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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.

An International Comparison of Payments Patterns
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.
Exhibit 8.2 gives a breakdown of the composition of cashless payments in the United States, Europe, and Japan. 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 (in Exhibit 8.2, wire transfers are included in the category “giro” for the United States).
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’.

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.

International 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 international 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.

There are other historical and legal factors that have determined payments patterns. Some examples:

Until quite recently, in many countries-Germany and the United Kingdom, for example- the law required firms to pay             their hourly workers in cash. As a result, such workers generally did not have checking deposits and so did not use             checks.

Low rates of street crime in Japan and high rates in the United States make cash a much more attractive means of  payment in the former than in the latter.

One reason credit cards are less attractive in Japan is the cost of telecommunications there. which makes  authorization via switch too expensive. The result is a higher rate of fraud, making credit cards more expensive.

One reason Eureopeans are willing to allow routine bills to be directly debited from their deposits is that  Eureopean  banks commonly offer overdraft credit. U.S. banks do not, and Americans therefore feel uncomfortable with automatic  payments debited from their deposits.

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
 

The CHIPS computer and the computers of the individual banks keep track continuously of each bank’s net position relative to every other bank. For example, if Chemical has made a total of $11 billion in payments to Bankers Trust, and Bankers Trust has made a total of $13 billion to Chemical, then the net position of Bankers Trust is that it owes Chemical $2 billion. 

At 4:30 P.M., the CHIPS computer sends each participant a summary of its payments for the day and of its final net positions. The summary also indicates the participant’s net position-its net position relative to all other participants. For, example, suppose that in addition to the $2 billion it owes to Chemical, Bankers Trust owes a further $2 billion to Dresdner and is owed $5 billion by Barclays. Then the net position of Bankers Trust is

 -$2 billion – $2 billion + $5 billion = + $1 billion 

That is, Bankers Trust is owed $1 billion. 

On receiving its summary from CHIPS, each bank checks the information against its own records for accuracy. If it has a net debt, it must transfer funds over Fedwire to a special account at
the Fed by 5:30 P.M.

If Fedwire is the electronic equivalent of payment in cash, then the electronic equivalent of payment by check is CHIPS (the Clearing House Interbank Payment System). This system, operated by the New York Clearing House, links some 130 banks with branches in New York City to a central computer. 

Most payments over CHIPS are related to the foreign exchange and Eurodollar markets. For example, suppose a British bank needs to pay a French bank $100 million in U.S. dollars. The British bank executes the payment through its branch in New York-if it has one-or through a New York bank with which it has a deposit. They payment is made to the New York branch of the French bank, if it has one, or to a New York bank at which the Paris bank has a deposit. The London bank sends its instructions to New York via SWIFT (Society for Worldwide Interbank Financial Telecommunications)-a private electronic message transfer system. The payment is made over CHIPS. 

Throughout the day, thousands of payments like this pass from bank to bank. As with the check-clearing process, these payments are netted to minimize the need for final settlement in cash.

The credit card interchange and switch are the basis of a new method of payment very similar in nature to payment by check or giro-the delayed debit card. (The qualifier “delayed” distinguishes this type of debit card from the electronic debit card, to be discussed shortly.)

Unlike the credit card it physically resembles, the delayed debit card involves no credit. Rather than extending the purchaser credit to the end of the month, the issuing bank debits the amount of the purchase from the purchaser’s checking deposit as soon as the slip clears through the interchange. Since the bank extends no credit, the discount charged the retailer is correspondingly lower. 

Notice that the delayed debit card overcomes many of the problems of payment by check or giro. There is no bad-check problem-the transaction is not authorized unless the purchaser has
sufficient funds-and the retailer is guaranteed payment. However, unlike the giro transfer, the delayed debit card can be used for unplanned purchases. While in the United States delayed debit cards are much less popular than credit cards, in Europe the opposite is the case