Academic journal article Economic Review (Kansas City, MO)

The Federal Reserve's Reduced Role in Retail Payments: Implications for Efficiency and Risk

Academic journal article Economic Review (Kansas City, MO)

The Federal Reserve's Reduced Role in Retail Payments: Implications for Efficiency and Risk

Article excerpt

The payments system in the United States has undergone fundamental changes in the last decade. The use of paper checks has declined rapidly, replaced by the automated clearinghouse (ACH) and card payments. The processing of paper checks has also changed, with the vast majority of checks now converted to electronic form before collection. The industry that processes payments has adjusted as well, as increased use of electronic payments has enabled a variety of private-sector entities to enter the market.

These changes have reduced the Federal Reserves role in the clearing and settlement of retail payments. Clearing noncash retail payments consists of transmitting payment information among financial institutions in preparation for the transfer of funds; settlement refers to the process of funds transfer. The Federal Reserve has traditionally played a significant role in the clearing and settlement of checks and of payments through the ACH, a network for electronic transfers between bank accounts. In both types of payment, expansion of private-sector clearing organizations has reduced the Federal Reserves role in clearing and settlement. Further reduction in the Federal Reserves role has come from the shift from check payments to debit card payments, all of which are cleared through the private sector.

Whether the decline in the Federal Reserve's role in clearing and settlement is cause for concern is a matter of debate among policymakers. According to one view, the main role of the Federal Reserve should be to carry out settlement of payments among financial institutions after clearing has been performed by the private sector. Others argue that the Federal Reserve also needs to be actively involved in the clearing of retail payments to ensure adequate competition among payments providers and to protect the integrity of the payment system.

This article examines the change in the Federal Reserves role in the clearing and settlement of retail payments since 2000 and discusses possible implications. Section I describes how the Federal Reserve participates in the clearing and/or settlement of each major type of noncash payment. Section II explains the factors that have reduced the Federal Reserves role in clearing and settlement over the last decade and presents estimates of the magnitude of the decline. Section III discusses the implications of the decline. The article concludes that a further decline could reduce the efficiency and increase the risk of retail payments.

I. HOW THE FEDERAL RESERVE PARTICIPATES IN CLEARING AND SETTLEMENT

Noncash retail payments made by consumers, governments, and businesses require a transfer of money from a payer's bank account to a payee's bank account. The transfer is facilitated by a clearing and settlement system) This section discusses the clearing and settlement of established types of payments and reviews emerging payments, which sometimes combine clearing and settlement of established payments. Each discussion highlights the role of the Federal Reserve in the clearing and settlement process.

What is clearing and settlement?

Noncash payments (wire, ACH, card, and check) are initiated in three steps that occur before clearing and settlement can take place. First, the payer authorizes the payment (such as by signing a check) signaling permission to transfer money out of a bank account. Second, the payee and the bank may then authenticate the payer and/or the payment instrument, for example, by looking at the payer's identification or by consulting records of the card issuer. And third, the payment is screened to help ensure it is not fraudulent, such as when a merchant consults a "bad check" list or a card issuer compares the payment with the cardholder's transaction history. The payment is accepted if it passes the screening tests.

After the payment is accepted, the payment is cleared. Payment clearing requires transmission of payment information from the point of initiation to banks and to third-party payment processors. …

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