A cheque is a negotiable instrument used to instruct a financial institution to pay a specific amount of money, in a specific currency, from a specified transactional account. The cheque is drawn in the name of the person or entity holding the account, known as the drawer, and is payable to a specified individual or organization, referred to as the payee.
Key Features of a Cheque:
- Negotiable Instrument:
- A cheque is classified as a negotiable instrument, meaning it can be transferred from one party to another. The payee can endorse the cheque, allowing them to assign the right to receive the payment to a third party.
- This makes cheques a secure way to transfer funds without physically exchanging money, as ownership of the cheque can be passed along with the endorsement.
- Order Instrument:
- Unlike a bearer instrument, which can be cashed or transferred by simply presenting it, a cheque is an order instrument. This means that it is payable only to the designated payee (or any endorsee if it is transferred).
- The payee must be explicitly named on the cheque for it to be valid, ensuring that the payment is made to the correct party.
- Payable to Specific Payee:
- The cheque is typically made payable to the payee named on it. The payee can be a natural person, a business, or a legal entity.
- In certain countries like the US, the payee can endorse the cheque, authorizing it to be cashed or deposited by a third party. This ability to endorse adds flexibility to the cheque as a negotiable instrument.
- Source of Funds:
- The drawer must have sufficient funds in the account from which the cheque is drawn (the account held with the bank, known as the drawee). If the account does not have enough funds, the cheque will bounce, meaning the bank will refuse to honor it.
- Currency and Amount:
- The cheque specifies the exact amount of money to be paid, which is written both in numbers and words to avoid confusion or fraud.
- The currency in which the payment will be made is also stated, which is important for international payments or cross-border transactions.
Cheques as a Type of Bill of Exchange
- Bill of Exchange:
- A cheque is a type of bill of exchange, a financial document that functions as an order for payment. Bills of exchange are used for both personal and commercial transactions, facilitating payment without the immediate need for cash.
- Bills of exchange evolved from promissory notes and share similar characteristics, as both are negotiable instruments, with a promise to pay a specified sum.
- Historical Evolution:
- Cheques were developed as a convenient alternative to carrying large sums of physical cash. Before cheques, people relied on promissory notes, which were written agreements to pay a certain amount to the bearer.
- Promissory notes were the precursor to cheques in that they were also negotiable and transferable. However, promissory notes were generally used as an agreement to repay a debt, while cheques serve as an instruction to a bank to transfer funds from one account to another.