The Bankwatch

Tracking the consumer evolution of financial services

Should the Fed be the 14th payment network, and how would that solve the problems?

President Kohn of the Kansas City Fed speaks at the ECB/De Nederlandsche Bank Conference conference in Frankfurt.  He argues for greater control by the Fed over the payments system.  While his outline of problems makes sense, they also describe the failure of the current system, and the lack of foresight from the existing controls, and its unclear that the proposed solution from them will have any impact other than exacerbating those problems.  The problems he describes are real and more importantly consumer facing.  They are also imho problems that large banks could address given their scale and the opportunity for customer loyalty.  I am thinking of BofA and Wells specifically, but that is for another post.

The Future of Retail Banking and Payments – President Thomas H. Hoenig

In light of the trend toward greater industry concentration and the existence of important payments system externalities, the Federal Reserve should play a larger and more active role in electronic retail payments if it wants to promote the efficiency and integrity of the payments system.

There are two broad categories of problems that he identifies with the payments networks

  1. lack of competitiveness: In 2007 81% of the payments volume went over three networks, compared to 46% just few years earlier.  In addition the number of networks are down from 43 to 14.
  2. integrity of the system(s): He sees single point of failure and prominence of non-banks as issues of concern.  The variety of systems introduce externalities that undermine the entire system.  His example is the continued use of mag stripe and the security implications of not shifting to chip card as the rest of the world has done.

On that last point I would add that the fact of holding on to the mag stripe is influencing the rest of the world with  counter productive results.  For example in Canada banks are issuing cards with stripe and chip which makes no sense.  So long as the stripe exists the flaws associated with strip exist.  But the sheer size of the American market pressures the issuers to continue with stripe for the forseeable future.

Then he makes this statement:

Historically, the Federal Reserve’s role in both checks and ACH reflects a preference to operate within the market rather than as a pure regulator. We are well aware that industries can – and do – quickly develop methods to exploit any regulatory loopholes and avoid the intended outcome. By competing with the private sector on a level playing field, the Federal Reserve can encourage efficiency and integrity from an “on the ground” position.

That statement reads to me as rationalisation of inaction and continuation of the status quo.  His conclusion is that the best form of regulation and solution to the aforementioned problems is to compete with the other networks.

Thus, in my view, the Federal Reserve’s future role in retail payments should be built around its current position in ACH. For example, in its operator role, the Federal Reserve could augment its ACH products and services, with the aim of enhancing competition and safety within the ACH industry.

… … …

Finally, the Federal Reserve could enhance competition in payment card markets by positioning ACH services as an alternative to debit card payment networks.

It certainly is a strategy and we can debate whether government ought to be engaged in payments systems directly, as regulators, or not at all.  All I know is that consumers (and banks) will suffer from the real problems he identified at the outset, and its not at all clear that the Feds 14th network will address those problems at all.  This reads as a recipe for disaster in American payments.  For example the very issue he outlined of underinvestment in security and integrity will only accentuate as the other 13 networks work to compete with the Fed, and protect profits.  Expect continued data leakages, network outages, and identity theft.

Written by Colin Henderson

May 26, 2009 at 10:59

2 Responses

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  1. No, the real future form factor of payment cards isn’t cards it’s mobile.

    It makes no sense to spend billions reissuing the hundreds of millions of magstripe cards in circulation just to stamp little chips on them… when almost everyone holds mobile devices already, with a secure embedded identity chip already, a device that would be, and can be far more capable as payment tool than a simple/dumb/passive chip card.

    New payment networks need to be far more connected and agile in design to be able to deal with (and enable) the rapidly changing ways we do business, shop, and exchange value over the internet. They also need to be adaptable and flexible to deal with threats, risks and security challenges as they evolve as rapidly.

    How effective do you think government-run payments scheme would be at those sort of requirements?

    When was the last time you saw a government service with a really excellent forward-thinking vision of consumer mobile/web interaction design?

    Thomas Purves

    May 26, 2009 at 13:13

  2. @thomas … indeed re government operating a payments company, and yes to the mobile ideas. Those are innovative and will only come from business oriented people (banks, startups) who can see beyond traditional payment networks.


    May 26, 2009 at 17:19

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