U.S. Payment Systems and the Federal Reserve
Business has changed a great deal in the past century but the payment system and the Role of the Federal Reserve in facilitating it have remained key components in the receiving and sending of payments between customer and vendor. This article looks at the historical perspective of the Federal Reserve’s roll in the United States Payment system, how its facilitated, how technology has impacted the system, and what the future holds in this advancement of technology in a country where paper payment still reigns.
The United States has undergone many changes through the 1900’s through present times. Industry, technology, medicine, as well as many other mainstays of the American story have gone through explosive growth and have seemingly endless possibilities. Riding the coattails of this growth, corporations in the United States, and the way they conduct business, has grown exponentially and increasingly complex from the way products are produced and marketed, to the scope of the marketplace. Interestingly, despite the growth of business itself in the United States and worldwide, paper based payments are still the norm (Maness & Zeitlow, 2005). Check’s and drafts still account for how the vast majority of U.S. businesses send and receive payments. Understanding the role of the United States Federal Reserve in the payment system process, how they facilitate the payment mechanism, and how current technology has made its impact can go a long way towards understanding what the future holds.
Illustration of the Federal Reserve
Payment Systems and the Federal Reserve: A Historical Perspective
The Federal Reserve of the United States, also known as the “Fed”, is the central banking system that lends money to banks through a discount window, plays a role in the supervision and regulation of banks and is the facilitator of the Country’s payment mechanism (Maness & Zeitlow, 2005). The Fed’s role in the payment system include the circulation of new money, the retiring of old money, the moving, sorting, and tabulating of checks and the debiting and crediting of corresponding bank accounts, the supporting of private clearing systems, providing an automated clearing system for small electronic payments, and the facilitating of wire transfers via a nationwide transfer system (Maness & Zeitlow, 2005). In 1907, a breakdown in the U.S.’s payment system led to the 1913 passage of the Federal reserve Act which established the Fed’s initial roll as facilitator of the American payment system (Maness & Zeitlow, 2005). At this early time, congress envisioned the Federal Reserve as both an operator and regulator of the U.S. payment system, a view that was reaffirmed by in the Monetary Control Act of 1980 (The Federal Reserve Board, 1990).
The Fed consists of 7 members known as the board of governors that are appointed by the President of the United States with the approval of the U.S. Senate (Maness & Zeitlow, 2005). There are 12 main Federal banks with 25 branches and an additional 9 locations dedicated to the processing of checks (Maness & Zeitlow, 2005). The United States is broken into 12 Federal Reserve districts that are covered by their branch locations (Maness & Zeitlow, 2005).
Payment Systems: The Federal Reserve’s facilitation
To many, writing a check is a simple way to pay for goods or services without having to carry around cash that can be bulky and have little to no traceability upon the occurrence of a payment dispute. In actuality, behind the scenes, a series of fluid steps across various regions and banking locations are required to ensure the payor’s funds are transferred as expected to the payee’s financial accounts. This is where the Fed and its district branches and banks critical roles lie. When an individual writes a check at a supermarket, the check is sent to the supermarket’s bank and is deposited to their banking or checking account (Maness & Zeitlow, 2005). The check then moves onto the customer’s bank and then through the Federal Reserve branch or location that plays the role of clearing agent (Maness & Zeitlow, 2005). Once the check clears, the payee’s and payor’s bank accounts are debited and credited finalizing the transfer of the actual monetary transaction (Maness & Zeitlow, 2005). This simplified description of the multiple step process explains why the it can take up to a few days for a check transaction to complete, particularly depending how far the check must travel and whether the payee’s and payor’s banks reside in different Federal Reserve districts. This period of time, known as float, has a direct effect on both the recipient and issuer of the check in terms of their individual cash flows. Individual’s risk overdrawing their accounts if there is an extended delay in the processing of their check and receivers of checks can suffer shortfall of cash flow, which can hinder or even make its operation more expensive due to additional need to borrow funds. In a society like the United States where such a large portion of commerce is still dependent on paper payment systems, and its facilitation by the Federal Reserve, the continuously expanding marketplace will increasingly demand the most efficient and cost effective form of collection and payment of funds to conduct business. From an inside perspective, the Federal Reserve involvement in the U.S. payment system promotes efficiency by motivating public interest while stimulating improvement in the payment system’s efficiency (The Federal Reserve Board, 1990). Not surprisingly, technology, as it has in every other aspect of our lives, has played a vital role in the Federal Reserves ability to handle a rapidly growing interstate banking and business environment.
Technology’s Impact on The Federal Reserves Facilitation of the U.S. Payment System
The First Vice President and Chief Operating officer of the Federal Reserve Bank of Boston Paul Connolly stated “... that, at least occasionally, innovations with potential benefits for the overall payments system, and indeed for society, will languish, unless the Federal Reserve or some other entity with broad-based, longer-term benefits in mind will pursue them”(Connolly, 2000). This statement makes an important point about technology’s impact on the Federal Reserves role as payment facilitator that without the Fed or other large-scale operations capable of making change happen, technology innovations that improve the lives of many individuals and businesses likely would not come to fruition. As far back as 40 years ago, the Fed was responsible for nurturing the development of computer -aided check sorting that helped provide automation to the check clearing process (Connolly, 2000). Magnetic ink invented by American Bankers Association and used on the bottom of checks to help with the electronic sorting of checks, was encouraged as a standard feature by the Fed in the 1950’s (Connolly, 2000). In the 1970’s, the Fed supported the first Automated Check Clearing (ACH) system that introduced the U.S. to now common luxuries known as direct deposit and direct payment (Connolly, 2000). The Fed also led the way in the 1980’s and 1990’s in the research and development of digital image technology for the use in check processing (Connolly, 2000). These technologies supported and developed by the Federal Reserve have gone great lengths toward streamlining further efficiencies in the U.S. payment system helping support the rapid growth of commerce. The Fed’s influence and ability to encourage the standardization of new technology and methods played an important role in enabling banks ability to exchange check images produced in different systems (Connolly, 2000).
Through the use of technology, the Federal Reserve has gone to great lengths to eliminate fraud in the U.S. payment system. In 2004, the Fed helped international agencies develop software code that discourages the digital counterfeiting of paper currency (Daukantas, 2004). Adobe Photoshop, software used by many of us today, was coded to disallow users the ability to scan and upload images of currency (Daukantas, 2004). The Fed recognizes that innovation in technology not only helps the Fed but can also be used to help criminals defraud the public and the U.S. payment system itself. Their efforts are extremely important because the increasingly low cost and availability of photo-shop software intended for non-malicious intentions makes it easier for those who wish to defraud the system to do so. It is clear that the Fed holds these efforts in high priority as can be seen by their 2003 budgeting of $2.9 million in counterfeiting deterrence research (Daukantas, 2003).
U.S. Payment System: What does the Future Hold?
It can easily be seen that the Federal Reserve has held a large role in the furthering use of technology in the payment system over the years. Many of these technologies, once seemingly beyond the realm of possibilities, have come about and transitioned themselves into the norms of financial transactions. It is not long ago when all paychecks were received in an envelope and required depositing or cashing at the local bank. The money was only available for use after the check cleared. Today, not only does direct deposit of paychecks exist, their use is highly encouraged by employers because of their efficiency and cost effectiveness. It was not long ago when writing a check or using cash at the grocery store was the norm. Today, if a market place does not accept credit or debit cards, it is seen as a great inconvenience to the customer. Not to mention the aggravation of being behind a check-writing customer in line at the store when in a hurry. For many, it is hard to imagine making financial transactions the way they were done just 15 years ago. Fifteen years from now, what technologies will have been developed and implemented in the U.S. payment system that will make today’s technologies and convenience seem passé? What does the future hold for the U.S. Payment system?
Currently, credit cards, debit cards, electronic fund transfers, and Paypal style internet payment systems are widely used in many market places in the United States and around the world. The growing internet market place including banking, retail, as well as wholesale and others has created demand for safe, secure, and quick methods of payments the will appeal to the current consumer. A new form of payment system called “contact-less” payment technology allows consumers to pay for goods with items they have with them (Sky News, 2008). At first glance, one might be confused as to what paying for goods with any item the consumer has on hand means. According to Sky News article entitled “Is this the End of Credit Cards” (2008), Barclays, a large global investment services provider, has developed the contact-less payment system that allows a consumer to pay for goods with items such as their mobile phones, key chain sensors, or even through their finger prints or eyes. For example, a customer could hold their mobile phone up to a product they wish to buy and it is added to their virtual shopping cart (Sky News, 2008). When the customer is finished shopping, the customer could confirm what they have purchased, collect their items, and leave the store without having to stop at the cash register (Sky News, 2008). Interestingly, this idea is kind of a cross between Internet shopping using a pay-pal type of payment and traditional retail shopping using a credit card. With the growing concern over identity theft, some believe that user- friendly secure biometric payment systems are the wave of future.
Biometric payment systems such as “Pay by Touch” uses fingerprint technology as a secure method of payment for goods via the Internet (Ecommerce Journal, 2008). The way it works is the consumer purchases a USB input fingerprint scanner, when a payment is being made for an online item, the customers fingerprint is scanned and compared to the registration of the USB fingerprinting device (Ecommerce Journal, 2008). Once the individuals identification is cleared, payment is made for the item.
A third technology that has been discussed widely as the wave of the future for a good number years is RFID otherwise known as Radio Frequency Identification. Essentially, RFID employs the use of tiny microchips that emit a unique radio frequency that can be picked up by a scanning device. Currently, the technology is used to a large scale in complex warehousing establishments to assist in accurate picking of orders and as assistant to Just In Time inventory systems for manufacturers. RFID is similar to a bar scanning system except through the use of radio frequency, an entire area of items can be counted and quantified at the same time. As a payment system, it is hoped that RFID could be used in consumer good items that would eliminate the need to scan items via a bar code allowing more efficient use of human resources for the retailer as well as a more efficient use of time by the consumer. Potentially, this technology could be used in step with other technologies like the contact-less payment system and other technologically advanced electronic payment systems.
As alternative methods of payments including ACH checks, debit and credit cards and even in the future, contact-less payment systems, continue growing in popularity and begin to over take paper payment methods the Fed will be forced to take measures to adjust for the trend changes. Namely, according to a speech given by Governor Randall Kroszner at the 2007 Payments Conference Competitive Forces Shaping the Payment Environment, the Fed has cut the number of offices from which checks are processed in half since 2003 (Kroszner, 2007). He also states that the use of transportation to deliver paper payments, particularly air shipments, is beginning to shrink (Kroszner, 2007). To keep up with the ever-changing payment system environment federal regulators will be called upon to remove unnecessary and artificial regulation barriers to innovation (Kroszner, 2007). An example to regulatory changes that have been made to keep up with innovation was the implementation of a program called Check 21 (Kroszner, 2007). Check 21 encourage the banking industry to use digital images of checks and provide substitute checks only when absolutely needed to meet end user requirements (Kroszner, 2007). Reports to the Check 21 board found that the relaxing of regulations increased the use of electronic check images as compared to substitute paper checks on a 5 to 3 ratio (Kroszner, 2007). This figure shows that although the regulation didn’t provide immediate transition of banking activity to the use of digital imaging, it began the trend that likely will continue as the impact of the de-regulation is fully utilized by the private institutions. The Fed also modified regulations surrounding risks of fraud from checks that are remotely generated and shifted the risk exposure to the private institutions that can better handle risks of this type (Kroszner, 2007). In short, as the payment system in the United States continues to evolve, the Fed and private institutions alike must continue to readdress and adapt rules and regulations as well as enter endeavors to develop and promote innovate solutions for the ever-changing marketplace (Kroszner, 2007).
In the United States, paper payments and the system developed and coordinated by the Federal Reserve to handle the constantly changing needs of the growing marketplace is in the process of transitioning to accommodate and promote the advancement of the electronic payment age. Although the U.S. is still primarily a paper-based system, the electronic payment system is quickly becoming the bellwether as consumers and corporations alike are beginning to become more trusting of a non-paper system and more understanding of the benefits it can provide. As it has since its inception in 1913, the Federal Reserve is adjusting to the needs of the marketplace on an increasingly interstate and broad based platform. Internet commerce and border blurring national banks have increased the need for the Fed to loosen regulations to accommodate the changes without undermining the needed security and scrutiny that remains a necessary part of a stable economic environment. It can be assured that in 15 years whether we as consumers reach into our pocketbooks for our checkbook or for our Ipods to pay for groceries, the Federal Reserve will continue to play a vital role in the facilitation and regulation of how that payment is paid to and received by the consumers and vendors in our global marketplace.
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