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Different Payments Methods for Different Transactions

Different methods of payment are suited to different types of transactions. The major categories of transaction are

Payments at point of sale (POS)
Bill payments
Disbursements (mainly income payments)
Financial market transactions

Cash and cards are suited mainly to POS transactions, although bills are sometimes paid by credit card and disbursements sometimes made in cash. Check, giro, and ACH are well suited to bill payments and disbursements. However, checks are very flexible and are often used too at POS and for financial market transactions. Wire transfers are limited mainly to financial market transactions.
What is the relative importance of the different methods of payment? Cash is used in far more transactions than any other method of payment-in most countries for 80 to 90% of all transactions. However, the typical transaction is small, and the total value of cash transactions is therefore modest-less than 5% in most countries. Wire transfers, on the other hand, are used for relatively few payments, but each is large, and the total volume far exceeds that of all other methods of payment combined. Other methods of payment lie somewhere in between.

Payment on the Internet
An increasing fraction of all transactions now take place on the Internet. There are predictions that business-to-consumer transactions (B2C) on the Internet will soon be in the hundreds of million of dollars and that business-to business transactions (B2B) in the trillions.
Currently, the overwhelming majority of B2C purchases on the Internet are paid for by credit card. This works reasonably well, but there are some problems. The first is security. Hackers can acquire credit card information, either by intercepting communication between consumer and merchant or by gaining access to merchant computers.20 Once they have the information, they can use it by faking e-mail from the owner of the credit card . Credit card fraud is 12 times more common for Internet transactions, and the credit card companies consequently charge a larger discount on such transactions. The principal defenses against fraud are encryption of credit card information and better security of merchant computers.
A Second problem is that payment by credit card is not available for transactions between consumers (P2P) -for example, to settle purchases in online auctions. Various technologies are being developed to bridge this gap with some form of “online check”. One, called eCheck, is a relatively straightforward electronic version of the paper check. Another, called PayPal, provides consumers with the capability of linking up with the existing credit card and ACH networks to make payments. Yet another technology is planned to link up with existing ATM network.

A third problem with payment by credit card continues is that it is expensive. There is the potential on the Internet for a large volume of quite small transactions involving the sale of information, such as a single song, photograph, news item, or piece of data. The payments involved are likely to be small-from $10 down to 1c or even less. For such transactions, various technologies are being developed to provide some form of “digital cash”.
For the time being, however, the credit card continues to dominate Internet commerce. None of the new digital check or cash technologies have yet caught on. Of course the same network externalities that stand in the way of the smart card are part of the problem here. Consumers do not use the new technologies, because not enough merchants accept them. Merchants do not accept them because not enough consumers use them.

Prepaid Cards

The electronic equivalent of the special check is the prepaid card, commonly used on many campuses to operate copying machines. You buy the card, often from a vending machine, for cash, say $10. You insert the card into the copying machine to make copies, and the cost of the copies is debited from the balance on the card until the $10 is used up. There are other uses of prepaid cards- for example, paying for tickets on the Washington, DC subway system. Prepaid cards are popular in Europe and extremely popular in Japan.
A more sophisticated version is the smart card or “electronic purse or wallet,” which embodies a microchip and can be used as a general rather than a specific means of payment. Users “download” cash from their bank deposits via an ATM machine or a specially adapted phone. Smart cards can be used for payment wherever merchants have the equipment to read them. Unlike credit or debit cards, no verification is necessary. This saves on telecommunications costs which can be 8¢ to 15¢ for a credit /debit card transaction. Consequently smart cards are viable for much smaller transactions-purchase of a newspaper, for example.
Smart cards have been slow to catch on. One reason is again network externalities. Merchants do not find it worthwhile to install readers because few consumers have the card. Consumers do not find it worthwhile to acquire the card because few merchants accept it. Moreover, although the cost to the economy of using cash is substantial, the cost to a consumer of an individual transaction is small. There is therefore little incentive to go to a lot of trouble to avoid it.

Economic Incentives and the Use of Methods of Payment.
The different patterns of use of various methods of payment also relative costs. For example, the cost structure in the United States strongly favors the use of checks and credit cards.
Although your bank provides you with “free checking,” checks are in fact far from free. The average checks costs 76¢ to process. Total processing costs for all checks add up to some $45 billion a year. Your credit card transactions are also “free” to you. But processing costs average 44¢ per payment and merchants pay a substantial discount (as much as 5%) to receive payment.
Why is it that you do not pay the true cost of these transactions? One reason for “free checking” is taxes. The receipt of explicit interest on deposits is taxable, while the receipt of implicit interest, in the form of free services, is not. Another reason is the nature of competition among banks. Typically, when there are few firms in a market-as is the case in most local banking markets-they avoid competing on price because of the danger of a price war. Instead, they compete in the services they provide. Free checking is one of these services.
Why don’t retailers pass on to you the extra cost of them of a credit card purchase? Credit card customers tend to be wealthier and to spend more. Retailers may be willing to offer them a lower price-which is what they do when accept a credit card-because on the whole cardholders are better customers.

A Foreign Exchange Transaction
To see how foreign exchange works, let us look at an example. Henriette Gourmet Foods in the United States imports tea from Chelsea Tea in England. In payment for a recent shipment, Henriette needs to pay Chelsea in pounds sterling the sum of £ 100,000 (about $140,000). To do this, Henriette cannot simply write Chelsea a check. She does not have a deposit in pounds sterling, and her bank and Chelsea’s do not belong to the same clearing system.
Henriette must go to the foreign exchange department of her bank, First National. There she buys £100,000 in British bank money-that is, £100,000 in a bank deposit in the United Kingdom. A check drawn on that deposit is sent to Chelsea. It clears in the normal fashion through the British clearing system, and Chelsea ultimately receives payment in bank money at its own bank.
Where does First National get the British bank money to sell to Henriette? If it is large enough and does enough business in foreign exchange, it may maintain a deposit of its own at a British bank for just such a purpose. If not, it can by the pounds in the interbank market in foreign exchange where deposits in different countries are traded.

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Growth of the Market
The foreign exchange market expanded rapidly with the breakdown of the Bretton Woods system of fixed exchange rates in 1971 and exploded with the large increase in exchange rate volatility that began in the late 1970s. In 1977 trading volume in New York amounted to less than $5 billion a day (about $15 billion in 1998 dollars). By 1998 it had increased to $351 billion a day. Trading volume in London, the center of the world market for foreign exchange, was $637 billion a day in 1998, and the worldwide total was about $1.5 trillion a day. By 2001, total trading volume had fallen to $1.1 trillion. One reason for this was the creation of the Euro, which replaced 11 national currencies. Another reason has been the consolidation of the banking industry, which has reduced the number of participants in the market.
Trading volume in foreign exchange is nonetheless many times greater than the volume of international trade. In fact, most foreign exchange transactions are related not to trade but to finance. For example, if a Japanese pension fund wants to buy U.S. government securities, it must change its yen into dollars. Indeed, as the volume of international financial transactions has grown, securities firms have increasingly become dealers in foreign exchange, offering this service to their customers themselves, rather than referring them to a commercial bank.

Why Payment Patterns Differ
Payments patterns differ across countries for a variety of reasons-legal, historical, and economic.

Some Legal and Historical Reasons. Some countries use checks and others use giro payments for reasons that lie mainly in their legal histories. The check evolved in the English-speaking countries. English courts viewed it as a variety of commercial bill of exchange. 21 The early recognition by English courts of the negotiability of commercial bills, and so of checks, made their use much easier. If a check is negotiable, you can sign it over to your bank, and your bank can collect payment through the clearing system. If a check not negotiable, clearing becomes impossible and you yourself must present each check for a payment at the payer’s bank.

European courts did not regard the check as a variety of commercial bill, but rather as a variety of personal order of payment. The personal order of payment goes back to the medieval money-changer banks that we learned about in Chapter 6. These banks allowed their customers to make payments by transferring ownership of deposits. Initially, orders to transfer deposits were made orally, and they required the physical presence of all the parties involved-the payer, the payee, and the banker. The courts recognized transfers performed in this way as constituting a final discharge of a debt. The money changers had a rudimentary clearing system: transfers were cleared between banks by means of reciprocal clearing accounts that the banks held with one another.

“Domestic Exchange”
As in this example, most foreign exchange transactions today are international and involve bank deposits denominated in different currencies. This was not always the case. Historically, distance and poor communications were more important barriers than differences in currency. In the nineteenth century, a merchant in New Orleans would have found it just as difficult to pay a supplier in New York as to pay of the United States. Banks in New Orleans offered “domestic exchange” -claims on New York deposits-as well as foreign exchange-claims on London deposits.
The introduction of the Euro, a common currency for 11 of the 15 member states of the European Union in 1999 has created a situation in “Euroland” not unlike that in the early United States. The member countries all use of the same currency, but they have retained their individual clearing systems and these are only partially connected. The European Central Bank operates a system called TARGET that links the large-value online payment systems of EU member countries. This enables large-value, cross-border payments to be made relatively easily. However, there is no link yet for smaller payments. As a result, the cost of making payments in Euros between, say Rome and Pairs has remained quite high (much like the cost of making a dollar payment between New Orleans and New York 200 years ago). A survey in 2000 found that the average cost of a 100 Euro cross-border transaction was over 17 Euros, with enormous variations from country to country.

The Foreign Exchange Market
The interbank market in foreign exchange is an international market, active around the clock. Its major centers are London, New York, and Tokyo. The prices in the foreign exchange market are the exchange rates we studied in Chapter 4. For example, the exchange rate between the U.S. dollar and the pound sterling might be $1.40 to the pound. This means, in our example, that Henriette would have to give up $1.40 of her bank money(deposits at her bank) in order to obtain a claim on 1 of British bank money (deposits at a British bank). Trade in the foreign exchange market includes forward transactions as well as spot transactions like Henriette’s. 22