The Check Clearing for the 21st Century Act, commonly known as "Check 21," was signed into law on October 28, 2003, and became effective one year later on October 28, 2004. The purpose of the legislation was to modernize and enhance the efficiency of the check payments system by making check truncation and electronic exchanges possible through the use of a "substitute check," more commonly known as an image-replacement document (IRD). The use of IRDs for payment in lieu of an original paper check was designed to shorten the processing time and possibly create faster availability of funds by eliminating many of the costs and risks associated with physically transporting checks. The new legislation only required paying banks to have the capability to accept and process IRDs as if they were paper checks rather than enforce the use of the other features of Check 21, such as requiring banks to create IRDs or to accept checks electronically.
The Check 21 Environment
Early adopters of Check 21 tended to be the banks of first deposit that would find immediate advantage in collecting checks faster than traditional physical methods. These "sending" institutions included banks of all sizes intent on improving their float times and reducing their transportation costs. Recent data provided by the Electronic Check Clearing House Organization highlight the increasing rate at which financial institutions have adopted the new processing environment within the past year. The volume of checks collected under Check 21 rules increased from 28.1 million images in August 2005 to 283.3 million in August 2006, with the daily average volume increasing from 200,000 to 5.8 million. Within that same time frame, the dollar amount of Check 21 items grew 154.7 percent, increasing from $192 billion to $575 billion.1
However, institutions appeared to be less intent upon implementing the receiving aspects of Check 21, since the new operating practices involved making extensive and costly changes to institutions' check processing equipment and procedures. Most banks found that sending electronic files containing imaged checks was relatively easy, as was creating IRDs when necessary. However, most financial institutions also found that receiving and processing these same files as a paying bank were very challenging. Thus, the adoption rate for receiving "image exchange files" by banks as paying banks continues to be far lower than the participation rate for these same banks as banks of first deposit. In the year following the implementation of Check 21, both the send and receive rates were insignificant, with some statistics citing that such checks sent under Check 21 rules represented only 1 to 2 percent of checks processed annually in the United States, with the checks received being even lower.2 Despite the slow initial adoption of end-to-end processing within the Check 21 environment, payment system experts anticipate that the majority of the largest banks will fully implement the technological standards within the next year.
Impediments to the Full Transition to the Check 21 Environment
Despite the probable benefits associated with Check 21, a number of obstacles have impeded the industry's migration to the new processing environment. Rather than elaborate on the wide array of potential challenges, however, this article will focus only on a few. As mentioned above, in order to transition from the practice of processing paper checks to that of processing imaged checks, financial institutions must greatly overhaul their check processing infrastructure and integrate the imaged items into their back office processing and risk management systems. Such actions require significant investments of both time and money at a time when the industry is experiencing a decline in the use of paper checks in favor of alternative forms of electronic payment. According to a 2003 Federal Reserve study of the use of retail payment instruments, the volume of paper checks processed decreased from 42 billion in 2000 to 37 billion in 2003, with U.S. noncash retail payments decreasing from 57 percent to 45 percent during that same time frame.3 Nevertheless, while the volume of paper checks is expected to continue to decline, experts predict that paper checks will continue to be widely used and will co-exist with electronic checks for years to come.
Another significant impediment relates to the ongoing threat of check fraud that has continued to increase in recent years, despite the overall reduction in check volume. According to the results of the 2004 American Bankers Association (ABA) Deposit Account Fraud Survey Report , approximately 75 percent of all commercial banks incurred losses related to check fraud during 2003, with losses totaling approximately $677 million. Moreover, within the past few years, attempted check fraud increased 28 percent, from $4.2 billion during 2000 to $5.5 billion in 2003, with forged checks and counterfeit checks representing 23 percent and 16 percent of check fraud losses in 2003, respectively.4 Traditionally, financial institutions relied upon the physical security features of a paper check, such as watermarks, microprint, special ultraviolet ink, and others. Unfortunately, these features are rendered useless for verifying the authenticity of check images. Consequently, in an era of increasing check fraud and in a new image-based processing environment, institutions need to develop acceptable alternative methods for detecting fraud without using the original physical check prior to implementing such Check 21 processes.
Taking Advantage of Technology to Combat Check Fraud
Well before the implementation of Check 21 and in anticipation of the aforementioned concerns, the Federal Reserve, along with other federal agencies, financial institutions, industry partners, and technology vendors, acknowledged that new "image-survivable" security features would be necessary to mitigate check fraud in the new processing environment. The Federal Reserve and the U.S. Treasury in particular invested heavily in development projects to pilot selected technologies that could be adapted to the check processing environment, providing new protections for times when the original check is truncated and no longer available for fraud inspection. Several technologies were tested, and some were piloted for a full assessment of the capability to still perform check fraud detection solely from the digital image of a check. This research proved so successful that one technology is now fully deployed on the over 200 million U.S. Treasury checks issued annually.
It became increasingly obvious, however, that check fraud detection at the paying bank still exposed all "upstream" participants in the payment process to risks of check fraud losses. For instance, a merchant might accept a fraudulent check for goods sold and find itself with no recourse. Alternatively, a bank of first deposit might accept a fraudulent check in deposit only to find too late that the check was worthless after money was withdrawn.
To that end, the Financial Services Technology Consortium (FSTC), a nonprofit trade association that sponsors and facilitates the development of technology for the financial services industry, commenced the Interoperable Verification of Check Security Features project in June 2004. The objective of the project was to research the effectiveness of various security features that would function within the proposed imaged-based environment of Check 21.
While some financial institutions independently developed image-survivable security features to operate within the new environment, FSTC's project was unique in that it focused on attaining interoperability among institutions. For this project, interoperability was to be achieved through the use of standards that identify the roles and responsibilities of various constituents as well as communication requirements and message formats needed for financial institutions to verify the imbedded security features on any check. Federal Reserve Bank of Philadelphia Executive Vice President Blake Prichard noted that the "FSTC's proposed national standard was viewed as a major step forward in reducing check fraud."5
Furthermore, the FSTC's proposed business practice presents a significant departure from existing check fraud prevention processes used in today's paper-based environment, which typically take place in the back room operations department of the paying bank and rely on the inspection of the physical check. Instead, this process permits the bank of first deposit, or sending bank, to verify the image-survivable security features embedded on the paying bank's imaged check, thus allowing for the detection of the fraudulent item much earlier in the processing cycle. Ultimately, the goal of the process is to enable the bank of first deposit to verify a check's authenticity at the point of presentment, thereby preventing a fraudulent item from actually entering the payments system. Unfortunately, such an endeavor is extremely challenging and complicated to implement since it involves integrating so many variables; as a result, it is realistic to assume that upon initial adoption of this practice, the verification may be performed within the bank of first deposit's back room review. Regardless of which point in the payment process the security features are verified, its attributes provide an advantage, as they allow the item to be validated earlier than in current practices and permit interoperability among institutions. As a result, all involved parties are expected to be better protected from loss.
The FSTC's project was completed in March 2006, meaning that effective security features were identified for incorporation into a registry, and core communication and messaging standards were developed to enable a bank of first deposit or its merchant customers to verify the security features of an imaged check to the registry. Currently, the project is awaiting its registry to be sanctioned by the Accredited Standards Committee X9, Inc., a company based in Annapolis, Maryland, that sets imaging standards for the industry. As a testament to the project's significance and quality, the standards committee immediately accepted the project for consideration. In anticipation of formal sanctioning of the registry, the National Clearing House Association (NCHA) established a registry of eight image-survivable security features. According to the NCHA press release dated September 25, 2006, a draft standard for trial use of the registry and the messaging used to access it could be available by early 2007.
Recently, the FSTC indicated that four banks, the Treasury Department, and two technology vendors participated in a Proof of Concept test. The test was conducted to determine the feasibility of the interoperability among the various entities involved in the process, the quality and timeliness of transmitted imaged files, the ability of the central validation entity to verify the security marks and report exceptions to the submitting bank, and the ability of the central validation entity to install and support industry vendor solutions.6 The FSTC reported that the test yielded generally encouraging results, yet more security marks and vendors are needed in order to truly test operability.
Although the predictions of payment system experts differ concerning the future direction of check fraud and which type of banks will be targeted, one thing is certain: fraud will persist and continue to evolve in this ever-changing environment. While the post-Check 21 environment continues to change, it is essential that industry stakeholders continually reassess their corresponding risk exposures in an effort to reduce the opportunity for fraud and to maintain the integrity of the check processing system. Projects such as the one completed by the FSTC demonstrate that the collaboration of industry stakeholders and the utilization of technology can result in effective anti-fraud processes in this new generation of check processing.
Check 21 and Check Fraud: Additional Resources
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.