Cheque Truncation System

The Journey

Disclaimer: This graphical representation is not intended as an historical record and might have, therefore, taken some liberties with historical accuracy.

INDEX

Preface 02

Portrait of the Past 04

Emergence of Technology 06

Technologies the World is Embracing 08

Why CTS & ACH? 10

Recommended Best Practices 12

About Newgen 16

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PREFACE

The first description of a form of payment in the medieval world was observed in the early eleventh

century by an Iranian traveler named Nasir-i Khosrau while visiting the city of Basra (in present-day Iraq).

There he recorded a form of payment, known as the sakk, which was characterized as a merchant's written

instruction ordering his bank to make a payment from his account. This was more in the nature of an

instrument that came to be known as a ‘Bill of Exchange’ and was a convenient form of payment between

local merchants.

However, this laid the foundation for the development and progression of the modern cheque. From its

humble beginnings in the east Mediterranean, cheques became more versatile through the advent of

negotiability in sixteenth-century Europe. Cheques grew in stature after the suppression of banknotes in

eighteenth-century England.

Cheques began pervading the tumultuous shores of the United States after a nineteenth-century

legislation that discouraged other payment methods and led to a nationwide cheque payment system.

Under the Federal Reserve's leadership, cheque usage grew rapidly and eventually resulted in becoming

the nation's default payment method.

In modern times, many central banks across the globe mandate Cheque Truncation System (CTS) and

Automated Clearing house (ACH) processing within their respective geographies. However, even in the

absence of regulatory mandates, many banks choose image based clearing for their cheque operations,

as it leads to operational efficiencies, fraud control and preparedness for future regulations.

This document attempts to provide some generic suggestions for banks regarding these technologies,

in the process highlighting some best practices implemented by their peers across the globe.

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Money has become in all civilized

nations the universal instrument of

commerce, by the intervention of which

goods of all kinds are bought and sold,

or exchanged for one another

- Adam Smith

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PORTRAIT OF THE PASTBrief History and the Evolution of the Humble Cheque

Today, cheques have become synonymous with banking and the idea that a person can transfer funds by cheque seems as obvious

as buying a cup of coffee. However, the truth of the matter is that through much of recorded history, cheques were almost non-

existent. If we look at The Roman Empire, for example, there was a wide presence of bank-like institutions known as argentarii, but

there is no evidence that cheques were ever used for depositing or withdrawing purposes.

Cheques or negotiable instruments that were similar to them were in widespread use in the eastern Mediterranean during the first

millennium. Around the tenth century, cheques became commonly accepted and used in the Muslim world. In stark contrast,

monetary systems at this time were in an extremely primeval state in mainland Europe.

It was during the 11th, 12th and 13th century that Europeans came into contact with the Muslim world. These civilizations had been

cut off from each other for generations. The Europeans were inadvertently influenced by the banking and monetary systems they

encountered in the eastern Mediterranean. These were adopted by them, with modifications and additions. Thus, the foundation

for the banking and monetary system in Europe was laid.

The earliest forms of cheques were called 'Bills of Exchange'. The first bills of exchange were probably modeled after a document

used in the Muslim world, known in Arabic as the suftadja. Very much like the modern cheque, a bill of exchange consisted of a

written instruction by a drawer to have a third party give funds to a payee.

It was not until the 13th century that Europe began its tryst with the Cheque, nearly 200 years after the origin of bills of exchange. It

began to be used widely in cities like Venice, which had both deposit banks and were well acquainted with bills of exchange.

Gradually, the widespread distrust and disdain of banks towards cheques began to wane owing to the convenience and obvious

advantages of cheque payment.

Despite these advantages, cheques still had some critical limitations. The most pervasive limiting factor was the non-negotiability of

cheques. Negotiability basically meant the ability to circulate among various parties. Hence, early cheques were non-negotiable i.e.

once written; they could only be collected by the party to whom it was made out to. So in case a payee wanted to transfer a bill to a

creditor, banks would not recognize the creditor as having any legal claim on the drawee.

Therefore the introduction of Negotiability has been cited as the single most important factor that defined the fate of the cheque. It

is this character, which catapulted the cheque into banking ubiquity.

04

In the late 19th century, several countries enacted formal laws regarding cheques and

their usage. The UK passed the Bills of Exchange Act in 1882. In 1931, in order to simplify

the international use of cheques, the Geneva Convention called for the Unification of the

Law Relating to Cheques. Many European and South American states as well as Japan

joined the convention. However, countries including the U.S. and members of the British

Commonwealth, did not participate and so hurdles persisted with respect to cheques

used across country borders.

The unassuming simplicity of the modern cheque belies the centuries' worth of legal and

operational experimentation that have contributed to its transformation from a bill of

exchange to its current form. When seen in this perspective it's easy to appreciate the

immense contribution of the cheque towards the development of negotiable

instruments, money transfer and banking as we recognize them today.

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EMERGENCE OF TECHNOLOGY

With a rise in check volumes during the 1950s and 60s, it became evidently difficult to sort and process cheques. Therefore,

necessity became the mother of invention and automation of the sorting process was introduced.

The next technological ingression came about during the late 1950s when American banks collaborated with US business

machinery manufacturers and printers to produce and patent the E13B standard MICR (Magnetic Ink Character Recognition) code.

This development also necessitated the innovation of readers/ sorters to process the MICR code on the cheques. These machines

offered speeds of 1,500 documents per minute (DPM). On the other hand, their European counterparts were produced by EMI

(named FRED, the Figure Reading Electronic Device) and De La Rue Bull and offered speeds of between 300 and 750 DPM.

In a landmark development, the London clearing banks carried out their own research and experimentations of different automatic

check sorting machines, both in the UK and abroad, to deliberate on the most ideal system for Great Britain. The outcome of this

magnum operation led to the launch of the world's first fully operational electronic cheque and document sorter in 1960.

Incidentally, the banks also reached a consensus on reserving the area at the bottom of the cheque specifically for encoding the

branch and account details. Thus, the concurrence of MICR encoding with high-speed reader/sorters revolutionized cheque

processing for the foreseeable future.

With automation becoming pervasive, there was a dire need for cheques to be made of much higher grade paper. As a result of this,

from February 1962 cheques would, in future, be printed on thicker and stiffer paper. This greatly increased the efficiency and

quality of processing using automatic sorters.

In 1969, cheque guarantee cards were introduced in several countries, allowing a retailer to confirm that a cheque would be

honored when used at a point of sale. The drawer would sign the cheque in front of the retailer, who would compare the signature to

the signature on the card and then write the cheque-guarantee-card number on the back of the cheque. Such cards were generally

phased out and replaced by debit cards, starting in the mid 1990s.

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Technology is a gift of God. After the

gift of life it is perhaps the greatest of

God's gifts. It is the mother of

civilizations, of arts and of sciences

- Freeman Dyson

“

”

TECHNOLOGIES THE WORLD IS EMBRACINGCheque Truncation System and Automated Clearing House

From the mid 1990s, many countries enacted laws to allow for cheque truncation, in which a physical cheque is converted into

electronic form for transmission to the paying bank or clearing-house. This eliminated the cumbersome physical presentation and

saved time and processing costs.

Cheque Truncation System (CTS) promises to bring multiple benefits to customers by substantially reducing the time taken to clear

the cheques as well as to the banks by enabling them to offer better customer service and increasing operational efficiency by

cutting down on overheads in physical clearing. In addition CTS also offers better reconciliation and fraud prevention.

CTS technology uses the cheque image, instead of the physical cheque itself for clearing. The cheque image is truncated at the

presenting bank. Subsequently, the cheque image moves through various steps in the cheque-clearing cycle and transactions are

settled on the basis of images and electronic transactions.

A traditional point-solution for CTS can meet all mandatory operational and regulatory needs of a bank. However, to derive

additional benefits out of this application, banks can also opt for a CTS solution based on a Business Process Management (BPM)

platform. This provides the required flexibility and speed of implementation to derive additional benefits of the CTS technology.

These augmentations can help facilitate the following activities:

? Cheque exchange for Central Banks

? Cheque truncation for branches and service branches

? Transportation and security for data transfer from branches to service branches, or to the Central Bank

? Cheque processing for inward/outward clearing and image quality analysis

Another major technological development was the conception of the Automatic Clearing House (ACH) payment system in the

United States, during the early 1970s. It was a result of studies conducted by the Federal Reserve and also suggested by industry

stalwarts that the increasing volume of paper cheques used by businesses and consumers to pay their bills would eventually exceed

the ability of the existing computer systems to process and sort the cheques efficiently.

Hence, the ACH payments system was designed to allow corporations and consumers to reduce or eliminate the use of paper

cheques to make routine payments. To give you an idea about the volumes, this network processed an estimated 8.05 billion ACH

transactions with a total value of $21.7 trillion in 2002.

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Regulatory Stipulations:

Any new or emerging technology disrupts the status quo and therefore is met with resistance. However, it

was the laws related to cheques that proved to be the biggest obstacle in the adoption of CTS. As early as

1995, New Zealand became one of the first countries to introduce cheque truncation when they amended

the cheque act 1960. The amendment paved the way for the electronic presentment of cheques. Numerous

other countries followed suit and over the next few years, the technology was met with mixed reactions.

Some remained tentative as a result of the steady decline in the use of cheques in favor of electronic

payment systems. Other countries especially in Europe like Germany were of the opinion that the cost and

effort to implement truncation was not justified for a diminishing payment method and subsequently

phased out the use of cheques altogether.

Another major development took place in 2004 when the United States implemented the Cheque 21 Act.

The act authorized the conversion of original paper cheques into electronic images for presentment

through the clearing process. The law allowed for the acceptance of a ‘substitute cheque’ in lieu of the

original paper cheque. Therefore, banks that received original paper cheques could now remove or

"truncate" the paper cheques from the clearing process.

In recent times, the central banks of many countries in Asia, Africa and the Americas have made CTS/ACH as

regulatory mandates. All banks functioning within their jurisdiction must adopt and implement CTS and/or

ACH technology in their clearing processes.

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WHY BANKS IMPLEMENT CTS & ACH?

The introduction of imaging and truncation means that the physical movement of instruments can be limited, while the electronic

movement of cheques as images will speed up the settlement process and measurably alter the clearing cycles. With the shortening

of the clearing cycle, customers are able to realize the proceeds of cheques much earlier. One of the most notable advantages is the

reduction in the time of float, i.e. the time from the point of issue of cheque to the point of time the actual debit takes place. It also

augments inter-city cheque clearing by ensuring the realization of inter-city instruments faster thus ensuring early availability of

funds to customers.

Similarly, ACH technology helps banks to adhere to the central bank's guidelines on enabling transfer of funds across banks using

electronic instructions only. The clearing cycle includes outward, inward, and returns processing.

Benefits:? A Cheque Truncation or an ACH solution helps the bank to automate the outward and inward clearing processes, using scanned

images of cheques and mandates instead of physical instruments travelling from one location to another. This results in a faster

clearing cycle and reduction in clearing and forwarding times. This also minimizes the float and misuse of float funds.

? Automation of the inward signature and technical verification process by the drawee bank, results in a faster verification process

by enabling the signatures and other cheque/mandate related details to be viewed in a single screen.

? Better Customer Service: A CTS/ ACH solution helps banks to monitor the status of cheque/ transaction at every stage of

processing. It helps banks to respond to customer queries better and faster, on the status of the transaction/cheque, what stage is

it pending, and so on.

? Smoother Inter branch reconciliation: Cheques being received and processed physically at each branch may lead

to reconciliation issues. An automated solution will help to consolidate the cheques/ mandates scanned at each branch (along

with the branch tag) to avoid reconciliation issues during processing.

? The jurisdiction of the Clearing House can be extended to the entire country, therefore, no geographical dependence.

? Operational Efficiency will benefit the bottom lines of banks since local clearing is a high cost no revenue activity.

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? Reduces operational risk by securing the transmission route. CTS/ACH solutions strictly adhere to the

file encryption and secure transmission standards prescribed by a particular geography's central bank. This helps to

reduce the operational risk while processing cheques/mandates from one location/bank/entity to another.

? Early and more effective detection and addressing of fraud: The solution is able to identify duplicate

cheques/transactions automatically, based on MICR codes, account numbers, etc. and avoid possibility of fraud

right at the cheque origination/truncation point. Also, once a cheque/mandate is scanned and archived securely; its

image literally becomes tamper-proof. Hence, automation reduces the chance of fraudulent/intentional tampering

with the instrument.

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RECOMMENDED BEST PRACTICES

Based on our extensive experience of implementing CTS / ACH and related products in around 50 banks across APAC, MEA and

South Asia in the last 5 years, we recommend a set of best practices for cheque and ACH processing operations. These guidelines

will help banks to move up the learning curve and help gain operational efficiencies.

However, this change of approach in handling cheque/ transaction processing (especially if re-engineering operations from

scratch) may have resistance from some quarters. Hence, while implementing the solution, to ensure success in shortest possible

time; banks may like to work with ready-to-deploy templates. Experience of managing such changes would be helpful and

therefore banks can include experienced professionals as part of the team to assist in this Change Management. Let us look at some

of these best practices as elaborated below:

Outward Clearing Automation? Depending upon the volume of cheques and the network of branches and volume of cheques at each branch, a bank needs

to take a decision of whether to truncate the cheque at each branch (decentralized scanning), or only at one service branch

(centralized model), or a using a hub-spoke model of scanning. The number and cost of scanners at places where scanning is to

be done, is another factor in making this decision. Hence, in any CTS solution, a bank should enquire if it supports centralized,

decentralized and hub-spoke model of scanning? Similarly, based on the volumes of the ACH mandates received from corporate

customers, a bank will need to decide whether it wants to scan mandates at individual branches or at a central location.

? In a lot of geographies across the globe, individual branches may not always be connected to a stable network. Hence,

it becomes all the more important that the CTS/ACH solution supports offline scanning without connectivity, as the need arises.

Banks can also opt for clearing operations at the branch level itself. However, this may not be advisable as this requires integration

with the Central Bank's server at a branch level, and reconciliation issues may crop up.

? Depending on the volume of cheques, a bank may opt for Teller Level Scanning (individual scanning by users, in which scanning

and data entry interfaces are combined) or Bulk Scanning (separate scanning and data entry interfaces) model.

? There might be a need to scan and present a defined set of cheques on a given date; the solution should help the banks to handle

this. Banks may also require a functionality to be able to choose the presentment cycle, date of presentment, bank branch, etc.

while starting the scanning station. A solution that offers these features should be an ideal choice.

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? As a corollary, banks may want the solution to be extendable to Multiple Clearing Cycles/Sessions, so that if the need

arises in future, they do not need to procure additional licenses/development efforts for the same.

? At the time of scanning, most banks require that in a single cycle, the solution should be able to perform the

following activities:

¡ Capture Front and back image of the cheque in the resolution/standards as mandated by the Central bank.

¡ Capture and decode the MICR code line details, as per the central bank's configuration. Fields like cheque/ instrument number, bank code,

branch code, city code, short account number, Transaction Code (determining the type of instrument), etc. will be read by the system.

¡ Printing an endorsement number at the back of the instrument (the need and configuration depends on the central bank's requirement).

? The CTS solution chosen by a bank should adhere to MICR configuration, Image Quality Analysis parameters, file formats

and file exchange mechanism mandated for its country of operation.

? Banks can also choose platform/scanner agnostic software, i.e. integrated with a scanner/server of their choice.

? Many banks like to have the option of integrating the Core Banking System with the CTS/ ACH solution. Some banks like

to keep these separate. One needs to decide the priority of the bank & decide accordingly. If required, the integration

methodology may differ from bank to bank based on their specific requirements (e.g. can be file hands off exchange, API based

integration, etc).

? In addition to the data captured during scanning, banks may require functionality where users can perform data entry for fields

like amount, account number, payee name and issue date, and modification for MICR code, account number, etc. This applies

both to CTS and ACH transactions.

? As a best practice, it is often seen that a solution has the capability to run an ICR/OCR engine, and automatically capture

the amount, account number, etc. Banks may wish to go with these add-ons to improve the extent of straight-through-

processing, but can manage operations efficiently even without these.

? Image Quality Analysis should be as per the Central Bank's guidelines/ parameters. Banks usually follow a practice where users

get an alert for only those instruments where the image does NOT conform to the standards; with an option to rescan the

specific instrument.

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? The Central Bank of a country requires banks to generate the requisite files, in the mandated file formats and adhering to the

exchange mechanisms (may use secure FTP upload if required). This includes acknowledgement from Central Bank, and

modification of rejects, if any. The solution chosen by the bank must meet this critical requirement.

? Archival and retrieval of instruments/mandates, data and audit trail, based on configurable search parameters is a critical need.

This is important because the regulatory body or the customer may ask banks to provide details of a particular historical cheque/

transaction record. It will be helpful if the bank has a centralized archived repository, where historical documents can be accessed.

? For ACH transactions, banks may like to automate either the outgoing/incoming debit or credit transactions or both. This decision

mainly depends on the regulatory environment.

? Based on the same platform, banks may like to upgrade the solution in future to include Forex Cheque Processing, Future-dated

instruments processing, Signature and Mandate Management, Integration with Cheque Deposit Kiosks. The decision to add

these up-gradations may be taken based on the regulatory environment, the current capabilities of the CBS and the pain areas the

bank might be facing.

Inward Clearing Automation

? The inward process for CTS and ACH should ideally be made as Straight-Through-Processing. This can be achieved through

enabling integration with the Central Bank Server for automatic pick up of inward files/images/data and also with Core

Banking System to check for account validation, balance sufficiency cheques, etc.

? The only place where human intervention should be required is while doing signature and technical verification of the

instrument. Ideally, in one single screen the operator should be able to view instruments' scanned images, the master

signatures fetched from the core banking, core banking status (i.e. whether account is valid and balance is sufficient or not)

and the details received from the central bank. In ACH scenarios, the mandate form will be displayed instead of the

instrument copy, and operator shall match the instruction with the mandate, instead of matching the signature.

? It is preferable to have a provision wherein a bank can classify and distribute the incoming instruments/ ACH transactions

into buckets – amount based, or region based, or based on any other such rule.

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? Another recommended practice is having the provision of amount/value capping based on type of instruments/ ACH instructions.

? A desirable optional feature worth considering is where the operator can refer an instrument to the Relationship Manager (Branch) of

the customer to take a final decision of accepting / rejecting a cheque/ ACH transaction. This is more applicable when the balance in

a customer's account may be less than the amount of the cheque, and RM needs to decide whether OD facility needs to be given to

pass that particular cheque/ ACH transaction or not. A lot of banks find this practice as a good service to their High Net Worth

(HNW) customers, to help them avoid the harassment and financial/reputation losses due to cheque dishonor.

? Cheque Clearing, esp. inward processing, being a business critical activity for the bank, may require a solution in which the

architecture is designed to ensure maximum up-time including ease of installation and configuration. Similarly, it helps to build in

clustering and DR environments. It is also recommended that the solution have a functionality to handle high value or specific

cheques on priority, in cases of exception.

? A solution with pre-configured dashboards and online reporting tools is a great advantage as it will help banks to improve

operational efficiency and monitoring of incoming/ outgoing transactions.

Returns Processing

? Banks ideally warrant the complete return processing to be Straight-Through-Processing for both outward and inward returns.

? At the drawee bank's end, the solution can be integrated with the CBS to automatically pass reversal entries (to reverse the debit

passed, if the cheque was subsequently rejected by the RM), to generate the desired return file for Central Bank in mandated format,

etc.

? At the presenting bank's end, similarly the solution can receive the files from Central Bank server on pre-defined time windows, pass

reversal entries in its CBS (shadow balance reversal), and generate return memos for distribution to end customers.

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ABOUT NEWGEN

Newgen Software Technologies Limited is a leading global provider of Business Process Management

(BPM), Enterprise Content Management (ECM) and Customer Communication Management (CCM) with

a global footprint of 850 installations in over 45 countries with large, mission-critical solutions deployed

at the world's leading Banks, Insurance firms, BPOs, Healthcare Organizations, Government, Telecom

Companies & Shared Service Centers.

Newgen Software has been positioned in the Magic Quadrant for Business Process Management (BPM)

and Enterprise Content Management (ECM). The company has been recognized by distinguished analyst

firms like Frost and Sullivan as A 'Hot Company to Watch for' in their global ECM Market report, 2009 and

by IDC in its exclusive report “Newgen Software: Global Leader in Business Process Management and

Document Management Solutions”. Newgen is the winner of prestigious awards, such as the CNBC-TV18,

“Emerging India Award 2008”.

Newgen's Quality Systems are certified against ISO 9001:2008 and Information Security Standard, ISO

27001:2005. Newgen has been assessed at CMMi Level3.

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New Delhi

Newgen Software Technologies Ltd.

E-44/13, Okhla Industrial Area Phase II

New Delhi - 110 020

Tel: +91-11-4653 3200, 2638 4060, 2638 4146

Telefax: +91-11-2638 3963

Email: [email protected]

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Ground Floor, Quanta ZEN

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Tel: +91-44-4356 0890

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New Delhi

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