Cumberland Advisors Market Commentary – The Payments Modernization Act

Author: Robert Eisenbeis, Ph.D., Post Date: August 22, 2019
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Legislation has recently been introduced to require the Federal Reserve to develop a real-time payments system to compete with existing systems. Interestingly, a short time after the introduction of the legislation, the Federal Reserve announced its intention to proceed with plans to develop just such a system.

Cumberland Advisors Market Commentary - The Payments Modernization Act

In describing the intent behind the legislation, co-sponsor Senator Elizabeth Warren states, “Our bill would create a national, real-time payments system so that families have faster access to the money they earned and don’t have to pay overdraft fees or rely on a shady payday lender to make ends meet.” Despite the claims, the proposal would duplicate a private-sector alternative already in place and would not address most of the problems proponents claim to care about. Given the recent attention on cryptocurrencies as real-time payments systems, it is worth taking a look at our existing systems before endorsing the Federal Reserve to spend significant resources to compete with existing private-sector alternatives.

Let’s us consider the attributes of the alternative payments systems that are already in place and the way they provide different alternatives when it comes to transactions, clearing, and settlement. People use various combinations of payments and are willing to pay for some of the different features of the systems that exist.

Currency: The simplest form of payment is currency. When a transaction takes place with currency, goods and services are exchanged immediately; the transaction is cleared and settled simultaneously; and the transaction is anonymous, in that no record exists of who participated in the transaction. Federal Reserve notes are the main currency in circulation in the US. They are backed by the government and are the only form of legal tender for the settlement of government debt contracts, but of course other forms of payment are in fact accepted for payment of taxes and other debts.

Checks: Paper checks are used in a variety of transactions, to make spot payments as well as payments to settle debts. Checks differ from currency in that in the case of a spot transaction when goods or serves are exchanged, the receiver of the check first deposits the check at a bank; a bank deposit account is debited in the form of a bank liability demand deposit; and the check is then cleared by sending it to the payor’s bank through either a local clearinghouse or the Federal Reserve. In either case, the payment is settled by transfer of a reserve deposit at the Federal Reserve. Of course, if the check is deposited in the receiver’s account at the payor’s bank, then the payor’s account is drawn down, and the receiver’s account is debited, settling the transaction. There is a processing delay of anywhere from to one or two days to as much as five days. There have been changes in this process, automating part of it so that checks are aggregated at the bank receiving the checks, images are created, and then the checks are cleared in a batch though an automated clearinghouse (ACH), either a local ACH or the ACH run by the Federal Reserve. A hold may be placed on a deposited check if it appears to be an unusual transaction or if there is a question about whether there are sufficient funds in the payor’s account. Paper check handling has declined dramatically, to the point where the Federal Reserve, which used to process paper checks in over 50 different facilities, now does so in only one office at the Federal Reserve Bank of Cleveland.

Travelers checks: They are little used now, but travelers checks are an interesting form of payment in which the buyer of a travelers check clears and settles by exchanging a bank deposit for what is a claim on a presumably better-known entity. The travelers check is then presented at a later date as payment and cleared and settled without any future involvement by the payor.

Credit cards: Payment using a credit card is much more complex than payment by currency or check. It involves several different entities, most of which are largely invisible to the user. When a card is swiped at a merchant location, an electronic message is sent to an acquirer acting on behalf of the merchant, who forwards the electronic payment request to a credit card network such as Visa, Mastercard, Discover, or American Express. The card network then forwards the payment request to the card-issuing bank, which verifies that funds are available and checks for fraud. When the payment is authorized, a message is sent back to the merchant, who concludes the transaction. A hold is placed on the payor’s account until payment is made. As far as the merchant is concerned, the transaction is cleared and settled, but settlement is deferred as far as the payor is concerned. It may take as much as two days for the entire clearing and settlement process to be completed, the merchant to receive funds, and the obligation to be recognized in the payor’s credit card account. From the payor’s perspective, the credit card transaction has an embedded set of options. First, payment is delayed until a monthly payment is due, so free credit is extended by the bank over that period, after which the payor has two options: payment can be made and the payor’s bank account reduced by the amount of the monthly accumulated transactions, or the payor may opt to incur a loan with a fairly high interest rate and defer final payment.

Debit cards: For purposes of this discussion a debit card transaction is virtually the same as a credit card transaction, with some important exceptions. The debit card is directly linked to a payor’s checking account; and hence when a transaction is verified, it is listed as pending until transferred to the seller’s bank, which can take as long as two or three days. From the merchant’s perspective, at the end of each day transactions are batched and sent through the system for posting. Settlement takes place when the merchant requests payment. From the payor’s perspective, the funds are not available once the transaction has taken place, so in that sense it is like a real time transaction.

Paypal: Paypal is a hybrid payments tool that is interposed between the merchant and payor’s normal payments media (credit card, debit card, checking account). The service protects the payor’s media from the merchant’s being able to see account numbers, etc., while protecting the merchant, who can rely upon Paypal to have screened the payor and know that funds are good – if not, Paypal will reimburse the merchant. Interestingly, at the time a Paypal transaction is executed, the payor has the option of paying with a debit card, a credit card, or directly out of a bank account. Additionally, if credits have been accumulated through Paypal, those may also be used to settle a transaction. Finally, if goods arrive damaged or are not as advertised, Paypal will arrange for a refund.

Bitcoin and similar cryptocurrencies: While Bitcoin gets a lot of attention, there are now over 1600 so-called cryptocurrencies trading on at least 500 different exchanges.[1] Given the number and complexity of arrangements, only general observations are offered here.[2] While these systems offer varying degrees of real-time clearing and settlement, the exchanges are not interconnected; and not all currencies are available on each. In fact, some are single-currency exchanges. In many respects, attempting to convert one cryptocurrency into another is the same as engaging in a foreign-exchange conversion; but with so many currencies the number of pairs of exchange rates is very large, and it is made even more cumbersome because exchange rates may also vary from exchange to exchange. Finally, it is important to note that there are often significant transactions costs, and the delay in conversion back to a home currency may take anywhere from two to five days before the seller receives good funds. So these are not real-time transfer systems as envisioned in the Payment Modernization Act. Indeed, the cryptocurrency environment is quite similar to the Wildcat banking period in the US in the 1800s when individual banks issued their own currencies, usually backed by a promise to redeem in gold. These currencies did not trade at par with each other, and there were books printed to help users identify issuing banks and their associated currencies.

Despite all the positive hype, there have been some significant problems with hacking and loss of funds by cryptocurrency holders. A recent study revealed some interesting facts.[3] Considering just Bitcoin alone, it was determined that one quarter of Bitcoin users and about half the transactions were associated with illicit activities, amounting to an estimated $72 billion per year in that one currency alone. In addition, there have been numerous exchange failures, one of the most famous being the 2014 failure of Japan’s Mt. Gox, one of the largest in terms of volume of transactions. About 650,000 bitcoins were lost due to hacking, and the exchange’s creditors were said to have lost $2.4 trillion.[4]

A supposed desirable feature of cryptocurrencies is their anonymity, in that transactions are said not to be traceable. Whether that is true or not, it is interesting that the Mueller investigation of Russian interference in our 2016 election resulted in indictments of 12 Russian security agents; and the investigation revealed that the use and tracking of Bitcoin payments was an important piece of evidence. So, these transactions may not be as hidden as most think.

The proposed Libra/Calibra payments system put forward by Facebook is a closed system variant of blockchain cryptocurrencies.  The key distinctions are that the currency-value is to be backed by a basket of currencies, the system is not truly anonymous, the user receives no return on the purchase of a Libra and it is unclear how and under what terms a user can convert a Libra back into the home currency.  All of these are details that are yet to be resolved.  Indeed, some have argued that Libra is more like an ETF than an actual cryptocurrency.[5]

Real-time payments (RTP): There are two main US systems for transferring funds in large volume among banking institutions. One is a wholesale automated clearinghouse run by the Federal Reserve, and the other is a private network called The Clearing House, owned by a consortium of 25 US and foreign banks.[6] These systems transfer among financial institutions aggregated debits and credits that total about $2 trillion per day, representing about half of all such interbank transfers. Supporting this activity is an image exchange system that eliminates the necessity of physically delivering paper checks by converting them to images and transferring only the images electronically.

Recently, The Clearing House launched a new system called RTP, which is exactly the kind of real-time payment transfer system that the Payments Modernization Act requires the Federal Reserve to create. That system is open to all institutions. The system is used mainly by large banks, while smaller institutions have been slower to sign up.

Two of the key issues concerning real-time clearing and settlement are who benefits and what are the risks. In terms of consumers, while they might like immediate crediting of funds like paychecks and other receipts, it is not at all clear that the current situation disadvantages them. Paychecks are deposited either electronically or locally, which means that people can usually get access to their funds with at most a 24-hour delay. With real-time debiting of their accounts, they lose access to float, which is hardly a benefit. Businesses are more likely to benefit from real-time clearing and settlement. However, the biggest problems that businesses face is the time delay between when goods and services are delivered and when payment is made. Those delays are not really a function of the lack of real-time payments but rather of the structure of the ordering, delivering, payment, and billing processes. What is ignored by the proponents of real-time payments are the safety measures embedded in the current payment systems processes – with debit cards, credit cards, etc., the added screening and verification mechanisms incorporated into the system detect and protect users against fraud. We have all received notifications of potentially questionable transactions, especially those coming from abroad or out of our normal living area. Banking institutions have not only incorporated screening and verification into the present system but also provide indemnification of users against the cost of fraud and illegal transactions that goes deeper than current law requires. It is not clear that it is possible to embed similar protections into a real-time payments system, when a customer’s account could be cleaned out before anyone noticed.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


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