Flow of Funds

Aside from cash, when money moves, it always moves from one bank account to another. The flow of funds is composed of one or more “hops” of money between bank accounts. These accounts may be owned by you, a third-party processor (TPP), customer, vendor, and so on. The flow of funds is a common way to understand a business and model its payments risks.

How does the Flow of Funds work?

When thinking about the flow of funds, there are generally four models used to track the “hops” the money takes from the source to its ultimate destination, be that one or more hops. In its simplest form, this looks like:

Different types of businesses can use each method, we will use the example of an online marketplace to illustrate what each looks like.

Our marketplace is Modern Desks, a place where businesses can sell and purchase used office furniture. Buyers pay and that money makes its way back to the Sellers. In our methods, the Buyer is the Source and the Seller is the Destination. Let’s see how this works:

Method 1: Direct

In a direct approach, money flows directly from the Source to the Destination. In this case, Modern Desks is not in the Flow of Funds. Modern Desks is simply displaying the Seller’s goods but not processing any payments directly. Perhaps when a buyer clicks on a used desk to purchase, they are taken off Modern Desks’ website and onto the Seller’s website where they can pay. 

Given this Flow of Funds, there is virtually zero risk or liability to Modern Desks; they never touch the money, and therefore they are not liable should the Buyer issue a return.

Method 2: Third Party Processor

In some cases, money moves through a third party processor (TPP), who will temporarily hold the funds in a separate account while a transaction is being processed. This adds another “hop” in the flow.

For Modern Desks, perhaps they have a “Purchase Now” button, which collects the Buyer’s banking information and initiates a debit. The debit will be the TPP (not Modern Desks) pulling the money from the Buyer’s bank account. The TPP will then later transfer that money to the Seller (less Modern Desks’ fees).

The key benefit of this method is reduced liability. These liability benefits are typically seen if the TPP has a strict compliance program, requiring them to limit amounts transferred, verify identities, and ensure that the originating account can cover the cost of the transaction. However, because the third party processor takes on this liability, there are often fees associated with using one. Additionally, the fact that they hold funds, means the payment will take longer to settle.

Method 3: Business in the Flow

This has the same amount of “hops” as Method 2, but instead of a third party processor in the middle of the source and destination, it’s Modern Desks.

Now, Modern Desks has a “Purchase Now” button on their website, but they will be the one directly debiting the Buyer’s bank account to their own account. When the funds settle in Modern Desks’ bank account, they will credit those funds (less fees) to the Seller.

Being directly in the flow of funds, Modern Desks is liable for any risk in the two transactions: pulling money from the buyer, and pushing money to the seller. The riskier of these is pulling, or debiting, from the buyer. However, if most of Modern Desks’ buyers are larger corporations who have funds to pay for their goods, they might assess this flow of funds as “low risk.”

There are also benefits in this method. The first major benefit is cost. Most TPPs charge a high percentage fee for just the transaction alone. The second major benefit is a completely custom flow of funds, only restricted by your bank. Sitting in the flow of funds gives businesses the most control over user experience, timing, and more. The final major benefit is control of risk tolerance and compliance programs.

Method 4: Third Party Processor + Business

This model is similar to Method 2. The same issues apply, but in this case it can be more financially risky given the TPP first sends money to Modern Desks which is later transferred to the Seller.

Should the Buyer issue a return against the TPP, the TPP will immediately issue a return against Modern Desks’ bank account. The return will cost Modern Desks money, and Modern Desks will have to cover the balance if they have already transferred the money out to the Seller.

In some cases, TPPs may only offer Method 2 or Method 4 based on their agreements with their banking partner. For example, they may be forbidden to hold funds on behalf of a customer’s customer or be restricted to only paying out verified direct customers.