George Selgin on Repo Market Stress, Fed Balance Sheet Volatility, and a Standing Repo Facility

George Selgin is the director of the Cato Institute’s Center for Monetary and Financial Alternatives and is a returning guest to the Macro Musings podcast. He joins the show today as part of a two week special on the Fed and repo markets, as he helps us take a look at recent repo market stress from the Fed’s perspective. Specifically, David and George discuss the basics of the Fed’s balance sheet, the problematic nature of the Treasury General Account and foreign repo pools, and how George would tweak standing repo facility proposals to more directly address balance sheet volatility

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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Hey Macro Musings listeners. This is your host David Beckworth. Today's show is the first of a two week special on the Fed and repo markets. As you may recall, repo market interest rates spiked in mid-September, reached nearly 10 percent, while the interest rate on reserves was around two percent. This caught many by surprise, including the Federal Reserve, and revealed there was a severe funding pressure in the repo market, that is, there weren't enough bank reserves to fund repo activity. As a result, the Fed injected liquidity into the financial system through overnight repos, term repos, and outright purchases of assets.

Beckworth: There is some concern however that at the end of 2019 there will once again be repo market stress as lending by the big banks into the repo market will be dialed back as these big banks tidy up their balance sheet for regulatory reasons. No one knows for sure, but there are good reasons to be worried, and today's show, part one of the series, we will take a look at this problem from the Fed's perspective with the help of George Selgin. Next week we'll be joined by Josh Galper who is deep in the trenches of the repo market, and he will help us examine this problem from the perspective of the repo market. George, welcome back to a show.

George Selgin: Great to be here again, David.

Beckworth: Yes, you've written several interesting pieces on this situation, this development. We'll link to those in the show notes. You've also outlined some proposals to fix this problem for the near term, some practical fixes that kind of sits to the side for the time being, what type of operating system the Fed has, but given where we are, what are some pragmatic next steps and we'll get to those probably near the end of the program. What I want to do though is work our way through what happened in September and then talk about what might happen in December, this month, but later in the month, and there are some concerns about that.

Beckworth: The last time you were on the show we talked about real-time payments and I encourage our listeners to go back and listen to that. George had some great suggestions there too for some fixes for helping those who struggle with the payment system, those lower income folks. But today we want to get into the repo market stress and the Fed's relationship to that, and this is the road map we're going to take with George today. First we're going to review what happened, as I mentioned in September, what could happen, and his suggested solutions. And there are some really interesting ones, a little provocative, George, I will say, I'm sure you've got some feedback on those proposals as well.

Beckworth: But to help us understand, help me understand before we get into all of this, let's talk about the Fed's balance sheet. The basics of the Fed's balance sheet. So like any body, any institution, the Fed's balance sheet has an asset side and a liability side. And on the asset side, I think that's pretty straight forward. The Fed buys treasuries, they bought agency bonds and debt, can issue loans. Where it gets tricky and where the story I think is really buried is on the liability side.

Selgin: That's right. Yeah.

Fed Balance Sheet Basics

Beckworth: So talk us to the liability side of the Fed's balance sheet.

Selgin: Right. So, people are familiar with one of the most important Fed liabilities, that's the currency that's circulating in the economy, Federal Reserve notes. Next to that, they may be familiar with the fact that banks keep deposits at the Fed, which deposits count along with currency they have in their tills and vaults and ATMs, as part of their reserves. So those are the two more familiar Federal Reserve liabilities. There are others, however, and those turn out to be very important in the repo market troubles that the Fed has been experiencing.

Selgin: And chief among them as far as that issue is concerned, are two liabilities. First, the so-called treasury general account, which is an account the Treasury keeps at the New York Fed, which is a consolidation of accounts it has at all of the Federal Reserve banks that they put the money all together at the end of every day. And the other one is the foreign repo pool, and that is liabilities consisting of deposits by foreign central banks and other foreign official institutions that can place money at the Fed on deposit as it were, and earn interest on it because the Fed turns around and does repo operations with those funds. So those are the liabilities that people are less familiar with and that I think we're going to be talking about a lot.

Beckworth: Yeah, absolutely. And part of the story for September, or THE story for September, was that there weren't enough reserves given the demand for them during this time, given some of the developments in these accounts, these sub-liability accounts. And so what I want to think through before we get into the details of the story is, how do you get changes in reserves on the Fed's balance sheet? So there's several ways I can think, I want to walk through them with you and help me understand them.

Selgin: Sure.

Beckworth: So the first way there could be fewer reserves would be for the Fed to shrink its balance sheet outright. So the Fed sells off assets and it has to pull in reserves. So when it sells a treasury bill back to the public, it's taken out the reserves that would correspond to that. And that's what happened with quantitative tightening. Is that right?

Selgin: Yes, that's right. One way to think about this is to first imagine that the Fed's liabilities are all bank deposits at the Fed, and they're all therefore reserves that banks have. And then start asking what happens, is those other kinds of liabilities become important. So the first case would be people are taking currency out of their banks. That's going to obviously reduce bank reserves. The second… and this is holding the size of the Fed's balance sheet constant. Second is a growth in the TGA where the Treasury puts more money in the Fed. But that means that there are less reserves in the banking system because they're taking away the liabilities of the banks and transferring them accounts from the banks to the Fed. And the last one is these foreign repo pool, which again whenever an institution keeps a larger balance at the Fed that's not a bank. It means the banks have to have less.

Selgin: Finally though, you have the case where the Fed is shrinking its balance sheet as it did during its unwind operation. And then of course its liabilities are going down along with the assets going down. So the whole balance sheet is-

Beckworth: Shrinking.

Selgin: ... getting smaller and there the decline in reserves doesn't have to take the form of a redistribution from reserves to other Fed liabilities. It's just that there are fewer liabilities in total.

Beckworth: Okay. So with quantitative tightening, the last case you just described where the Fed's reducing the absolute size of its balance sheet, my understanding is about $600 billion in reserves was eliminated.

Selgin: That's correct.

Beckworth: Disappeared out of thin air, or disappeared into thin air. So we saw about a $600 billion reduction in reserves during QT, quantitative tightening, from 2017 and 2019. Then on top of that… so that's the first part of the story. But on top of that, there's these other developments which I didn't really pay attention to, I think many people didn't pay attention to, and this is the shuffling of the categories on the liability side you just described. So walk us through why is it that when the Treasury increases its account at the Fed, there's fear of reserves? What's the actual steps?

Selgin: Well, to give a typical example, let's say the Treasury is collecting taxes. So people are paying their taxes to the Treasury, they're writing checks to the IRS, and of course those checks are checks against their banks, commercial banks. And the IRS in turn places these funds in the Treasury general account. Well, and then the checks clear. When the checks clear, the count to TGA is credited, finally credited. And at the same time, some commercial bank accounts at the Fed are debited. So the reserves, which are those commercial bank deposits at the Fed go down, and the TGA balance, which is not part of bank reserves, of course, because the Treasury isn’t a bank, goes up, and there you have it. So the amount by which the TGA increases is the amount by which the stock of bank reserves in the form of deposits at the Fed declines.

Beckworth: Okay. And that means there's fewer reserves for these banks to lend into the repo market when this happens. This is one of the reasons that there were fewer reserves available.

Selgin: That's right.

Beckworth: Let me ask about the history of this, because you wrote quite extensively in these two pieces that we're going to link to about the TGA account. It hasn't always been used. In fact, you have a great chart in the article that shows before 2008, before the switch to the floor system the Fed currently has, it was hardly used at all. Now if you look at it, it's used extensively and it's very volatile, big, big swings. So, what's the history of this account and why do we see this change today?

The Treasury General Account

Selgin: Well, first of all, it's important to realize that putting cash in the Fed is only one of several options that for some time now have been available for the Treasury, for its cash management. The Treasury is always going to have some cash resources on hand or some liquid resources on hand like any of us would, so that it is always prepared to cover its expenditures it keeps a balance. Now it keeps these resources in several forms. It can hold its own bonds, is can actually issue so-called cash management bonds, which are bonds it issues for the purpose of managing its own cash. It can put money in the Fed of course, it can also put money in commercial banks through the so called treasury tax and loan program, which in one form or another has been around for a long, long time, actually since before the Great Depression.

Selgin: Finally, there's another investment it can make, which is a longer term, basically term deposits. And that's called the Treasury Optional Investment Program. So you have a bunch of alternatives and depending on the circumstance, the Treasury, like any of us, is going to look at these alternatives and say, "Which is the most economical way for us to keep liquid funds. And as you said, for most of the time before the 2008 crisis, the Treasury found it economical to use resources other than the TGA for most of its cash balances or liquidity. In fact, for a long time before 2008, the Treasury had a policy that it would try to keep a balance in the TGA of only about $5 billion. That's a lot for you and me, but it's very small.

Selgin: Today for example, there's something like, I don't know, I haven't looked lately, but let's say $350 billion in the TGA. There may be more, maybe a little less, but it's around there. So that's a big change. So, of course that meant that in those days the Treasury was mostly using these other programs for its funds because even though it was smaller, it wasn't that much smaller. So it had a fair amount of money in the TT&L accounts, the Treasury tax and loan accounts. It also used the Treasury Optional Investment Program. And through a combination of that and also keeping its own cash management bonds on hand, it was able to keep that TGA balance low and stable. Occasionally it would, certain times of year it would go up more as much as maybe to seven billion, but it was stable and low, and that meant that the Fed's balance sheet could be that much smaller because the Fed didn't have to compensate for the fact that part of its resources were going towards providing the Treasury with cash or with a cash balance.

Beckworth: So the Treasury can either hold its cash outside the Fed and the private marketplace at banks, different storage facilities in terms of term deposits or overnight accounts, or it can hold them in the Fed and the Treasury general account.

Selgin: Yes.

Beckworth: And the decision to do so depends on the cost it generates to the Treasury. And part of the story, not the only story, but part of the story post 2008 is that it's been more cost effective to park the cash at the Fed than to store it outside the Fed and the private sector. Is that right?

Selgin: Yes, absolutely. The big change, the most important change, though there are other elements to the story of course, was interest on reserves, and it's a little bit strange why that matters. So let me explain. The Treasury's account at the Fed doesn't pay any interest. So you might think that the fact that the Fed introduced interest on reserves would mean that commercial banks now can pay more interest in theory on deposits and maybe that would be a better place for the Treasury to put its money. But it doesn't work that way because the interest that the Fed pays on the reserves of commercial banks is interest it could be paying to the Treasury. So when the Treasury puts money in TT&L accounts at commercial banks, it may get a little interest on those accounts, it does get some interest, but it's also losing the interest that is being paid on the bank's reserves, which would not be paid if it kept its money, which would not lose if it kept its money at the Fed.

The big change, the most important change, though there are other elements to the story of course, was interest on reserves, and it's a little bit strange why that matters.

Selgin: So, depending on conditions, but generally speaking, it is a money losing proposition with interest on reserves for the Fed to keep money in the commercial banking system instead of…

Beckworth: The Treasury.

Selgin: Pardon me, David, yes, for the Treasury to keep money in the TT&L accounts rather than just leave it at the Fed. So that's the big change.

Beckworth: So Treasury gets a bigger check from the Fed if it parks its funds at the Fed?

Selgin: Yeah. That's right.

Beckworth: I understand that appeal. That makes a lot of sense.

Selgin: The Treasury might get some interest from those banks, but then it gets so much smaller, a check from the Fed as it were, that it actually is worse off.

Beckworth: And there were a few other reasons as well. I mean, that's the main one, but it wanted to have a bigger account balance for emergencies, a lot of things going on post process.

Selgin: Yes, the Treasury at one point, 2015, it had already shifted a lot of its funds into the Fed, but in that year it decided that it wanted to maintain a balance of at least $150 billion at the Fed, up from the five billion we were talking about before. That's a huge change and its rationale for that was that in the event of another major crisis, it wanted to be able to have sufficient resources on hand at the Fed to cover all of its expenses for… I think it was for a week, without having to go to private markets under the assumption that anything it had outside of the Fed might not be available during a big crisis. That's a rather extreme assumption and there are ways I think you could deal with that concern.

Beckworth: Now, was there some role the Fed itself played in this? Did the Fed kind of maybe beforehand discourage the Treasury and then after 2008 say, "Well, whatever, we've got ample reserves." Because part of the story here is prior to 2008, the Fed had to actually actively engage and try to manage the amount of reserves based on what it thought would be the demand for reserves. But after 2008, if there's ample reserves in the system, why worry about it? Why not just let the Treasury keep as much as it wants at the Fed because as you mentioned, there's a consequence. If the Treasury puts more funds into its account, there's less reserves at banks, but no big deal if there's ample reserves. So the Fed kind of let its guard down. Is that right?

Selgin: Well, it did, but it thought that it knew what it was doing. So in the old system, which was a scarce reserve system, and of course you and I have talked about this, and you've written a lot about it on the corridors versus floors, in that corridor-like system, the Fed relied on very minimum bank reserves and fine tuning of the quantity of bank reserves to keep interest rates on target. But of course to do that, it was desirable that the Treasury should not have a large and volatile TGA balance, because that would interfere with the quantity of reserves causing it to also be volatile, unless the Fed very actively intervened in the market. It would make the job of fine tuning the reserve supply much harder for the Fed. So there was certainly an understanding between the Treasury and the Fed that the Treasury should try to manage its TGA balance in the interest of making life simple for the Fed and allowing it to operate that system without too much difficulty.

Selgin: When they switched to an abundant reserve system in 2008, it did become less desirable from the Treasury's point of view to keep money outside of the Fed as I explained, but it also became less important for it to do that from the Fed's point of view because under an abundant reserve system, the Fed doesn't worry about small changes in the reserve supply and doesn't rely on such changes to keep rates at their target level. Instead, it just sets the IOER rate, the interest on excess reserve rate, and that's how it controls other rates.

Selgin: So at that point, with that change, the Fed was happy to say to the Treasury, "Oh yeah, sure. Put all the money here you want. Do what you want, increase it, reduce it. It's no problem for us." For example, it might be, let's say a Treasury withdrawal of $140 billion from a TGA account that had that much and more in it originally under the old system. That would have been a huge shock to the quantity of bank reserves and the Fed would have had to come in there and make up for it by buying more securities. But circa 2015 let's say, that would have been a very small percentage of the outstanding amount of excess reserves. And so it wouldn't have mattered that much.

Beckworth: Yeah. And that's what the Fed thought and it was true for a long time up until recently when that complacency came back to bite the Fed in the rear. And we'll get to that because we'll see the TGA got so big relative to the demand for reserves it actually became an issue again. But before we get into that, we have a few more things we've got to work through, and I do want to highlight something else you bring out in your paper about the TGA account, and it was really interesting some of the history, and that the Fed and the Treasury had in similar issues they do today back in the '70s. So, the Treasury today is saving money by putting, as you mentioned, funds into the TGA, given interest and excess reserves, but in the '70s, it also resorted to that tactic because of double digit inflation and double digit interest rates. So tell that story because it's really interesting.

Selgin: Yes. So I think it was 1978 and basically the relationship between the interest rates being paid on the market. And I remember this was when interest rates that banks could pay, were still controlled by Regulation Q and related regulations and the rate that was being paid ... Sorry, those rates became sufficiently unattractive that the Treasury found it desirable to put money back in the TGA account and start using it heavily again, which it hadn't done for a long time. And in the end this had to do partly with the interest rates that the TT&L accounts were yielding.

Selgin: So, what ultimately happened was they worked out a new arrangement. They created a special kind of TT&L note account that bore more interest as a way to get the Treasury to once again use the TT&L program as it had done before. And the significance of this episode is that it was very similar to what happened recently in that the Fed found that because the Treasury was using the TGA account heavily again, and that account had become volatile, the Fed was having to intervene in the reserve market much more heavily to keep rates on target and was really having a hard time. So it had to work with the Treasury to come up with a way to fix that, which for a while it managed to do. So that's what it needs to be thinking of doing today. And for some odd reason, there's no talk that I'm aware of from the Fed or the Treasury about, "Hey, let's get together and-"

And the significance of this episode is that it was very similar to what happened recently in that the Fed found that because the Treasury was using the TGA account heavily again, and that account had become volatile, the Fed was having to intervene in the reserve market much more heavily to keep rates on target and was really having a hard time. So it had to work with the Treasury to come up with a way to fix that, which for a while it managed to do. So that's what it needs to be thinking of doing today.

Beckworth: Let's coordinate.

Selgin: "... figure out how to make these substitutes for TGA balances viable again."

Beckworth: Has there been a lot written on this episode from the '70s that's very similar to today?

Selgin: I don't know about a lot, but there's certainly a few sources out there on it. And I do link to one or two in my post.

Beckworth: Okay. So this would be a great area for research for some enterprising young scholar or current scholar, someone in the money markets group at the Fed to take a look at this period compared to the present. Okay. So the TGA, to summarize, is being more heavily used by the Treasury. At first, not a big deal given the ample amount of reserves, but we have seen it now is a big deal, like in the '70s, and it's causing problems for the Fed's management of its balance sheet. In fact, that's kind of a key theme. We're going to talk about the TGA and we're going to move on to the foreign repo. But in both cases, I mean, the striking point is the Fed has a sizeable portion of its balance sheet that is not under its control and is volatile.

So the TGA, to summarize, is being more heavily used by the Treasury. At first, not a big deal given the ample amount of reserves, but we have seen it now is a big deal, like in the '70s, and it's causing problems for the Fed's management of its balance sheet. In fact, that's kind of a key theme.

Beckworth: Now, currency has always been there. So currency has been beyond the Fed's control. It grows at a certain level. It's predictable.

Selgin: It's very predictable. Yes, very predictable.

And so part of the challenge we're trying to show here is that the Fed's having a hard time managing its balance sheet because there's these items that are beyond its control.

Beckworth: Very predictable. And it's relatively stable. Whereas these other two accounts have been explosive and volatile. And so you can just imagine your own balance sheet. I mean, imagine trying to plan your activities when there's a sizeable portion of your balance sheets, your liabilities are going to swing one direction to the other, be tough to make plans, be tough to implement what you want to do. And that's what the Fed's facing. And so part of the challenge we're trying to show here is that the Fed's having a hard time managing its balance sheet because there's these items that are beyond its control. So let's go to the second item and that's this foreign repo pool. So tell us what that is and what's happened to it recently.

The Foreign Repo Pool

Selgin: The foreign repo pool was created, I think it's close to 50 [ago] years now, but anyway, many several decades ago, and it's a facility, again, at the Fed designed for foreign official institutions. So that includes central banks, but also some of the international institutions that work with central banks. And it was designed to be a safe place for these foreign entities to place their funds, dollar funds. And it has its counterparts, it should be said, in like facilities provided by foreign central banks to the Fed for example. So, it's part of a reciprocal set of arrangements. However, of course, reciprocal in this case doesn't mean exactly symmetrical because the dollars, they're so much more important. So there's a lot more need for foreign central banks to have a place to park dollars than there is for the Fed to have a place to park most other kinds of… park its holdings of foreign exchange. So, that's the basic setup.

Selgin: Here once again though, the Fed's facility is a substitute or a supplement to private market alternatives, right? So the foreign central banks don't have to put dollars in the Fed. They can use private repo markets. They can, in principle, they could put funds in commercial banks, they can hold dollar securities, treasury securities-

Beckworth: Outside the Fed?

Selgin: All of these would be outside of the Fed.

Beckworth: Outside the Fed, yeah.

Selgin: All of these are alternatives for holding dollars or for depositing dollars or investing dollars that don't drain reserves from the US banking system. That don't mean an increase in the Fed's non-reserve liabilities. So here again, the question that foreign official entities [and] institutions face in this context is, "Okay. What is the best place for us to park dollars?" And that's going to depend on considerations of risk certainly, but also on what the return the foreign repo pool pays compared to other alternatives. And here I think the biggest problem is simply that the Fed, which sets the foreign repo pool rate, has made it too attractive. And it's the solution in this case, and I know we're going to get to solutions more detailed later, but it's relatively simple for the Fed to adjust that rate if it wants to and make it less attractive relative to alternatives so that the foreign repo pool doesn't get used to such a vast extent as has been the case lately.

And here I think the biggest problem is simply that the Fed, which sets the foreign repo pool rate, has made it too attractive. And it's the solution in this case to adjust that rate if it wants to and make it less attractive relative to alternatives so that the foreign repo pool doesn't get used to such a vast extent as has been the case lately.

Beckworth: And to be clear, its use, again, went up dramatically post 2008 compared to pre. So I'm sure part of the story here is also the Fed got a little relaxed again for the same reason they got relaxed about the TGA account, because ample reserves, not a big deal if these foreign central banks are depositing at the Fed, but it has created problems along the same dimension, same channels as the TGA and Zoltan Pozsar, a well-known analyst who looks at these issues, he's called it the black hole of the money market. So, why does he call it the black hole of the money markets?

The “Black Hole” of Money Markets and the “Accidental” Corridor System

Selgin: Well, the easiest way to think of that is you have a Federal Reserve that of course by expanding its balance sheet and buying securities adds to the supply of reserves. But to the extent that the foreign repo pool grows, and it has grown tremendously since 2008. It's like a black hole where those reserves instead of staying as bank reserves get-

Beckworth: Sucked in, okay. Yeah.

Selgin: ... sucked out of the banking system. But what that really means is that you have formerly, you have what were once Fed reserve liabilities being switched for non-reserve liabilities. So you can have this situation and Pozsar is very good about describing the circumstances in which the Fed's efforts to expand the supply of reserves by buying securities just end up pouring that many more reserves down the foreign repo pool drain. And it becomes a futile thing.

Selgin: So there are two different issues here, but they're related. One is that the absolute size of these non-reserve Fed liabilities, the foreign repo pool and the TGA, the bigger they are, the fewer bank reserves you have given the size of the Fed's balance sheet. Therefore, the bigger they are, the bigger the Fed's balance sheet has to be to create a given total reserve pool. But the other one is the volatility, and in this case the volatility is much worse for the Treasury general account. That thing really has bounced around dramatically. The foreign repo pool has ratcheted a lot, so you'd see a little bit of fluctuation all the time, but you also have seen several big steps.

So there are two different issues here, but they're related. One is that the absolute size of these non-reserve Fed liabilities, the foreign repo pool and the TGA, the bigger they are, the fewer bank reserves you have given the size of the Fed's balance sheet. Therefore, the bigger they are, the bigger the Fed's balance sheet has to be to create a given total reserve pool. But the other one is the volatility, and in this case the volatility is much worse for the Treasury general account.

Selgin: In any event, the volatility of these non-reserve liabilities, that particularly poses a problem as you get to a scarce reserve situation. So to tell the whole story, think about it this way. As these non-reserve liabilities grow, total reserves have been shrinking, other things equal. Add to that the Fed’s unwind, of course, they'll shrink even more.

Selgin: At some point they shrink to the point where reserves are no longer abundant. That is they're reaching a point where some banks are feeling shortages. Then the volatility means that you're going to have some interest rate action out there in the money market that's independent of the Fed's interest rate settings. Interest rates are going to take on a life of their own and the Fed is going to have to go in there with repos or whatever to try to stabilize those rates and keep them down as if we were back in a corridor system. But it's the worst kind of corridor system because it's an accidental corridor system.

Beckworth: No, no. That's the way I describe it in an article I wrote.

Selgin: Did you?

Beckworth: The Fed kind of stumbled or tripped back into a corridor system.

Selgin: It kind of, yes.

Beckworth: And now it's trying to get back out into a floor system.

Selgin: Yeah. It's not an argument, and I'm sure, I want to stress this point, both of us… it's not an argument against the corridor system. It's an argument against an accidental corridor system. And if you're going to have a corridor system, you can do it well or you can do it really badly. This is bad. This is very bad.

It's not an argument, and I'm sure, I want to stress this point, both of us… it's not an argument against the corridor system. It's an argument against an accidental corridor system. And if you're going to have a corridor system, you can do it well or you can do it really badly. This is bad. This is very bad.

Beckworth: Yeah. As I like to say, and I've mentioned this in the show many times, and people I talk to I've mentioned this, but Canada had a corridor system. Like the Fed it went to a floor system during the crisis, but then it successfully went back to a corridor system. So it is possible to have a smooth transition. Now they have some things that are different up there, so maybe it's not like a fair comparison, but there are ways, and we'll actually maybe get at the end, but we're really, again, working within the framework or the assumption that we have a floor system, how can we help the Fed manage its balance sheet in a practical, easier way?

Beckworth: Because again, the challenge of these last two categories, the TGA and then the foreign repo pool is, again, you've got a sizable portion, a meaningful portion of the Fed's balance sheet and a liability size that is exogenous, kind of beyond the control of the Fed, at least directly, and it creates real problems for the Fed in terms of managing reserves. And why does that matter? Because that then influences funding available to the repo market. And the repo market is hugely important to funding the financial system. It's how they fund activity on the longer end of the curve.

The challenge of these last two categories, the TGA and then the foreign repo pool is, again, you've got a sizable portion, a meaningful portion of the Fed's balance sheet and a liability size that is exogenous, kind of beyond the control of the Fed, at least directly, and it creates real problems for the Fed in terms of managing reserves. And why does that matter? Because that then influences funding available to the repo market. And the repo market is hugely important to funding the financial system. It's how they fund activity on the longer end of the curve.

Beckworth: Now, speaking of curves, one other question I have that's been brought up a lot, and that is that the inverted yield curve also made the foreign repo pool attractive relative to buying other treasuries, other long-term securities. So, having an inverted yield curve, this kind of tightened the screws of this problem, is that right?

Selgin: Yes. Well, it means that short-term funds are more attractive than long-term funds. And that means that as far as both the Treasury and the foreign official institutions are concerned, they're not thinking of longer term securities as a good place to vehicle for maintaining liquidity, and they're looking towards instead various kinds of deposits. And that's narrowing the field and it's narrowing the field in a way that makes it more likely that they're going to be holding funds, keeping funds at the fed.

Beckworth: And the Fed does have some influence over that.

Selgin: Yes, it did. Yes.

Beckworth: Okay. All right. We'll go beyond that. So here we are, we've discussed the Fed's balance sheet, the liability side. We've discussed these categories that are kind of beyond the Fed's control. I mean, really currency growth is beyond the Fed's control, but it's lived with that for a long time. It's just these other recent categories, the change, the volume, the volatility, and just to make this concrete, the Fed's shrinking of its balance sheet, quantitative tightening, reduced reserves by about $600 billion as we mentioned earlier, but the growth in the Treasury General Account and the foreign repo pool combined is a little over $600 billion too. So the magnitudes are very similar, just as big as the QT is, these other accounts have contributed as well. So this is a nontrivial development.

Selgin: Yes, that's right. It's nontrivial and your way of describing the sense in which it’s so is quite correct. The other way to think about it is that if you look at the amount of money parked in the TGA and foreign repo pool today combined, the Fed by reducing, taking steps with the Treasury's helps perhaps to reduce those accounts, those balances to small amounts, could create more reserves that way, than it's going to be creating in the next half a year or so by buying more securities again. And that means that if it wanted, in other words, if it wanted to create $600 billion in fresh reserves, it could do so without expanding its balance sheet or buying any more securities if you could just get those other liabilities back down again.

Beckworth: And just so we're clear on the numbers right now, the amount of reserves in the system are a little over one and a half trillion, and just to kind of do a back the envelope calculation, what if there had been no quantitative tightening? What if the TGA hadn't grown? What if it had maintained a kind of pre 2008 level? And what if there hadn't been any growth in the foreign repo pool? Then reserves would be up around 2.6 trillion. So, I mean that would have been presumably more than enough to maintain the ample reserve, the floor system that's in place. So again, the issue is these things have grown and the story now in September is closely tied to these and that there were big corporate tax receipts coming in, and the government was issuing a bunch of debt, which meant TGA was ballooning. The yield curve also contributed to the foreign repo pool growth.

Beckworth: So kind of the story there is reserves are shrinking both from quantitative tightening and from these other kind of exogenous developments beyond the Fed's control. So kind of the Fed was shifting its supply curve back, but it was trying to shift it back not too far, just far enough so it could reduce the balance sheet without becoming a corridor system. Again, that's accidental falling into it. But that coinciding with increased demand for reserves from regulatory reasons kind of pushed it in there.

Beckworth: Now looking forward to December, we know the Fed is earnestly trying to increase the amount of reserves in the system and it's quite hard to add up everything it's doing. But Jim Bianco, who does market research, he has an estimate out there that all combined, all these different measures, and again, to be clear, some of these are overnight, their loans will be liquidated, and in the future some of them are outright purchases. But combined, by the end of the year, there'll be about $300 billion plus injected. And the question is, will that be enough? And it's not clear we know the answer to that question, is it?

Selgin: No, it's not. And I know some very smart people who believe that a heightened reserve demand will, toward the end of the year, despite these additions by the Fed, will cause repo rates once again to climb up possibly above the Fed funds market upper limit, and that the effective Fed funds rate may also rise above its upper limit, which of course defines a failure of monetary control in our system.

And I know some very smart people who believe that a heightened reserve demand will, toward the end of the year, despite these additions by the Fed, will cause repo rates once again to climb up possibly above the Fed funds market upper limit, and that the effective Fed funds rate may also rise above its upper limit, which of course defines a failure of monetary control in our system.

Beckworth: Right. And in fact, one of the arguments for the floor system is we'll have much better interest rate control, and we've seen anything but that. And I sympathize with the Fed…

Selgin: It's been a long practice period too.

Beckworth: Yeah, I mean, again, compared to the Canadian corridor system, we're doing a pretty horrible job down here.

Selgin: Or our pre 2008 system, which had a much better record of the Fed despite the extra work involved, because in that system it was expected that the open market desk would be busy all the time. They had to predict, they had to do a lot of work. And one of the big arguments was we'd go to a floor system and everybody at the open market desk they'll have their feet up on the desk and they'll be telling jokes, and-

Beckworth: Be on Twitter.

Selgin: ... tossing paper airplanes. But in fact, they've been very busy, as we know, and still they have failed in a number of remarkable instances to get rates to behave the way they want them to. So that's not very good.

Beckworth: Yeah. So the issue then going forward, the end of this month, will be will there be enough reserves? And I guess the way I think about it is there's a potential outward shift in the demand curve for reserves, and it's going to arise because of these big banks having year end regulatory inspections. So they call them the global systematically important banks, the G-SIBs, and there's a capital surcharge that's applied to them. And my understanding is end of the year, they try to tidy up their balance sheets, make them smaller, leaner, so the charge they get will be less. But in doing so, these banks will lend less into the market. So effectively the demand for those reserves will have increased. So, even as the Fed is increasing supply of reserves, that demand curve might be shifting out going beyond where the Fed is.

Selgin: That's right. And it's important to remember that the demand for reserves of these large banks is, an increase in that demand, is equivalent to a reduction in the availability of reserves to be lent in the repo market by those banks, because those banks are holding most of the reserves. I don't have the recent percentage immediately on hand, but we know that they hold an outsized percentage of the total available stock of excess reserves. So if there's a reserve shortage anywhere in the system, and those banks are not in a lending mood, so to speak, or are not in a position to lend, then that's when you get these desperate bids by people trying to pay whatever to cover themselves because it's hard to find anybody who's got reserves who wants to part with them.

And it's important to remember that the demand for reserves of these large banks is, an increase in that demand, is equivalent to a reduction in the availability of reserves to be lent in the repo market by those banks, because those banks are holding most of the reserves.

Beckworth: Yeah. So these banks effectively will reduce the supply of funding available to the repo market. For them it'd be an increasing demand, but from the repo market perspective, reduction in the supply of reserves.

Selgin: That's right, and it can also affect the Fed funds market too, and that's why those rates could ...

Beckworth: Yeah. All the overnight markets.

Selgin: All the overnight rates.

Beckworth: But we see kind of a headlines coming from the repo market, because that is probably the most important overnight funding market.

Beckworth:  And Zoltan Pozsar makes this point that it's one thing to have maybe a temporary spike in the repo market, but if it continues to persist, then you're leading to actual credit problems, actual businesses going bust, funding drying up for longer term projects. So it becomes serious. I mean, this is a technical issue right now, but a technical issue can turn into a real credit issue if it's not fixed.

Selgin: Sure. Yeah. This is definitely serious. This is not just about wanting to make the Fed look better. This is about the wellbeing of many ordinary participants in those overnight markets.

Beckworth: Okay. So that's the problem. And the concern again is, we might accidentally fall back into a corridor system at the year end, rates will spike. All kinds of problems will emerge from that depending on how long it lasts. So the solution that's been presented by one of our previous guests, David Andolfatto and Jane Ihrig, who's at the Board of Governors, and it's received a lot of discussion and discussed elsewhere extensively as a standing repo facility, which would allow these big banks to let go of some of the cash reserves they're holding because they could take treasuries to the Fed and easily convert that into cash. So right now they could be holding treasuries instead of cash, but they think they may not be able to liquidate quickly. There might be losses if they try to do it quickly, but if the Fed were there, it would solve that problem.

Beckworth: But you bring up in your paper a way to improve the standing repo facility because what the standing repo facility fixes right now as proposed would only address these big banks. It doesn't address the problems we've discussed with the TGA or the foreign repo pool directly. And you have some additions to make it kind of an all-encompassing solution. So walk us through that.

How to Improve Proposals for a Standing Repo Facility

Selgin: Well first of all, David, the standing repo facility is conceived by Andolfatto and Ihrig, it is meant to be there as not as a substitute for these ad hoc repos that the Fed's been doing. But it's not a substitute for the Fed's security purchases, which are also going on now, which are meant to make permanent additions to the stock of reserves to get back to an abundant reserve situation. So the idea is you pursue those reserve creating steps by the Fed, and then you have the standing repo facility, which will help because it reduces the demand for reserves by allowing banks, big banks especially, to treat treasury securities as closer substitutes, as better perfect substitutes as it were, for actual excess reserves.

So the idea is you pursue those reserve creating steps by the Fed, and then you have the standing repo facility, which will help because it reduces the demand for reserves by allowing banks, big banks especially, to treat treasury securities as closer substitutes, as better perfect substitutes as it were, for actual excess reserves.

Selgin: Now, I should mention there that this only works if the supervisors and the regulators go along with it, right? They have to say, "Okay. You can treat treasuries as perfect substitutes for excess reserves," which Basel allows in its definition of high quality liquid assets, tier one, high quality liquid assets, but which I understand and several people understand is not necessarily satisfying the regulators, particularly with regard to the so-called living will liquidity requirements.

Selgin: So anyway, assuming that David and Jane's facility exists, it would both reduce the supply or the demand for reserves, and thereby make it possible for the Fed to increase the supply of reserves and be done with it and never have to do that anymore. That's the idea. And if it's working the way it's supposed to, it shouldn't actually be used very often. You know, there might be some rare instances where reserves are a little scarce at the margin and then it would kick in.

Beckworth: Okay. So it would stand available, it probably wouldn't be used much, but it would create this certainty so you wouldn't want to hold a bunch of precautionary reserves?

Selgin: Exactly, yeah.

Beckworth: So it's kind of a nice backstop that hopefully you don't have to ever use?

Selgin: Yeah.

Beckworth: And presumably it would overcome the stigma of the discount window. I mean, the discount window in some sense it's very similar what it would provide, but people don't want to use the discount window because of the stigma. So, this would be a work around to that solution as well. But again, it wouldn't solve this problem of the Fed's balance sheet being beyond its control and the TGA and the foreign repo. But you have a fix for that.

Selgin: Yeah. So, the thing is that what you want to do is to make the demand for reserves lower but also more stable, and make the supply of reserves more stable, and the standing repo facility helps. But to really, really do that and to achieve what has long been the Fed's supposed idea of a balance sheet as small as is consistent with carrying out its monetary operation successfully, steps should be taken in my opinion to rein in the TGA and to reign in the foreign repo pool. And so I propose a number of those.

Selgin: For the foreign repo pool, that's pretty simple because the Fed is completely in charge of that facility. It is a facility that it operates as a favor for foreign banks. It's not in the Federal Reserve Act. It's not obliged to operate it and it can certainly operate it any way it wants to, within reasonable limits. It should set that foreign repo pool rate lower than it does. I suggest in my paper that it take the SOFR rate, which it's probably now using as a guide to the foreign repo rate and set the foreign repo rate something like 10 basis points below and make it a little bit of a penalty rate relative to private market rates. SOFR rate, if anything, is a little bit above private market repo rates because it's an index that includes a broader set than the usual private market rates. So that's the one thing it could do.

I suggest in my paper that it take the SOFR rate, which it's probably now using as a guide to the foreign repo rate and set the foreign repo rate something like 10 basis points below and make it a little bit of a penalty rate relative to private market rates.

Selgin: It could also put caps on the foreign repo pool, it used to have caps. It could tell the foreign banks, "Look, you can only hold this much. Here's your maximum balance. Here's how much you can change it with any limited period of time. There's plenty of scope for the Fed to work on these agreements.

Beckworth: And it used to do that because it was a scarce reserve environment.

Selgin: That's right, yeah.

Beckworth: Okay.

Selgin: But the point is, and maybe this is a big takeaway from this, even if you have an abundant reserve environment, still there are reasons to not have more reserves than necessary to manage that system. You still want it to be efficient in that sense. And that has always been the Fed's principle. That's why it had the unwind in the first place. Otherwise, why didn't it just stay with the maximum amount of reserves it had way back then? So, if that's the principle, and I think it's a sound principle, well then these steps should be taken because they allow the Fed's balance sheet to be that much smaller within a floor system framework. And though they also serve as stepping stones for getting to an efficient corridor system, which is important, and maybe we'll get to that. But in any event, if the Fed is serious about keeping a small balance sheet as small as possible, consistent with its monetary operations being successful, this is a step towards doing it.

If the Fed is serious about keeping a small balance sheet as small as possible, consistent with its monetary operations being successful, this is a step towards doing it.

Selgin: And the other thing I recommend for the Treasury is, actually, what I recommended, one of the things I recommended is something it turns out the Treasury already is able to do. There was a program experimented with by the Treasury starting in 2006 called the Treasury Repo Program. It was a direct repo borrowing program so the Treasury could go into the repo market, and that was a good substitute for keeping balances at the Fed. It earned a higher return and it obviously earned the private repo rate return for the ... which is more than the TT&L accounts. And turns out that in fact, in an obscure law that had to do with adoptions in 2008, I didn't know about this when I wrote about it at first, that tentative program, that experimental program was in fact made permanent. But something like three weeks after that law was passed, the crisis hit, interest on reserves hit. And so-

Beckworth: People forgot about it, huh?

Selgin: ... they forgot about it because remember, for a long, long time, private repo rates were below the interest rate on reserve. So it was costly even with that to take advantage of that program for the Treasury. Now, that program should be-

Beckworth: It makes sense.

Selgin: Makes sense. Apart from, and this is the hitch, and it's also a bit of a hitch for the foreign official institutions, the hitch on all that I've said is you still have the contingency of a possible major financial crisis. And in those circumstances, these alternatives I've been proposing might not be fully attractive. So the Treasury might worry about using its direct repo purchases because there could be a shutdown and that's why it would still want to have, unless something else has done $150 billion in its TGA.

The hitch on all that I've said is you still have the contingency of a possible major financial crisis. And in those circumstances, these alternatives I've been proposing might not be fully attractive.

Beckworth: Okay. So the private sector may not be able to fund Treasury?

Selgin: Yeah, if the private sector completely breaks down of course, it's very hard to make up an alternative for the keeping money at the Fed that can compete. That's true also for the foreign repo pool. But, this is where I propose my very-

Beckworth: Radical.

Selgin: ... radical-

Beckworth: I like radical George, so go ahead.

Selgin: And some will say non-free market, non-libertarian or whatever solution, not that that kind of thing bothers me too much. And that is simply this, let the Treasury and the foreign official institutions that presently contribute to the foreign repo pool, let them be counterparties to the proposed standing repo facility. I understand that there are a lot of laws that have to be worked out and the details, let them be counterparties, impose penalties or haircuts on them. Haircuts are essentially penalties, so it's not too attractive for them to use these facilities, but the facilities are there and can reassure them so that they have no reason, so that the Treasury has no reason to have always $150 billion or more in its TGA account. In the worst possible scenario where it's been repo-ing, it can take advantage of the standing repo facility if everything dries up for the foreign official institutions.

Let the Treasury and the foreign official institutions that presently contribute to the foreign repo pool, let them be counterparties to the proposed standing repo facility. I understand that there are a lot of laws that have to be worked out and the details, let them be counterparties, impose penalties or haircuts on them.

Selgin: Now of course the complaint will be, "Why do we want to make last resort lending facilities of any sort available to foreign firms?" Is one complaint, or, "How can we possibly risk letting the Fed directly lend to the Treasury? We know how dangerous that is," et cetera, et cetera. And none of them are very compelling. Those arguments aren't very compelling because the penalty rates, these emergency facilities aren't going to be abused. And with respect to the Treasury, there's really no difference here between the Fed buying securities, which you'd have to do, or the Fed directly lending to the Treasury offering to do that.

Beckworth: So this would cut out the middleman in the middle of a crisis.

Selgin: In the middle of a crisis you cut out the middleman, but you're not changing the fiscal situation.

Beckworth: I think your point is in normal times, this facility wouldn't be used by banks, by the Treasury, by these foreign official entities.

Selgin: You could certainly structure it so that there's absolutely no way for them, you can make that part of the law even, "If there's not a crisis going on, forget it."

Beckworth: But in a crisis, the Treasury, banking system, foreign entities would come knock at the door, the standing repo facility, and have access to it. I mean, I think another argument against the critics of this would be if you want the dollar to maintain its status as a reserve currency of the world, then you have to open the door of the standing repo facility to the rest of the world. I mean, it's part of the price we pay for making the dollar so wide reaching and powerful.

Selgin: Perhaps that's right. But the point is there are right and wrong ways to manage a last resort-

Beckworth: Fair enough.

Selgin: ... lending facility in constitutions. We do need constitutional constraints. It's not clear that the right constraints are let's not have the Treasury under any circumstance ever be able to borrow directly from the Fed. And in fact, as I mentioned in my paper, until 1981 for many decades, the Treasury did have so called a direct draw authority, and it used it routinely. And it used it by the way to stabilize the TGA balance so it wouldn't be trouble for the Fed to manage monetary policy. It was exactly for that purpose, here it's a little bit different, but the same basic principle. And so it's been done before and it's a question of doing it again under a somewhat different operating system and with a different facility. But otherwise, there's nothing new here under the sun.

Beckworth: So the Treasury used to have access to the Fed through its security draw.

Selgin: Yes, or direct draw authority.

Beckworth: Direct draw authority. So it's not entirely new as you mentioned.

Selgin: Not unprecedented.

Beckworth: And again, going back to the point of this discussion, this is part one, part two will be next week. We're nearing the end of the show here. The whole point, or the big point here is that if these changes were implemented, the Fed could control its balance sheet a whole lot more effectively.

Let the Treasury and the foreign official institutions that presently contribute to the foreign repo pool, let them be counterparties to the proposed standing repo facility. I understand that there are a lot of laws that have to be worked out and the details, let them be counterparties, impose penalties or haircuts on them. And [it] could have a much smaller balance sheet.

Selgin: And it could have a much smaller balance-

Beckworth: And [it] could have a much smaller balance sheet. So yeah, for those who are concerned about the Fed's footprints, that actually would shrink it. But for right now, I guess the practical concern right now is the Fed is having a hard time controlling its balance sheet, a good portion of it, and that's the Treasury General Account and the foreign repo pool. And this would provide a way to kind of fix that problem. Very pragmatic, very practical, with other great benefits down the road of a smaller footprint as well. And I think that's a great, great point. So it may seem radical, but I think it's very pragmatic.

Possible Return to a Corridor System?

Beckworth: Yeah. So this is a great proposal, George. I'm glad you've written about it. I encourage our listeners to take a look at the pieces. It's a two part piece George has posted. So we've talked about how this will be useful. It's something that Fed officials should think about, because I know they're talking about the standing repo facility right now. So they should consider these other changes in concert with maybe consulting the Congress, but in addition to the pragmatic fixes for the here and now, this could also be a stepping stone down the road to a return to a corridor system. So this is more long thinking, future thinking. So walk us through that scenario.

Selgin: Well, it's actually pretty simple, David. Once you have all these reforms in place, if they're able to do that, then as I said, the Fed could operate a floor system with a much smaller balance sheet, but it also would be much easier for it to return to shrinking its balance sheet to the point where it's back in a scarce reserve situation because having tamed the TGA and having tamed the foreign repo pool, it could manage the needed open market operations to operate a corridor system again.

Selgin: If you read the statements of Fed officials about why they don't want to go back to a corridor system or don't think it's possible, they talk about the TGA, and the foreign repo pool, and these liabilities… would be so hard. So, solving that problem of how those liabilities behave, containing their extent and volatility would eliminate the main rationale given by the Fed for not going back to a corridor system… would make doing so much, much easier. But that's what I would ultimately like to see happen, of course.

So, solving that problem of how those liabilities behave, containing their extent and volatility would eliminate the main rationale given by the Fed for not going back to a corridor system… would make doing so much, much easier. But that's what I would ultimately like to see happen, of course.

Beckworth: And I share that view as well. Well, with that, our time is up. And again, I encourage our listeners to tune in next week when Josh Galper from Finadium, who's in the heart of the repo market, will talk to us on the same topic from the perspective of the repo market. But George, thank you for coming on and a happy holiday season to you.

Selgin: Thank you, David. You too. It's always a pleasure.

People: 
David Beckworth
Calendar Date: 
Dec 16, 2019
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Libsyn Podcast ID: 
12394208
Subtitle: 
Tweaks to current standing repo facility proposals would be an important step toward helping Fed gain more control over its balance sheet

George Selgin on the Past, Present, and Future of a Real-Time Payments System

George Selgin is the director of the Cato Institute’s Center for Monetary and Financial Alternatives and is a returning guest to the Macro Musings podcast. Today, George joins Macro Musings to talk about recent developments in the payment system. Specifically, George and David discuss the history of attempted payment system solutions, the challenges and costs facing the implementation of a real-time payment system, and why we should care about this issue today.   

Read the Full Episode Transcript

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu

David Beckworth: Our guest today is George Selgin. George is the Director of the Cato Institute's [Center for] Monetary and Financial Alternatives. And as a previous guest of the podcast, George joins us to discuss recent developments in the payments system [and] also what is happening with the Fed's review this year, and finally, the latest developments in the Fed's operating framework. George, welcome back to the show.

George Selgin: Always nice to be here, David.

Beckworth: Well, it's good to have you back on. You are the reigning champ on Macro Musings in terms of show appearances. I believe this is your fifth appearance.

Selgin: Hey, whoopee!

Beckworth: So, you are like the Mike Munger of econ talk, that's what you are for Macro Musings. So, he's, I think, like a regular, reoccurring, almost a co-host. So, you're like the number one appearance on this show. If you haven't heard any of George's previous shows, go back and check them out. But, today, I have brought George on to talk about the payment system. We will probably spend most of the time talking about the payment system, and then we'll get into the review, and finally, the operating framework as it relates to some of the developments in the money markets and in repo. But, there's been a lot going on with the payment system, George, and you've been a big part of that conversation recently, you were at a Senate hearing on facilitating faster payments.

Beckworth: Lots of real-time payment discussions, we've had Aaron Klein on the show, we've had a few others. But, I want to really dig into the weeds today and learn what's going on, and why does it matter? Because, for many people, including myself a few months ago, this is an esoteric technical subject that, it didn't get much attention. It's probably not on most people's radar, but it's very consequential. So, talk us through, why should we care about the payment system? And then, after that, maybe tell us what's been happening.

What’s Going On With the Current Payment System and How Can We Fix It?

Selgin: So, David, for a lot of people, the payment system seems just fine. So, you get paid, and you get your funds reasonably quickly for your needs and et cetera. But, there are many people who actually have reason to be very unhappy with the way the payment system works. Merchants sometimes have to wait a while, maybe for an extended period of several days for their funds to actually come through, and payments are recorded, but the actual final payment doesn't clear for a while, and it's only then that they have funds credited to their accounts that they can use. But the people who suffer the most from the slowness of payments in this country, and it is a problem, particularly in the United States, are poor people who live from paycheck to paycheck, and this is something that Aaron Klein has been particularly eloquent about.

But the people who suffer the most from the slowness of payments in this country, and it is a problem, particularly in the United States, are poor people who live from paycheck to paycheck.

Selgin: And the fact that it can take several days for a paycheck to clear for them can be very costly. Costly because they have to resort to payday lenders, or check cashing services, if you like. Costly because they incur overdrafts in their accounts, because the money isn't there yet. And that is really the most serious, but not the only adverse consequence of the fact that we have a relatively slow payment system in this country. So, we don't all notice it, we don't all care. But, plenty of people do, and there really is no good reason for it. And especially when you consider that there are many, many countries that have payment systems that are very quick or practically all payments are completed and credited within minutes, if not instantly. So, we have some serious catching up to do.

Beckworth: So, we're behind other countries when it comes to real-time payments.

Selgin: Many countries, yes.

Beckworth: Okay. Which is surprising and you'd think we'd be at the cutting edge, but, like U.K. and Canada and Europe, they have much faster payment systems there.

Selgin: Indeed, yeah. I'd say that many of these countries are a decade ahead, conservatively. So, partly, it's the fact that our legacy payment system, in some respects, was pretty good, and so, there wasn't the urgent need that was felt, at least, widely enough to drive reforms. Some countries, in a sense, benefited from the fact that the payment systems were so slow that they knew they had to overhaul them, and they did. And now, they're ahead of us. But, we also have a challenge that other countries don't have in having so many banks and credit unions, not mention other payment services. And therefore, coordinating reforms that require that all of these firms be operating on common networks, is a lot more difficult in the United States than it is elsewhere.

Selgin: So, it's not an easy task that can be done to make our payment system as fast as the payment systems of other countries that have more concentrated banking systems, and are smaller, to begin with.

Beckworth: Yeah, we recently had your colleague, Diego, on the show, and he talked about one defining characteristic of the U.S. banking system is it's fractured. There's just so many different banks in many places, and you've written about the history of this yourself, but that's a big part of the story here, right?

Selgin: Yes, it is. So, we're talking about roughly five to 6,000 banks and almost equal number of credit unions. And then there are other kinds of depository institutions and other kinds of payment service providers. And many of them are very, very small. So, coordinating them, getting them all, just, you could establish a network that could handle fast time payments, you're only a third of the way down or something like that, because then you've got to get everybody to join. And as you'll see, when we get into this a little bit further, that can be a real problem, but it's important because networks can be much more effective, are much more effective, if everybody's in them.

Selgin: So, if I want to send a payment to somebody, if that person's bank is in the same network, that can make it a lot easier, and may not be possible at all for my network to send him a payment quickly, if his bank isn't in the same network.

Beckworth: Okay. So, that's the backdrop, the story to why we care about this and why it's an issue in the United States. We have an antiquated payment system, it takes time, it's costly for people in the lower half of the income spectrum, and for merchants as well, for businesses. So, there is a need for change. And there's been several developments, there's been two big stories, I think. One is the private sector's attempt to solve this with pressure from the Federal Reserve. And now, the Federal Reserve is attempting to address it itself. So, walk us through the history of attempted solutions. Selgin:  So, really, things got started back in 2014, and the Fed quite rightly took the initiative by convening a task force. A task force that had many participants from the private sector, particularly, and interest groups. And the Fed challenged or charged this task force with coming up with ways to improve payments. Particularly, the challenge was to come up with the so called solution to the problem of providing so called real-time gross settlement services for retail. Now, that's a real mouthful. So, the essence of real-time payment is that, the same message, the same, if you like, computer clicks that deliver the payment instructions, also deliver the funds, it's all done instantaneously, so there is no delay between a payment instruction being sent, and actual funds being transferred to the payee's bank, and thus, to the payee. It all happens instantaneously.

Selgin: Now, that's quite different from conventional payments, retail payments, which, depending on what form, the specific form they take, can take quite a long time, because, the payment order is one thing, but the actual transmission of funds from one bank to another is another. There is a process of clearing, which is, reconciling the different payment messages, and finally, a process of settlement, which is, when good funds, so called, think of them as bank reserves, get moved from the payer's bank to the payee's bank. And it's the clearing and settlement process, and particularly, the settlement itself, that's what can take a long time, and that's where those unfortunate delays come in.

Selgin: And so, with real-time payments, that is a solution. I'll try to emphasize that it is not the only solution, but it is certainly a solution. It is the fastest solution because it does away with the gap between a payment order being made and instruction being given, and actual funds getting where they need to get.

Beckworth: Okay. And so, the Federal Reserve encouraged the private sector to come up with a solution, and so, what was the private sector's solution?

Selgin: So, right, they convened this task force in 2014, and they got a number of proposals out of this task force, and they're all very interesting. But, only one of them really scored very high points. The Fed and others, they graded, they actually graded, they gave them like a report card on the different proposals. And one in particular, which was a proposal from The Clearing House, TCH, a private payments organization that's been around since 1853, based in New York, their proposal got very high marks all around, it was an A+. And this had to do with security, reliability, potential for becoming ubiquitous, which is to say, a universal, everybody could, in principle, join, equity. There were a number of criteria, got very high marks.

Selgin: Well, TCH, in fact, went ahead and set it up. They spent something like a billion dollars, and by 2017, they had the system up and running.

Beckworth:  What was the coverage like by that point?

Selgin: Well, of course, when it first was established, it may have had some preliminary subscribers, but, eventually, it had membership that covered about 50 percent of all bank deposits. That number's probably gone up some now, but it consisted mostly of the large banks, and which, of course, it doesn't take that many large banks before you're at 50 percent. They did not get that much membership from smaller banks, and they were struggling to do so. But, I suspect and they believe that over time, they would get more and more members, because this was a desirable service that smaller banks would want to be able to offer and not just leave to the large ones.

Beckworth: The bigger network grows, the more it is in your advantage to join the network. So, they're on this trajectory of this growing network of real-time payments, and then, a big shock on the road appeared before them, and what was that?

Selgin: Well, the shock was, let me step back a bit to make clear that, up to that point, to 2017, and for some time later, the clear, a fairly an unambiguous signal the Fed was sending was, "We're going to see if the private sector can do this. If it can, that'll be that."

Beckworth: So, the Fed was cheerleading this process.

Selgin: They were very much so, and they gave every indication that if the private sector solved the problem, they had not suggested that they might come in and offer this service themselves. And this is all, by the way, quite consistent with the spirit, if not the letter of the 1980 Monetary Control Act, and with the Fed’s own rules, which hold that it should not offer any new payment services, that, a service that the private sector is capable of providing. So, the idea is, if the private sector can do it, the Fed won't do it. The Fed will only do it if the private sector can't do it.

Selgin: So, TCH, with this understanding, had passed with flying colors, the competition to come up with a solution for real-time payments, set up its system, which is called RTP, for real-time payments, and had it running in 2017. And as I say, by that time, or, by sometime in 2018, had about 50 percent of the market, when the Fed, I think this was in August 2018, suddenly sent out a request for comment on the possibility that it would set up its own real-time gross settlement retail system, and also requested comment, and this is very significant, on whether it should provide 24/7/365 days a year settlement services, or some kind of settlement service. And that other part of that request for comment is very important, and I want to get to it.

Selgin: But, the first part, where it said, "Oh, we want to know whether we should enter in the real-time space," that was the bump in the road or the shock that TCH suddenly found itself confronted with, because now they're saying, "Good gracious, we've just spent a billion dollars, we're halfway, we've got half of the bank deposits signed up, and now, the Fed has really thrown a wrench in the works. Because, first of all, the possibility that they will set up a rival service, means that banks may wait and see about that service, because they won't want to join both. It's expensive for a bank to join any of these services. There are hardware costs, there are other costs that have to be expended by the bank, in order to link up, so to speak.

Selgin: And these two services, and this is very important, there's no indication, there was never any indication, and there still isn't from the Fed, that its rival service, which has since been given the name FedNow, will be interoperable with the RTP system. Which means, basically, that, if you want to send a payment, and your bank is on RTP, to someone whose bank is on the Fed system, when that gets set up, that may not be a fast payment because they're not connected, they're not interoperable. So, that meant that, of course, every bank that hadn't signed up for RTP, now has to worry about what's the right thing to sign up for. So, it had a chilling effect on membership to RTP, that the Fed might join, might compete with it.

And these two services, and this is very important, there's no indication, there was never any indication, and there still isn't from the Fed, that its rival service, which has since been given the name FedNow, will be interoperable with the RTP system. 

Selgin: And, of course, it faced RTP with the prospect of, The Clearing House, with the prospect of having to keep compete directly with the Fed, which is never something you really want to have to do. Because, and this is extremely important, we are economists, and many of your listeners will also be economists, so, of course, we like competition. But, competition with the Fed is not plain old competition, the Fed has lots of ways to cheat, to put it bluntly. First of all, they're regulator, as well as a competitor. So, they regulate firms they compete with, and that is a conflict of interest that is extremely problematic, extremely problematic.

Selgin: Second, although the Monetary Control Act requires the Fed to recover its costs for any service it provides, essentially, so that it can't cross-subsidize, it can't use its monopoly rents from issuing currency over which it has a clear monopoly. It can't use those, for example, to underprice other services. At least, it can't, according to the law. But, enforcing the Monetary Control Act is not easy. It's not always clear whether there are cross-subsidies involved and we rely on the Fed's own accounting procedures to determine whether it's recovering its costs, and those procedures haven't been subject to an outside audit since 1984. So, it's very loosey-goosey, to use a phrase that my good friend Bill Trumbo likes to use. And so, you have a lot of issues.

Selgin: You have a third issue with respect to the Monetary Control Act in this case, in that, the Fed is merely speculating that it's going to satisfy the MCA requirements, right? It doesn't know, but if it... I should say that I've jumped ahead a bit. Of course, ultimately, the Fed did decide to go ahead with FedNow. But it, in doing so, implicitly asserted that it would be able to meet the Monetary Control Act's provisions, even though it doesn't really know how much money it's going to make, it doesn't even know what it's going to charge. Because, unlike RTP, it hasn't resolved, made up its mind about a fee schedule, and that's another important issue. Anyway, this was all very disconcerting to the folks at The Clearing House, understandably.

Selgin: And they joined with some others in responding to the comment, request for comment, naturally, quite critically. And I also wrote critically on this, saying that I did not think it was going to be helpful for the Fed to compete in this space, and I did not think it was going to be necessary. So, there were a few people who wrote against the FedNow, what became the FedNow plan. On the other hand, they were also thousands of letters, mostly rather perfunctory, from community bankers, mainly who'd been urged to chime in in favor of FedNow, which they did. So, ultimately, what the Fed did, was to say, "Look, the overwhelming number of comments have been favorable for FedNow, therefore, we're going to do it."

Selgin:  And that was a correct statement, if you just went by the sheer volume of comments that were favorable, even if they weren't very substantive, and many were not. But, there were many comments, fewer, of course, but there were many very substantive comments that criticized the proposal and said the Fed shouldn't go ahead with it. So, anyway, they went ahead, and now, you have two potential rival systems, one of which is already in existence, and the other which will be coming, according to the Fed, in four or five years, which is a very long time. We can talk about that too.

Beckworth: Right. So, let me summarize what you've said. I want to use the analogy here of a sports game. Let's say is football, all right? So, the Fed got this team together, called the private sector, and they're saying, "Hey, go play that other team out there. The other team it's the lack of a real-time payment system. We want you to play and beat them, and we're going to cheer from the sidelines. We're going to cheer loud, hard, we're going to encourage you." So, the private sector gets out there, The Clearing House takes the lead. It's playing and it's making progress, it's getting out to near the end zone. And all of a sudden, they hear this loud whistle, and they look in the stands, and suddenly, the cheerleaders say “Get off the field, we're going to play."

Beckworth: And they're like, "Well, we've almost won." And they're like, "No, we want to play, and moreover, we're going to rewrite the rules. If you don't like it, we're going to rewrite the rules, we're going to get in, and we're going to take over." Which seems kind of strange. And I have to ask this question, were some of those cheerleaders in the past, now supporting the Fed? I mean, specific people, like Dan Tarullo, I imagine he must have been one of the people who supported the TCH's plan, did he change his tune? I mean, how did this conversion take place, I guess? Going from cheerleader to proponent of the Fed’s own system, there's got to be a story there.

Selgin: I'm sure there is, David. By the way, I really like your analogy, because the Fed has, indeed, announced it's coming on the field itself, and it's going to be the umpire, or the referee. And I also like it because it stresses the fact that, although people have said, "Oh, we can't let The Clearing House run a monopoly," the payment space is very crowded with different providers, some of which do provide instant payments, but for small networks. And TCH is competing with all these other established payment services, including the legacy services that are not real-time. So, it's not as if there's no competition, and I'll talk about how the Fed could have confronted TCH with much greater competitive pressure, without doing what it did, when we get around to talking about 24/7 settlement services.

Selgin: Anyway, I really like the analogy, I think it's correct. And I completely forgot what you were asking about.

Beckworth: What I was going to ask, so, the interesting part of this-

Selgin: Oh, whether the change, how did the... Yeah.

Beckworth: How did you go from being a cheerleader, to just saying, "I want to take the field"? I mean, that's a pretty big move, right?

Selgin: It is, indeed. And as I said, it caught a lot of people by surprise. I wish I could tell you what the inside politics of all this consisted of. The only prominent Fed official I know who does not, who has argued that the Fed's entering directly into this space is not a good idea, is Randy Quarles. I don't know about Tarullo.

Beckworth: Well, he's no longer at the Board of Governors, but I'm just wondering like how his views of evolved…

Selgin: I don't know what his views are.

Beckworth: Or Lael Brainard, I mean, I know she was pretty strong advocate, I wonder where she stood back in 2014 in all of this.

Selgin: Yes. I don't know, I don't know. I do know that the major source of this decision for the Fed to create its own system, a lot of that is coming from the Federal Reserve Bank of Kansas. Which, the economists at that bank have made a specialty of real-time payments. And clearly, for quite some time, I think really predating the task force of 2014, have been, as it were, looking forward to the Fed moving in and establishing its own real-time payment system. So, I suspect that a lot of the pressure came from the Kansas City Fed.

Beckworth: All right, let me play my analogy out a little bit more then. So, you have these cheerleaders, the Fed in the stand of the game for starts, and there's a bunch of fans out there, all the different Fed officials, but there's a small group of those Fed officials sitting quietly with their arms folded, that's the Kansas City Federal Reserve Bank. Everyone else is cheering, "Rah, rah, rah, RTP," and they're just grumpy, they're upset, and they slowly work the crowd over and say, "Hey, it's time for us to take the field." Maybe that's part of the story then, huh?

Selgin: I suppose. Like all analogies, this one's starting to get a little bit frayed at the edges.

Beckworth: Okay, fair enough.

Selgin: But I do think that you had a sort of technocratic impetus, where, you have people who have been thinking about these things for a while, and they really like get their hands dirty, running a system, they think they can do it. And you also, let's face it, have the usual bureaucratic motives. For a long time, the different Federal Reserve Banks, their main function, we think of them as most people think of the Federal Reserve Banks, other than, apart, I'm not talking about the board, I'm talking about the 12 banks, think of them as places where you have some expert economists, and then you have a president who takes part in the FOMC, perhaps, and helps make decisions about monetary policy. Or, you also have bank supervisors, et cetera.

But I do think that you had a sort of technocratic impetus, where, you have people who have been thinking about these things for a while, and they really like get their hands dirty, running a system, they think they can do it. And you also, let's face it, have the usual bureaucratic motives. 

Beckworth: Well, let me give them a hearing here.

Selgin: Sure.

Beckworth: I'll take their side, a little pushback on that point. So, Thomas Hoenig now, who's a colleague of mine here at the Mercatus, and I had him on the show, and he mentioned that he had to actually lay off a bunch of people because of this whole technology change, in terms, we don't carry cash, checks, around much anymore. And so, there were people who were let go from the Fed, but you're saying, the incentive is always there to find a new reason for existence, to be relevant.

Selgin: Yes. If they could have found something quick enough, they wouldn't have had to lay off those people, and Tom wouldn't have had that unpleasant experience. And so, they're trying to be forward-looking, and, of course, I didn't mean to imply that they don't actually want to see their budgets grow, which is also part of the standard bureaucratic model. So, there are a lot of bureaucratic factors that I think play in here. I don't think ultimately it matters what the Fed's motives are, what matters is whether their intruding the spaces is necessary and whether it's the best thing they can do to promote faster payments. And that, I'm sure, the answer to the second question is no. And that's what I want to talk about, if you don't mind.

I don't think ultimately it matters what the Fed's motives are, what matters is whether their intruding the spaces is necessary and whether it's the best thing they can do to promote faster payments. And that, I'm sure, the answer to the second question is no.

Beckworth: Yes, please do.

Selgin: I want to talk about the other part of the Fed's request for comment back in 2018, and what resulted from that.

Beckworth: So, just to summarize, the first part was a real-time payment system.

Selgin: Yes.

Beckworth: And now, let's jump into the second one. Tell us about that.

Selgin: Yeah. So, the second thing the Fed asked about, was whether it should set up, or offer 24/7 settlement services, and to assist the liquidity management in private payments networks. Or, in the established legacy networks. Now, let me give you an example of how this reform could help RTP, for example. But, first, let me step back and say, at present, and for some time, the Fed has two wholesale settlement services it offers. They're the, Fedwire is one, and the other one is the National Settlement Service. Now, I don't want to go into any real deep details about those, but these are services that essentially see to the final settlement I was talking about earlier.

Selgin: That is, they see to it that, after payment instructions are sent from one bank to another, that the funds get transferred from the sending bank to the receiving bank, and so, the receiving bank can give credit to whoever the payee is. And so, that's done either using Fedwire or using the National Settlement Service or both. Now, here's the thing, both of those services have limited operating hours. They're not open 24 hours a day, and that already restricts the number of payments. It restricts the potential for payments to be settled within the same day. There's just something called the ACH system, Automated Clearing House, and depending on when payments are sent through it, there are two payment windows during the day, and if they're sent in time for those windows, they're settled on the same day.

Beckworth: Why is that? Why don't they have a 24 hour system?

Selgin: That's a good question. But, if payments don't come on time for that second window, they don't get cleared until the next day. And that is a lot of payments are processed through there. And again, the problem here is, Fedwire's hours are limited. It's extended its hours somewhat over time, but I think it closes at nine o'clock now. 9:00 P.M. Eastern Time, if I'm not mistaken. And, Fedwire and the National Settlement Service are closed on weekends and holidays. It's because of these limited Fedwire and National Settlement Service hours, that payments can sometimes take days to settle. It's because of those.

Beckworth: Which is hard if you're a poor person.

Selgin: Your average poor person doesn't mind, isn't harmed that much, I should say, right? They're not harmed that much by payment that takes hours to settle, but it's still settled the same day. They're not even harmed that much if it gets settled the next day, but they’re harmed some. But they really suffer if it's a weekend or with holidays. But that's all because these established existing Fed settlement services don't run 24 hours a day, seven days a week, 365 days a year. Other countries have services, a central bank operated settlement services, that do run all hours.

They're not harmed that much by payment that takes hours to settle, but it's still settled the same day. They're not even harmed that much if it gets settled the next day, but they’re harmed some. But they really suffer if it's a weekend or with holidays. But that's all because these established existing Fed settlement services don't run 24 hours a day, seven days a week, 365 days a year. Other countries have services, a central bank operated settlement services, that do run all hours.

Selgin: Okay. So, the other component of the Fed's 2018 request for comment, was, should we provide this kind of extended wholesale settlement service, either by increasing the operating hours of these existing services, or by providing what they called a new liquidity management tool? And the response to that component to the comment letter was unanimously in favor. Yes, the Fed should do this. And that's not surprising, because, actually, various people in the payments industries have been pushing the Fed to do just that for years, and the Fed has known. It has talked about doing these extended hours for years, but it keeps dragging its feet.

Selgin: Even a third payment window was supposed to have done it some time ago, and it dragged its feet, didn't do what it needed to do, and now, it's delayed for almost two more years. That's just to get a third-

Beckworth:  Why? Why this delay?

Selgin: Well, it's a great question, David. Because, think about it, the Fed has managed, in a very brief period of time, to convince itself that it has the know-how and ability to go forward with their new, completely new technologically sophisticated real-time payment service. It was able to say, "Yes, we can do that." Because that was the result of that part of the comment letter to determine that there was enough support, they can do it. But, apparently, they need more time how to increase the hours. And this is the thing, it's absolutely shocking, if you go to the Fed's 2019 announcement, I think it was January 2019, where they said, "Okay, here's what we've decided to do in response to this feedback." The first part of that announcement is, "We're going to go ahead with our real-time FedNow system."

Selgin: The second part, which is kind of buried in there, but I urge your listeners to go ahead and look this up and read it. You can provide a link.

Beckworth: I'm going to put a link to it on the show, yeah.

Selgin: Well, look for the paragraph where it says what it decided to do about 24/7, and this is absolutely scandalous. They say, "Well, as for that, we're going to keep thinking about it. We need to explore that possibility further." And this is a possibility, remember, that's, they were urged to pursue for years. And then, at one point, way back, they said, "Oh, yeah, we're going to eventually get around to this." And this one, this no brainer of a decision, they say, "We have to explore further." And just to add insult to injury, they say, "We may get around to requesting comment on the possibility."

Beckworth: Comment on a comment.

Selgin: Yes, comment on a comment. This is a response to a comment request that asked for comment on extending the hours of Fedwire and National Settlement Service, and now, they're saying, "Well, in response to the universal comment in favor of doing that, we've decided that we may seek comment about this possibility." It's absurd. Now, this is where things get really nasty. So, remember that, the main, not the only, but the main impetus here, and most important reason for wanting to make change is the poor people who are suffering from, not just from delays of a few hours in settlement, but delays of a day, or two days, or three days, or four days, and depending on holidays.

Selgin: This simple, relatively simple reform would be able to solve that problem, eliminate those delays, on just using existing or legacy payments services, and arrangements, and networks, and could probably do it. I can't imagine why it would need to take more than two years. But, the Fed has decided not to take that step, where the cost-benefit ratio, you would think, the benefit to cost ratio would be pretty darn high. But it did find it easy to decide to undertake a much more ambitious reform, the necessity of which is hardly clear because it would replicate the services of an already established real-time payment network, and which will, according to the Fed's estimate, not be up and running for another five years. And you can bet that adding two years to that is a conservative proper adjustment.

This simple, relatively simple reform would be able to solve that problem, eliminate those delays, on just using existing or legacy payments services, and arrangements, and networks, and could probably do it. I can't imagine why it would need to take more than two years. But, the Fed has decided not to take that step.

Selgin: And in the meantime, what are all these poor people to do? They're going to have to put up with exactly the costs, and delays, and hardships that they've been putting up with for all these years, for another five, six years. It's disgusting. Finally... Sorry, I'm on a rant.

And in the meantime, what are all these poor people to do? They're going to have to put up with exactly the costs, and delays, and hardships that they've been putting up with for all these years, for another five, six years. It's disgusting. 

Beckworth: Please do, this is great.

Selgin: I hope your listeners will forgive me, but this really is terrible. The other point that's very crucial here is, if the Fed had in fact decided to take the steps to make its existing settlement services operate 24/7/365, that alone, of course, would have confronted RTP, The Clearing House system with an important source of competition. Because, it would have meant that ordinary payments would be much faster, there would be no really serious delays. And they wouldn't be as fast as real-time payment, that's true, but the difference would have been small enough that, for RTP's ability to overprice its service, which is what you worry about a monopoly doing, right? Its ability would have been very limited.

Selgin: Because, if the fee goes up just a cent or more in the RTP arrangement, and we need to talk about fees more.

Beckworth: Yeah, absolutely.

Selgin: But, their ability to extract rents would be limited because of the greater contestability of the payments markets, where contestability isn't just a matter of having more than one provider of the exact same service, but of having multiple providers of close substitutes or near substitutes, that's enough, that would have done a lot. So, the Fed could have, as it were, by making the opposite decisions it made in response to the comments that it requested, by deciding, "We're not going to do RTP, but we are going to do the 24/7 thing with our settlement services." It would have provided relief for the poor much sooner, and it would have provided an important source of competition to RTP, and therefore, it would have had the best of everything.

Beckworth: Yeah, the best of both worlds.

Selgin: And it did just the opposite. And I believe it did so because of completely unjustified bureaucratic motives, also encouraged by misguided perceptions in the part of the public that it did nothing to allay about the potential for abuse from RTP. And I do want to talk about that.

Beckworth: Yeah, this is very interesting. I wasn't aware of the second part of the story. I knew the RTP story somewhat, but the second part of the story is interesting. So, that, the second part of the story, so, the legacy or the ordinary payment systems that we have, could have been dramatically improved. I mean, and you said, they talked already about having a third window, but just simple fixes on existing frameworks could have been tweaked, could have been fixed. And because they hadn't been fixed, there was this push to do real-time payment system. So, the real-time payment system is a symptom of a deeper problem that could have been fixed easily, and so, they're going to take a whole different approach, a whole different tack, which is kind of mind blowing, really.

Beckworth: I mean, why take such a difficult course when there was a much shorter direct path to accomplishing the goal of helping getting faster payments?

Selgin: Well, I don't know the answer to that. I do want to say that I don't want to imply that having a retail payment system, and even one that could cover most of the country was an unnecessary goal or unworthy goal, I think it's a fine goal, it's a fine objective, but it isn't the whole story about how to improve payments in this country, and it doesn't make sense to have left the legacy payments arrangements in their decrepit backward state, when they too could be improved. And so, I'm all for real-time payments, but I think that the Fed already had accomplished much of what it needed or perhaps all that it needed to accomplish with those, by getting the private sector to step up to the plate and establish a system, which has been in place since 2017.

Selgin: What the Fed should have been doing, first and foremost, is healing itself, right? Doctor heal thyself. Fix up your existing payments, you have a monopoly on settlement services. The Fed is the only institution that can push reserves from one bank to another directly. And I can explain how RTP handles that in a moment, and I probably should. But, RTP, ultimately, is also dependent on the Fed for funding. The Fed has this monopoly on settlement services, which it runs inefficiently, or, at least, inadequately, from the point of view of all the payments providers and who, unanimously, see that it should be open for more hours. They could have provided three windows a day for ACH payments, 24 hour service, and weekend service, holiday service, and provided a vast improvement for it would have made a huge difference. There'd still be scope for real-time payments.

Selgin: Because, some people really do need, it really matters a lot to some people, mostly to merchants, the difference between it taking a couple hours and it taking seconds, that can matter to a lot of people. And real-time payments can also be very useful for inventory management and information purposes, because the message is used to also include other information about the transaction. So, real-time payments is great, I don't want to put it down at all. But, if the Fed were responsible public servant, it would have improved its settlement systems, first of all, and then, it would have seen if it could also encourage the development of real-time payments, and it would only have intervened to do that if it was absolutely sure that private sector couldn't.

If the Fed were responsible public servant, it would have improved its settlement systems, first of all, and then, it would have seen if it could also encourage the development of real-time payments, and it would only have intervened to do that if it was absolutely sure that private sector couldn't.

Beckworth: Well, let me restate what I said earlier then, real-time payments is great, and there's good reasons to pursue it, but the reasons that have been listed, or argued for it have been the poor story, those in need. And what you're saying is that it could have been fixed a whole lot easier, and there's this more direct way of doing that. And I think there should be a cautionary tale for all those out there, who've argued, "Let the government do it, because they're the ones that they're going to care about the poor, they're the ones they're going to solve the problem." This should be a very cautionary tale that sometimes they don't get it right. And we could have had the best of both worlds, we could have had a system that does help the poor, as well as a real-time payment system been developed by The Clearing House.

Selgin: Yes, absolutely.

Beckworth: So, let's move on to some of the challenges with the real-time payment system in terms of costs, because, our time is running out here, and it looks like, listeners, we’ll have to have George back on to talk about the Fed's review.

Selgin: Yay, I've been preserved by status.

The Cost and Implementation Challenges Facing a Real-time Payment System

Beckworth: Yeah, bring you on for your next show. But, let's talk about some of the challenges in implementing the real-time payment system. So, I know you've touched on this cost issue, but one of the requirements of that 1980 law is that, whatever the Fed gets into, it has to recover its costs, when it does something. So, if it does a real-time payment system, it's going to have to cover its cost. It can't just have a freebie, where it hands out their service to the public.

Selgin: That's right, unless it cheats.

Beckworth: Unless it cheats. And what's interesting is, one of the implications that comes out of this, and this is where I've been really puzzled, and maybe you can explain why this is the case. But, if the Fed has to cover its costs, there's a good chance it will have to start offering volume discounts, so that, someone who does a whole lot of use of this payment system gets a cheaper price, which is typical, you see that in any walk of life. And so, who will that be? The big banks. The big banks will get cheaper prices than the small banks, most likely, if this cost rule applies, and so, small banks themselves, may be harmed by the Fed stepping into the real-time payment space.

Selgin: That's exactly right, David. I think the small banks, the community bankers have been sold a bill of goods. And here's how the story actually developed, when the RTP launched, they did so with a contractual commitment to their customers, to charge a flat fee. That is, no volume discounts. And that's a legally binding contractual commitment that they have. When the Fed announced that it was prepared to compete with them, or maybe after it decided that would compete, then RTP said, "Well, we may not be able to continue to offer this flat rate fee commitment, if the Fed enters."

Selgin: Now, they were very good reasons for the RTP to do that, because, RTP knew, The Clearing House knew, from experience, that the Fed was likely to offer volume discounts, and then it would have to follow suit, because it would lose the business of the large banks, and including, ironically enough, including many of the owners of The Clearing House. But, they, the bankers, are going to take the cheapest solution. And, in fact, that's exactly what happened in the Automated Clearing House space. Today, the Automated Clearing House network is jointly run by, ACH payments are jointly provided by the Fed and The Clearing House. Originally, The Clearing House charged a flat fee, then the Fed turned to volume discounting, to compete, not with The Clearing House, but with Visa, which was a big player and was offering volume discounts.

Selgin: Then, as ACH, sorry, as The Clearing House became a more important player or wanted to preserve its market share, it, too, resorted to volume discounts. So, The Clearing House has good reason to know that, if you're competing with the Fed, you might be competing with a firm that offers volume discounts, and you'll have to match. That's the only reason why they announced that their commitment to flat fees was contingent on whether the Fed ended up competing with them or not. Well, the Fed, it was a clumsy announcement, because it played into the Federal Reserve's hands, and the Federal Reserve and its supporters, they started saying, "See, you can't trust TCH. Look at them, they're planning now, to renege on their commitment to flat fees, they're going to screw all the community bankers. This is why you need us to intervene."

Selgin: But, the reality is, that TCH would have had no reason to renege on those commitments, and has no reason now, unless it's to be able to compete effectively with a Fed that's itself charging volume discounts. So, volume discounts are probably going to be the outcome of all of this, whether the community bankers like it or not, but it won't be TCH's fault. And this relates to another point, the TCH, at least, has made a now, qualified commitment to flat fees, right? They're going to be there until the Fed makes it impossible. And I think they'll stick to that, which is to say they'll stick to it till the Fed actually gets its system up and running.

Selgin: What about the Fed? The Fed has been urged to say what its pricing policy is, will it commit to a flat fee, if ACH does? I mean, if TCH does. And the Fed absolutely refuses to do that. When, at the hearing, you mentioned, they were pressed, Esther George was pressed to say, "Well, what is your pricing strategy?"

Beckworth: Now, who's Esther George? For our listeners.

Selgin: She's the president of the Federal Reserve Bank of Kansas.

Beckworth: Okay.

Selgin: She was pressed to ask, "Well, what are your pricing plans? RTP has its pricing schedule and its commitment that's qualified, what about yours?" And her answer, shockingly, was, "Well, we haven't figured out what rates we're going to charge." Now, you tell me, how did the Fed determine that this was a good thing for it to get into, and that it could do it and meet the obligations of the Monetary Control Act, if it still doesn't know what fees it's going to charge? Wouldn't it need to have thought about that, in order to determine whether this was a worthwhile project, and whether it could recoup its costs? I think so.

Now, you tell me, how did the Fed determine that this was a good thing for it to get into, and that it could do it and meet the obligations of the Monetary Control Act, if it still doesn't know what fees it's going to charge? Wouldn't it need to have thought about that, in order to determine whether this was a worthwhile project, and whether it could recoup its costs? I think so.

Selgin: So, what essentially George was admitting, though, perhaps unwittingly is, the Fed has no idea whether it can do this in a way that allows it to meet the Monetary Control Act, and it has no idea whether it's going to charge volume discounts or not, and it's unprepared and unable to commit to not doing so. There will be volume discounts, there's no question about it. But, again, it won't be RTP's fault.

Beckworth: Let me ask this, the Fed now has made a decision to pursue it, has the authority to pursue it, I guess, may it still opt out of it? I mean, it says, "Look, we have made a decision we can do it." Could it say, "We've looked at this, we've decided maybe it's not in our interest, we'll let The Clearing House have the RTP, and maybe we'll just focus on the existing legacy payment system"?

Selgin: The only way that could happen, David, is if there's such an outcry against what the Fed is up to, which will require people to give a lot more thought to the whole question of The Clearing House's role and whether it's okay to have a private organization operating an important payment service. If enough people were to study this matter, you could potentially get sufficient outcry. There are already some representatives, mainly Republicans, who are concerned about the Fed's decision. That, such an outcry could cause things to change. But I think it's very unlikely because of the misperceptions out there.

Selgin: At the hearing, again, you had Sherrod Brown just essentially identifying TCH with big banks, and saying, "Look at all the bad things big banks have done, we don't want these big banks to ruin the payment system." And, of course, he's correct insofar as TCH is owned by 20 big banks, but not all those banks were bad. And TCH is not responsible for what Citibank did, or what some of the other big banks did. Furthermore, the ownership and governance of RTP is separate from that of The Clearing House itself. It has its own little association, et cetera, and it has representatives from community banks on its advisory board, I think three of them. And finally, what people don't know about RTP is that, it's always operated its payment service is like a public utility.

Selgin: It doesn't seek profits, it pays no dividends, it gets no dividends from any of its payment services. And that's because it was formed, in the first place, back in 1853, as a club for banks to provide services that would themselves be beneficial to its members. It doesn't need to make profits from the services. The fact that the banks can use the service is enough of an incentive. Finally, there was a lot of silly talk about how this could be dangerous. You can't trust them to have enough safeguards, et cetera. But, The Clearing House's record, again, going back to 1853, is better than the Fed's. On safety, it's never had any failures on any of the several payment services it supplies, its outstanding. And, of course, if anyone had found anything bad about TCH in its history, they'd have brought it up. Nobody has, they can't, they just make claims out of thin air, as it were.

Beckworth: So, the RTP, or the real-time payment system that it set up, it's owned, there’s shares that are owned by the big banks, but it's run separately.

Selgin: Yes.

Beckworth: And let me ask this question, so, let's say, one of the big banks did have problems. The big bank's balance sheet is not overlapping with RTP. So, you could have a bank have problems, and RTP still would run just fine, is that right?

Selgin: Absolutely, yeah. RTP is fully funded. So, the way it operates is very simple. For listeners who are aware of the history, the Suffolk System in the 1820s in Boston, it's just remarkably similar. There's a joint account at the Fed, and this funded by all the banks that have joined the RTP system, that are members. And they have to put money in that account. And all the clearing and settlement is done on the books of this one account, just transferring funds, or credits, debit here, credit there, and it's fully funded. Now, that means they have to preload the account or the payments won't go through.

Selgin: So, that's where Fedwire and the National Settlement Service, that's where they put a wrench in the works, because, the account has to be pre-funded enough by the participants, to last through the weekend and last through the holiday. Of course, they wouldn't have to, they'd be more liquid and wouldn't have to pre-fund as much otherwise. So, that adds a little bit to the cost. But, anyway, it's fully pre-funded, there's no risk of failure in the settlements, because they are essentially backed, the payments are all backed by 100 percent reserves, and the reserves move… real-time gross settlement, you can't have a failure. It's not like where you're waiting for the funds and something could happen before the end of the day or something. So, there's no risk here, there's essentially no risk.

Selgin:  And as for security and all that, I dare say, the folks at The Clearing House know more than the Fed does, about how to get those things right.

Beckworth: Okay. Well, with that, our time is up. And, again, listeners, we will have George back on for, I believe, his seventh show next time, when he comes on and then we'll talk about the items I mentioned earlier, we didn't even get to the review and the Fed's operating system. But, George, thank you so much for coming on and enlightening us on this debate over the payment system.

Selgin: Oh, thank you very much, David. It's a pleasure to be here again, and I really appreciate the opportunity.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app. And while you're there, please consider rating us and leaving a review. This helps other thoughtful people like you, find the podcast. Thanks for listening.

People: 
David Beckworth
Calendar Date: 
Nov 11, 2019
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Subtitle: 
The US is trailing the world on real-time payments, and it’s important we get caught up to speed

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

Friday, April 26, 2019
Authors: 
Brian Knight

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.

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.

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.

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

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

Thursday, April 25, 2019

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.

Jim Angel

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.

Aaron Klein

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.

George Selgin

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.

Photo credit: Jessica McGowan/Getty Images