Introduction to Traditional Payment Systems

In this module, we will be exploring

the legal and policy issues associated with FinTech developments in payments,

wealth Management and account aggregation focusing primarily on developments in the US.

We will begin by diving deep into the world of payments,

which can immediately be very esoteric and could be a whole course unto itself.

Rather than get bogged down in the technical details of how US payment systems work,

I'll provide a high-level overview of how consumers have historically paid for goods and

services and legal and regulatory frameworks applicable to each of these payment methods.

From there, we will explore the latest FinTech developments in the payments sphere,

and how they fit into the existing regulatory framework.

We will end our discussion on payments by looking at an effort spearheaded

by the Federal Reserve to bring about a faster payment system in the US.

Imagine the year is 1908 and Kate walks into our local Starbucks to buy a cup of coffee.

To pay for her coffee,

Kate has four options;

cash, credit card, debit card or personal check.

Now fast forward 20 years into 2018 and Kate still loves her Starbucks.

Now when she walks into the store,

she has a multitude of payment options available to her.

She can still pay with cash,

credit card or debit card or she can pay with the Starbucks mobile app,

Chase Pay, Apple Pay,

PayPal or Visa Checkout.

However, one option available to Kate in 1998 personal check,

is no longer accepted by Starbucks,

which is probably appreciated by the people waiting in line behind her.

All these payment options have different implications for Kate and for Starbucks.

For Kate, her choice of payment determines whether she can resend the transaction,

whether her money is at risk if her account is

compromised and whether she's exposed to overdraft or limit fees.

For Starbucks, Kate's choice of payment determines when they will

receive value for her purchase in the amount of if any,

transaction fees they must pay.

As we will see, behind each of

these payment methods is a unique system with its own procedures and

rules that transfers value from

the customer's financial intermediary to the merchants financial intermediary.

Many of the new payment technologies we will explore,

want to top the rails of older payments infrastructure and

therefore fit within established legal frameworks that govern various payment methods.

While other new technologies such as payments sent through distributed ledger technology,

utilize entirely new networks that are not subject to a well-defined legal framework.

Before we get into these details,

let's take a look at how US consumers pay for things

and how their payment preferences have changed over time.

This chart utilizes data from

the Federal Reserve's diary of consumer payments choice which

tracks consumer payment transactions over

a three-day period for a representative sample of consumers.

We can see that cash remains the most frequently used payment instrument.

Accounting for 31% of all consumer transactions.

While debit card is the second most frequently used payment method.

Accounting for 27% of payments volume.

However, cash payments account for just 8% of the value of

consumer purchases while electronic payments in the form of

electronic credit and debit transfers using the automated clearinghouse system,

account for 32% of the value of all transactions.

These rules imply that the value of the payment

appears to influence whether a consumer chooses to use cash,

debit, credit or another form of payment.

In this graph we can see that cash is used most often for payments of less than $25,

while credit and debit cards are used more frequently for

payment's value between $25 and $100.

Checks and electronic payments are used more

frequently for transactions that are at $100 and over.

FinTech payment platforms such as Venmo,

are part of the other category which you can see

accounts for a small share of payments volume and value.

As you saw with the Starbucks example,

consumer payment preferences have evolved over time.

Here we're using data from a separate federal reserve study that reports

the aggregate number of various non-cash payments

that have been made by US consumers and businesses over time.

We see that in 2003,

checks were the most common non-cash payment method

accounting for close to half of all non-cash transactions.

The digital revolution quickly made checks obsolete and today,

checks account for just under 13% of all non-cash transactions.

As sharply as checks have fallen,

debit cards have risen.

Today, debit cards account for 59% of

all non-cash transactions while credit cards are the next most popular payment method,

accounting for 24% of all non-cash payment transactions by businesses and consumers.

Different laws, rules and regulations govern all of these payment methods.

The laws governing payment systems are passed by the US Congress and

state legislatures and regulations are then

established by federal and state agencies to implement these laws.

In addition, payment system operators and providers have established their own rules and

agreements that provide more details on

the rights and obligations of the users of the payment system.

These frameworks are designed with one purpose in mind, to facilitate settlement.

Settlement simply means that whatever is purchased is delivered

to the buyer and the payment per said purchase is major the seller.

Well this may sound straightforward,

achieving settlement is a complicated process.

So let's take a look at the steps that typically

take place before any kind of payment is complete.

The initiation of a payment begins when

either the payer or payee in a payment transaction or

a third party sends an instruction to

another entity that triggers a process ultimately leading to a payment.

This initiates a process that authenticates the identity or veracity of a participant,

device, payment or message connected to a payment system.

Authentication may happen at multiple points in the payment process,

for example end-user identity maybe verified when the end-user enrolls with

a provider or additional checks maybe built in to verify the identity of the payer,

account or account provider for

instance by entering a password during the payment process.

During the authentication process,

the payer's account provider verifies that the payer's account has

good funds or credit necessary to complete the transaction.

From there, the payment is authorized which involves

explicit instructions including timing, amount, payee,

source of funds and other conditions given by the payer to

their account provider or to the payee to transfer funds on a onetime, a recurring basis.

The next step is to clear the payment,

which involves the payer and payee's account providers

exchanging payment information to confirm a transaction prior to settlement.

Then comes receipt, which is the point when funds are received by

the payee such that funds can be withdrawn or transferred.

Next comes settlement, which in some payment systems come before receipt,

where obligations and respective funds between two or more entities are

discharged and finally the payment is reconciled.

Meaning a procedure is followed to verify that the records are

issued by entities involved in a transaction match.

Note that each payment method uses a slightly different processing approach,

it may not follow all the steps I just mentioned or in the order I mentioned them.

Nonetheless, these steps reflect

the general process a payment go through to achieve settlement.

With that in mind, let's turn our attention to two of

the oldest payment methods in the US, cash and check.

While the government is required to accept cash as valid payment,

there's no law that requires private individuals

or businesses to accept cash or coins as payment.

Therefore cash is a trust-based system

that works along as the public has confidence in it.

Cash is a preferred form of payment for many people because

it does not require or record the identity of end-users.

Until the launch of Bitcoin,

cash was the only payment instrument with such features.

The main risk associated with using cash is theft or loss,

and this rest is borne entirely by the holder of cash.

However, this loss is limited to the amount of cash the owner actually carries.

When you use cash to pay for goods,

say a carton of milk at the store,

settlement is achieved the moment you hand

your cash to the cashier and he hands you the milk.

Checks on the other hand,

achieves settlement by moving funds from the payer's bank to

the payee's bank by decreasing

the payer's account balance and increasing that of the payee's.

So imagine again the year is 1998 and Kate pays for a Starbucks with personal check.

Settlement is achieved for the following steps.

First, Starbucks deposits Kate's check and Starbucks' bank credits Starbucks account.

Starbucks' bank in turn presents a check to its regional federal reserve bank,

which credits Starbucks' banks account at the Federal Reserve,

and passes the obligation on to Kate's bank.

The Federal Reserve Bank then debits the account that

Kate's bank maintains as a Federal Reserve Bank.

Finally, Kate's bank satisfies the claim by debiting the amount from Kate's account.

Well we know that checks are becoming less frequent form of payment,

the process by which checks are settled is similar for all non-cash payment systems.

In essence, settlement is achieved by updating

ledgers at different financial intermediaries to adjust

deposit balances in accordance with the transfer of

claims as they move along the chain from payer to payee accounts.

Checking is governed by both state and federal law,

at the state level checks are negotiable instruments,

such as provisions of the Uniform Commercial Code which was

established to make it easier for

businesses in different states do business with each other.

At the federal level,

checking is governed by provisions of

the the expedited funds availability act and the Check clearing for the 21st Century Act,

also known as check 21.

The expedited funds availability Act,

requires banks to make funds available to account holders within

specified time frames and to disclose their policies on funds availability.

Federal Reserve regulation CC,

is a regulation that implements the Act.

Check 21 allows the recipient of

the original paper check to create a digital version of the original check,

thereby eliminating the need for further handling of the physical document.

In essence, the recipient bank no longer returns a paper check

but effectively emails an image of both sides of the check to the bank it is drawn upon.

Another effect of the law is that is now legal for anyone to use

a computer scanner or mobile phone to capture

images of checks and deposit them electronically.

A process known as remote deposit.

Unlike cash, checks do not settle instantaneously which

therefore exposes depository institutions to the risk of non-payment and fraud.

Generally speaking, the laws and regulations governing checking require

banks to bear the responsibility for

losses that would be typical for another party to avoid,

such as a loss arising from an unauthorized check.

As you will see in the next lecture,

debit cards are subject to many of the same laws and regulations that apply to checking.

We will also discuss the legal framework associated with credit card transactions.

FinTech Law and Policy

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