Understanding clearing in payments

We hear the word “clearing” used in a lot of different ways. The check cleared. The woman was cleared of all charges. The prisoner cleared his name; the jumper cleared the bar.

In all contexts, though, “clearing” implies a process – someone, or something, succeeding; passing a test, or going through an ordeal and coming out the other side in one piece. It implies clarity, resolution, finality, progress: the removal of obstacles.

It’s exactly the same in payments.

All payments – whether you’re accepting them through debit cards or digital wallets, or making them through a wire transfer or a direct debit – most go through clearing. Basically, clearing is the process by which banks verify a payment: checking the transaction details, analyzing it for fraud, and ensuring legal and regulatory compliance.

For more, though, read on. Below, we’ll define what clearing in payments is in full, and explore the concept of a clearing house. Then, we’ll explain how clearing works, provide some examples of clearing in practice, and unpack clearing’s wide range of benefits for merchants.

What does clearing mean?

Clearing is the process all financial transactions – such as a credit or debit card payment, a wire transfer, or the purchase of futures or bonds – must go through before they can be completed.

Essentially, clearing is the process by which the financial institutions involved in the transaction exchange information: reconciling and confirming the payment details before any funds are actually moved. The clearing process allows banks to assess the transaction’s level of risk, analyze it for fraud, check the payer has sufficient funds, minimize scope for error, and ensure the exchange complies with regulatory requirements such as Anti-Money Laundering (AML).

So, who’s responsible for the clearing process? Typically, that depends on the type and complexity of the transaction, and what level of checks and balances are required.

Clearing can be undertaken by:

• Banks: In wire transfers and typical credit and debit card payments, banks will usually handle the clearing process themselves. In a card transaction, for example, the issuer (the customer’s bank) works with the acquirer (the merchant’s bank) to clear the transaction, with the card schemes (such as Visa, Mastercard, American Express, and Discover) facilitating the exchange of payment information.
• Clearing houses: Some high-value or cross-border transactions may utilize a clearing house: a central entity that acts as an intermediary to ensure payments are verified, matched, and netted correctly. Clearing houses can be independently owned, or operated by central banks and industry associations. The Automated Clearing House (ACH) and the Clearing House Interbank Payment System (CHIPS) are widely used in the US, as is the Clearing House Automated Payment System (CHAPS) in the UK.
• Payment processors: These are businesses, like Checkout.com, that handle the technical aspects of a payment during the clearing process. They relay data to and from banks and clearing houses, and supply extra services, such as fraud detection.

Once a transaction has been cleared successfully, it will later be settled. Settlement is the process of transferring the funds to the recipient’s account, where they’ll be made available to access. Clearing and settlement are often confused – so explore our guide to clearing vs settlement to understand these processes’ key differences.

How does clearing work?

Here’s a quick breakdown of how a typical clearing process looks.

1. First, the payer initiates a transaction. This could be a customer making a purchase with a credit or debit card from a merchant’s online store, or a business wiring money to pay vendors.

2. This payment instruction is relayed to the banks, or the clearing house, involved. They verify the transaction’s details, ensuring they’re correctly formatted and that the instructions from the payer’s bank match the payee information provided.

3. The funds are held, securely, while clearing takes place. Sometimes, a clearing house may ‘net’ multiple transactions between the same banks together – a process which involves calculating the net amount those banks owe each other, rather than processing each transaction individually. This can slow the clearing process down a little, so it’s best to opt for a real-time payment service – such as FedNow – if you require immediate clearing.

4. After the transaction has been cleared of any suspicion and resolved of any discrepancies, the clearing house confirms the details with the financial institutions involved.

5. The payment instruction is sent off for settlement, and money changes hands.

Why is clearing important?

Clearing plays an important role in facilitating smooth, seamless, and secure payments. It:

• Ensures all transaction details are accurately recorded, matched, and reconciled
• Reduces the risk of errors and discrepancies incurring financial losses and disputes
• Mitigates a variety of risks – including credit, liquidity, and operational – for businesses
• Streamlines the handling of large volumes of transactions, boosting efficiency
• Identifies and prevents fraudulent activities, protecting banks and customers from loss
• Enhances confidence and trust in the payment process and the wider financial system
• Complies with regulatory standards and requirements, such as AML and KYC
• Provides a clear audit trail of transactions, enhancing transparency and trust
• Introduces standard procedures and protocols for processing payments: simplifying and harmonizing operations across a number of different financial institutions and markets

What is a clearing house?

Clearing houses are organizations that act as intermediaries in the clearing and settlement processes: facilitating the exchange of payment information between the different parties – including financial institutions and payment processors – involved in the transaction.

Some examples of clearing houses for payments include ACH and CHIPS (in the US), CHAPS (in the UK), and the European Central Bank’s TARGET2 system.

There are other clearing houses specializing in derivatives – such as the London Clearing House (LCH) and Chicago Mercantile Exchange (CME) – and yet more, such as Options Clearing Corporation (OCC), that handle securities (rather than payments).

By acting as central counterparties in the clearing process, clearing houses reduce systemic risk – mediating and reconciling a payment and playing the role of go-between for the banks.

Once a payment has cleared, it’s the clearing house that prepares the transaction for settlement: ensuring that all necessary conditions are met before any funds are transferred.

Example of clearing

All digital financial transactions – be they wire transfers, credit card payments, or digital wallet payments – must go through the clearing process.

For the purposes of this example, though, we’ll illustrate the clearing process with a typical bank-to-bank transfer made through the Automated Clearing House (ACH). ACH payments do, after all, account for around 30 billion payments made in the US every year – at a value of close to 80 trillion dollars – so they’re a good place to start.

In our example, Danny wants to pay his monthly utility bill online. (This could also be a business paying another business, a customer making a purchase from a business, a company paying its staff’s salaries – or even a company issuing a customer a refund.)

Danny could have initiated the payment through his bank (a ‘push’ payment), but in this case, he has a direct debit agreement in place for the utility company to ‘pull’ the funds from his account on a pre-agreed monthly basis. So, the utility company submits a batch of ACH debit requests – Danny’s payment among them – to its bank.

The utility company’s bank (known as the originating depository financial institution; ODFI for short) compiles this batch of ACH transactions, along with others, and sends it to the ACH operator. In the US, there are two primary ACH operators:

• The Federal Reserve
• The Electronic Payments Network (EPN)

Then, the actual clearing happens.

The ACH operator receives the batch, sorts the transactions by bank, and processes them to ensure they’re correctly formatted and meet the required standard. At this stage, the ACH operator works with the banks involved to look for fraud: validating account numbers, checking transaction amounts, and screening for suspicious patterns. Then, the ACH operator usually nets the transactions to avoid processing each transaction individually.

Following this, the ACH operator sends the netted transaction details to the banks – including Danny’s – which then debits his account, and credits the money he owes for his utilities to his provider. Despite how long and complex the process we’ve described here sounds, the money should typically be settled – that is, in the utility provider’s account – by the following day.

Benefits of clearing

Given how invisible clearing is to all but the entities involved with it, it can be difficult to feel invested in the process. But despite its ‘behind the scenes’ nature, clearing is something your business should care about. And it benefits your payment process in several ways, including:

• Rapid access to funds: By ensuring that payments are processed (and thus can be settled) quickly, clearing allows your business to get paid – fast. This has positive knock-on effects for your cash flow management, as well as your ability to plan, invest, and forecast more accurately for your business’s financial future.
• Lower risk of chargebacks: Payments go through rigorous checks during the clearing process, which lowers the likelihood of fraudulent transactions, chargebacks, and the associated costs. Better still, once a transaction is cleared, the payment is essentially guaranteed – allowing you to sidestep the risks of non-payment or default.
• Cost savings: By netting transactions, clearing systems can offer lower transaction fees and banking charges – making accepting payments more affordable and accessible.
• Increased customer trust: Efficient, secure payment clearing processes boost the reliability and reputation of your payment system, building trust with cardholders.
• Simplified compliance and reporting: Clearing systems help you toe the line of a number of regulatory requirements – KYC and AML included – and can even assist your business with its financial tracking, auditing, and payment reconciliation processes.
• Flexible and scalable: Clearing systems can handle any number of transactions – even large volumes – which makes them suitable for merchants of all sizes.

How can Checkout.com help you with the clearing process?

Here at Checkout.com, we’re not just a payment service provider: we’re an acquirer, a payment gateway, and a payment processor all rolled into one.

Our full-stack, end-to-end payments solution equips businesses like yours with a comprehensive suite of payment solutions: allowing you to accept debit cards and credit cards, plus a plethora of alternative payment methods. With our fraud detection tools, machine learning-powered approach, and dedicated support, we can streamline the clearing process for the merchants we work with: ensuring faster, more secure, and more cost-effective payments.

Plus, we’ll always keep you in the loop about what’s happening with the payments your business accepts and sends.

Through our granular reconciliation reports, you’ll have the status of all your transactions, at your fingertips and ready to analyze, wherever you need them – so you’ll never be kept in the dark about whether or not your payments have cleared. This makes it easier to reconcile your accounts, and manage your business’s money – now, and long into the future.

To explore what your business could gain from a faster, more efficient clearing process – plus the ability to dive deeper into the data so crucial to your payments strategy – get in touch with Checkout.com’s team of payment experts today for a no-strings, no-obligation conversation.