How do the Modern Payment System?

The payment systems in use today rely on concepts developed in the eighteenth century and before as well as on those developed in the twentieth century. Paper instruments are vital to commerce and so are electronic systems. To understand the long-term incentive for the spread of electronic payments and potentially new forms of money, one must appreciate the complexities and costs associated with our current payment system.

As checks came into more widespread use, banks that accepted checks for deposit had to find ways to exchange checks drawn on a variety of other banks and to receive appropriate value for those checks--processes called "collection" and "settlement." First, banks sent messengers directly to other banks to collect the money due to them and their customers, the direct presentment method of check collection. Second, out-of-town banks would send checks to a correspondent bank, which in turn would collect the check, the correspondent banking method. Both of these methods required significant travel and could require the movement of large amounts of banknotes or gold.

According to banking lore, a third solution to the interbank check collection problem evolved at a British pub. A London bank messenger stopped by for a pint (or two) and allegedly met another bank messenger. They quickly discovered that they each had checks drawn on the other's bank and decided to save time by exchanging them on the spot. More messengers joined the group. These messengers found that they could not only centralize the exchange of checks, they could also net the amounts of money that had to be exchanged among them to settle (pay) the checks they exchanged. This arrangement, the clearinghouse method, was first adopted in the United States by the New York Clearing House in the mid-nineteenth century, and it is still used by banks all over the world today--although, generally speaking, the exchanges are not held at a drinking establishment. In fact, all three methods of interbank check collection still are in use in the United States.

In the early twentieth century the creation of the Federal Reserve System helped to improve the efficiency of the payment system in at least two important ways. First, the Fed set up a national system of check-clearing, in which the Fed acts like a correspondent bank with an ability to collect checks throughout the United States. This system improved the existing localized check clearing system by facilitating the collection and settlement of interbank checks among banks scattered throughout the country. Second, the Fed was able to act as a central repository for the reserves of the banking system. Reserve balances held at the Fed are widely used as the settlement vehicle for interbank check-clearing.

According to a new Fed survey, households, businesses, and government entities write approximately 50 billion checks each year. The costs of using these checks include processing by depositing and receiving banks and by intermediaries, transportation, accounting, and resolving problems. The estimated cost to the banking industry of operating the entire check clearing system range from approximately ј to 1 percent of GDP. In addition, fraud losses in connection with checks are significant, perhaps in the tens of billions of dollars annually, and are growing rapidly. The level of these costs provides an incentive to improve the efficiency of the check clearing process. These costs have also encouraged innovation in substitutes for checks, that is, electronic payments, and may foster the development of new payment instruments, such as electronic money. Of course, developing and implementing electronic payment alternatives is expensive; however, electronic payment methods tend to be characterized by high fixed investment costs but low marginal costs, so the average cost per transaction should fall as use rises.

The process of innovation, driven by attempts to increase the efficiency of the payment system, is continuing. Banks and technology providers are attempting to develop new payment methods, in many cases building upon the underlying the automated clearing house (ACH), debit card, and credit card networks to find more convenient and secure ways to make purchases, pay bills, settle debts, and post credits, especially over the Internet."On-line" banking involves electronic access to information over the Internet about accounts and loans--including current balances and transactions history--as well as providing the ability to carry out payment related transactions--including transfers among accounts, receiving and paying bills, applying for bank credit cards, and reordering checks. Some so-called virtual banks have been set up to service customers exclusively through electronic channels, but an increasing number of traditional "bricks and mortar" banks see the Internet as another delivery channel that improves convenience for some of their customers. Similarly, the emergence of e-money reflects the attempt to develop new payment methods as a more efficient alternative to existing electronic payment means.
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