– September 11, 2020

Last month, Citibank transferred $900 million to a number of its customers. But Citibank messed up. It was only supposed to send $9 million, not $900 million. It requested the recipients to return the funds. Most of them did. But the rogues at Brigade Capital Management opted to keep their $176 million bonanza. (Brigade was only owed $1.5 million by Citibank.)

Citibank is now pursuing Brigade in court to recoup its missing $174,651,497. But why didn’t Citibank just unwind the payment the moment the mistake was done?

The answer has to do with a concept in payments and banking called finality. For reasons that I’ll outline below, the payments system guarantees that, once a payment passes a fixed line, those funds are irrevocably available to the receiver. Without this guarantee of finality, economic activity might seize up.

Let’s not single out Citibank’s gaffe. Similar errors occur with paper instruments. Suppose you want to buy a $10,000 used car. You could pay with $100 bills, but this is quite cumbersome and somewhat risky. Few sellers will accept a cheque, as they can’t be sure it won’t bounce. Luckily there is an ideal third option: a certified cheque or bank draft. With both of these instruments, the bank locks up the payers’ funds. The bank affixes its guarantee that the check or draft will not bounce. And so the seller of the $10,000 car can safely accept either instrument as payment.

There is a catch, however. Each year, hundreds of certified checks and drafts go missing. In 2017, Ian Camacho sent a bank draft to his cousin for $17,475, but it was lost in the mail. More recently, UPS lost a $846,000 bank draft for Louis Paul Hebert, his portion of an inheritance. In both cases, the bank refused to release the money. The funds were stuck in limbo. Neither the sender nor the intended recipient could access the funds.

These are certainly tragic personal situations. But, in each case, the bank is on the hook for the full amount of the draft or certified check if someone were to ever find them and bring them in. Yes, the bank can issue a replacement $846,000 draft to its customer, and thus rescue the customer’s funds from financial limbo. But then the bank could be potentially liable for double that amount, $1.692 million.

Nor can the bank just cancel the original check or draft. That would compromise the crucial guarantee of finality.

So what do I mean by finality? For consumers, finality is best thought of as the moment at which a banking transaction is 100% complete. At that point the funds are definitively in the recipient’s possession and can be used without fear of being revoked.

Consumers can choose between payment options that offer “soft” finality and “hard” finality. Citibank’s $900 million bank payment is an example of hard finality. So are certified checks and bank drafts. Once the payment appeared in Brigade’s account, Citibank lost the ability to claw it back. And the moment a certified check passes hands, there’s no way for the originator to hit the undo button.

A guarantee of finality provides economic actors with a crucial degree of certainty. Their money is safe to be spent, lent, invested, or donated. Without this certainty, we’d be much more hesitant to transact. The wheels of trade would grind to a halt, as no one would know when they had really been paid. 

That’s why it is important to uphold the principle of finality. Most of us would probably agree that it would be fair if Citibank could click an undo button and get its $175 million back from Brigade. But the ability to do so would compromise something much larger: the system’s ability to guarantee irrevocable payments and the body of trade that depends on this feature.

Soft finality, by contrast, is quite forgiving to the purchaser. Under soft finality, there may be a long window of time over which a payment can be cancelled and reversed by the consumer. The best example is a credit card payment. Anyone who uses a credit card to buy something online has up to 75 to 120 days to get the transaction reversed.

But if soft finality offers buyers and shoppers flexibility, it is onerous for sellers and retailers. They never quite know if the $1,000 they have received will be suddenly switched back until the 75- to 120-day window closes. This uncertainty could potentially be catastrophic for a business. Imagine receiving a large payment, then using these funds to buy an expensive upgrade to one’s shop, only to have those funds be recalled. A business owner could easily go bankrupt.

It’s for this reason that soft finality is generally only available in small amounts, and usually only to consumers. Large commercial transactions require a degree of hard finality.

Regular consumers can easily botch hard finality, which is why banks try to keep it out of their hands. I cannot log into my online bank account and execute a wire transfer. Wire transfers are 100% final. They cannot be reversed. 

My bank probably worries that I’ll ham-handedly send the wire to the wrong account number. Or they worry that I’ll be sloppy and let my account be taken over by fraudsters, who will take advantage of the wire transfer’s finality to move their funds out of the reach of the law. For these reasons, and perhaps others, my bank insists that I go into a branch and safely conduct the wire transfer under the careful eye of a teller.

Citibank will certainly try and get its funds back. But it can’t do so on its own. It has to go through the legal system. Perhaps the courts will agree that the transaction should be reversed, making the hard finality of the system somewhat softer than usual. Or, perhaps the courts will say, “Too bad! You should have been more careful.”

Cases like Citbank’s $900 million mispayment and $846,000 bank drafts stuck in financial limbo make for interesting stories. But keep in mind that the participants in these transactions are the accidental victims of a payments system that provides hard finality. What is unseen is the huge amount of trade that the certainty of hard finality facilitates. For each innocent bystander, there are thousands of happy customers. And most of these customers would be less happy if the finality of their payments were not so hard.

J.P. Koning

listpg_koning

J.P. Koning is a financial writer and blogger with interests in monetary economics, economic history, finance, and fintech. He has worked as an equity researcher at a Canadian brokerage firm and a financial writer and publisher at a large Canadian bank. More recently, he has written several papers for R3, a distributed ledger company, on the topics of central bank cryptocurrency and cross border payments. He founded the popular blog Moneyness in 2012. He designs economics and financial wallcharts at Financial Graph & Art. Koning earned his B.A. in Economics from McGill University.

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