Why pay? An introduction to payments economics

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Abstract

This paper surveys the growing literature on payments. We begin by presenting a simple model that illustrates the essential function of payments and how this may be implemented through various arrangements. We show how the basic models of payments have been used to address a variety of microeconomic and macroeconomic policy issues. We then discuss the links between payments economics and other fields, including monetary theory, corporate finance, and industrial organization. We conclude with an overview of the empirical literature and directions for future research.

Introduction

Payment systems are the plumbing of the economy—a collection of conduits that is essential, pervasive, and boring (until there's a malfunction). Economists studying payment systems have long labored under the shadow of this unsavory metaphor. Recently, however, payments economics has begun to achieve some respect, because of the significant changes in payments technology and infrastructure, because of the important policy concerns associated with the industry, and possibly because of the sheer magnitude of payment activity.

A payment occurs when one economic agent transfers value to another agent for the purpose of discharging a debt. In developed economies, the action of payment is so mundane and apparently simple that a definition hardly seems necessary. But economists have struggled to understand the nature of this everyday activity: constructing a convincing microeconomic model of payments is a challenging task. Payments and payment systems, so ubiquitous and obviously essential to real-world economies, are conspicuously absent from the world of Arrow–Debreu.

But what precisely are the frictions that give rise to payment arrangements? Do these frictions, and the payment systems designed to overcome them, matter for economic allocations more generally? How do payment systems interact with the machinery of financial intermediation and macroeconomic policy? And how will these systems evolve with the ongoing improvements in information technology?

This essay is an (admittedly idiosyncratic) introduction to some of the policy issues dealt with by payments economics and to some of the empirical work on payment systems, but above all to the models used to understand the role of payments in an economy and the forms which payments take. The first generations of models of payment systems have been valuable in informing certain policy debates, for example within central banks on payment system design and stability. Recent improvements in the microfoundations of these models will broaden their relevance, not only to issues in banking and financial intermediation, but also to economic history, macroeconomics, and industrial organization. By the end we hope the reader will conclude that plumbing can be an interesting, as well as important, object of study.

The plan for this paper is as follows: The remainder of this introduction documents the magnitude and growth of the payments industry and outlines the important policy questions at both wholesale and retail levels.

The next two sections outline a basic theory of payment and describe various extensions. While the discussion ranges over a broad spectrum of arrangements and models, the general direction is from abstract to concrete. We argue that the fundamental imperfections which give rise to payments are a time mismatch in consumption, and imperfect enforcement of credit arrangements. Section 2 introduces the basic model and the two fundamental types of payments arrangements: accounts systems and store-of-value systems. It discusses the relative advantages of each, and the briefly considers factors involved in an apparent move over recent times away from store-of-value towards accounts based systems.

Section 3 discusses “hybrid payments arrangements” intermediate between the two fundamental types. The most important example is transferable debt, also known as “inside money” in the monetary theory literature. We review some models of inside money, showing how the payments approach provides a fresh perspective—highlighting the evidentiary role of transferable debt, potential links to corporate finance, and insights on netting arrangements in securities settlement.

Sections 4 Payments and monetary policy, 5 The industrial organization of retail payments review in greater detail the studies of payment systems in light of the two fundamental policy issues linked to them: one macroeconomic—how do payment systems affect monetary policy—and one microeconomic—what, if any, are the market failures associated with privately-run payment systems. Section 6 reviews the still small but rapidly growing empirical literature on payments.

Payments are big business, even by the standards of macroeconomists. For example, 89 billion payments of $937 trillion were recorded in the United States in 2005, not counting payments made in currency.1 This figure corresponds to about $75 in payments for each dollar of GDP, a ratio that has been steadily rising over time. Payment statistics in all developed economies display similar levels and trends (summary statistics can be found in Committee on Payment and Settlement Systems, 2007).2

Much of the recent pickup in payments activity comes from the large-value or wholesale payment systems used to settle obligations between banks. Since the “funds side” of financial market trades3 must ultimately settle through such systems, volume over these systems has mushroomed with the upsurge in financial market trading.4 But volume is also expanding quite rapidly over certain types of small-value or retail payment systems, those used by households and nonbank firms. In the U.S., for example, usage of debit cards and direct transfers5 is expanding at double-digit rates (measured either in terms of the volume or value of transactions), even as the usage of checks and cash is declining (Humphrey, 2004, Gerdes et al., 2005, Garcia-Swartz et al., 2006a, Klee, 2006a). Transactions that were once only conducted solely with cash are increasingly made using cards that electronically link buyers to their payment histories.6

The past decade has also witnessed tremendous innovation in payments. Besides the spectacular rise of card payments, innovative web-based payment systems such as PayPal have enabled individuals to “wire” funds across great distance, instantaneously and at low cost (Kuttner and McAndrews, 2001). At the wholesale level, the multicurrency CLS system (beginning operations in 2002) has allowed banks to coordinate the settlement of foreign-exchange transactions across national borders, binding together all major national payment systems in a way that was unthinkable a decade ago. And there is no reason to believe that the rate of innovation will slow down anytime soon. The “payment card” of the future will likely be just a “smart card,” cell phone, or other portable computing device, able to instantaneously transfer value to anyone so equipped.7

While the technology-fueled expansion of payments activity has clearly generated tremendous economic benefits, it has also generated noteworthy and in many cases, unresolved questions for policymakers.

Important policy issues for wholesale payment systems include access, liquidity, and systemic risk. Important policy issues for retail payment systems include competition and fraud. Cross-border coordination is an important problem at both levels.

Economic models of banks have usually focused on the roles of banks as financial intermediaries, parties able to exploit the synergies between the provision of extremely liquid deposits and illiquid loans (e.g., Diamond and Dybvig, 1983, Kashyap et al., 2002). But banks have always served another, equally essential role, as providers of payment services—as parties able to transfer liquid claims quickly and cheaply and with a minimum of legal uncertainty.8

Financial innovations such as securitization, syndication, and credit insurance have eroded banks' advantages as financial intermediaries, subjecting them to competition from both financial markets and nonbank financial institutions. But, for the moment at least, banks continue to enjoy significant advantages over nonbanks as payment service providers. These advantages include, most critically, full access to wholesale payment systems. Such access is usually restricted to (regulated) banks, and sometimes only to banks whose home charter is in the same jurisdiction as the system itself.9 Indeed it has been argued that such access has become the definitive feature of a bank (Lacker, 2006). Recent policy discussions in the U.S. regarding the acquisition of banks by nonfinancial firms have focused on this issue. Wal-Mart and other would-be acquirers of banks have stated that their principal motivation is not to compete with banks as financial intermediaries, but instead to gain unfettered access to interbank payment arrangements.10

Liquidity is a concern because of the very high value of payments routed through wholesale systems. No intraday markets exist to allocate this liquidity. Instead, such liquidity has traditionally been allocated implicitly through agreements between banks to settle payments on a net basis. During the 1990's, however, net settlement of large-value interbank payments came under criticism as being vulnerable to systemic risk, roughly defined as the risk that a failure by one bank to settle might result in multiple settlement failures.11 Chains of failures have rarely been observed in practice, but there have been enough “near misses” to produce considerable regulatory angst.12 Consequently net settlement has in many cases been abandoned in favor of real-time gross settlement (RTGS).

In an RTGS system,13 each payment by a bank to another bank consists of an irrevocable transfer of central bank funds—in the U.S., for example, between reserve accounts with the Federal Reserve Bank. Until the payer has access to such funds, no payment can be made. RTGS systems thus insulate an individual payee from systemic risk, but their operation requires many times more central bank liquidity than operation of net settlement systems. How such liquidity should best be provided remains an open question. The Federal Reserve System, for example, routinely allows banks using Fedwire to incur uncollateralized intraday overdrafts, but other central banks (Euro area, Japan, UK) only grant such credit against collateral. The Fed charges fees against overdrafts (over a ceiling), but many other central banks do not. Other large-value payment systems—CHIPS in the U.S., LTVS in Canada, and the multicurrency CLS—have opted for arrangements that employ modified versions of net settlement, often in conjunction with queuing arrangements that attempt to optimize the extent to which queued payments may be netted (Intraday Liquidity Management Task Force, 2000, McAndrews and Trundle, 2001, Willison, 2005). The right price for liquidity, taking into account system-wide safety concerns and bank incentives, is a fundamental issue for both private and public systems.

For retail systems, the principal policy controversies have centered on issues of competitive efficiency. Payment systems are a relatively expensive component of financial infrastructure, as much as 3 percent of GDP in the U.S. (Humphrey et al., 2000). In the U.S. case, one reason this figure is so high is the continued widespread use of checks, but the cost of electronic alternatives can also be substantial, particularly for card-based payments. Merchant dissatisfaction with the fees charged for card payments has resulted in some spectacular antitrust litigation in the U.S. (the “Wal-Mart case” against Visa and MasterCard, settled in 2003 for $3 billion; additional lawsuits are pending) and outright regulation of card fees in countries such as Australia (Lowe, 2005). As is the case with some other “network” industries, there is little consensus on what constitutes an efficient fee structure for card-based payments (Rochet and Tirole, 2006a).

Another policy controversy associated with retail payments has been the emergence of new forms of payments fraud such as “identity theft.” Electronic payment systems can offer tremendous efficiency gains, by allowing for rapid and easy transmission of information across system participants. But the flipside of this efficiency is that these same systems can allow for rapid propagation of fraud. A single loss of confidential data, such as the compromise of 40 million credit card accounts at CardSystems Solutions Inc. in June 2005, can lead to significant fraud losses.14 Payment service providers and policymakers have struggled to find a balance between the inherent advantages of information-sharing, and the potential costs that can arise due to fraud and loss of privacy.

Payment systems have traditionally observed national boundaries, but over the past decade cross-border arrangements have become increasingly common. Cross-border credit card and ATM card transactions are now routine, and cross-border direct (ACH) transfers are starting to see increased usage. At the wholesale level, the Euro-area-wide TARGET system (beginning operations in 1999) and the multicurrency CLS system are now the world's two largest payment systems, measured by the value of funds transferred. The advent of these cross-border arrangements has no doubt facilitated international commerce, but at the same time their operation has raised the spectre of risk from mismatch of systems and regulations combined with greater potentials for participants to exploit cross-border incompatibilities. Addressing these concerns has required a much greater degree of coordination among central banks and regulatory authorities than was previously the case.

Section snippets

Theory of payments

Payments arise in environments characterized by two potential impediments to exchange: a time mismatch of trading demands, and limited enforcement of pledges about future behavior.

The notion of a time mismatch is less stringent that Menger's celebrated “lack of double coincidence of wants.” What is key is not an absence of counterparty-by-counterparty matchups in consumption good demands, but instead an inadequate supply of liquid (desirable) assets to allow for exchange to proceed as a

Hybrid payment systems: transferable debt

Most actual payment systems incorporate features from the two basic models outlined above. An idea common to all of these hybrid arrangements24 is the use of privately issued, transferable debt (inside money) in one form or

Payments and monetary policy

The widespread use of RTGS systems for payments between banks implies a close connection between payments and monetary policy. “Policy” interest rates (e.g., the fed funds rate in the U.S.) are, after all, simply the prices at which a central bank is willing to provide funds over an RTGS system today (e.g., Fedwire) in terms of a reverse transfer the following day. As noted in the Introduction, the use of RTGS requires that traditional, “overnight” monetary policy30

The industrial organization of retail payments

Papers in the monetary literature often assume that payment arrangements are administered by a benevolent social planner, or by a club of payment system participants. Such exercises offer useful benchmarks, particularly for wholesale payments where government-sponsored or cooperative arrangements are the rule. At the retail level, however, payment services, apart from those provided by currency, are usually provided by profit-seeking firms. As purveyors of “information goods” (Varian, 1998),

Empirical work in payments

The ideal payments dataset would be nothing less than a complete record of all transactions in an economy: a list of all purchases and financial trades, combined with the identities, demographics, and financial conditions of all transactors. Armed with this data, economists could then happily set about investigating and refining the relevance of the theories outlined above.

Obviously no such dataset exists. But there is a huge amount of data “out there.” Payments service providers (commercial

Conclusion

Payment is more than a mechanical act. It is, in a sense, the quintessential economic activity, the “glue” that binds together the gains from trade. As such, an act of payment also represents a decision. The choice of whether, when, and how to pay depends on a variety of characteristics of the agents involved in the trade: demographics, value, variability, and liquidity of assets, differential information, risk aversion. The choice also depends on the environment: legal structure enforcing

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    The views expressed in this paper are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. An earlier version of this essay was presented by the first author at a conference, “The Economics of Payments II” held at the Federal Reserve Bank of New York, March 29–30, 2006. We thank participants in that conference and in seminars at the Bank of England for valuable comments.

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