Global Trade Center

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.

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.

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.

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.

When you pay by check, you also benefit  from float. If you send it by mail, the legal date of payment is the date of the payment is the date of the postmark. You earn mail float on the time it takes the check to be delivered to the recipient . It also takes time for the check to go through the  clearing process. You earn bank float until your deposit is debited. If the total delay is a week, you earn an extra week’s interest on the amount of the payment after it has legally been made.

Methods of payment that do not involve float seem less attractive. The transaction cost of electronic payment (EFTPOS, for example) is much lower than that of payment by check or credit card. It is also much faster. But this speed is a disadvantage to you because it reduces float.

The loss of float is one reason debit cards have been slow to catch on in the United States. Checks and credit cards offer greater float. In Europe, payments by cash and giro predominate. Since neither method offers float, the greater convenience of the debit card is not offset by any loss of float, and debit cards have proven very popular.

The Use of Cash. Immediate payment  in cash by definition involves no float. Why is it, then, that there are so many cash payments? There are, in fact, good reasons why immediate payment in cash is the preferred method both for very small payments and for very large ones .

Cash is the preferred method for small payments because it is the only method that involves no credit (no promises). Methods of payment that involve credit involve substantial fixed costs. For example, the costs of credit verification and of clearing a check do not depend on the amount of the check. Consequently, a check is relatively more expensive for small transactions. Therefore, when you buy a newspaper at the corner newsstand, a check or credit card will not be accepted. You have to pay in cash.

For quite different reasons, immediate payment in cash is also preferred for very large payments. For large payments, the recipient may not be willing to accept the loss due to float. At an interest rate of 5% per annum, a day’s delay on a payment of $100 million costs about $13,000 in forgone  interest. Moreever, many large payments are related to very-short-term lending-perhaps for as little as a day. Lending money for a day and sending the money by check would not make much sense. Large payments in “cash” are made by Fedwire.

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.

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.