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Choosing an ODFI for You and Your Merchants

Posted by Brandes Elitch | Fri, Oct 11, 2013 @ 03:00 PM

Risk1As an ISO, you primarily sell card processing, but sometimes a merchant will ask about your ability to process other payments. This might include recurring payments, such as monthly health club dues. Recurring payments are a natural for the Automated Clearing House (ACH). Some ISOs do not have a solution for processing ACH payments or they have tried to find one and have come up short. It is difficult to find a bank to process ACH transactions for ISOs, and here we’ll explore why.

In the last blog, I explained how the Automated Clearing House works and what ACH transaction roadblocks exist. In this column, we will explore in more detail one of the participants in an ACH transaction: the Originating Depository Financial Institution, ODFI for short. You, the Originator, send a file in a standard entry class code as defined by the National Automated Clearinghouse Association, to your ODFI, the bank, for processing. The ODFI in turn sends it to the ACH Processor, EPN or the Fed, and from there it goes to the Receiving Bank, which holds the account to be either debited or credited.

This is all about the bank managing risk: credit risk, operational risk, and fraud risk.

Credit risk happens when one party in this loop is unable to meet its funding obligations to ensure a proper settlement. For example, let’s say you initiate an entry two days before settlement day to debit one account and simultaneously initiate a credit entry to move the funds elsewhere. What if the debit fails, but you have already pushed funds to another receiver? 

There are ways to mitigate this risk. The ODFI bank can make a loan or can approve a daylight overdraft, to be paid back by the end of the day. The ODFI can put a hold on funds in the account to be debited, if it is in the account’s bank, so that no other debits hit. But the real answer to credit risk is the due diligence of the bank in really knowing its customer. How long has the customer banked there? What is the recent history? What are the current financials? Are there any consumer complaints or NACHA rule violations or fines pending? What is the chargeback history? The bank can set exposure limits, restrictions on the type of transactions, and stipulate the right to audit and the right to terminate the account.

The originating bank can also suspend a file if it is over the preapproved dollar limit. This can require a lot of manual intervention and is guaranteed to get the originator’s attention! 

Debits cause more problems than credits. The ODFI assumes the risk for debit returns. The overall return rate last year for all debits was just shy of one percent of all originating debits. This may not seem high, but there are definite problems in certain business segments, for example, gaming, entertainment, check cashing, Money Service Businesses, and telephone and internet authorizations.

For checks, there is a rule called the Midnight Deadline: a bank must return a bounced checkMidnight Deadline by midnight following the day after the institution receives it. In the ACH debit world, the receiving bank must notify the originator by the opening of business on the second banking day following settlement of account closed, stop payment, frozen account, or NSF. Of course, the receiver of the debit, the consumer, has 60 days to claim that the entry was unauthorized or the authorization was revoked. Imagine in the check world if a check writer could claim two months after a check was cashed that he didn’t really mean to write it! Originators are supposed to send prenotes and Receivers are supposed to send Notifications of Change, but sometimes it just doesn’t happen that way. Instead, these items are routinely ignored.

Returns are where the ACH really differs from check law. There are multiple types, for example:

01 = NSF
02 = account closed
03 = no account
04 = invalid account
07 = authorization revoked
08 = stop payment
09 = uncollected funds
10 = not authorized

You can only resubmit a return if:

  • You correct an error
  • Resolve the reason for the stop payment
  • The claim of unauthorized debit is revoked
  • You get a subsequent authorization
  • There are insufficient or uncollected funds

You can only re-initiate a return entry two times, and this is for RO1 and RO9 only. Operational risk pertains to a transaction that is altered or delayed due to an unintentional error. This could be due to software, hardware, or even telecommunications problems (they happen!).

Fraud risk happens when someone tries to misdirect or misappropriate funds willfully. There is tremendous focus on fraud and security today at financial institutions. The bank has only one business day to dispute an unauthorized corporate ACH debit, so it must do daily reconciliation and use positive pay, check block, ACH filters, etc.

It now should be a little easier to see that banks view originating ACH transactions as riskier than processing checks, and only slightly less risky than originating a wire transfer. Check law is settled, and all states (except Louisiana) use the Uniform Commercial Code for adjudicating check issues. It is easier to run a check through an imager and email the file to the bank than it is to prepare an ACH file. ACH works great for small dollar, recurring transactions where there is a consumer authorization, and you should be able to get your depository bank to handle these transactions for you. The bank will underwrite your ISO and your customer and set limits for daily and monthly transaction size. You will need to learn how to use the bank's PC-based ACH product, and you will need to comply with the bank’s requirements for managing fraud. Talk to your banker about what is offered for ACH processing (besides direct deposit of payroll!) and find out what is required. Ask for a demo. If you don’t like what you hear, it’s time to find another bank! 

Thinking about becoming an ISO? Download our free eBook or watch the webinar, custom-created just for you!

                     check services, ongoing residuals, check processing          ISOs Insider's Guide

Topics: Brandes Elitch, Independent Sales Organization (ISO)

Written by Brandes Elitch

Brandes Elitch is Director of Partner Acquisition for CrossCheck Inc. A certified cash manager and accredited ACH professional, he garnered a Master of Business Administration from New York University and a Juris Doctor from Santa Clara University.