Related Links

• Diary of Consumer Payment Choice
• FedNow Explorer
• Payments 101: How Your Money Gets From One Place to Another
• Money and Payments: The U.S. Dollar in the Age of Digital Transformation

Transcript

Tim Sablik: Hello, and welcome to Speaking of the Economy. I'm your host, Tim Sablik, a senior economics writer at the Richmond Fed. I'm joined today by Vanity McDaniel, senior payments business analyst in the Payments Outreach group here at Richmond, and Zhu Wang, a vice president for research in financial and payment systems in our Research Department.

Vanity and Zhu, welcome to the show.

Zhu Wang: Thank you.

Vanity McDaniel: Thank you for having me here.

Sablik: As our listeners might have guessed by your job descriptions, today we're going to be talking about the Fed's role in payments, specifically payment innovations.

I don't know if both of you have had similar experiences but based on my own conversations with friends and family, I think many people associate the Fed with printing money, which is not quite right. I always have to disappoint them by telling them that I can't print money at work. But that said, the Fed does have a long history of involvement in the country's payment system. Maybe Vanity you could start by talking a bit about that history.

McDaniel: Sure. I'll begin by mentioning that the Federal Reserve has three core functions. That's monetary policy; supervision, regulation and credit; and then, of course, payments.

A quick history lesson for our audience today: It's commonly stated that the Federal Reserve was created to help end banking and financial panics that were frequent during the late 19th and early 20th centuries. But more accurately, the Fed was created to solve the currency problem, meaning the supply of currency did not expand or contract with the needs of the economy. Also, interestingly enough, during that period there were more than 30,000 kinds of currency in circulation. Therefore, on December 23, 1913, the Federal Reserve Act was created and it created a central bank that would furnish an elastic currency.

I will say the best way to view the Federal Reserve is that we are a bank for other banks. We have 12 districts that are independent of one another and they work collectively together to provide payment and settlement services to depository institutions that have master accounts with us. Payment services that were most prevalent in our earlier years include cash and checks.

I'll also highlight the payment services that are provided to the depository institutions are done at a cost. This cost is minimal and it allows us to compete with the market. There are other players in this space, which includes the Clearing House. They are a private entity owned by several large depository institutions. The Clearing House provides settlement services as well, and other third parties are in that mix, too. But circling back to the Fed, we also charge for our services, which allows the Fed to recover the cost for operating, which is a requirement under the Monetary Control Act of 1980.

Fun fact for you all: Present day, the Fed processes about 5 trillion payments daily. That's definitely a lot of payments.

Sablik: Wow. Can you give us some detail about the Fed's role in processing cash and coins?

McDaniel: The Fed distributes currency and coin to depository institutions. The Fed also sorts and authenticates and stores fit currency and then we destroy unfit currency. I'll also point out the Fed does not print currency as you mentioned earlier — that's the US Bureau of Engraving and Printing, known to us as the BEP — and the Mint produces coin.

Although cash trends continue to fluctuate significantly, cash is no longer the most used payment. Our currency in circulation numbers do remain high and have increased throughout the pandemic because people are using cash as a store of value, which is something we have seen in the cash operation even prior to the pandemic. Typically, cash orders will increase significantly during times of uncertainty, like the pandemic and natural disasters, etc.

We also do a lot of research on consumers' payment behaviors here at the Fed. I encourage the audience to take a look at the Diary of Consumer Payment Choice, which is a survey designed to study the purchase and payment behavior of US consumers. This study is provided by the Cash Product Office, known to us as the CPO, and they partner with the Atlanta and Boston Feds on this initiative.

Sablik: Yeah, that's a great suggestion. We can definitely put a link up to those studies on the show notes.

McDaniel: Sure.

As far as checks, back in the day Reserve Banks provided check collection services to depository institutions. If we were to go back in time back to 2003, there were 45 check processing sites within the Federal Reserve System. But not surprisingly, with the decline in check usage and the move to processing checks electronically due to Check 21, the Fed significantly consolidated its check processing services.

Just to clarify for the audience, Check 21 is a federal law that was designed to enable depository institutions to handle more checks electronically. I'll also emphasize that the Fed championed the effort to pass the Check 21 Act. I think that speaks to the Fed's willingness to make difficult decisions and take difficult actions that benefit our payment system as well as the public as a whole.

Fast forward to present day, we only have one check processing site and that is located at the Atlanta Federal Reserve. Although check volumes continue to decline, a lot of businesses still use checks to process payments because it's an easy audit trail, there's an opportunity to float payments [and] it's easy for a smaller organization [to use checks] that doesn't have the resources or maybe payment volumes to participate in other settlement options.

Sablik: That's a great example of how the Fed has adapted over the years to changes in payments and payment technology. As you were mentioning, fewer people pay with cash and checks today than when the Fed was founded over 100 years ago. How is the Fed involved in newer emerging payment technologies now?

McDaniel: Our payments role here at the Fed has definitely evolved over time. In the beginning, we were currency and then check intensive in our work. But with the introduction of electronic payments, we found ourselves serving as more of a primary provider of electronic services, including things like ACH and wires. ACH is also known as the Automated Clearing House system that is owned by the Federal Reserve.

Earlier in the conversation, I mentioned the Clearing House that is owned by several large banks. Well, they provide ACH settlement services as well. So, ACH is just another payment method that helps facilitate the movement of funds between depository institutions. It uses a batch process typically for regular reoccurring payments, like your mortgage or car loans, direct deposit payments that are known days ahead.

We began offering Same Day ACH last March. That allows you to process ACH last minute. We also offer FedGlobal ACH, which is for cross-border payments or payments outside of the US. We offer that service to more than 30 countries. Then there's also Fedwire Funds, another system that is owned by the Fed. Wire payments are usually large dollar and non-recurring in nature, real time and irrevocable. I'll also mention that the Clearing House provides wire services as well via CHIPS, which is the Clearing House Interbank Payment System.

I will say wires are typically an expensive payment rail to use. There's definitely a markup in the pricing for consumers to use this payment method. That is because this method is more secure. It allows individuals to have quicker access to their funds, anywhere from a few minutes to a few hours. Worst case scenario, it might take up a couple of days for it to clear and that just might depend on the verification process that has to happen.

Sablik: Right. Certainly, when it comes to purchases at retail stores or things like that, many consumers are more used to using debit or credit cards and those use payment rails that are operated by private companies like Visa or MasterCard.

I know a lot of [Zhu's] research has focused on how card networks compete with one another. I'm wondering if maybe you could talk a bit about that and how the Fed fits into that picture.

Wang: Sure. Credit and debit cards have indeed become dominant payment means for consumer purchases, for both in-person and remote transactions. A recent Federal Reserve study shows that card payments accounted for almost three quarters of noncash payments, with a combined value exceeding $7 trillion a year.

Unlike in the case of cash, check or ACH, the Fed does not play an operator role in the card payment space. Rather, it has served them mainly as an overseer or regulator.

To give an example, the most controversial issue of the current payment system is interchange fees, which are the fees paid by merchants for card issuers for accepting card payments. Over the years, merchants have complained that card networks and their issuing banks have used market power to set excessively high interchange fees, which drive up merchants' costs of accepting card payments. Following Congress' mandate known as the Durbin amendment of the Dodd Frank Act, the Fed has regulated debit card interchange fees since October 2011. The regulation caps the maximum interchange fee that the issuer can collect from merchants for debit card transactions. It also sets rules that prohibit certain restrictions imposed by card networks on merchants. Since its implementation, the regulation has made a major impact on the industry.

One thing we may want to keep in mind is that the arbitrator role and the regulatory role that the Fed plays in the payment space are not independent to each other. For example, being an operator in the noncredit payment space allows the Fed not only to provide a competitive service in those sectors but also to provide competing services to cards, which helps to enhance the competition and performance of the card market.

Sablik: Yeah, that raises a good point that the Fed has this dual role as a provider and also a regulator. How does the Fed decide whether to provide a payment service itself versus leaving it to the private sector?

Wang: I think the fundamental consideration here is the value of the Fed as a central bank. It has comparative advantages in providing service comparing with the private sector. The value of the Fed's entry could effectively address market failures and improve the efficiency and acceptability of the service.

For example, central banks maintain reserve or settlement accounts on behalf of major financial institutions. Because of this, central banks have a competitive advantage in performing interbank funds transfer services. This comparative advantage, along with concerns over systemic risk, is a main reason why most central banks, including the Fed, operate large-value payment systems.

As another example, the Federal Reserve has been active in check operations since its founding. Its early involvement was a response to the fragmented nature of the industry. At the time, many banks charged a fee for clearing checks and remote locations were inadequately served. By entering the market and ultimately becoming a prominent operator, the Fed was able to address market failures – namely coordination difficulties and the network effects — and to improve the efficiency and accessibility of check collection and processing.

Most recently, the Fed has announced that it will be creating a real-time payment service called FedNow, which is slated to launch next year. The question has been debated regarding whether the Fed should enter the space as an operator. Vanity, you probably can share with our audience how the Fed decided to launch the FedNow Service.

Sablik: Right. Maybe you could start by explaining what FedNow is for listeners who might not be familiar with it.

McDaniel: Sure. FedNow instant payments has been a hot topic in the industry. The service is an interbank, real-time gross settlement service that will allow payments to be processed 24/7 by 365. When available in 2023, the service will enable depository institutions to deliver end-to-end instant payments to their customers.

The FedNow team is based out of the Boston Federal Reserve and the team is led by Ken Montgomery. He's their program executive and he is also the first vice president at the Boston Federal Reserve.

The overarching goals for FedNow is to provide the industry with a secure, efficient instant payment method that is cost effective. We want all institutions to have access to this new technology, especially our smaller institutions. Beyond speed [and] convenience, instant payments can yield a real economic benefit for individuals and businesses by allowing them to make time-sensitive payments whenever needed and providing them with more flexibility to manage their money.

As far as the Fed getting in this space, the Board of Governors, who provides oversight to the Federal Reserve System, have established a set [of] criteria for evaluating new or enhanced payment services. As the Federal Reserve considers the introduction of new services or major service enhancements, the policy requires all of the following criteria to be met.

That is, the service should be one that other providers alone cannot be expected to provide with reasonable effectiveness, scope and equity. For example, it may be necessary for the Federal Reserve to provide a payment service to ensure that an adequate level of service is provided nationwide. This is a big reason that led us to creating our own instant payment method via FedNow — to ensure all institutions have access. Currently, the only instant payment that is out there is through the Clearing House with RTP or Real Time Payments. Although all institutions have the opportunity to have access to RTP, in my opinion I will say there could have been an opportunity to exclude smaller institutions if RTP were ever to have volume restrictions, etc. Overall, I think it's a good idea to have two organizations providing instant payments instead of just one.

Sablik: Mm-hmm.

McDaniel: Another criteria that has to be met is the Federal Reserve must expect that providing the service will yield a clear public benefit. Another big reason for creating FedNow, as I mentioned earlier, [is] instant payments will allow individuals to make time sensitive payments whenever needed and it will provide them with more flexibility to manage their money. Rather than waiting a few days or a few hours of access to their funds, they'll have immediate access to those funds.

The last requirement that has to be met is the Federal Reserve must expect to achieve full recovery of costs over the long run. This is another requirement that is stated in the Monetary Control Act of 1980.

Sablik: Gotcha. So, it's got to be competitive and fairly priced.

McDaniel: Right.

Sablik: You both mentioned that FedNow is scheduled to launch next year. Do you have any updates to provide on how that's going?

McDaniel: Yeah, that's always the burning question: What do we know? Tell us. Share more information about FedNow.

I will say I don't have the intricate details of the launch, per se, but I do know the FedNow team is still on track to have the service available by 2023. In addition, there is a pilot program happening right now that includes over 120 financial organizations. They have been able to attend different advisory sessions, webinars and roundtable discussions to learn more about FedNow and provide meaningful feedback to the team. At some point, various pilot members will assist with end-to-end testing, however I'm not sure when that will happen.

Recently, the FedNow team announced the pricing schedule. The cost for a single credit transfer is four and a half cents. This cost aligns with the industry. As I mentioned earlier, Real Time Payments through the Clearing House offer instant payments at the same price. However, there are some different nuances between the two services, such as FedNow requires a monthly fee and the transaction limit will default to $100,000 but can go as high as $500,000. Currently with the Clearing House, they don't have a monthly fee and their transaction limit is $100,000. [Note: The Clearing House increased the limit to $1 million on April 6.]

If you want to learn more about FedNow, I highly encourage the audience to sign up to receive email updates, and you can do that by visiting frbservices.org. The FedNow team also recently created a training tool as well. It's called FedNow Explorer and you can visit that at explore.fednow.org to learn more about FedNow.

Lastly, if you want to learn more about payments, please visit richmondfed.org. Click on the Education tab at the top then click on the Resource and Programs tab at the top and there'll be a module called Payments 101. That is an interactive training course that will guide you through the evolution of the payment rails that we provide here at the Federal Reserve.

Sablik: Great. Thanks, Vanity. Thanks for that overview. We'll definitely be keeping an eye on those FedNow developments.

In addition you mentioned faster payments is a hot topic, people are talking about it. People are also interested in digital currencies and the Fed and other central banks have been exploring possibly issuing a digital currency. China, for example, is in the pilot phase of launching its own digital currency. The Fed's Board of Governors recently released a discussion paper on digital currencies earlier this year.

Zhu, maybe you can talk about how would a digital dollar be different from what we have today and what would be the potential benefits of issuing one?

Wang: Central bank digital currency, or what we call CBDC for short, has indeed been a very hot topic these days. In recent years, as cash transactions decline and cryptocurrencies emerge, many central banks around the world are exploring the potential for creating their own digital currency. A recent Bank of International Settlements study shows that amongst 65 central banks surveyed, 86 percent indicated that they are exploring CBDCs and a few of them have moved into pilot or even launching stages.

In simple words, CBDC is a central bank liability issued in digital form to the general public. When we think a CBDC is just a digital form of physical cash, because it takes a digital form a CBDC can fulfill functions and have use cases different from physical cash.

Sablik: Mm-hmm.

Wang: There are various reasons for central banks to consider issuing CBDC. For many developing countries, CBDC can be a useful tool to modernize their payment system with digitalization. However, for an advanced economy like the U.S., digitalized payment systems already exist and they function well.

So, I think a more compelling reason for the U.S. to consider a CBDC would be to futureproof our payment systems from emerging challenges in an increasingly digital world, especially the potential rise of private and foreign digital currencies. For example, private or foreign digital currencies, if not effectively regulated, could raise major concerns on issues such as payment fragmentation, views of privacy, market power, monetary policy and financial stability.

At this stage, whether or when to issue a CBDC and how to design the CBDC are open questions. The Federal Reserve has been conducting active research and development in this area. As the recent Federal Reserve Board discussion paper pointed out, the Fed will continue its exploration of CBDC and we will also continue seeking input and feedback from a wide range of stakeholders and the public along the process.

Sablik: Yeah, it will be an interesting space to watch, for sure. It'd be great to have both of you back on the show to talk about any new developments on faster payments and CBDCs as those happen. But I think that's all we've got for this episode.

Vanity already mentioned some resources that listeners can check out if they're interested in keeping up with developments in faster payments and we'll have links up to those on the show notes. For those interested in Zhu's research on payment networks and CBDCs, you can head over to the Economic Research section of richmondfed.org.

Vanity and Zhu, I want to thank you both for coming on to talk with me today.

Wang: Thank you, Tim.

McDaniel: Thank you so much. Happy to be here.