Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

The Organization of Private Payment Networks

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

The Organization of Private Payment Networks

Article excerpt

One of the key roles banks have traditionally played is in the execution of payments among participants in the economy. Liabilities issued by banks, such as demand deposits, are a primary means of payment. The widespread acceptability of such private liabilities requires a reliable method for the settlement of such obligations. In a world where people and economic activity are dispersed in space and time, settlement often requires a method for communication between locations where purchases of goods take place and those where payment liabilities are issued. That is, the use of bank liabilities as means of payment requires the support of an interbank network for clearing and settlement.

Throughout U.S. banking history, such multibank networks have played important roles. In New England during the Free Banking period (1836-1863), the system that was centered around the Suffolk Bank in Boston widened the area over which many banks' notes could circulate at par.l In the latter part of the nineteenth century, banks participated in clearinghouses for the clearing and settlement of local checks and had correspondent relationships to handle checks over greater distances.2 While the Federal Reserve (the Fed) ultimately took over a large part of the clearing and settlement of checks, the banking industry has developed other private, multilateral networks for handling interbank payments. Most notable, perhaps, are the nationwide credit card associations.

Recently, interbank networks have received considerable attention. The ongoing growth and consolidation of Automated Teller Machine (ATM) networks has stimulated discussions in the academic and public policy communities of possible antitrust issues raised by such large joint ventures of banking organizations. Much of the discussion of possible public policy concerns regarding coming forms of electronic money centers on the network characteristics of these instruments.

This article takes the position that networks are fundamental to the role played by intermediary institutions in the payment system. Clearing and settlement, as the means of managing the financial relationship among individuals or institutions across time and distance, are inherently network services. The characteristics of network services have important consequences for the industrial organization of the payment system.

Arrangements for clearing and settlement of payments, whether private or public, involve an effect that is sometimes referred to as a network externality. Broadly, the private value to an individual of belonging to a network increases with the number of endpoints to which that network connects. Put differently, the private value an individual derives from participating in a network is that the individual can communicate with the other network members. At the same time, the individual's participation creates value for other members by adding to the number of endpoints.

There is an important difference between network externalities and other forms of externality. Perhaps the most common textbook externality is pollution; the economic activity of some individuals may produce pollutants that affect a much broader set of people. While individuals make choices about participation in the activity that generates pollution, they may have little choice as to whether to be affected by pollution. In the extreme case of the greenhouse effect, for instance, it may be impossible to avoid incurring the costs of pollution. Pollution is an external cost that has effects beyond the set of people engaged in the polluting activity. Network externalities, on the other hand, are more selfcontained. An individual's decision to subscribe to a network creates external benefits for other subscribers by increasing the size of the network. Notice, however, that in order to enjoy the effects of the externality, one must join the network. The benefits to network participation, although partially external to the individual participant, are entirely internal to the network as a group. …

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