Payment Systems

A payment is the flow of funds from the payer to the payee, usually as compensation for a product or service or to pay off a liability. Most personal payments involve the exchange of cash. Although money, in the form of coin and currency, has served as the medium of payment for millennia, and continues to serve that purpose in most personal transactions, it has severe limitations: it is not easy to pay someone who is remote geographically; it is inconvenient and insecure to make large numbers of payments, such as an employer paying its employees; it has no inherent record of the transaction.

One of the primary purposes of banks is to provide a payment system. Banks solve payment problems by providing checking services and electronic funds transfers (EFTs). There are 2 fundamental processes to both checks and electronic funds transfers: there is an instruction to transfer money from one account to another; then there is the actual exchange of money, where the payer's account is debited and the payee's account is credited. Accounts are nothing more than electronic records. In the case of paper checks, the accounts are updated by an operator working at a computer terminal, or read by optical character recognition software. In the case of electronic funds transfers, the updating of accounts is entirely electronic, which is why it is faster and cheaper to pay using electronic funds transfers.

One step in most payment processes is the transfer of funds from the payer's bank to the payee's bank. To facilitate the transference, each bank is assigned a unique routing number (aka routing transit number, ABA number), which is a number assigned by the American Bankers Association to a bank that uniquely identifies it in the same way that a social security number uniquely identifies an individual.

With paper checks, the payer's bank routing number and the payer's account number are listed at the bottom of the check in magnetic ink, which allows reliable optical character recognition of the numbers resulting in the automated delivery of the check from the payee's bank to the payer's bank and account for payment. Before the payee's bank sends the check to the payer's bank for payment, it stamps its routing number on the back of the check, so that the payer's bank knows where to send the funds.

With electronic funds transfers, all of the required information—payer's bank routing number and account number, the payee's bank routing number and account number and the amount of the payment—are contained in the EFT message so that the payment can take place without any human assistance, which is why EFT payments are much cheaper and faster than payments by paper check.

Checks

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Because checks are paper documents, there are more steps in completing a check-based transaction. Unlike currency, checks are not money, but are legal instruments instructing the bank to take money out of the check writer's, or the payer's, account and give it to the payee of the check. Only then is the payment final.

Typically, the payee deposits or cashes the check at her bank. At the end of the day, the bank sends the check to a clearinghouse operated by the Federal Reserve or to a private clearinghouse, where both the payer's and payee's banks have accounts. The clearinghouse offers clearing and settlement services to its members, who are the participating banks. Clearing is the transfer of the check from the payee's bank to the payer's bank and the transfer of funds from the payer's account to the payee's account, and settlement is the actual adjustment of accounts that reflects the transaction, where the payer's account is debited and the payee's account is credited. The clearinghouse credits the account of the payee's bank and debits the account of the payer's bank. However, the transaction at this stage is only provisional, since the payer may not have sufficient funds to cover the transaction. From there, the check is sent to the payer's bank, then the bank debits the payer's account. If there are insufficient funds in the account, then the payer's bank returns the check, which follows the reverse order, through the clearinghouse, then back to the payee's bank. Historically, canceled checks were usually returned to the payer to give the payer a proof of payment. Nowadays, banks only provide electronic images of the checks, if the check writer requests it.

Not every transaction uses a clearinghouse. On-us payments are payments where the payer and the payee use the same bank, and also include ATM transactions by a customer using the bank's ATM.

In October 28, 2004, the Check Clearing for the 21st Century Act, also known as Check 21, was enacted that gave banks the authority to save only the image of the front and back of the check and to transmit the image to clearinghouses and other banks instead of the paper check. Check 21 gives these substitute checks the same legal proof of payment as paper checks. Check 21 saves banks billions of dollars every year and reduces the time between when a check is deposited and when it is debited from the payer's account. (Source: http://federalreserve.gov/paymentsys.htm)

The Check 21 law allows the use of substitute checks, such as this sample image, to serve as proof of payment.
Source: http://www.federalreserve.gov/pf/pdf/pf_7.pdf

Electronic Funds Transfers (EFTs)

Electronic funds transfers (EFTs) are basically electronic checks that automatically debit the payer's account and credit the payee's account. EFTs do not require clearinghouses because the routing information is contained in the electronic message.

EFTs require a secure network and operating standards. There are various EFT networks, but the most common type of EFT is the automated clearinghouse transaction (ACH), which many businesses and people use to pay recurring bills. The ACH Network is operated by the Federal Reserve and the Electronic Payments Networks, and most banks use this network in the same way that they used clearinghouses — to exchange payment information. An ACH transaction consists of the account numbers of the payer, the payer's bank, the payee's bank, the account number of the payee, and the amount of the payment. An ACH transaction has the same basic type of information on the payer as a paper check with its bank routing number and the payer's account number. It differs from the paper check in that it also has the payee's bank routing number and the payee's account number so it can be completed as a single transaction.

Some retailers, such as Wal-Mart, can convert a paper check directly into an ACH transaction by scanning the check for the bank's routing number and customer's account number. The customer then signs and gets a receipt. This saves the retailer the cost and risk of transporting paper checks. According to the Federal Reserve, 8% of checks written in 2006 were converted electronically into ACH payments, while only 1% were converted in 2003.

Another EFT network is Fedwire, which is operated by the Federal Reserve, and is used transfer large sums of money, mostly between banks and other large institutional customers. The Federal Reserve consists of 12 district banks in different areas of the country. Most of the banks in the area have accounts at the local Federal Reserve. When they want to send money to another bank, they send payment information to their local Federal Reserve Bank, which then sends the payment information over the Fedwire to the Federal Reserve Bank in the payee's district, who then credits the payee's account for the amount of the payment.

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Number of noncash payments—checks and electronic payments—for 1971, 1979, 1995, 2000, 2003, and 2006.
Number of noncash payments—checks and electronic payments—per capita for 1971, 1979, 1995, 2000, 2003, and 2006.
Number of noncash payments—checks and electronic payments—for 2000, 2003, and 2006 for Japan, European Monetary Union, United Kingdom, Canada, and the United States.
Source: http://www.federalreserve.gov/pubs/bulletin/2008/articles/payments/default.htm

Debit, Credit, and Stored-Value Cards

A common method of payment is through the use of debit and credit cards or stored-value cards (aka gift cards, prepaid cards, smart cards). All transactions involving cards require an electronic payment network. The cards have the payer's information and the payee's information is supplied at the time of payment. However, the payer's information may differ depending on the type of card used, because the payer is not necessarily the cardholder. A debit card works like a check, in that the cardholder's bank account is debited for the payment. However, the payer for a credit card is the issuing bank, since the payment is a loan by the issuer to the credit card holder that is paid directly to the payee.

Number of electronic payments by type—electronic benefits transfers, ACH, debit card, and credit card — for 2000, 2003, and 2006.
Source: Federal Reserve

Another type of electronic payment is the stored-value card, where money, as account information, is stored on a card. Gift cards are the most common type of stored-value card. Prepaid cards, such as those issued by VISA, is also becoming more common. Stored-value cards allow customers with poor or no credit and no bank account to pay electronically.

However, the stored-value card still uses a bank account—that of the bank itself. When you pay to have money loaded onto a stored-value card, what is actually loaded is the account information that has been set up just for the card. When you purchase an item from a merchant with the card, the card is read by the merchant's card reader, which sends the account information over the network to deduct the payment from the account set up for the card and credits the merchant's account. Because of the way this works, a stored-value card can be canceled just like a debit or credit card if it is lost or stolen.

E-Money

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An increasing amount of retail business is being conducted over the Internet, but there are 2 deficiencies in the payment systems provided by banks that reduce the value of their services to many Internet merchants. The first is that the current EFT system does not provide a way for a person to send money to another person or to send it to a business that does not have a merchant account that would allow it to accept credit and debit cards. The other drawback to using payment services with the cards is that the banks issuing the cards charges the merchants a significant fee for each transaction, so cards are not a good way to sell items for a few cents, or even less than a penny — so-called micropayments.

Because of these deficiencies, there have been numerous businesses that have sprung up to provide payment services to satisfy these needs. Some have called these special services e-money, because purchases can be made over the Internet, but they differ from credit and debit cards, and other types of electronic payments provided by banks.

PayPal is probably the most successful business that allows people to send money to other people or to merchants without a merchant account with a bank. The way PayPal usually works requires that the payer and payee both have accounts at PayPal. The money is initially transferred to the PayPal account by debit or credit card or by an ACH debit from the account holder's bank account. Each account is designated with an email address. So if a person wanted to send money to another person, the payer only needs the email address of the payee, then the payer sends payment instructions to PayPal that includes the amount of the payment and the email address of the payee. There is no fee to make payments, but there are fees associated with receiving payments, which makes PayPal unsuitable for micropayments.

As it stands now, there are no prominent companies offering micropayments that are widely accepted, although cryptocurrencies, such as Bitcoin, are starting to be used as such. However, advancing technology should decrease the cost of using the traditional payment networks, including debit and credit cards, which would obviate the need for a special micropayment network or for cryptocurrencies.

Bitcoins and Cryptocurrencies

Another form of payment receiving media attention recently is through the use of bitcoins or other cryptocurrencies. Some of the main advantages advanced for bitcoin are that:

However, some of these advantages touted for bitcoin result because it is an entirely electronic form of money. If the United States dollar or the euro was made entirely electronic, then those currencies can be subdivided indefinitely to allow for micro-payments. Most fiat currencies have a lower limit for value because they are represented by coins and paper currency, which cost money to produce. Indeed, the US penny and nickel cost more to produce than their represented value. On the other hand, the value of electronic money can be reduced, virtually without limit, to form smaller payments.

That transaction costs for bitcoins are usually lower than using other electronic payment systems, such as credit cards or debit cards, is also artificial, since transaction costs are generally set by banks and other payment service providers, such as MasterCard and Visa, who are reluctant to lower prices that constitute a major source of profit. The transaction costs for current methods of payment could be much lower, but the lack of competition and government control has kept these transaction costs higher. When money becomes entirely electronic and the government institutes reforms to take advantage of electronic payments — which I believe is inevitable — then all of the advantages of electronic payment, such as enabling micro-payments and lowering the cost of transactions, will become available to that money.

That the supply of bitcoin is limited is actually a major disadvantage, since the value of bitcoin varies widely over short spans of time because supply cannot be increased or decreased to meet changing demand. The problem with bitcoin and other cryptocurrencies, or for that matter, any other means of payment, such as gold, where the supply cannot be controlled, is that it cannot satisfy 2 of the primary functions of money, as a unit of account and as a store of value. It cannot serve as a unit of account because the price of the money itself varies widely, making its exchange value for goods and services unpredictable; likewise, it cannot serve as a store of value, since it can lose value very quickly, as has already occurred several times with bitcoin and many times with gold. Additionally, using methods common in business and investments, such as calculating present value or future value of projects or investments or even calculating many forms of financial risk, becomes almost impossible. Calculating present value or future value is only meaningful if the value of the currency is stable. Even though most currencies decrease in value because of inflation, inflation is usually low and predictable, so it is easier to account for inflation.

Hence, in my opinion, bitcoin or any other types of money where the supply cannot be controlled will never serve as a major currency, or even as a co-currency. Instead, bitcoin will remain as it is, a novelty currency that can be used as a medium of exchange for those businesses or individuals who are willing to assume the risk of a widely fluctuating currency.

Future of Money

Soon there will be many more ways of payment. For instance, in Asia and Europe, people can pay using their cell phones by waving the phones in front of special electronic readers, which transfers banking account information. However, these forms of payment are just special forms of the EFT payment system described above.

Financial transactions are increasingly becoming electronic, since there are tremendous savings in both time and money in settling transactions electronically. The advantages of electronic money are that it is much less apt to be lost or stolen and it will become more convenient as the technology improves. The big disadvantage is that there is no privacy. Where you go and what you spend money on will be listed in databases on some network. Governments can construct a profile of you simply by aggregating this information, which is trivial with today's technology.

Money in the form of coin and currency may disappear entirely when the means of payment becomes totally electronic. However, the units of money will still be needed as a unit of account so that the prices of goods and services can be quoted.