Every transaction that doesn’t involve two parties exchanging cash requires a payment network. Someone has to move the money from one metaphorical pocket to another, and that transfer has to occur over some medium. It’s obvious, but our transactions happen so quickly that we don’t spend much time thinking about those networks, and that’s okay. Payment networks are nevertheless one of our favorite topics here on the Simple blog—we’ve covered a lot of ground and looked at some specific cases. Today we’d like to take a step back for a broader historical perspective.
Checks (and balances?)
When you think of a check, what’s the first thing that comes to mind? A birthday card from your grandma? The book of cute kitty checks you ordered ten years ago and still haven’t finished? We don’t write very many checks now, but our financial system retains a lot of the payment infrastructure that existed to handle millions upon millions of paper checks each day.
The last decade has seen widespread development of remote deposit capture, which makes it possible for almost anyone with a smartphone and a checking account to deposit checks from the couch. RDC is possible thanks to the Check 21 Act, a 2004 law that allows banks to accept “substitute checks,” or images of checks, as if they were the originals. Banks are no longer required to physically move pieces of paper to other banks, which saves resources and time between depositing a check and having all of the funds available.
What is a Clearing House?
Back when banking involved hauling checks between buildings, clearing houses were at the center of the action. The Federal Reserve has been involved in the check clearing process (PDF) since its establishment; Fed banks process checks themselves, and regulate private clearing houses. They worked to popularize checks in the 1970s and 1980s by making check processing more efficient and introducing regulations that require banks to make funds available within set time periods.
The Automated Clearing House, or ACH, is a network that individuals, businesses, and financial institutions use to process some electronic transactions. If you take a look at your bank statement, you’ll probably see a few lines that start with ACH, and those payments will probably have something in common. Like paper checks, ACH transactions are processed either by the Fed or by a private company regulated by the Fed. Under the Check 21 Act, paper checks used for payment may be converted into ACH transactions. For instance, if you send a check to your utility company, they can choose to process the charge over the ACH network instead of sending a check or substitute check through the check clearing system. It’s cheaper, faster, and doesn’t require the customer to do anything differently, since the same account and routing numbers are used.
Credit or Debit?
The introduction of electronic networks for payment processing was one of a few significant tech advances for banking. By speeding up transactions and making check and ACH payments more attractive to businesses, customers became more and more attached to using their checking accounts for everyday payments. By the 1990s, checking was pretty efficient. Except for the part where you had to write the darn thing. The person taking forever to get the check right at the grocery store used to be a mundane annoyance; now, it’s an anachronism, thanks to the magic of debit cards.
Companies that had previously issued credit cards for other financial institutions were able to issue debit cards that could easily function over existing card payment networks. If a merchant could accept the credit card, that same merchant could also accept the card company’s branded debit card. When you sign for a debit purchase as you would for a credit purchase, the transaction is processed over the card association’s network. When you enter your PIN, the transaction is authorized in real-time over EFT, the electronic funds transfer network, the same network that processes ATM transactions. These transactions are typically settled at the end of the day using ACH.
It’s fairly common for merchants—especially smaller ones—to process all card transactions as credit if they do not have equipment for PIN processing. As we’ve mentioned before, interchange fees vary on different networks, and the card networks profit most from credit card transactions. Merchants pay more for credit than for debit transactions.
Paper or Plastic?
We’re most familiar with credit and debit cards, but you might find a few anomalies in your wallet. Many employers issue cards that can be used for mass transit, stores offer re-loadable gift cards, and those who receive public assistance use cards with dedicated funds for food and necessities. Magnetic stripes on some of these cards contain more information than an account number—they tell the payment network how much money is available, and they will be declined if the cardholder attempts to make an unauthorized purchase.
Still, most of the plastic in your wallet is pretty lo-fi. A single piece of magnetized material can’t hold much more than an account number, and they’re not especially durable. If your debit card is a cassette tape, then RFID chips are flash drives: they can hold far more information, they last longer, and it’s much harder to make a good counterfeit.
Our debit cards may be stuck in the nineties, but we’ve come a long way since banks sent representatives to actual houses to do their check clearing. There was even a time not long ago when it seemed novel that ATMs could read handwriting and deposit checks, and RDC apps made us feel like we lived in the future. Other countries have integrated RFID and NFC technology into their banking systems, and it may be just a matter of time before we’re nonchalantly waving our phones to pay for things. Like any new tech—especially in banking and trade—adoption will probably be an expensive, lengthy process. And even in the future, there will still be that guy in front of you at the store who takes forever to wave his phone at the thing just right.
(Unless otherwise specified, background information is sourced from FFIEC Retail Payment Systems 2010 Handbook)