The basics of ACH

An intro to one of the most popular ways to move money electronically

More than 90 percent of the value of all U.S. electronic payments go through ACH, but most consumers don’t even realize they’re leveraging the network—or know what it is. The ACH, or Automated Clearing House, network is the primary way money moves electronically, with more than $40 trillion moved in nearly 23 billion electronic financial transactions annually.

Essentially, ACH facilitates bank-to-bank transfers—the kinds of transactions that don’t go through credit or debit card networks. A few types of transactions can be handled via ACH: direct deposits and direct payments, as well as settlements for credit, debit, and ATM transactions. To make the transfer, ACH uses the amount as well as two pieces of customer information: the routing number and bank account number.

Part of its popularity stems from the advantages it provides to merchants: ACH is often cheaper and easier than credit card transactions or checks, though it is a good deal slower. Unlike the credit card network, the ACH network doesn’t provide real-time authorization of funds, though much has been made of plans to do same-day ACH, a solution NACHA, which governs ACH, is actively working toward.

Authorizing accounts

Only banks can initiate ACH transactions, which means that merchants need to partner with banks in order to set the ACH process in motion. Whoever originates the payment is the Originator, while their partner bank is referred to as the “Originating Depository Financial Institution,” or ODFI.

Let’s say an electrical company’s customers pay their monthly bills on a recurring basis via ACH. When these customers enroll in automatic bill pay, they provide authorization for their utility to pull money from their accounts on a recurring basis. To get paid, the utility would originate an ACH debit transaction on its customer’s account, making the utility the originator, its merchant bank the ODFI, and its customer’s bank the RDFI (Receiving Depository Financial Institution).

Verifying that accounts exist and have sufficient funds can help prevent errors. And it’s the Originator’s responsibility to do so.

There are five ways to verify an account, according to NACHA:

  1. Micro-deposits (one of the most common methods)
  2. Check verification (which compares an existing database of account numbers for the largest originators/receivers)
  3. Pre-notification entry (executing a zero-dollar transaction to verify the receiver account)
  4. Debit card number authorization
  5. Account verification (which uses the customer’s bank credentials)

Example of ACH authentication The Plaid Auth Flow

How ACH works

So let’s say that electrical company wants to debit a customer’s account for the monthly bill. Once everything is verified, here’s how ACH works:

  • As the Originator, the electrical company sends ACH files, which contain the amount of the transaction and the appropriate routing and bank account numbers, to Wells Fargo, its partner bank and the ODFI in this situation. (Wells Fargo also happens to have been the largest originator of ACH payments in 2014, initiating 2.6 billion debits and 1.5 billion credits.)
  • Not every bank is an ODFI, which means the banks that do act as ODFIs typically handle a high volume of ACH files. Rather than forward them as they come in, it will accumulate ACH transactions throughout the day for later processing. This makes the ACH Network a batch processing system. It also slows things down a bit.
  • Wells Fargo will credit the company’s account—and debit the end customer’s—and essentially create a hold for the amount. Note that Wells Fargo is making an assumption here: It doesn’t check whether the customer’s account exists or has sufficient funds, which means this bank is also assuming some risk.
  • At the end of the day, Wells Fargo forwards all the ACH files it has received in batches to a clearinghouse. Typically, it’s the Federal Reserve, but the American Clearing House Association, the New York Automated Clearing House, and VisaNet ACH Services among approved alternatives.
  • The ACH transactions are sorted and sent to their respective Receiving Depository Financial Institutions, so called because they receive the ACH files from the clearinghouse. In this case, let’s say the customer uses Bank of America, which would be his RDFI. When Bank of America receives the ACH file for this transaction, it will note a debit on the customer’s account for the right amount of money.

At this point, no money has actually changed hands, though the bank accounts may now reflect pending transactions. Then comes settlement, which basically follows the same principles of Net Deferred Settlement, or the process through which banks resolve all their transactions at the end of the day. Each ACH credit transaction typically settles in one to two business days, and each debit transaction settles in one business day. In our example, settlement would follow these steps:

  • The clearinghouse calculates the net debit and credit positions of the utility's Wells Fargo account and the customer’s Bank of America account and posts them to the banks’ reserve accounts.
  • The two banks rely on their Settlement Account, which is funded by each bank’s own capital, to fund the transfers, pending the actual net settlement of funds.
  • Once Bank of America receives the information, it reconciles the accounts. It checks to make sure the customer’s account has sufficient funds to complete the transaction. If it does, the transaction is cleared. If it doesn’t, well, they’ll get an error message back.
  • Finally, the money is officially deducted from the customer and deposited into the utility’s company’s Wells Fargo account. In other words, it’s settled among the banks.

We’ll tackle other elements of ACH in future features, but in the meantime, check out this excellent primer from our friends at Gusto, which unpacks the system from a developer’s perspective.

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