Carol Clark

Erin Davis

Sujit Chakravorti

Thomas Ciesielski

English

Research Papers in Economics

Chicago Fed Letter
SPECIAL ISSUE THE FEDERAL RESERVE BANK OCTOBER 2003
OF CHICAGO NUMBER 194
Can existing payment networks meet future needs?
A conference summary
by Sujit Chakravorti, senior economist; Thomas Ciesielski, vice president; Carol Clark, project leader; and Erin Davis,
senior analyst, Emerging Payments & Policy Group
The proportion of retail, non-cash payments made electronically in the U.S. grew
from 15% in 1979 to 40% in 2000. A recent Chicago Fed conference addressed the
important question of whether today’s payment networks can adequately support
emerging payment technologies.
Credit card, debit card, and
automated clearinghouse
payments have grown
fivefold since 1979.
The last few years have seen a steady
decline in check volumes and explosive
growth in electronic payments. How-
ever, not all payment innovations have
gained market acceptance and not all
market segments have enthusiastically
abandoned paper-based instruments.
Changes in the U.S. payment industry
landscape are most dramatically evi-
denced by a fivefold increase in the com-
bined number of credit card, debit card,
and automated clearing house (ACH)
payments annually since 1979, with debit
cards growing significantly toward the
end of that period. The proportion of
retail, non-cash payments made elec-
tronically grew from 15 percent in 1979
to 40 percent in 2000. Near term, busi-
nesses and financial institutions will
need to maintain both paper and elec-
tronic payment processing systems, while
the migration toward electronic instru-
ments will likely drive future investments
in technology and the payment infra-
structure, raising the question: Can
today’s payment networks support
emerging payment technologies or
will new networks emerge?
On May 29–30, 2003, the Federal Re-
serve Bank of Chicago hosted an in-
dustry conference titled “Can Existing
Payment Networks Meet Future Needs?”
The conference brought together ap-
proximately 150 participants, including
representatives from financial institu-
tions, payment networks, corporations,
retailers, and government, with the
objective of fostering dialogue on the
development and adoption of more effi-
cient payment methods. This Chicago
Fed Letter summarizes the presentations
and views expressed by conference par-
ticipants, who focused on opportunities
to improve the payment system while
addressing the challenge of balancing
end-users’ needs and the profitability
goals of payment service providers.
Speaker biographies and presentations
are available at www.chicagofed.org/
paymentsystems/conferences.cfm.
The conference centered on the fol-
lowing questions:
• Why invest in payment technology?
• What are the costs and benefits to
end-users of using and accepting
various payment instruments?
• How can networks leverage their
existing infrastructure to meet the
evolving demands of payment sys-
tem participants?
• How will the payment landscape
evolve?• What is the role for the Federal Re-
serve in promoting a more efficient
payment system?
In his introductory remarks, Gordon
Werkema, first vice president and chief
operating officer, Federal Reserve Bank
of Chicago, emphasized the Federal
Reserve’s mission to foster efficiency in
the payment system through facilitating
discussion among payment industry par-
ticipants. He went on to introduce the
keynote speaker, Carl Rutstein, vice presi-
dent and head of Americas Payment
Practice, Boston Consulting Group.
Rutstein argued that technology alone is
not sufficient for successful market adop-
tion of payment innovations. He stressed
the importance of execution and the
need for financial institutions to direct
their efforts toward areas where they
have sustainable competitive advantages
and where their customers will benefit.
For example, a bank’s online bill-pay ser-
vice has the potential to attract and re-
tain more profitable and loyal customers
if it is integrated with the bank’s other
products, such as loans, deposit account
services, and investment services. Banks
can leverage this broader access to cus-
tomers’ financial information to find
cross-selling opportunities, tailor more
products to customers’ needs and, con-
sequently, increase their share of cus-
tomers’ “wallets.”
Investing in payments
The first conference panel featured
Collin Roche, principal, GTCR Golder
Rauner, LLC; John Perry, chief executive
officer (CEO), InterCept Payment Solu-
tions; Nick Alex, senior vice president,
Bank of America Corporation; and David
Roberts, senior vice president, First Data
Corporation. The discussion focused on
when, why, and how firms invest in pay-
ments. The panelists emphasized that
profitable opportunities do exist. Pay-
ment services generally produce stable
revenue streams and account for about
one-third of profits at the largest banks.
Despite the importance of payments to
their businesses, the panelists’ firms were
reluctant to invest in innovative but un-
proven payment products. Importantly,
they choose to wait to invest until the
product has established sufficient
market demand.
This panel also addressed the role of
joint ventures in the evolution of the
payment system. While the panelists
recognized that joint ventures could
aid in the development of industry stan-
dards, distribute development and im-
plementation costs among partners, and
potentially achieve the critical mass
necessary for adoption, several panelists
also cited some challenges. Perry, for-
merly the CEO of Spectrum, suggested
that joint ventures can provide immedi-
ate scale and speed to market, but may
have high indirect management costs
and potential risk to the reputations of
the participants. While emphasizing the
value of information and risk sharing,
Alex argued that large institutions might
have greater influence than smaller
members in such partnerships, which
may diminish the venture’s value to
smaller participants.
End users’ perspective
In the second panel, a diverse group of
end users shared their insights on the
potential uses of existing and emerging
payment mechanisms. Jay DeWitt, se-
nior manager, Amazon.com, Inc., said
consumers have their fingerprints
scanned by a biometric reader at the
cash register. Then the reader matches
customers to their desired payment in-
struments, which are kept on file, and
the consumer authorizes payment. West
Seattle Thriftway has used its system to
steer customers to PIN-based debit cards,
a less costly alternative to credit cards
and signature-based debit cards. In ad-
dition to greater convenience for con-
sumers and lower fraud rates, Kapioski
argued that the novelty of the payment
experience has increased the customer
base and customer loyalty.
While electronic payments may reduce
costs for businesses, Gail Hillebrand,
senior attorney, Consumers’ Union,
questioned whether these changes are
always in consumers’ best interests and
whether legal protections are keeping
up with changes in the marketplace.
For example, while in practice, payment
providers often offer similar consumer
protections on credit and debit cards,
consumer legal protections typically
vary based on the payment instrument
used. Hillebrand recommended the
Barriers to electronic payments are much higher for
business-to-business payments.
that rather than push customers toward
the least costly payment mechanisms,
Amazon tries to accommodate their
preferences. A major concern for
Amazon, like many merchants, are the
fees charged by the banks that process
their credit card transactions, often
referred to as “acquirers.” Credit cards
are currently the most popular method
of payment for Internet transactions.
To reduce payment processing costs,
Amazon is developing an ACH payment
option that will allow consumers to
make payments to Amazon via their
demand deposit accounts at significant-
ly lower processing costs than for cred-
it card transactions.
Paul Kapioski, owner, West Seattle
Thriftway, described a new system in-
troduced at his store last year whereby
development of uniform statutory pro-
tections for all payment products to
reduce confusion among consumers.
The barriers to electronic payments
are much higher for business-to-busi-
ness payments than for consumer-to-
business payments, according to Cathy
Gregg, partner, Treasury Strategies,
Inc. Gregg said that 95% of business
transactions still use checks. In this
market segment, the cost of a payment
itself is inconsequential, compared
with the costs associated with receiving
and processing payments, known as
the accounts receivable workflow. For
many businesses, electronic payments
have not lowered costs, but rather have
forced businesses to create separate,
manual procedures to accommodate
those customers who prefer to payMichael H. Moskow, President; Charles L. Evans,
Senior Vice President and Director of Research;  Douglas
Evanoff, Vice President, financial studies; David
Marshall, team leader, macroeconomic policy research;
Daniel Sullivan, Vice President, microeconomic policy
research;  William Testa, Vice President, regional
programs and Economics Editor; Helen O’D. Koshy,
Editor; Kathryn Moran, Associate Editor.
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electronically. Gregg suggested that elec-
tronic payments should be bundled with
value-added services, such as integra-
tion with supply-chain management
systems or back-end processes, that are
currently not provided with checks.
Leveraging the payment
infrastructure
The third panel of the conference fea-
tured Bond Isaacson, co-chief execu-
tive officer, Concord EFS, Inc.; George
Thomas, president and chief executive
that the recent decision to allow con-
sumers to initiate ACH payments over
the Internet should be reconsidered.
They argued that the chargeback system
is too cumbersome for consumers and
the risk of fraud too high.
Each of the panelists discussed profit
opportunities in electronic payments.
Isaacson mentioned small-value pay-
ments as one such opportunity, but said
that industry collaboration would be re-
quired to create a successful instrument.
usually fixed. For example, the cost of
ATM (automated teller machine) with-
drawals is often zero, but the cost of
providing these cash withdrawals is not
zero. As a result, consumers tend to use
cash instead of other more efficient
payment forms.
Austin Adams, chief information officer
and executive vice president, Bank
One Corporation, outlined some of the
opportunities in the delivery of payment
services that Bank One has implement-
ed or is considering. Adams stressed
that payments make up about half of the
bank’s total revenue and that managing
payment products using an enterprise-
wide, coordinated approach is a priority.
Recently, the bank has been conducting
accounts receivable conversion (ARC)
trials, in which consumers’ checks are
imaged and converted into paperless
ACH transactions. These trials have been
very successful in lowering processing
costs and have had the unexpected
benefit of reducing the number of re-
turn items by 40 percent.
In his presentation, Norman Litell,
vice president, Visa U.S.A., Inc.,
stressed that innovations in payment
systems do not always come from tech-
nological change—they can also be
the result of changes in the soft infra-
structure, such as rules. For example,
Visa Commerce addresses businesses’
payment needs by allowing payments
to be scheduled and negotiated between
Cost-based pricing could encourage greater use of more
efficient payment instruments.
officer, the Electronic Payments Net-
work; Steve Abrams, senior vice presi-
dent, MasterCard International, Inc.;
and Andy D’Amato, senior vice presi-
dent, Certegy, Inc. The panelists stressed
that existing payment networks will be
able to meet the future demands of pay-
ment system participants. Some panel-
ists noted that most payment innovations
leverage the existing payment infrastruc-
ture. For example, Isaacson suggested
that while new payment solutions might
emerge for micropayments, which range
from a few cents to a few dollars, even-
tually these systems will piggyback on
existing networks. A payment might be
authorized with a mobile phone, billed
on a phone bill, and eventually paid
with a credit card.
Some panelists also discussed the growth
of fraudulent payments. D’Amato sug-
gested that fraudulent checks, as a per-
centage of total checks, will continue
to grow because a greater proportion
of non-fraudulent check payments will
migrate to electronic alternatives. Simi-
larly, Thomas predicted that as ACH
transactions grow, especially those ini-
tiated over the Internet and telephone,
fraud will increase dramatically unless
new controls are put in place. He sug-
gested that the use of a database al-
lowing operators to match name and
address information against demand
deposit account information would
reduce fraud. Several panelists agreed
Abrams identified business-to-business
payment cards as a promising area. He
emphasized how important the oppor-
tunity to analyze purchase data is to
firms. MasterCard will soon have the
ability to provide customers with more
detailed information on each item pur-
chased, including the individual bar
codes for purchases made with a busi-
ness-to-business payment card.
Future of payment networks
On the final panel, Leo Van Hove,
assistant professor, Free University of
Brussels, presented a survey of elec-
tronic retail payments used in several
European countries. Van Hove dis-
cussed possible reasons behind the
large divergence in payment prefer-
ences across countries, especially in
the adoption of new payment instru-
ments. General-purpose stored value
has had particularly strong growth since
the introduction of the euro, primarily
in smaller countries and in countries
where debit cards are popular.
Van Hove also suggested that consumers
might not be facing the right incen-
tives to use the most efficient payment
instrument. He suggested that cost-
based pricing could encourage greater
use of more efficient payment instru-
ments. He emphasized that, in general,
the cost of making a payment is too
low; the marginal cost is typically zero,
and if fees are charged at all they arethe parties, rather than processed
immediately. Litell identified some of
the challenges and opportunities associ-
ated with being a global organization
like Visa. Products often need to be
customized between and within coun-
tries to adapt to consumer preferences
and various regulations, while maintain-
ing compatibility across market segments
and jurisdictions. However, this diversity
does allow Visa to accumulate and trans-
fer expertise with different products to
new environments.
Federal Reserve role in payments
Gary Stern, president and chief execu-
tive officer, Federal Reserve Bank of
Minneapolis, and chair of the Federal
Reserve System’s Financial Services
Policy Committee, emphasized that the
Fed “should not provide new payment
services unless markets are failing and
the Fed has a unique competitive ad-
vantage.” He also stressed the difficulty
the Fed faces in responding to changes
in the demand for existing and future
services. He suggested a new principle
to guide these decisions, that the Fed
“should ensure that the size, reliability,
and capabilities of its basic retail infra-
structure supporting established services
correspond to market demand.” How-
ever, he acknowledged that forecasting
market demand is a difficult task.
Jeff Marquardt, associate director,
Board of Governors of the Federal
Reserve System, shared the results of
the Payments System Development
Committee’s study on the future of
clearing and settlement. The study was
based on interviews with 49 organiza-
tions regarding the barriers to innova-
tion in the payment mechanism. While
no single, consistent recommendation
emerged from the survey, the inter-
viewees emphasized that technical in-
novation alone is not enough—new
services must provide significant benefits
for key participants. Interview partici-
pants also voiced their concern over the
lack of a mechanism for Internet pay-
ments that combines reasonable cost,
security, and reliability.
Conclusion
In his concluding remarks, Sujit
Chakravorti, senior economist, Federal
Reserve Bank of Chicago, noted that
most participants thought that networks
can meet future needs, but that signifi-
cant opportunities exist for financial
institutions, merchants, payment pro-
cessors, and networks to improve upon
today’s payment mechanisms. Many
networks are expanding from their core
market segments. For example, online
and point-of-sale merchants are consid-
ering ACH payments that were primarily
developed for recurring payments.
Payment innovations may take longer
to adopt than innovations in other indus-
tries because of the need to balance the
interests of multiple agents—consumers,
merchants, financial institutions, and
networks. In addition, payment provid-
ers must often operate both legacy and
new systems side by side, increasing
costs in the short run.
Several speakers identified a well-de-
signed implementation plan as a neces-
sary precondition for the adoption of
technological payment innovations. Con-
ference participants agreed that while
many challenges remain in the evolving
payment landscape, opportunities exist
for the industry to innovate by improving
the security and reliability of the payment
mechanism, and by increasing the val-
ue of payment-related activities to par-
ticipants in the payment marketplace.

Can existing payment networks meet future needs? a conference summary

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