Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Can the Fed Be a Payment System Innovator

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Can the Fed Be a Payment System Innovator

Article excerpt

We live in a time of rapid technological change, in which the arrival of new ways of conducting business has become a commonplace occurrence. One segment of the economy where these changes are having a particularly significant effect is the payment system, the web of banks and other institutions through which payments for goods and services are cleared and settled. New mechanisms such as smart cards and internet-based electronic money have captured the imagination of many payment system observers and participants. While earlier predictions of the death of paper money have proven premature, the unprecedented pace of technological advance in the last decade has given new hope to the prophets of the electronic age.

The Federal Reserve (the Fed) plays a prominent role in the payment system, both as a provider of payment services and as a regulator. The public interest in an economically efficient payment system has been at the core of Fed payment system policy since the Fed's founding in 1914. With new electronic payment mechanisms apparently within grasp, there has been renewed attention to the role of the Fed in the innovative process. A committee headed by Federal Reserve Board Vice Chair Alice Rivlin recently completed a study of the Fed's role in the payment system, which gave special attention to how active a role the Fed should play in guiding payment system innovation.1

Within the Federal Reserve System, electronic check presentment (ECP) is seen as a potentially promising step in the evolution toward electronic payments. With ECP, consumers and businesses continue to make payments with paper checks, but banks and clearinghouses that clear and settle payments use electronic information "captured" from the checks shortly after they are first deposited in the banking system. (See Appendix.) While some ECP services are now available, many important aspects of full-scale implementation are still under discussion. The Fed's role in developing and promoting ECP is clearly aimed at the public interest objective of enhancing payment system efficiency. In what follows, we ask whether the Fed can be a payment system innovator while remaining loyal to its fundamental public interest objective. In particular, how can we ensure that the Fed's payment system leadership contributes to economic efficiency?

Our approach to this policy question is founded on the notion that the payment system is a communications industry. Such industries involve substantial common costs-costs that cannot be uniquely attributed to any one user. This cost characteristic has important implications for industry behavior. The critical issue in such industries is how common costs are allocated across users.

Markets for communication services (including payment services) tend to be heavily regulated and, in some instances, served by government-owned enterprises, such as the U.S. Postal Service. Concerns about "universal access" often motivate government intervention. Here, universal access is usually interpreted as a concern about the cost of services to a particular class of users: residential phone customers, rural postal patrons, or small and remote depository institutions. Access has been provided through price regulation, as in telecommunications, and by direct government provision, as in the U.S. Postal Service.

We show that government involvement in other communications industries offers lessons for the role of the Federal Reserve in the payment system. In both the telecommunications and postal services industries, legal barriers to competition historically have helped sustain the provision of universal access. Barriers to competition allow the shifting of common costs to be pushed to the point where some users are subsidized, in a sense that we will make precise later. Such subsidization is inconsistent with economic efficiency, and would be impossible without barriers to competition. We point out that the Federal Reserve Banks still benefit from some barriers to competition-privileged treatment under current check presentment regulations-that would allow them to subsidize should they choose to do so. …

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