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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.

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 76c 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 44c 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.

Float. The main thing that makes a credit card purchase so attractive to you, and so costly to the merchant, is delay. You receive the merchandise immediately, but you do not have to pay until the end of the billing period. In the meantime you earn interest on the amount of the payment. The merchant avoids having to wait for payment only by discounting the debt with a bank. Essentially the bank lends the merchant the amount of the payment until you pay it. The benefit of delay to you from such a transaction is called float.

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.

Because European courts regarded the check as a personal order of payment, they did not recognize its negotiability. As a result, the giro proved amuch more convenient  method of payment-first the paper giro and then, more recently, the electronic giro. Most countries do now recognize the negotiability of checks, but the giro was become entrenched. The French government launched a major campaign in the 1960s and 1970s to encourage the use of checks. Then European preference for giro payments over checks has carried over to a  preference for debit cards over credit cards.

All developed countries use all of the different methods of payment to some extent. However, the pattern of use differs widely across countries. Americans rely mainly on checks and credit cards. Europeans prefers giro payments and debit cards. The Japanese (and other Asians) rely far more on cash.

The breakdown is for the number of transactions per person. This differs radically from the breakdown by value. For example, in the United States, wire transfers account for a negligible percentage  of the  total number of transactions, but they  account for 85% of the total value .

The total number of noncash payments is highest in the United States because cash is used less than elsewhere (less than 1% of the total value of all transactions). It is intermediate in  Europe and lowest by far in Japan. The Japanese rely on cash for most POS transactions. You can see that the United States is the biggest user of checks and that the second largest category is credit cards. Europe relies on giro payments more than on checks and  on debit cards more than on credit cards. Japan uses giro more than any other method, but its use of cashless methods of payment is much lower than other countries’.

Settling banks” (some 20 in number) do this themselves; others have arrangements with settling banks to do this fro them. By 6:00 P.M., banks that are owed money receive payment out of the same special account.

In 1999, CHIPS handled some 230,000 payments a day, averaging a total of $1.2 trillion. Because of the economies of netting, these payments resulted in only a few billion a day in settlements.

A payment over CHIPS differs in its basic nature from a payment over Fedwire. While payment over Fedwire (like payment in cash) is final, payment over CHIPS (like payment by check) is merely a promise to pay. As with a check, there is a danger that the promise will “bounce”: a bank may be unable to settle at the end of the day. If this happens, all the banks to which it owes money will remain unpaid.

Naturally, there are safeguards. First, the CHIPS system has stringent admission standards. Second, participants set bilateral credit limits on net positions. Third, each bank also has a debit cap on its net position set by CHIPS, based on these bilateral limits
 

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-tobusiness 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 secuirty. Hackers can acquire credit card information, either by intercepting communicationbetween 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 comapnies consequently charge a larger discount on such transactions. The prinicipal 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 avialable 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.

Because of the bad check problem, personal checks may be unacceptable in some transactions. For example, if you buy a car the dealer may insist on a certified check. This is a promise to pay from the bank itself. The U.S. Postal Service and some private issuers offer similar instruments in the form of money orders.

The traveler’s check is a related form of payment. Like a certified check, a traveler’s check is a promise to pay on the part of the issuer, not the payer. Traveler’s checks are issued in small denominations and insured against loss or theft. (They can be seen as a kind of insured private banknote.) traveler’s checks are issued by
banks and by other financial institutions. The largest issuer is American
Express, which is not a bank.

To obtain a certified check, money order, or traveler’s check, it is usually necessary to pay the issuer in advance. Since such payment may be made incash, these payment instruments are available to those who do not own bank deposits certified checks, money orders, and traveler’s checks clear through the check-clearing system much like ordinary checks.

Another way to reduce the problem of bad checks is the overdraft. This is a line of credit that is automatically drawn upon if there are insufficient funds in the customer’s deposit to cover a check.

 Overdraft facilities, too, are more common overseas than they are in the United States. As an alternative to an overdraft, many U.S. banks offer the following arrangement: if there are insufficient funds to cover a check, the bank automatically transfers money from another account, say a savings account, charging the ustomer a transfer fee.

In some countries, the problem of bounced checks is addressed through criminal penalties. In Japan, for exaple, if you bounce tow checks in a 6-month period you are liable to 2 years of probation. In Taiwan, the penalties are sufficiently server that postdated checks are used as loan contracts. There is, in Taiwan, an informal or “curb” market for loans outside the highly regulated official financial system. In this curb market, a lender will hand over a sum of money in exchange for a check that is dated o the day the loan comes due (say a year later). The amount of the check includes principal plus interest

Before it accepts your check, Videomax will want to see some form of identification and perhaps some evidence of creditworthiness, like a credit card. The reason for its caution is that it has no way of knowing whether the check is good. If, when the check finally arrives at First National., it turns out that you have less than $700 in your deposit, the check will “bounce”. It will be returned unpaid to Videomax, reversing all the steps of the clearing process. Videomax will then have to do the best it can to collect the money from you in some other way. The possibility that a check may bounce reduces the acceptability of checks as a method of payment.

 Various ways have been devised to deal with this problem. One is the check guarantee card. A bank issues its customers a special card that must be presented whenever a check is written. The bank guarantees to honor checks written in this way up to some limit-say $200. If the check bounces, the bank takes the loss. Check guarantee cards are relatively rare in the United States, but they are quite popular in Europe. In France, banks must honor checks for amounts of 100 francs or less: no check card is required. Presumably this makes French banks more careful about handing our checkbooks.

If a check is drawn on a bank outside the area of the local clearinghouse, the procedure is more involved. For example, if First National is in Los Angeles and Metrobank is in New York, Metrobank will deposit your check at the New York Fed.

The New York Fed will credit Metrobank’s deposit with it for $700. The New York Fed then send the check to the San Fransisco Fed.

The San Fransisco Fed will send it on to its Los Angeles branch, which will take it to the local clearinghouse to present it to First National. Once the check has cleared, First National’s deposit with the San Fransisco Fed will be debited $700.

The physical transportation of paper checks is costly, both in the process of presentment and in the return of canceled checks to the depositor (banks in many countries do not do this). Attempts have been made, therefore, to use an image of the check, which can be transmitted electronically, rather the physical check itself. The Fed has introduced an experimental program and a group of large banks has set up its own system, Small Value Payments Corporation, to create an electronic check exchange network.