Pay By Group University: Payments 103
Welcome to the final entry in our series of introductory articles on payment in the U.S.! We’ve covered a lot of ground so far, including core payments systems, domains of payment, and payments systems regulations, functions, and flows. Now we’re going to bring it home with a look at the economic models for payments systems, managing payment risks, and the dynamics of cross-borders payments.
Payments Systems Economic Models - How to Make Money Sending Money
As payments systems gatekeepers, providers (e.g. processors, networks, and banks) make money by providing system access to end parties (e.g. merchants, consumers, businesses, governments, and other enterprises) and charging for that access. Processors and networks can make money by providing payments services to various intermediaries (like banks), and such intermediaries often provide services to other intermediaries as part of their business relationships. Merchants can also provide revenue-generating services (such as gift cards) directly to consumers.
Providers have a direct business relationship with their end parties in both open- and closed loop systems. They set service prices and create revenue directly via fees and indirectly via net interest on deposit balances, float, and interchange.
- Float: “duplicate” money that has been credited to an account holder before being deducted from the sender’s account, due to delays in check clearing. The money therefore appears in two places at once! Because of this quirk, the money can be used as an investible asset by the intermediaries on both ends of the transaction. Since check use is generally on the decline, and innovations like electronic check presentment or “image clearing” (by which checks are cleared using a scanned image of the check, instead of receipt of the physical check) are constantly reducing check clearing time, float may soon go the way of the dodo.
- Interchange: value transferred directly from one intermediary in a transaction to the other involved intermediary. Although the payments system sets the interchange rate, it does not itself receive the value of interchange. Interchange thus acts as an incentive by offsetting some of the costs incurred during the transaction for one of the intermediaries. Essentially, it’s a fee paid by one intermediary to its counterpart in partial recompense for conducting the exchange. There can be a vast difference in transaction costs between systems that have interchange and those that don’t.
Providing payments services incur a mix of fixed and variable costs. Fixed costs are traditionally high (e.g. staffing and maintaining a bank branch) while incremental, per-transaction costs tend to be low. Newer models such as online-only banks capitalize on this discrepancy by reducing the typical fixed costs of brick-and-mortar institutions, passing savings along to their customers and driving volume. However, technological advances such as image clearing reduce certain fixed costs (in this case, sending and storing physical checks) for traditional banks and allow them to stay competitive in the ever-changing payments world.
Providers who generate revenue based on the gross value of their payment transactions (known as ad valorem revenue) tend to receive greater profits than those who are paid on a fee-per-transaction or “click fee” basis. This revenue may be direct or indirect as discussed above.
Exceptions occur due to human or technological error, bounce, or charge inquiry and dispute. Costs tend to be much higher for exception items than normal transactions, and the efficiency a provider brings to bear in handling them can be the defining economic factor for a particular product or service.
Over time providers have grown ever more audacious in the prices they charge their customers for exception processing, such that the revenue from a given exception transaction can vastly eclipse the cost of the original transaction. Think of a $35 overdraft fee due to the absent-minded purchase of a $3 latte, and the profitability of such pricing becomes painfully apparent.
Risks and Risk Management - What Can Go Wrong, Will
Payments, like most things in life, are subject to risks, and all participants in a transaction shoulder some part of that risk. There are several broad categories of risk inherent in payment transactions, with fraud being perhaps the most visible and prevalent, so we’ll begin there:
- Fraud risk: Some of the countless types of fraud risks are specific to a particular payments system or systems (such as check forgery), while others are more broadly applicable. Some systems have clearly defined fraud management rules and procedures, while others allow participating intermediaries and end parties more leeway in managing such risks. A note on the cycle of fraud: Since the payments industry is constantly evolving, and scammers are quick to probe new services, practices, and technologies for fraud potential, there tends to be a cycle of fraud management whereby fraud spikes in a given system, providers implement new safeguards, and fraudsters jump ship to a new tactic, system, or environment. Since preventing and reversing fraud incurs costs of its own, a certain amount of fraud is essentially accepted by the payments industry as the cost of doing business, and providers are perpetually evaluating the cost of fraud versus the cost of fraud protection.
- Credit risk: The most obvious credit risk is borne by credit card issuers, since a cardholder might fail to repay their balance. Additionally, banks incur credit risk when they extend an overdraft instead of bouncing a pull payment due to nonsufficient funds. Also, the “sending” bank in a pull transaction incurs credit risk by assuming financial liability for its end party’s actions.
- Operations risk: This happens when parties to a transaction fail to act as expected or err somewhere in the transaction process. These could be human errors, mechanical failures, software bugs, or one of many other possible situations that can result in severe financial consequences. While each payments system operates with rules and practices meant to help intermediaries recover from and mitigate losses due to such errors, it’s not always possible to recoup the full cost of such operational mistakes. Since third parties often act on behalf of banks in the transactional chain, the banks usually bear the legal onus of mistakes on the part of these non-bank intermediaries. As such banks are often required to regulate and even certify such third-party participation by the larger payments systems.
- Liquidity risk: This occurs when one party to a transaction fails to fulfil their financial obligation to the other. End parties have liability to their banks and banks have liability to the network in open loop systems. The network has liability to the banks in return, and their vulnerability is called settlement risk. Banks don’t have to worry about the liquidity other banks in their network when receiving money from them for this reason, but the networks do. If a network member goes out of business when in a net debit position, the network usually has to pay that member’s obligation to the others. Most open loop networks limit participation to regulated financial entities that meet specified capital criteria.
- Data security risk: This is when end party data stored by providers, intermediaries, networks, and other end parties is vulnerable to theft and fraudulent usage. The card networks have created and enforce the Payment Card Industry Data Security Standards, or PCI-DSS, in order to combat this risk.
- Reputation risk: This occurs if and when end parties lose faith in the integrity of a given payments system, as when the theft of credit and debit card data from major merchants is publicized by the media. A great enough blow to a system’s reputation causes end parties to withdraw participation and look elsewhere.
- Legal risk: Intermediaries, processors, and networks become vulnerable to varying degrees of risk when rules or regulations are understood or acted upon inconsistently, usually during periods of change in established practices.
When an end party in the U.S. (or any nation) wants to pay a party in another country, they must use cross-border payments. Because payments systems typically operate on a single-country basis, cross-border payments frequently require two totally separate transactions in the sending and receiving countries respectively. This holds even when the transaction involves the same currency, such as between two countries in the European Union.
Still, the transactions must be settled among the involved banks. In open loop systems this is accomplished by the use of correspondent accounts banks have with one another, which may be located in either of the involved countries or a separate one altogether. The Society for Worldwide Interbank Financial Telecommunication, or SWIFT, provides a global network for just such interactions, and the majority of international interbank communications travel via this secure and standardized matrix.
Because payments systems in different countries can have vastly different rules and regulations, practices, and data formats, cross-border payments are extremely complex and often incur sizeable fees.
Certain payments systems that appear to have a unified global scope, such as the global card networks, actually bind various single-country payments system “behind the curtain.” This hides the complexity from end parties, and often participating intermediaries. There are, however, emerging services and systems that seek to bypass multi-system intricacies, such as the Single Euro Payments Area, or SEPA, which creates new debit and credit systems that banks in participating countries can join directly.
Closed loop payments systems and payments services providers (such as PayPal) also allow end parties in different countries to transact with each other, but still must create relationships with country-specific banks or payments systems to process such transactions.
Summary of U.S. Payments Systems - Bringing it All Together
We’ve taken a basic look at payments systems in general and their operations in the U.S. in particular. Given what we’ve learned, let’s take a parting look at how the six systems all stack up with regard to ownership, regulation, operations, payment types, and risk.
- Cash” Operates under virtual ownership with regulation by the Federal Reserve Bank (FRB) and U.S. law. There is no transaction processing or settlement with cash, and all payments are push payments. Cash recipients are vulnerable to counterfeit.
- Check: Also a virtual ownership system, regulated both by the FRB and U.S. law but also private rules and agreements. Processes via batch and transitioning from paper to electronic means, and settlement occurs on a net basis. All payments are pull payments, and the depositing end party risks fraud and bouncing.
- ACH: Owned by banks, and regulated both by the FRB and NACHA, the Electronic Payments Association (formerly the National Automated Clearing House Association). Uses electronic batch processing with net settlement. Payments can be push or pull. With pull transactions, the originator bears fraud and nonsufficient funds risks.
- Credit Card: Can be owned by public or private non-bank enterprises, regulated by the FRB and network rules. Uses real-time authorization, batch clearing, and net settlement. Payments are pull payments. Merchants risk fraud except for most card-present transactions, when they are guaranteed good funds.
- Debit Card: Has a nearly identical profile to the credit card system, except that banks own some local and regional networks.
- Wire Transfer: Owned by banks and regulated by the FRB, and operates with real-time clearing and settlement. All payments are push payments, and payment recipients are guaranteed good funds and shielded from fraud.
And that about wraps things up! Now you know how Nana’s $5 birthday check gets her pension money to your bank account. In all seriousness, you’ve got a much clearer grasp of how payments work “under the hood” in the U.S., and will find useful applications for this knowledge in your personal and professional life.