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The future of the check: how Check 21 and emerging technologies will change our payments system.

As government finance professionals are aware, our national payments system is now undergoing significant evolutionary changes. In the past decade, adoption of electronic payment technologies in both the public and private sectors has accelerated, and dependence on the check as our nation's primary payment mechanism is declining. Consider the following statistics:

* In its 90th Annual Report to Congress, the Federal Reserve System reported that it processed 15.8 billion checks in 2003, 4.7 percent less than in 2002. This was the steepest rate of decline in the past four years. Meanwhile, the Fed's check processing unit cost increased to 5.1 cents, up 13.3 percent from 2002.

* The Fed reported that in 2003 it processed 5.6 billion commercial Automated Clearing House payments, an increase of 12.1 percent over 2002. Meanwhile, the unit cost to process an ACH payment decreased to 1.1 cents, a 15.4 percent decline from 2002. In 1995, the unit costs for checks and ACH were virtually identical. Today, checks are nearly five times as expensive to process as ACH payments.

* In 2003, for the first time in U.S. history, consumers made more purchases in stores by electronic payment than by cash and checks. According to a December 2003 report by the American Bankers Association and Dove Consulting, in-store shoppers used electronic payment methods for 51 percent of their purchases. Debit cards accounted for 31 percent of the total volume, virtually dead even with cash at 32 percent. Consumers used credit cards for 21 percent of their purchases, checks for just 15 percent.

The federal government has been one of the primary drivers of the move to electronic payments. A new federal initiative, the Check Clearing for the 21st Century Act, promises to greatly accelerate this migration. Check 21, as the act is commonly known, was passed into law last year and goes into effect October 28. The objectives of Check 21 are to facilitate check truncation, foster innovation in the check payment system without mandating the receipt of checks in electronic format, and improve the nation's payment system overall.

In this article, we examine what Check 21 is and how it will work, how U.S. financial institutions are addressing the act, and how Check 21 and emerging electronic payment technologies will change our national payments system. We also offer some specific suggestions on what government finance professionals can do to prepare for Check 21 and the electronic payments future.


One of the principal lessons learned from the terrorist attacks of September 11, 2001, was that our national payments system, like our national security system, needed to be strengthened to deal with terrorism. One of the immediate consequences of 9/11 was a disruption of the check clearing process, which relies on airplanes to physically transport checks all over the country to paying banks. For four days after September 11, all flights nationwide were grounded, which meant that millions of checks sat in airplanes parked on runways at airports across the nation and could not be presented to paying banks.

To prevent a liquidity crisis, the Federal Reserve continued to provide credit for these checks on its usual availability schedules, in effect supplying an enormous loan to the banking system. How enormous? On just one day, Wednesday, September 12, the float on deposited checks credited to depositors but not debited from check writers totaled almost $23 billion. This was about 30 times the average float for the previous 10 Wednesdays.

These events made it clear that the current legal requirement to physically present checks to paying banks was a potential weakness in our payments system. To eliminate this vulnerability and strengthen and improve the efficiency of the U.S. payments system, the Federal Reserve and leading private sector financial institutions proposed changes to check clearing regulations so that checks would no longer need to be physically transported between banks. These proposals became the basis for Check 21.


Check 21 provides a legal basis and a process for replacing the physical transport of checks with the electronic transfer of check images. Check imaging technology enables banks, thrifts, and credit unions (which we will refer to as banks in this article) to capture digital images of the fronts and backs of checks as they are processed through high-speed check sorters. While most large U.S. banks and some smaller ones already use imaging, it would be extraordinarily expensive to require all banks to immediately implement image technology. Consequently, Check 21 is intended to encourage greater use of imaging without mandating its use. Here we describe how Check 21 accomplishes this objective.

Substitute checks. The key feature of Check 21 is the creation of a new negotiable instrument called a substitute check. A substitute check is a paper reproduction of the original check that includes electronically captured images of the front and back of the original check and a reproduction of the check's MICR line. Substitute checks make it possible for banks that are not yet in a position to use image technology to participate in Check 21.

Under Check 21, banks will be able to create substitute checks from the original deposited paper checks and then truncate the original items (i.e., remove them from the check clearing process). All checks, except foreign checks, are eligible to become substitute checks. This includes government warrants, U.S. Treasury checks, consumer checks, business checks, money orders, controlled disbursement checks, payable through drafts, and traveler's checks. There is no dollar limit on substitute checks and no prior customer authorization is required. To meet the legal requirements of Check 21, a substitute check must:

* Contain an image of the front and back of the original check.

* Bear a legend that states, "This is a legal copy of your check. You can use it the same way you would use the original check."

* Display a MICR line containing all the MICR information appearing on the original check.

* Conform in paper stock, dimensions, and other applicable industry standards established for substitute checks.

* Be suitable for automated processing in the same manner as the original check.

All U.S. banks will be required to accept substitute checks starting October 28. However, no bank is required to create substitute checks. If a bank is not image-enabled, it may continue to use the paper check clearing process. For example, returned substitute checks will be processed in the same way that returned checks are currently processed.

Substitute checks are subject to all of the consumer protections granted under the existing check laws in Articles 3 and 4 of the Uniform Commercial Code and the Federal Reserve Board's Regulation CC. In addition, Check 21 establishes further warranties and indemnification to protect consumers. Detailed information on the legal and technical aspects of Check 21 is available on the Internet. Exhibit 1 lists some of the sources of this information.
Exhibit 1: Check 21 Information on the Internet

* Final version of Check 21 Act:
cgi-bin /getdoc.cgi?dbname=108_cong._bitls&docid=f:h 1474enr.txt.pdf

* Wausau Financial Services:


* SVPCo:

* Federal Reserve:


Image cash letters. Substitute checks provide a mechanism enabling banks to truncate original checks, process and deliver checks electronically, and then print substitute checks at a location near the paying bank for presentment. To understand how this works, consider how non-local checks now clear.

Banks present checks to other banks through the use of cash Letters--packages of checks that include a document (the cash letter) stating the total amount of the deposited checks, along with tapes showing individual check amounts. Banks sort non-local checks for cash letters in various ways. Some cash letters contain only checks drawn on a single bank and are sent directly to that bank. More often, cash letters contain checks from various banks in a specific region and are presented to the Federal Reserve, correspondent banks, and local clearinghouses, which in turn present the checks to the paying banks.

Under Check 21, banks will be able to create image cash letters that contain both the MICR data and electronic check images. The Federal Reserve, national and regional banks, correspondent banks, clearinghouse associations, and third-party deposit processors with the necessary image technology will be able to accept image cash letters and print substitute checks for presentment to paying banks. This is how Check 21 will help to reduce the number of checks that are physically transported to paying banks.


Before we proceed any further, there are two key facts to keep in mind about Check 21: (1) Check 21 is not the same as electronic check presentment; and (2) Check 21 is not the same as check conversion.

Electronic check presentment, or ECP, enables two banks to present checks to each other through purely electronic means. Check 21 makes use of the electronic transfer of check information and check images, but ultimately ensures that a paper substitute check can be presented to the paying bank if required. Although Check 21 does not provide specific legal equivalence for electronic check presentment, it does encourage image-enabled banks to enter into bilateral ECP agreements. Under such agreements, banks that can both create and accept electronic cash letters can present checks to each other electronically, without the need to provide substitute checks. Many of the nation's largest banks have already entered into these agreements.

Check 21 is also totally different from check conversion. In check conversion, checks are converted into ACH debits either at the point of sale or through an accounts receivable conversion (lockbox) service. Check conversion processing captures the check image and the MICR line information and then creates an ACH transaction that directly debits the check writer's account.

Private sector check conversion is governed by NACHA rules. A check converted at the point of sale must be marked "void" by the terminal that captures the check image and MICR data, and the check must be immediately returned to the check writer. Checks processed by an accounts receivable conversion service are imaged and then destroyed so that they cannot be reintroduced into the check clearing system. If a converted check transaction is returned unpaid, it is processed as an ACH return, not as a returned check. Under current NACHA rules, only consumer checks are now eligible for conversion. Business checks, money orders, government warrants, third party checks, and travelers checks are ineligible for check conversion.


Since October 2003, U.S. financial institutions have been taking different paths in response to the Check 21 legislation. Here is an overview of progress to date.

Federal reserve initiatives. Through its check modernization initiative, the Fed is instituting standard check processing platforms nationwide. New Check 21 services the Fed will offer to financial institutions include forward and return image cash letters and image cash letter delivery. These products will speed check clearing, streamline return item processing, and improve deposit times. The Fed is also introducing FedImage services, which will provide a national archive of check images, and a new Internet-based suite of check services called FedLine Web.

Private sector initiatives. The nation's largest banks are moving ahead rapidly to introduce new services and processing in response to Check 21. These initiatives leverage the banks' existing image technology and newly formed image processing alliances. Viewpointe Archive Services LLC, owned by Bank of America, three other banks, and IBM, has already created an archive of more than 38 billion check images. Similarly, the "vanguard banks," seven of the 20 owner banks of Small Value Payments Co. LLC (SVPCo), have entered into agreements to pilot image exchange before the Check 21 effective date.

A number of small banks appear to be well positioned for Check 21, either because they already have in-house image systems or use image-enabled third-party deposit processors. Small banks were among the first to adopt image technology, primarily because it is less costly to image-enable a small processing system than a large one.

So what do these trends suggest for the future? The Viewpointe and SVPCo vanguard banks process well over 50 percent of the nation's checks. Consequently, Check 21 initiatives at those institutions should result in substantial volumes of checks moving to image-based processing over time. However, a significant percentage of checks will continue to be processed as they are today.


How Check 21 will affect your organization depends on whether your banking partners are engaged in Check 21 initiatives or not. If you are a customer of a bank that is not addressing Check 21, the only change you may see is substitute checks created by other banks. On the other hand, if your banking partners are implementing Check 21 solutions, we believe you will see positive changes. While it is still too early to predict with certainty what will happen after Check 21 goes into effect, here is a summary of what we think you can expect.

Faster check processing. Check 21 enables participating banks to process checks faster, so items will clear faster and processing of returns will also accelerate. For your organization, this means improved risk management. Over time, as more banks move to processing under Check 21, you may also see a gradual reduction in float on deposits and disbursements.

No change to controlled disbursement or positive pay services. With Check 21 processing, both controlled disbursement and positive pay services will continue to work as they do today. Reporting will remain the same. Image positive pay services may become even better.

Introduction of new and improved check-related services. Check 21 will likely lead to the creation of new treasury management services. One new service that will be offered by some banks with multi-state operations is "remote deposit." This will enable an institutional or corporate customer to use accounts receivable check conversion to convert incoming consumer checks into ACH transactions and to process all other checks as substitute checks. A bank providing this type of service will be able to transmit check images to its operations in other states, create substitute checks there, and present them locally. However, the real value of remote deposit is that it allows the consolidation of depository relationships so that the physical proximity of a banking center or vault will become less important from a depository perspective.

Loss of certain check security features. One possible drawback of substitute checks is that they eliminate some of the physical security features built into check stock, such as watermarks. However, keep in mind that those features are primarily aimed at preventing fraudulent check encashment at a branch. As banks and other deposit processors continue to develop technology around images and substitute checks, new methods for protecting against check fraud will evolve.


What should government finance professionals do to prepare their organizations for Check 21? Here is a list of action items yon should consider to take maximum advantage of the benefits of Check 21.

Talk to your banking partners. This is the single most important step you can take. Meet with your bank representatives to discuss their plans for addressing Check 21. Ask about possible impacts to your treasury operations and new services that may become available to you.

Evaluate the cost components of your check-related treasury operations. Do you know exactly how much time and money you spend cutting checks, processing check remittances, dealing with returned items, reconciling accounts, and maintaining check-related audit controls? If not, you are not ready to determine how to take full advantage of possible Check 21 benefits.

Move to check image services now. We estimate that fewer than 25 percent of government agency and corporate customers now receive check images via online image retrieval services or on CD-ROM or DVD. Moving to image services now will help prepare your organization for Check 21. By receiving images electronically, you will save time and money, and eliminate all the inefficiencies of handling physical checks.

Implement electronic consumer payment solutions. If you receive consumer check payments, talk to your banking partners about electronic solutions that can improve funds availability, cut costs, and reduce the amount of paper in your operations. We previously mentioned the new remote deposit service that Check 21 makes possible. Here are three other types of electronic solutions to consider:

* Check conversion services enable you to convert checks into ACH debit entries, giving you fast access to funds. You will also be able to electronically re-present converted-check returned items for better collections.

* Electronic billing and payment services provide customers with an Internet option for making payments via payment card or ACH debit to their checking accounts. You benefit by improved funds availability and fewer returned items.

* Integrated electronic consumer bill payment reporting consolidates payments and payment detail from Internet bill pay services into a single electronic file. This is especially valuable to agencies like government-owned utilities that now receive checks from bill pay services that do not include remittance coupons.

Use check and ACH fraud protection services. Rates of check and ACH fraud continue to rise. Control your risk by using online image positive pay services for check disbursements and ACH fraud filter services to prevent unauthorized ACH debit entries to your accounts.


We are convinced that Check 21 will ultimately result in major improvements to the speed, efficiency, and security of the national check clearing process, and should also accelerate the migration of payment volumes from paper to electronic channels. Remote deposit, check conversion, and online bill pay services will continue to drive ACH volumes upward. As check volumes decline at steeper rates, check processing costs will continue to rise, making what is already an expensive form of payment even more costly.

For government finance, preparing for Check 21 really means preparing for the electronic payments future. We recommend that you start working right now on evaluating your current payables and receivables strategies and develop new ones that will enable you to take maximum advantage of the new electronic payment services and processing options that you will start to see after October 28.

ARCHIE B. KELLY is senior vice president and treasury management regional manager for Bank of America in Columbia, South Carolina. An advisor to GFOA's Committee on Cash Management, he is a certified cash manager and holds a bachelor's degree in finance from the University of South Carolina.
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Title Annotation:Check 21
Author:Kelly, Archie B.
Publication:Government Finance Review
Geographic Code:1USA
Date:Aug 1, 2004
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