What does the Fed want? Faster, cheaper, and smarter payments. Photo: Federal Reserve
If the Federal Reserve is notorious for being vague and ambiguous—former Fed Chairman Alan Greenspan was particularly famous for his use of “Fedspeak”—the central bank has been unequivocally clear about what America needs: a universal real-time payment network.
The Fed outlined its position in a public consultation paper last September, identifying a number of key areas where the US system is lagging:
- Outdated technologies like paper checks and inefficient legacy systems remain pervasive because they work. They’re ubiquitous and convenient. The problem is that they don’t work that well and complicate the transition toward a truly digital system.
- Around the world, “countries are moving to ubiquitous near-real-time retail payment systems.” Meanwhile, the US is getting left behind.
- Innovation is happening in the payments space, but results are patchy due to the network effect.
- In general, cross-border payments from and to the United States are slow, inconvenient, costly, and lack transparency regarding fees and timing.
In light of these problems, the Fed thus concluded:
End users of payment services are increasingly demanding real-time transactional and informational features with global commerce capabilities. Legacy payment systems provide a solid foundation for payment services; however, some of these systems (e.g., check and ACH) rely on paper-based and/or batch processes, which are not universally fast or efficient from an end- user perspective by today’s standards.10 The challenge for the industry is to provide a payment system for the future that combines the valued attributes of legacy payment methods – convenience, safety, and universal reach at low cost to the end user – with new technology that enables faster processing, enhanced convenience, and the extraction and use of valuable information that accompanies payments.
The first sentence is key. Not only does the Fed want real-time payments, so does everyone using the system. And if this weren’t explicit enough, the paper goes on to outline, point by point, exactly what the central bank hopes to achieve:
“Desired outcome 1: Key improvements for the future state of the payment system have been collectively identified and embraced by payment participants, and material progress has been made in implementing them.”
In its custodial role overseeing the system, the Fed requires the consensus of industry participants. Along those lines, their number one outcome could be interpreted as a call to arms, imploring key players to come together and work it out. Beyond nudging the industry in the right direction, the Fed can only do so much on its own.
“Desired outcome 2: A ubiquitous electronic solution(s) for making retail payments exists that does not require the sender to know the bank account number of the recipient. Confirmation of good funds will be made at the initiation of the payment.11 The sender and receiver will receive timely notification that the payment has been made. Funds will be debited from the payer and made available in near real time to the payee.”
What does the Fed want the industry to work together on? A ubiquitous real-time payment system. They’re really not dancing around this point, are they?
“Desired outcome 3: Over the long run, greater electronification and process improvements have reduced the average end-to-end (societal) costs of payment transactions and resulted in innovative payment services that deliver improved value to consumers, businesses, and governments.”
Having answered the “What?”—these next set of outcomes describe the “Why?” It’s evident why the Fed is willing to be so blunt. The benefits of a real-time payment system are pretty obvious—such as having an economy built on a truly digital (electronic) platform.
“Desired outcome 4: Consumers and businesses have better choice in making convenient, cost- effective, and timely cross-border payments from and to the United States.”
Naturally, a more frictionless platform that’s compatible and connected with the rest of the world opens up new markets and opportunities here at home.
“Desired outcome 5: The Federal Reserve Banks have collaborated, as appropriate, with the industry to promote the security of the payment system from end-to-end amid a rapidly evolving technology and threat environment. In addition, public confidence in the security of Federal Reserve financial services has remained high.”
Which brings us to their final point. Having argued their case, the Fed wants us to understand that they’re doing the right thing.
So what’s holding us back? While the Fed can make a convincing case—outcomes 2 through 4—it’s hands are tied if the industry doesn’t play ball and without public support—outcomes 1 and 5.
Promisingly, the industry for the most part supports the Fed’s initiative, according to the feedback summary report released in March. Approximately three quarters of respondents agreed with the “gaps, opportunities, and desired opportunities” outlined in the consultation paper.
Achieving consensus, however, is a bit more complicated. In an industry as far-reaching and as fundamental to the economy as payments, there are a wide range of constituents and their incentives won’t always align. As is always the case, innovation is going to step on someone’s toes. Real-time payments could cannabilize existing revenue streams like credit cards and wire transfers while opening up the potential for outside competition.
Payments is a huge source of revenue for financial institutions. Chart: McKinsey
So it’s not particularly surprising that certain players would be supportive of these technologies but hesitant to immediately comply—which isn’t necessarily a bad thing. It just means certain businesses will have to carefully consider the implications of innovation so they can properly adapt. But it also makes reaching an industry-wide consensus all the more challenging.
“Payments is pretty lucrative for financial institutions so speed can be an issue,” one Fed insider told me of the challenges ahead. Beyond the issues of security and the risk of fraud, the industry needs to agree on a business model that works. “If I am able to offer that speed to a consumer or business or corporation, what are they willing to pay for that? Is there a way for financial institutions to turn that into a revenue opportunity?”
It’s this question that current industry players face, evidenced by the public response to the consultation paper by one of the country’s biggest banks. While expressing genuine support of technological innovation, JPMorgan Chase required further clarity on the business side of things:
JPMC is supportive of further innovation around near-real-time payments and wants to see the industry proceed with new solutions that make sense, recognizing that the industry is already at work on several such initiatives. The Federal Reserve can lead the industry dialogue on near-real-time payments innovation which have value to all stakeholders and meet the Federal Reserve’s safety and soundness requirements.
The industry has long talked about a “FedEx” model, where end users pay different prices for different levels of speed, certainty and information around payments. We believe this is fundamental to the successful implementation of a real-time payments initiative, and that the use cases need to fit into this model, where users will actually be willing to pay for the increased speed they are receiving.
Still, others took a more protective stance, especially ones already operating widely used payment networks. Visa and Mastercard both argued that the current market was well-served and that government intervention could inadvertently stifle innovation and competition.
Predictably, outsiders were resoundingly supportive with Google applauding “the Federal Reserve Banks’ effort to improve the speed and efficiency of the U.S. payments system.”
In the US, paper checks and costly wire transfers remain prevalent. Chart: McKinsey
The only conclusion then is the lack of one, which has become the Fed’s fundamental dilemma despite the central bank’s good intentions. And that’s a problem, says prominent economist Susan Athey. [Professor Athey is a board member of Ripple Labs.]
“It seems clear that innovation is needed, right? So it must be right around the corner? Likely, the relevant government regulators are just being slow. Right? Wrong. Rather, some key industry players don’t want to change, and even among those that do, it will take many years to reach consensus for how to change,” Athey said.
All of which leaves us with the final piece of the puzzle—outcome 5—the public. Payments has never been a particularly sexy topic, and in general, the public doesn’t seem to care, at least not enough to make a fuss about it. They probably have more important things to worry about—like unemployment or rising college tuition costs. But maybe they should, says Karen Gifford, a New York Fed alum and Chief Compliance Officer at Ripple Labs.
“The radical reduction of payment costs could be a huge engine for economic growth, right at a time when our economy needs it,” Gifford said. “Currently it doesn’t make economic sense to send $100 to Europe because of the fees involved. If fees go down enough that people could begin building businesses around payments of this size, just imagine the positive impact that could have. Small businesses are the job creators in the the US economy and small dollar value payments are the lifeblood of small businesses.”
And even if those being served by the current system feel that it’s good enough—as many financial institutions like to suggest—it’s the underserved that have most at stake, Gifford says.
“Today, unreasonably high fees are driving ordinary people out of the traditional banking system, and there is little discussion—or even recognition—of the risks to the system caused by this trend,” Gifford said. “The the implications for consumer protection are plainly concerning. There are concerns related to AML [anti-money laundering] risk as well. As people like teachers and firefighters are driven out of banks, they get mixed in with bad actors who can’t access the banking system for other reasons, effectively giving those bad actors cover.”
If convincing the public can be just as difficult, if not more so, as reaching an industry consensus, a solution might require a different approach, which admittedly is easier said than done. But in reality, it’s a narrative we’ve seen time and again—where the arrival of new technologies coax people to adjust lifelong habits and companies to address tired business models. Innovation always seems to find a way.
Take music: In the 90s, it looked as if nothing could challenge the supremacy of the CD, the industry’s most popular format ever by a wide margin. Despite being forced to buy an entire album even if they were interested in only one or two songs, consumers didn’t seem to care. They happily bought 785.14 million albums in 2000, the year sales peaked.
But we know how this story ends. Just before Y2K, the world had been introduced to Napster. A year later, Apple would unveil the iPod. Fast forward to today, CD sales are at historic lows. Rather than buying music from record labels, we experience it through technology companies—downloading it from iTunes or watching it on YouTube. Lately, we’ve taken to streaming—mostly for free—thanks to Spotify, Pandora, and countless emerging upstarts.
Chart: Michael DeGusta
Of course, this story really began in 1995 with the invention of MPEG-2 Audio Layer III—commonly known as MP3. Back then, many wondered the value of this lossy compression algorithm. Even today, the format serves little consumer or business purpose. What MP3 achieved with flying colors was proving a point, and in the end, that’s all that was required. This was the first time music lived and breathed on the internet. In doing so, MP3 would turn our world upside down. By showing us what was possible, we suddenly expected and demanded that much more.
Indeed, against the backdrop of the internet, it’s a transformation we’ve witnessed across nearly every industry—whether it’s music, print journalism, or more recently, television. For all intents and purposes, payments is the last man standing—which, going by history, can only mean that it’s next. Is Bitcoin the MP3 of money? Are there echoes of Napster in the now-defunct Silk Road? Could technology once again shift our expectations and demands? Will innovative outsiders provide the Fed with exactly what it wants but can’t get from the existing industry?
The Fed appears to be increasingly open to that possibility. Earlier this month, the Federal Advisory Council (FAC), a group that “consults with and advises [the Fed] on all matters within [US] jurisdiction” concluded that “Bitcoin does not present a threat to economic activity by disrupting traditional channels of commerce; rather, it could serve as a boon.”
These sentiments align with the views of St. Louis Fed Economist David Andolfatto. “As history shows over and over, when transaction costs fall, trade expands,” Andolfatto said. “This was true with the development of canals, railways, etc. I expect the new wave of technologies to promote trade in the same way.”
Indeed, Andolfatto encouraged the Fed to embrace such technologies in a presentation last month: “Well-run central banks should welcome the emerging competition—There is (in my view) room for beneficial coexistence.” Andolfatto added that “together with Ripple,” the Fed’s application of a peer-to-peer payment system could “facilitate low-cost payments.” In other words, just what the doctor ordered.
- Fidor: Building the Bank of Tomorrow With Ripple
- Banks of the Future
- Fidor Bank AG: The First Bank to Use the Ripple Protocol
- Why Payments Matter
- 5 Questions For St. Louis Fed Economist David Andolfatto
- Welcome Susan Athey to Ripple Labs
Follow Alec on Twitter: @sfnuop