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San Francisco Regional Outlook - Third Quarter 1998

In Focus This Quarter

The Payment System: Emerging Issues

  • Essential to the transfer of value in the U.S. economy, the once-arcane and bank-centered payment system is undergoing considerable change as new technologies bring new opportunities, new exposures, and new competitors into the payments business.
  • For most banks, the major issues lie in small-value payments, where they struggle for advantage in adapting new technologies into new products and services while protecting their traditional payments business from technologically adept nonbank competitors.
  • For regulators and a handful of the largest banks, large-value payments present the most serious challenges, as technology has enabled increasing payment velocity and volume but also has created the potential for systemic failures.

The payment system is the heart of the U.S. economic infrastructure, moving an estimated $670 trillion annually among consumers, businesses, financial institutions, and governments.1 Despite this volume--an amount equal to roughly 90 times the U.S. gross domestic product--the payment system remains transparent to most users because of its dependability in moving value safely. Historically, banks have been essential to this movement, reaping, according to the Bank Administration Institute, an estimated $117 billion each year in revenues both as payment agents and as the holders of the funds from which those payments are made.

1 Estimate for 1996 from the National Automated Clearing House Association; www.nacha.org/resources/marketing/direct-payment/us-payments-96.gif.

Broadly speaking, the payment system encompasses the numerous payment products, players, and the infrastructure that together transmit value throughout the economy. More specifically, it can be defined as a collection of individual systems constructed around specific payment products. Credit cards, for example, represent a payment system. So do debit cards, checks, foreign exchange, and even cash. This product-based definition is a relevant one for many bankers, since it centers on the products and services that generate revenue rather than on the less glamorous "back office" functions that are measured instead by their cost. A second definition segments the payment system by payment size. Using this definition, the payments world is divided into systems that carry small-value or retail payments and those that carry large-value or interbank payments. This latter classification is oriented more toward infrastructure than product but is convenient from a regulatory perspective because the seriousness of the risk posed varies considerably by payment size.

However defined, the payment system today is a source of new opportunities and exposures--a result of a host of new technologies that the "information revolution" has spawned. These technologies create different issues for banks and regulators. For banks, the issues involve adapting the technologies into new products and services while protecting their payments business from nontraditional competitors that specialize in its creation and use. For regulators, the issues involve managing the risks--principally systemic risk--that accompany the large increases in payment volume and velocity enabled by technology. Taken together, these issues frame a payment system that can be both a political and a technological battleground, with significant incentives for participants to shape payment products and channels in a way that favors their own objectives.

Small-Value Payments: A Technological Brawl

Nowhere has the battle to shape the payment system been more contentious than in the small-value segment, where emerging information technology can best be leveraged into new fee-based retail products. There are two battles here. The first involves maintaining the monopoly over the payments infrastructure that connects each bank with the Federal Reserve and, by extension, with every other depository institution in the United States.2 While this infrastructure is interbank--that is, it is dedicated to settling accounts between institutions and does not directly extend to their customers--the ability to aggregate and settle individual retail payments through it has enabled the banking industry to maintain its centrality to the nation's monetary flows.

2 Depository institutions were granted exclusive access to this infrastructure upon its creation by the Federal Reserve Act of 1913.

The second battle involves exploiting new technologies either to attract new customers or to serve existing ones more profitably. This battle is both highly visible and highly technical and underscores the potential of the passing of information to eclipse the passing of value as the most critical profit opportunity in payments. The best example of this potential is bill presentment, the process of posting vendor invoices--such as credit card or utility statements--on the Internet to facilitate electronic payment. The crucial question concerns where the customer transaction data will lie. If they lie on vendors' sites or on the sites of nonbanks that concentrate such data, those entities will effectively "own" the customer by owning the information needed to cross-sell or otherwise add value during the billing process. Owners of customer-specific data also can tailor new services--a process that can develop loyalty as well as related sales. Losing this battle would be doubly costly for banks because, regardless of where the data reside, electronic payments will eliminate most of the float in the payment process, to the benefit of vendors and largely at the expense of banks.

Another battle is building between banks and nonbanks with respect to digital cash and stored value applications. These applications are directed at the micropayment sector--that is, payments that are normally considered too small for credit cards. Whether they reside on a computer or a smart card, these applications substitute electronic data for actual cash, with the amount stored on each card covered dollar for dollar by balances on account with an issuer. The struggle is for the right to issue this value, and the American Bankers Association has contended that regulated depository institutions alone should be permitted to do so.3 The battle here is for more than just fees, for the interest on the balances that back this electronic value could provide issuers with substantial new sources of income.

3 The Role of Banks in the Payments System of the Future, www.aba.com.

With some new payment technologies, the distinction between opportunity and risk can blur. As the Internet enables the distance between shopper and shopkeeper to increase, the need to authenticate unseen customers, merchants, and banks increases as well. At the same time, the open nature of the Internet requires that the privacy and integrity of transaction information be protected. The building blocks to accomplish this are neither simple nor easily interwoven--successfully combining cryptographic protocols, specialized security hardware, and existing information systems is a difficult matter in itself if the whole is not to be weaker than the individual parts.

The VISA and MasterCard Secure Electronic Transaction (SET) protocols, designed to protect Internet credit card transactions, illustrate the complexity that banks and their customers will need to navigate in securing online transactions. Under SET, all banks and merchants will use digital certificates to authenticate themselves to consumers and each other for each Internet transaction.4 These certificates are electronic messages that contain a decryption key for the sender that is itself authenticated by a trusted third party. The infrastructure for storing, distributing, and vouching for these keys, known as a Public Key Infrastructure (PKI), will contain several tiers of certificate authorities (CAs) and will be difficult and costly to implement. Banks not only will use these certificates, but many are considering becoming--or have already become--CAs themselves. While banks acting as certificate authorities may represent a logical progression in banking services, there is little evidence of a homogeneous legal infrastructure or legal precedent sufficient to guide digital signature disputes. These voids leave unanswerable the question of whether the expected gains from providing such services will compensate for the potentially long-tailed liability from doing so.

4 Depending upon card brand and SET version, consumer certificates may be required as well.

A major stimulus for electronic payments could come on January 2, 1999, when the U.S. government is required by law to convert its vendor and benefit payments from paper checks to electronic transfers--the so-called Electronic Funds Transfer '99 (EFT 99) program. Three separate challenges arise from this mandate. The first is that the "unbanked"--those segments of the population that are socially, economically, or geographically distanced from a financially bank-centric world--must eventually be provided with a cost-effective means to receive, store, and spend their electronic value.5 The second challenge is that the EFT mandate applies internationally as well as domestically. Given the need for each international payment to settle in two currencies and countries, the ability to provide efficient cross-border EFT will vary considerably from country to country.6

5 Because of resistance from bankers and benefit recipients, compliance waivers are envisioned that will make the program largely voluntary until the details of the special electronic transfer accounts (ETA) are worked out.

6 www.fms.treas.gov/eft.

Perhaps more challenging to many financial institutions is that electronic payments to vendors, unlike those to individuals, will require electronic remittance data to accompany the payment itself. This information goes beyond simple routing instructions and includes the information--such as purchase order or invoice numbers--necessary for the vendor to apply the payment correctly. According to a study by Booz-Allen & Hamilton, only slightly more than 5 percent of financial institutions were able to receive and forward such remittance information as of early 1997.7 Developing this capacity will therefore be an industrywide challenge. Once again, there is an opportunity disguised as a cost. The development and implementation of financial electronic data interchange (financial EDI) standards will enable financial institutions to retain control of--and add value to--business-to-business transactions when commercial payments migrate to the Internet.

7 Remittance Data Study, Booz-Allen & Hamilton; www.fms.treas.gov/eft/remit.html.

The U.S. government is not alone in seeking an end to costly paper-based payments. Vendors too are pressing for the elimination of the slow check presentment process wherein checks must physically be moved from vendor to vendor bank to issuer bank before funds can be transferred. Point of sale check truncation shortens this process by converting the check into an electronic payment at the point of sale, leaving the customer with an executed check and the vendor with a transaction that will settle like a debit card--and in doing so eliminates much of the potential for check fraud. While this process is beginning to displace physical presentment, the outlook for banks is mixed. As the volume of checks that must be physically handled decreases, so too will the income from float and the returns from past investments in check-handling capacity.

Large-Value Payments: Making the World a 'Good and Final' Place

Unlike small-value payments, the issues surrounding large-value payments are not strategic ones for banks, and less technological wizardry pervades them. Instead, the common factor is the systemic risk posed by payment failures. For this reason, regulators--particularly the Federal Reserve and the world's other central banks--take very seriously the payments "plumbing" that is otherwise obscure even to many bankers. In an electronic and intangible world where a bank's accumulated exposures can routinely exceed its equity, the overriding objective for payment system designers, users, and regulators is "good and final" payment--a term referring to funds that are both irreversible and fully collected.

Recognition is building concerning the payment system's vulnerability and just how critical it is to the U.S. economy. An October 1997 report issued by the President's Commission on Critical Infrastructure Protection (PCCIP) warned that "the nation's core payment systems . . . seem to present a serious physical vulnerability within the financial system."8 The source of that vulnerability, in the eyes of the commission, stemmed not so much from a lack of security as from the critical importance of those systems to settling financial transactions throughout the economy and the lack of available alternatives if they failed. As such, it was feared that the payment infrastructure provides an enticing target for cyber-terrorists and information warriors and that such threats will only grow in the future.

8 www.pccip.gov/report_index.html, p. A39.

Concentration refers to the fact that while banks are central to payments and all enjoy equal access to Federal Reserve payment services, some banks are clearly more central than others. According to March 1998 Call Report data, a mere 25 banks hold nearly two-thirds of the U.S. banking industry's transaction accounts.9 Should one of these large banks suddenly fail, its inability to fund settlements could result in a loss of payment system liquidity and disruption of domestic and foreign financial systems alike. While this concentration is not new, what is new is the considerable increase in concentration that the new megamergers promise.10 How and whether to inoculate the payment system from the weight of these super-institutions will become an issue for the regulatory community.

9 Transaction accounts, in essence, are those accounts from which third-party payments can be made. The data used here are based only on transaction accounts held on behalf of other public and private financial institutions here and abroad--accounts from which interbank transfers are made.

10 As of March 31, 1998, the top three U.S. bank holding companies held approximately 25 percent of all reported interbank transaction deposits. The mergers announced through June 30, 1998, would increase that concentration to over 34 percent.

The criticality of a nation's payment system is not confined within its own borders. Because of globalization and the increasing velocity of payments, threats to one country's system become threats to those of other countries as well. There are a number of these emerging cross-border concerns. The most immediate and visible is the Year 2000 or Y2K problem. Because banks and the payment networks that join them are heavily computerized, the latent points of vulnerability to software and hardware failures have grown factorially with the number of interconnected internal and external systems. In this context, the concern is that any banks that have failed to correct their Y2K exposures will transmit that failure via the payment system to other institutions throughout the world, delaying or even arresting settlements in the process. This concern is heightened because, in both Asia and Europe, bank resources needed to fix Y2K are being consumed instead by more immediate problems. In Asia, it is surviving the decay in currencies and credits. In Europe, it is the Euro, which rates as an issue in itself--demanding the modification of bank and interbank payment systems throughout the world in anticipation of that currency's January 1, 1999, launch.

Although less well known to the general public, foreign exchange settlement risk remains of considerable concern to the Bank for International Settlements (BIS) and its member central banks. This exposure arises because cross-border payments, unlike domestic payments, have no single central bank to guarantee settlement, leaving U.S. banks exposed to their foreign counterparties and correspondents--sometimes for several days--for more than $244 billion in daily trades.11 Potential solutions to this problem include netting--offsetting risks so that only the differences are due--and simultaneous settlement. An ongoing effort by several of the world's largest banks to provide simultaneous cross-border settlement, a project known as the Continuous Linked Settlement Bank, will require considerable international cooperation since it will effectively span the central banks in each country whose currency it settles.

11 Settlement Risk in Foreign Exchange Transactions, March 1996, and Central Bank Survey of Foreign Exchange and Derivatives Market Activity, May 1996; Bank for International Settlements; www.bis.org/publ.

Efforts by individual countries to solidify their payments infrastructure are ongoing as well. Achieving finality in payments--a term meaning that a completed payment is irrevocable--is the most prevalent, and recognizes that payments must be irreversible to establish the liquidity for those that follow. One way of speeding up finality is with real time gross settlement (RTGS) systems. "Real time" means that there is no delay in settlement. "Gross settlement" means that transactions are settled in the full amount for which the original payment instructions were entered. FedWire, the U.S. Federal Reserve's large-value payment system, is an RTGS system. Many other countries also have them, and still more are developing or planning them. Complementary to RTGS systems are net or provisional settlement systems, which total up the accumulated debits and credits for each participant over the course of some period--usually one day, offset them against each other, and settle at the end of the period. The New York Clearing House's Clearing House Interbank Payment System is one such system. Although their use leads to smaller, or netted, settlement amounts for each participant and substantially lower liquidity demands on the payment system as a whole, payments in such systems are not final until the last creditor pays. Thus, there is a daily threat of recalculation and a potentially fatal change in members' liquidity positions if a major creditor bank fails. For such systems, the BIS is encouraging member collateralization levels sufficient to cover at least one, and preferably two, of each system's largest net creditor banks at any one time.12 While these are not new issues in developed nations, the increasing extent to which financially underdeveloped and underregulated countries are involved in global payments confers new importance on the development of finality and collateralization in payment systems worldwide.

12 Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries (Lamfalussy report), November 1990; BIS; www.bis.org/publ.

Differing Perceptions, Common Threat

Banks are united neither in their perceptions of these issues nor in their desire for regulation to address them. With respect to small-value payments, large and small banks have disagreed over whether the Federal Reserve should withdraw from providing retail payment services--a debate that ended in favor of the small bank faction earlier this year when the Fed announced that it would remain an active and, according to some large banks at least, a subsidized competitor in clearing and settlement. There also has been disagreement, again along lines of size, over whether the issuance of new products such as stored value cards should be limited to regulated depository institutions. In large-value payments, the differences are due more to relevancy than competition. Few small banks will feel compelled to address foreign exchange exposures or the vulnerabilities of the national and international payments infrastructure.

Whatever their individual perceptions of the issues surrounding the payment system, all banks are susceptible to its interruption. Likewise, they are strategically vulnerable--individually and as an industry--if they fail to preserve their role as a trusted gateway for the settlement of their customers' obligations. This is perhaps the most critical of all payments issues facing banks, for while their daily operations may depend on their continued success in maintaining the payment system's dependability, nothing short of their payments franchise may rest on their ability to market this success to their customers as a feature essential to the entire range of current--and future--payment services.

Gary Ternullo, Senior Financial Analyst
gternullo@fdic.gov


Emerging Issues in Small-Value Payments

Maintaining the payment system monopoly. Access to Federal Reserve payment services has historically been limited to depository institutions. Maintaining that monopoly--and thus maintaining its centrality to current and future payment products and services--is an important issue to the banking industry.

Electronic bill presentment is the process of presenting bills and receiving payments electronically. Internet bill presentment may be one of the most hotly contested services, because the owner of the site where invoices are posted could cross-sell to customers as well.

Digital cash and stored value are applications in which electronic data substitute for cash. Such applications can run on either smart cards or personal computers. An important issue is who holds the balances that back electronic value, because, unlike with paper cash, issuers may be able to earn interest on the digital balances held by consumers.

Securing online transactions. Ensuring the integrity, privacy, and authenticity of electronic transactions is widely desired by those engaged in electronic commerce. With larger payments, desirability will become necessity. Current implementations use combinations of encryption algorithms and specialized hardware.

Banks as certificate authorities (CAs). Authenticating Internet payers and payees may require a complex public key infrastructure in which trusted organizations supply decryption keys to authenticate the counterparties to a transaction. Some banks are already acting as CAs. Others are weighing the benefits and largely uncertain exposures of providing such a service.

Electronic Funds Transfer '99 (EFT 99). On January 2, 1999, the U.S. government will be required to make benefit and vendor payments electronically. This mandate raises issues of how to provide service to the "unbanked," how to provide service internationally, and for vendors, how to integrate remittance data with the payment itself.

Development of financial electronic data interchange (EDI) standards. For bank commercial customers to benefit from electronic payments, banks must be able to handle remittance information--information that accompanies payments and identifies sender and transaction detail. Standardizing such data is an important step in enabling banks to receive them and pass them on to their customers.

Point of sale check truncation. Checks are costly to handle and time-consuming to collect. Check truncation reduces cost and eliminates float by converting the check into an electronic transaction at the point of sale. Although banks will have fewer checks to handle under check truncation, they will lose float and the return on investment in check-handling equipment.


Emerging Issues in Large-Value Payments

Payment system vulnerability. According to the PCCIP, the nation's core payment systems may present a serious physical vulnerability within the financial system.

Payments concentration. Payment services are concentrated in a relatively few large banks, and that concentration is growing as megamergers are creating a smaller number of superbanks.

Y2K. The Year 2000 problem threatens to disrupt payments by transmitting computer problems via the payment system from banks that have not fixed the problem to banks that have.

The Euro. Bank and interbank systems in Europe and abroad must be modified to accept the Euro. In addition, the resources required to implement the Euro must be diverted from resolving Y2K problems.

Foreign exchange settlement risk. Foreign exchange transaction exposures can be many times a bank's capital. The failure of a major creditor to pay could drain essential liquidity from international markets.

Achieving finality in gross payment systems. Making a given country's domestic payments irrevocable and immediate is a major step in avoiding the international spillover of internal financial crises.

Collateralizing net payment systems. According to the BIS, systems that do not permit immediate final settlement must be collateralized to ensure the eventual satisfaction of member positions in the event of a participant's failure. Like finality, collateralizing helps prevent the internationalization of a domestic failure.


Sources of Additional Payment System Information

Electronic Bill Presentment

Checkfreewww.checkfree.com/ebill
Microsoft-First Data Corpwww.msfdc.com

Digital Cash and Stored Value

Cybercashwww.cybercash.com
Digicashwww.digicash.com
Mondexwww.mondex.com
VISACashwww.visa.com

Securing Online Transactions

Certicomwww.certicom.com
Entrustwww.entrust.com
RSAwww.rsa.com
SETCOwww.setco.org

Certificate Authorities

Certcowww.certco.com
Digital Signature Trustwww.digsigtrust.com
GTE Cybertrustwww.cybertrust.gte.com
Verisignwww.verisign.com

Electronic Funds Transfer '99, Financial EDI, and POS Check Truncation

National Automated Clearing House Associationwww.nacha.org
U.STreasury Financial Management Servicewww.fms.treas.gov/eft

Payment System Vulnerability

President's Commission on Critical Infrastructure Protectionwww.pccip.gov

The Euro, Foreign Exchange Settlement Risk,
Payments Finality, and Collateralization

Bank for International Settlements (BIS)www.bis.org/publ
Federal Reserve Board of Governorswww.ny.frb.org
New York Clearing House Associationwww.chips.org
U.S. Federal Reservewww.bog.frb.fed.us


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Last Updated 7/26/1999 insurance-research@fdic.gov