Cheque truncation (check truncation in American English) is the conversion of a physical cheque into a substitute electronic form for transmission to the paying bank. Cheque truncation reduces or eliminates the physical movement of cheques and reduces the time and cost of processing the cheque clearance system. Cheque truncation also offers the potential reduction in settlement periods with the electronic processing of the cheque payment system.
To settle a cheque, it has to be presented to the drawee bank for payment. Originally this was done by taking the cheque to the drawee bank, but as cheque usage increased this became cumbersome and banks arranged to meet each day at a central location to exchange cheques and settle the money. This became known as central clearing. Bank customers who received cheques could deposit them at their own bank, who would arrange for the cheque to be returned to the drawee bank and the money credited to and debited from the appropriate accounts. If a cheque was dishonoured or bounced it would be physically returned to the original bank marked as such.
This process would take several days, as the cheques had to be transported to the central clearing location, from where they were taken to the payee bank. If the cheque bounced, it would be sent back to the bank where the cheque was deposited. This is known as the clearing cycle.
Cheques had to be examined by hand at each stage, which required a large amount of manpower.
In the 1960s, machine readable codes were added to the bottom of cheques in MICR format, which allowed the clearing and sorting process to be automated. This helped to speed up the clearing process; however the law in most countries still required the cheques to be delivered to the payee bank, and so physical movement of the paper continued.
Starting in the mid-1990s, some countries started to change their laws to allow "truncation": cheques would be imaged and a digital representation of the cheque would be transmitted to the drawee bank, and the original cheques were destroyed. The MICR codes and cheque details are normally encoded as text in addition to the image. The bank where the cheque was deposited would typically do the truncation and this dramatically decreased the time it took to clear a cheque. In some cases, large retailers that received large volumes of cheques could also do the truncation.