve (Fed), are closely monitoring develop- processing and reduce costs for businesses and cus- ments in payment systems. By early 2017, the Fed tomers. The blockchain protocol, a form of distributed had assembled a task force representing , tech ledger technology (DLT), has exciting potential for a companies, and regulatory agencies to develop and variety of businesses, including banks. issue a request for proposals for the future of pay- U.S. banks and payment processing institutions ment systems (3). The Fed did not select any single (e.g., the National Automated Clearing Association, proposal as the winner, but it highlighted some for or Nacha) are in the process of exploring their current their success in meeting certain criteria and hence options (1). Nacha operates the Automated Clearing provided credibility to their underlying protocols. ______

Accepted: February 1, 2019. Address correspondence to Nasser Arshadi, Department of Finance, College of Business Administration, University of Missouri – St. Louis, MO 63121 USA. Tel: +1 (314) 516-6272, E-mail: [email protected]

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This paper focuses on the ACH the U.S., the payment systems involve banks, private and demonstrates how its protocol costs businesses third parties, and the Fed. The infrastructure in place and customers billions of dollars annually in oppor- is a function of banking history and communication tunity costs. To appreciate why the legacy systems and technology developments. are difficult to change, a brief review of their his- tory comes next. EVOLUTION OF ACH ACH transactions can involve online bank- BANK LEGACY SYSTEM ing payments between person-to-person, For most of its history, banking has entailed a rela- business-to-business, or business-to-customer. The tionship with businesses, and knowing the customer ACH is administered by Nacha and is operated by has been essential for risk assessment and pricing. For the Fed and the Electronic Payments Network, a customers, knowing the bank as a trusted interme- private sector payment network. diary has been crucial in financing decisions. Such At the retail level, a check issued by one party a long, established tradition makes technological to another party is cleared internally if both have changes slow and sluggish at best. accounts in the same bank and externally if they The regulatory structure overseeing banking has have two different banks. In the latter case, the followed the same pattern. The establishment of the check goes to the Fed, which debits the account three major regulatory agencies—the Office of the of the issuing bank and credits the account of the Controller of the (OCC), the Fed, and the receiving bank. The check in question could be a Federal Deposit Corporation (FDIC)—and paper check, or, since 2010, it could be in the form their subsequent evolution happened as a reaction of an electronic image of the check for a majority to financial crises. The OCC was established as part of cases. The check issued has a nine-digit number. of the Department of the Treasury in the National The American Bankers Association’s routing transit of 1863. The OCC is tasked with char- number, on the left side of the check, identifies the tering, regulating, and supervising all national banks issuing bank and the account holder. and thrift institutions and the federal branches and The vast majority of transactions require no check agencies of foreign banks in the U.S. The Fed was at all. If an employer pays salaries to employees established in 1913 as a response to a series of finan- through direct deposit, it goes through an automated cial panics starting in 1907, and its objective was clearinghouse and is considered a credit transac- to promote price stability and economic growth. tion. Similar cases include pushing money online Congress expanded its responsibilities in the after- to accounts in other banks for friends or relatives math of the Great Depression and again during the either once or periodically. The transfers of individ- recession following the Dot-com bubble. The FDIC uals who set up monthly payments of mortgage or was established in the to prevent utility bills from their accounts are considered debit bank runs and restore confidence in the banking sys- transactions. tem following the failure of one-third of all banks (4). The history of ACH goes back to 1974 when ACH Initially, FDIC covered losses of up to $2,500 per cat- associations from California, New England, and the egory, and this has increased several times over the Upper Midwest region came together to form a new years to $250,000 today. entity within the American Bankers Association (5). Over the years, most technologies introduced in the Over the years, it grew rapidly from over one billion banking industry have been incremental, improving in transaction volume in 1988 to 25.5 billion in 2016, existing protocols and reducing costs while keeping with a value of $43 trillion (5). the legacy systems in place. In one area—payment Settlements in early years took days, costing the systems—technologies involved both banks and their participating parties (e.g., businesses, customers) regulators. significant costs both directly in charged fees and The payment systems include institutions that use indirectly through the opportunity cost of not hav- technologies to transfer funds between parties. In ing access to funds in transition. Before the recent BLOCKCHAIN, PAYMENT SYSTEM, ACH 5 shift, the best settlement date available was the next eligible transactions. Remaining ineligible for the day, while banks had the discretion to lengthen avail- same-day ACH transfers are international transac- ability of funds to counterparties to several days. To tions and those greater than $25,000. address this problem, the Nacha undertook an ini- Among remaining inefficiencies are the infrequent tiative to move toward same-day ACH over three processing (i.e., twice daily) and the fees charged. phases (5): Currently, the ODFIs pay the RDFIs 5.2 cents per • Phase 1 (effective September 23, 2016) allowed transaction. For example, if there were 100 transac- for ACH credits to be processed during the tions in one month by an ODFI, it would owe $5.2 two same-day processing windows, all receiv- (.052 * 100). This fee will be handled by an ACH oper- ing depository financial institutions (RDFIs) to ator (e.g., the Fed) in a monthly statement. receive same-day ACH transactions. • Phase 2 (effective September 15, 2017) provided ACH AS A TRUSTED THIRD PARTY IN THE for ACH debits to be processed during the two CLEARING SYSTEM same-day processing windows. In the flow of payment from a sender to a receiver, • Phase 3 (effective March 16, 2018) mandated ACH plays the role of a trusted third party by ensur- RDFIs to make funds available from same-day ing: 1) the sender, who is initiating a transfer, has the ACH credits by 5 PM local time. funds; 2) the funds are credited to the account of the Among benefits of the same-day ACH is a reduc- receiver, and not someone else, at the level promised; tion in credit risk within a narrower transfer window. and 3) the sender forwards the funds only once to the It also supplies better support for payroll needs for designated receiver and not multiple times to others hourly workers and lowers transaction costs between at the same time. payers and receivers. Reducing ACH processing time The current trajectory of ACH services—the same- by one day or a few hours for $43 trillion annually in day payment submission, clearance, and settlement total ACH transactions value creates significant sav- twice daily—is an improvement over the previous ings in opportunity cost. protocols. The question is whether these functions During the period from September 23, 2016, to can be performed more quickly, more cheaply, and December 31, 2016, when Phase 1 of the same-day with fewer cases of fraud. ACH came into effect, there were approximately 2 billion total credit ACH transactions, of which THE BLOCKCHAIN AND BANK PAYMENT 13 million were in the same-day ACH category—a SYSTEM mere .006 of the total (6). (This figure is approxi- Blockchain offers a solution to issues and problems mated based on the fourth quarter data (October in the payment, clearing, and settlement systems, 2016 to December 2016) for all ACH transactions and including inefficiencies and costs incurred and September 23, 2016 (when Phase 1 of the same-day safety and security during the ACH processing of ACH credit went into effect) to December 31, 2016.) the payments. Instead of incremental changes, such The percentage of credit ACH transactions is approx- as reducing settlement days or marginally cutting imated at 42% of total using data from Nacha website. transaction costs, blockchain provides a disruptive It would take time for the Originating Depository alternative for payment systems that could entirely Financial Institutions (ODFIs) to get acclimated to bypass the function of ACH. the new settlement system, and the figures are right- Although blockchain protocol has received much fully expected to increase over time. Also, since the attention in recent years, elements of its fundamental ODFI shift to the same-day ACH is voluntary at the technology go back decades. At the core, blockchain moment, it is not clear how the overall numbers will utilizes a cryptographic system using pairs of keys, look once the dust settles. including a public key, which can be known widely, Once all phases of the same-day ACH processing and a private key, which is known only to the owner. system are fully in place, the Nacha will drastically Cryptography has been around for hundreds of change the payment system protocol for 99% of years. For most of its history, cryptography used 6 ARSHADI simple pencil and paper to establish schemes to trans- in sending or receiving messages or assets, includ- fer information securely between two parties. With ing cryptocurrencies. advances in mathematics and computer sciences, In using blockchain for transactions, one has to modern cryptography has evolved into using algo- address three problems: 1) how to ensure the per- rithms with keys to encrypt and decrypt information son who is initiating the transaction has the money (see, for example, Claude Shannon’s 1945 paper “A to do so; 2) how to guarantee the intended person mathematical theory of cryptography” (7)). In the gets the money and not someone else; and 3) how 1970s, Diffie and Hellman followed Shannon’s work to prevent double spending. through a series of papers (e.g., 8,9). Regarding the first problem, the asymmetric cryp- In 1977, the National Institute of Standards and tographic system in blockchain confirms that the Technology (NIST) published the Data Encryption sender is the rightful person who owns the account Standard (DES), a set of standardized algorithms with the money to afford the transfer. As those with to develop secure electronic communication for access to the public key on the network can decrypt financial institutions, among others. In 2001, NIST the message, they realize it is indeed issued by the introduced the Advanced Encryption Standard with sender, whose signature can be verified on the trans- a 128-, 192-, or 256-bit encryption key replacing action, and the availability of funds can also be DES with a 56-bit encryption key, making it more verified on the network. difficult to break. Since then, NIST has introduced a As to the second problem, those with access to the suite of standardized algorithms, such as secure hash sender’s public key on the network cannot re-encrypt functions and asymmetric key algorithms for digital the sender’s message to redirect its intended receiver signatures (see references in 10). because the person does not have access to the send- er’s private key to initiate such change. Finally, the HOW DOES BLOCKCHAIN WORK: PUBLIC AND sender cannot double-spend, as each transaction PRIVATE KEYS is posted on a block and added to a blockchain in To demonstrate how the blockchain protocol can chronological order with a time stamp. In order to replace functions currently performed by trusted spend it again, one has to remove the first transac- third parties such as ACH and banks, let’s look closely tion from the blockchain to add the second. This is at the core of its technology. A key pair could enable impossible because, in addition to the transaction in parties to conduct transactions and, depending on question, the blockchain contains other transactions the algorithm used, conduct them anonymously. that are sequentially linked, and efforts to change the A key pair includes a public key and its associated first has to remove and change the other transactions. private key. The public key is a cryptographic key In blockchain transactions, banks have to submit uniquely associated with an entity, and it may be pub- their transactions to a network for validation before lic. The public key can be used to encrypt information they can be added to the blockchain, which includes that can be decrypted using the corresponding pri- all previously settled transactions on the network. vate key, to validate a digital signature signed by the Depending on whether the network is considered corresponding private key, and to conduct a secret permissioned or un-permissioned, the validators are transaction between two parties. The private key is either specific parties or the general public. Currently, a cryptographic key associated with a public key and there is a consensus that for banks to use blockchain is not made public. The private key provides access soon, they will likely use permissioned blockchain for to its corresponding public key. The opposite is not its security, among other factors. The permissioned true; the holder of a public key would not be able blockchain provides access control to certain parties to access its associated private key. How does one who, in turn, provide the validation function. Also, acquire a key pair? The key pair is generated through permissioned blockchain determines who can partic- a wallet, which is acquired by downloading soft- ipate in writing smart contracts, which are computer ware on a device such as a desktop, a mobile, or as protocols designed to establish, verify, and enforce a USB hardware. The wallet stores the key pair used the provisions of a contract (11). BLOCKCHAIN, PAYMENT SYSTEM, ACH 7

The present value of flows using discreet ACH VS. BLOCKCHAIN: OPPORTUNITY COST twice-a-day ACH settlement is calculated as follows: ESTIMATES PV = PMT (1/r/2 – (1/(r/2 (1 + r/2)2n) Using 2016 ACH data, this section presents the = $85,657(1/.000075 - (1/.000075(1 + value advantage of blockchain over ACH. The cal- .000075)502) = $42,198,853.63 million. culations entail the following assumptions: For blockchain, the present value of the cost of • Transactions are under $25,000 daily real-time transactions is calculated by divid- • Transactions are domestic ing the annual payment by 251 and converting the • 2016 total dollar value of ACH transfer: $43 daily discrete discount rate into daily continuous trillion compounded rate: • 2016 number of days in operation: 251 • All banks have agreed to a twice-a-day settlement 1 + r = ex, LN (1+r) = LN (ex), LN (1+.0149) = x, • The annual discount rate: 3.75% x = .01479 The present value is calculated as follows: The first two items reflect ACH’s policy in including transactions in twice-a-day clearing and settlement. PV= PMT (1 - 1/exn) / (ex – 1) The third is the 2016 total annual dollar amount of PV = $171,315 (1 – 1/e(.0001479 x 251) / (e.0001479 – 1) all transactions. The fourth is the number of bank- = 171,315 (.0364423) (6,760.822386) = ing days used by ACH. The fifth is currently not in $42,208,585.45 place but assumes at some point all banks agree to a twice-a-day settlement, and the last is the prime The difference in redeployment cost: rate on December 15, 2016, supplied by JPMorgan $42,208,586.45 - $42,198,853.63 = $9,731.82 Chase and Co. million With its most recent iteration, ACH transfers funds twice a day, whereas blockchain can process transac- By using blockchain instead of ACH, there is an tions in real-time. Business and individual customers almost $10 billion savings per year. bear the cost of slower processing through ACH in the form of opportunity cost. The sooner customers This figure is likely underestimated due to the receive their funds, the faster they can invest them, underlying assumptions. For example, using block- and the present values of those investments will be chain, one can include transactions larger than higher than if they receive those funds twice a day. $25,000 and those in cross-border trades. Those cat- For ACH, the present value of the twice-daily dol- egories combined cover a significant percentage of lar amount of transactions is calculated by dividing the total value of all transactions. the annual amount by 251 × 2. The discount rate is In international exchanges, for example, payments calculated by dividing 3.75% by 251 × 2. Similarly, have to go through several correspondent banks, each the number of periods is 251 × 2. charging a fee, resulting in a substantial additional Dollar value of average transactions per day: charge to the customer. In addition to the direct cost, there is also the opportunity cost of delay and fail- $43,000,000 million / 251 = $171,315 ure. Correspondent banking costs could also make Dollar value of each of the two settlements for low-value payments unprofitable for banks, preclud- each half-a-day: ing segments of customers. $171,315/2 = $85,657 million In comparison, blockchain protocol provides Discount rate for each day: point-to-point real-time clearing and settlement, 3.75% / 251 = .0149% reducing costs and providing access to payments of all Discount rate for each half-a-day: sizes. In one estimation, a real-time payment system 3.75% / 251 x 2 = .0075% based on blockchain can cut these costs by 60% (12). 8 ARSHADI

One may argue that the cost savings is simply a start for bringing cross-border payments, clearing, zero-sum game, where delay in clearing and set- and settlements to the modern age. Ripple’s technol- tlement is benefiting the ODFI while costing the ogy is growing fast. For example, as of this writing, a receiver the economic redeployment cost. This may consortium of Japanese banks that use Ripple’s tech- be the case, but all parties lose if you count the cost nology for payments and settlement has risen to 61 of cybercrime. In 2017, $425 to $600 billion was lost banks, representing over 80% of banking assets in globally, an increase of around $100 billion since (14). 2014, through cyber attacks (13). The Fed’s report came out in late 2017. Most propos- als had done well by being strong in the effectiveness THE CURRENT STATUS OF BLOCKCHAIN IN criteria, such as speed of transactions. Some proposals THE PAYMENT SYSTEM did well in safety and security by employing a variety The Fed is keenly interested in how this process of methods for payer authorization, data encryption, plays out. Early in 2017, the Fed issued a request for and fraud prevention. Many of the proposals put proposals for a faster payment system developed forth ways to improve efficiency by taking advan- by a task force of 300 members from banks, tech tage of real-time messaging approaches to reduce companies, consumer groups, retailers, and gov- costs. The Fed concluded that, as a whole, proposals ernment agencies. The deadline was set for April 30, represented a major step forward in making the U.S. 2017. Acceptable proposals had to meet 36 criteria payment system faster and better (15). in six categories, including ubiquity, efficiency, safety and security, speed, legal, and governance. The pri- CONCLUSIONS vate-sector proposals were considered effective if they The U.S. payment system has evolved over a long could demonstrate initial implementation by 2019, period, and its current structure presents opportu- reaching all U.S. banks and credit unions by 2021. nities for improvements in cost efficiencies, security, McKinsey & Co. was retained by the task force to and convenience for businesses and customers. The conduct an independent review, as some members reason for the slow movement in the U.S. payment of the task force were also applicants. Among other system toward technology-driven changes compared factors, successful proposals had to demonstrate pay- to other countries is that the U.S. market is composed ment recipients could access their funds within 30 of more than 10,000 depository institutions and has minutes of initiation of the payment. a complex regulatory structure. Also, bank prac- Among applicants were start-ups such as Dwolla tices have evolved over centuries of practice based FPA, Ripple Labs, and the Clearing House in a joint on banking relationships. Such structure is difficult proposal with the banking technology vendor FIS. to alter if the alternative does not depend on such To meet the criteria, some applicants (e.g., Dwolla, relationships even in the presence of compelling argu- Ripple) used a version of the DLT (e.g., blockchain) ments for the benefits of new technology. to increase the speed of the payment transfer and Unlike other aspects of banking functions that promise more secure handling of payment data. may take time to incorporate blockchain technology One of the early adopters of the permissioned fully, the payment system is ripe for innovation. This blockchain was Ripple. As of mid-2017, Ripple had is consistent with the Fed’s recent efforts in bring- signed up several international banks to participate in ing together the best protocols through competition. across-the-border transactions using its permissioned As shown with the level of enthusiasm for the Fed’s blockchain technology. Traditionally, the Society for efforts toward a faster payment system, the banking Worldwide Interbank Financial Telecommunication industry is embracing the new technology for the has handled such transactions. Ripple has indicated payment system. that transactions through its network would take five In the U.S., the evolution of the payment system seconds to be validated using its proprietary serv- closely follows that of the banking system. As banks ers. Ripple has submitted its model to the Fed for move toward adopting blockchain in various aspects approval. Although it is too early to tell, this is a good of their operations, the payment system will follow. BLOCKCHAIN, PAYMENT SYSTEM, ACH 9

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