Apr 26, 2019

Round Two: What Role Should the Federal Reserve Play in Developing a Faster Payments System?

Brian Knight Senior Research Fellow , James Angel, Aaron Klein, George Selgin

This is round two of a multi-part debate series on The Bridge. The debate consisted of two rounds of email exchanges between three participants. An introduction was published Wednesday, April 24, and round one was published Thursday, April 25. The series has been lightly-edited to preserve the original spirit of the email conversation that took place.

Jim Angel

We are in broad agreement: the US economy badly needs faster payments and the Federal Reserve should play a large role in facilitating faster payments. The devil is in the details of what role the Fed should play.

Aaron seems to believe that the Fed can wave a magic regulatory wand under the Expedited Funds Availability Act and make faster payments happen. Were it so simple!

It is not clear at all that the Fed actually has regulatory power to just mandate faster payments. I believe Aaron is referring to 12 US Code § 4002(d)(1) which reads

“Notwithstanding any other provision of law, the Board, jointly with the Director of the Bureau of Consumer Financial Protection, shall, by regulation, reduce the time periods established under subsections (b), (c), and (e) to as short a time as possible and equal to the period of time achievable under the improved check clearing system for a receiving depository institution to reasonably expect to learn of the nonpayment of most items for each category of checks.

Alas, the referenced subsections refer only to check clearing, not wires or other non-check forms of payment. Alternatively, the Fed could use its broad rulemaking authority under Dodd-Frank §805 over payment system risk management and rightly declare that slow payments impose risk on the financial system. However, some may view this as a regulatory overreach.

Even if the Fed did have the authority to just mandate faster payments, a mere rule from the Fed would not be enough. The Fed itself is one of the biggest impediments to faster payments. The Fed is where the different payment providers can settle their payments. Even the bank-operated check clearing and ACH networks depend on the Fed for part of their activities. The Fed’s systems that allow banks to settle payments with each other operate on 20th Century East Coast bankers’ hours, Monday through Friday.

In order for our banking system to speed up and offer true 24/7 service to everyone, the Fed has to operate 24/7.

In order for our banking system to speed up and offer true 24/7 service to everyone, the Fed has to operate 24/7.

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George agrees that the Fed should offer 24/7 settlement services and a 24/7 liquidity management tool, but disagrees on whether the Fed should offer a 24/7 RTGS facility. I think that here we have different visions of what the Fed has actually proposed. I see the Fed’s proposal as a modern 24/7 version of Fedwire that would allow competing payment providers to interact with each other on a real-time basis. What is the problem with letting Fedwire operate 24/7? If competing payment providers cannot settle 24/7, they have to work out a system of deferred net settlement in which risk piles up until settlement occurs. Such accumulation of risk is totally unnecessary.

As far as legality goes, only the Fed can offer a service that settles in Fed money at the Fed with no counterparty risk. Thus, the Fed’s proposal easily meets the legality requirement that other providers cannot provide the service.

Rather than slow down faster payments, letting the Fed provide needed infrastructure to competing payment will allow numerous entities to innovate and provide 21st-century service.

Aaron Klein

The Federal Reserve has the legislative authority, what it has lacked is the will. Under the section of the Expedited Funds Availability Act that James cites, the Fed could mandate checks to clear within an hour, as well as cash deposits in ATMs (that is covered by subsection e). In addition, the Fed has broad authority under Section 15 of the Check 21 Act, which states: “The Board may prescribe such regulations as the Board determines to be necessary to implement, prevent circumvention or evasion of, or facilitate compliance with the provisions of this Act.” It is harder to get broader language than that, which is not surprising given that the legislation is based on a proposal from the Fed.

One of the three enumerated purposes of the Check 21 Act is “To improve the overall efficiency of the Nation's payments system.” Combining that broad authority and the purpose of the legislation, Congress has made it clear the Fed has authority. There are probably other regulatory hooks the Fed has at its disposal as EFAA provided and the Check 21 Act affirmed, Congress “provided the Board of Governors of the Federal Reserve System with full authority to regulate all aspects of the payment system.” The Fed has the authority.

We could have a real-time payment system for consumers without the Fed itself operating every aspect of it. That said, there are some critical areas where the Fed needs to up its game, such as making Fedwire 24/7x365, a proposal that I think all three of us agree on. In fact, the slow nature of Fedwire also reduces the ability of securities firms to settle, a separate but also important issue.

James and I are in agreement that the Fed itself is one of the biggest impediments to faster payments. George makes the critical observation that as the Fed continues to play Hamlet, debating whether to create their own system or not, has practical effects on other banks decisions to join alternative payment systems. Economists should be very familiar with uncertainty delaying adoption. The Fed has had the choice to adopt real-time payment technology for over a decade (the UK moved in 2008), formed multiple faster payment groups, and issued multiple studies over many years. The private sector moved forward, the Fed did not. The Fed’s waiting has taken billions out of the pockets of middle and working class families. The Fed’s delay has increased and continues to increase income inequality.

The simplest, most efficient, and fairest thing the Fed can do is use their own authority and change the system now.

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Americans who can least afford it are stuck paying billions a year in fees and high-cost loans to access their own money. The simplest, most efficient, and fairest thing the Fed can do is use their own authority and change the system now. As George points out, waiting for the Fed to build its own system will take years, maybe a decade or more. Unless the Fed is willing to use its own funds to pay the tens of billions that it will cost working families to handle that delay, then the Fed needs to fix the problem the best way it can: through adopting regulations requiring real-time payments.

George Selgin

Like Jim, I’m encouraged by the many points on which all three of us agree. I hope by my response today to narrow our remaining points of disagreement still further.

Jim observes, in reply to Aaron, that the Fed may lack the power to simply mandate faster payments. He concludes therefore that it can’t “wave a magic regulatory wand” to get us there. But while both statements are strictly true, the Fed could speed things up considerably by encouraging more financial firms to take part in TCH’s private RTP set up, instead of doing just the opposite, as it does by holding out the possibility of establishing a competing fast payment network—that is, by “playing Hamlet,” as Aaron eloquently puts it. It could, as we all agree, offer 24/7 settlement or liquidity management services.

It could allow RTB member account balances to count towards banks’ LCR requirements, while also allowing interest on those balances. It could encourage further widening of the RTP Business Committee to assure adequate representation of smaller banks. Finally, to encourage participation by certain non-bank payments service providers, it could allow, and could encourage TCH to allow, some of those suppliers to participate in the RTP network.

Jim points to certain advantages of the Fed’s proposed RTGS system, consisting mainly of the fact that it eliminates counterparty and other credit risks inherent in deferred net settlement arrangements. But while RTGS on the Fed’s books, rather than on those of a private clearing entity, may have certain advantages, it is not essential to achieving faster payments.

Therefore, although Jim is correct that the Fed is uniquely capable of supplying final RTGS services, it doesn’t follow that, so far as achieving faster payments is concerned, there is a compelling need for it to do so. Finally, RTGS, as an alternative to a 24/7 Fedwire (deferred settlement) system, is not free of disadvantages of its own, which consist of higher bank liquidity requirements and a correspondingly heightened risk of payment delays and gridlock. Indeed, according to some experts, drawing upon experiences with existing central-bank RTGS systems, such systems don’t really reduce banks’ credit exposure at all. Instead, they merely redistribute credit risk among various payment-system participants.

To have the Fed continue to toy with the possibility of establishing its own RTGS system today is to guarantee an avoidable delay of several years in achieving faster retail payments.

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In short, while a good debate can be had concerning the merits of deferred net vs. RTGS central bank settlement arrangements, that debate is largely orthogonal to the one concerning the most expeditious way to achieve faster retail payments in the US today. The two discussions overlap in but one crucial respect, to wit: that to have the Fed continue to toy with the possibility of establishing its own RTGS system today is to guarantee an avoidable delay of several years in achieving faster retail payments.

Brian Knight

Thank you, everyone, for an incredibly informative debate. This was a great discussion of a challenging topic and the scope of issues that were brought up go to show how challenging a question this is. I want to thank our participants for graciously giving us the benefit of their time and expertise and I hope our readers have found this as educational as I have.

Photo credit: Alex Wroblewski/Getty Images

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