Round One: What Role Should the Federal Reserve Play in Developing a Faster Payments System?
This is round one 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 two was published Friday, April 26. The series has been lightly-edited to preserve the original spirit of the email conversation that took place.
Thanks for asking me to begin.
- The US payment system is slow and archaic. This imposes a tax on economic activity that affects all Americans. Other countries have instant payment systems. Why don’t we?
- The Fed operates on 20th century East Coast banker’s hours. The fact that they are closed for the majority of the 8,760 hours is a year is a huge impediment to the launch of faster payment systems that can interconnect with each other.
The Fed has proposed two actions to facilitate faster payments in the US. From their press release, they call for
"1) the development of a service for real-time interbank settlement of faster payments 24 hours a day, seven days a week, 365 days a year (24x7x365)"
"2) the creation of a liquidity management tool that would enable transfers between Federal Reserve accounts on a 24x7x365 basis to support services for real-time interbank settlement of faster payments, regardless of whether those services are provided by the private sector or the Federal Reserve Banks."
To oversimplify, the Fed is mainly proposing to operate its existing services around the clock. This is long overdue. The first proposal is for the Fed to run a service similar to the venerable Fedwire around the clock. The second proposal would make it easier for competitive payment networks to interact with each other around the clock instead of waiting for the next business day.
To oversimplify, the Fed is mainly proposing to operate its existing services around the clock.
The Fed’s goal is to support the interconnection of private sector payment systems, not to replace those systems. Note the key word in their statement: interbank. When I served on the Federal Reserve’s Faster Payments Task Force (FPTF) it was abundantly clear that the Fed did not want to establish and run its own new faster payment system the way the European Central Bank (ECB) has.
What will happen if the Fed does NOT modernize and operate 24/7?
Numerous bank, fintech, and crypto players have launched payment solutions: PayPal, Venmo, Zelle, Square Cash, RTS, Apple Pay, and Google Pay are just a few of them. Behind the scenes, many of these systems still rely upon the slow 20th century rails of our existing payment system. Payments look instant inside these networks, but it may take days to get a payment out of the network. Most importantly, they don’t interconnect with each other. A user on one network cannot easily send a payment to a user on another network. The Fed’s proposal is to allow these different networks to meet at the Fed to transfer funds to each other around the clock. This is important for facilitating a 24/7 payment system as the different networks need to exchange funds immediately to avoid risk piling up overnight. This is also important for maintaining our global competitiveness as our financial system needs to be open when our trading partners are awake.
If the Fed does not act, we will be left with a slow, fragmented payment system that leaves out many Americans. Even worse, it is likely that network economics will kick in and leave us with one or two dominant networks that will monetize their market power to tax all Americans on every transaction while freezing out innovative new payment systems.
Our economy operates 24/7 and so should the Fed.
America’s slow payment system is a major hidden contributor to income inequality. When low-income consumers approach the zero lower bound of their bank account, myriad high costs for short-term liquidity appear that wealthier people never face. Just three of these fees, bank overdraft, check cashing, and payday loans, total over $35 billion a year. Demand for these arise, in part, from the long lag time between when consumers deposit funds and when those funds are available.
The rest of the world is far ahead of America. The UK adopted real-time payments 12 years ago. Poland, South Africa, and Mexico are already there, and soon the European Central Bank will have real-time payments. A Slovakian payment deposited in Ireland will clear before a payment from Minnesota is available in Florida. This is not a problem of technology; it is a problem of leadership.
The Federal Reserve once was a leader in payment modernization. In 2001, the Fed proposed and Congress adopted the Check-21 Act. Since then, the Fed has failed to use its legal authority to adequately keep pace with technology and benefit consumers. Under the law, the Fed has the legal authority to mandate and/or operate a real-time payment system. Instead, the Fed has done neither. That inaction continues to cost working class America’s billions a year.
Modernizing, our payment system will empower Americans to better manage their hard-earned cash and have more of it.
What should we do now? The answer is simple. The Federal Reserve should use its existing legal authority (Section 603 of the Expedited Funds Availability Act) and simply mandate real-time payments in six months. Safeguards to protect against fraud ($5,000 funds limit, existing customers only, etc.) can be reasonably carved out. Financial institutions can choose to participate in existing real-time payment systems, develop their own, or provide the funds to consumers before they actually clear (several already do). The Fed is conflicted in its dual role in operating a payment system while regulating payments for everyone. Modernizing, our payment system will empower Americans to better manage their hard-earned cash and have more of it.
Not so fast.
Let me first make clear my considerable agreement with James and Aaron. I agree that the slow speed of many US payments is harmful, to the poor especially, and that it should be possible for all payments to be processed in hours, if not instantly, rather than in days. I also agree that the Fed, as a monopoly supplier of final settlement services for the nation’s banks, has an obligation to reform those facilities as needed to expedite payments. Finally, I agree that it should do so in part by offering 365-day, round-the-clock interbank settlement services, either by extending the operating hours of Fedwire or by creating a special “liquidity management tool” (LMT) for the purpose.
I disagree, on the other hand, with James’ view that, to achieve faster payments, the Fed must also establish a new all-hours Real Time Gross Settlement (RTGS) facility, for several reasons:
It isn’t necessary. It’s important here to distinguish faster clearing of a payment, which makes funds available more rapidly to the payee, from faster final settlement of dues among involved financial institutions. Reducing the social costs of slow payments is a matter of arranging for faster clearing of those payments. It doesn’t necessarily require faster settlement among banks.
It’s important here to distinguish faster clearing of a payment, which makes funds available more rapidly to the payee, from faster final settlement of dues among involved financial institutions.
The proposed Fed RTGS system is uniquely capable of achieving both instantaneous clearing and instantaneous interbank settlement. But faster—and even instantaneous—clearance itself can be achieved without it. What’s more, a rapid-clearance arrangement already exists. With the Fed’s encouragement, The Clearing House (TCH)—a company owned by a consortium of large banks—launched its Real-Time Payments (RTP) system in 2014. The system maintains a pooled account at the Fed, in which all banks are able to maintain funds. Payments made within the RTP network are settled instantly on the RTP account ledger.
Although only a portion of US banks have joined thus far, in principle all might take part, thereby satisfying the Fed’s “ubiquity” requirement. And although many smaller banks have yet to join, RTP’s fee structure, which allows no volume discounts and is below the Fed’s present same-day ACH fee, actually favors them. Finally, non-bank payment service providers might take part using special purpose banking charters from the Comptroller of the Currency, though that’s likely to take some nudging of TCH by the Fed.
It may not be legal. In so far as the proposed RTGS system provides no essential public benefit “that other providers alone cannot be expected to provide with reasonable effectiveness, scope, and equity,” its establishment would be contrary to the criteria set forth by the 1980 Monetary Control Act.
It will delay, rather than expedite, the establishment of a ubiquitous faster payments network. Because the RTP system already exists, banks might easily comply with Aaron’s six-months mandate simply by joining it. In contrast, it will take the Fed several years to establish a new RTGS system. Yet the very prospect of an alternative Fed-administered fast-payments mechanism has discouraged many banks from joining the RTP network, for none wish to invest in a network that Fed actions may render obsolete.
It will stifle future innovation. While any established payment network enjoys a first-mover advantage, the fast-payments market remains both contestable and dynamic, with many players offering competing—if generally less than ubiquitous—networks. The Fed’s unique privileges, including its status as a regulator of private-market payment service providers, equip it with unique monopoly powers that may ultimately stifle competition and innovation. The history of the Fed’s involvement in check clearing offers an object lesson in this regard.
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