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Payments Evolution or Revolution?

Minneapolis Fed First Vice President James Lyon reviews trends in the payments system.

June 1, 2004


James M. Lyon First Vice President
Payments Evolution or Revolution?

Editor's note: The following remarks were delivered at the Global Electronic Payments Conference in London, England, Jan. 20, 2004.

I appreciate the opportunity to participate in this conference on global electronic payments. ... With the remainder of our collective time this morning, I'm going to try to do three things. First, I will quickly recap the key U.S. payment trends that we see driving change, whether evolutionary or revolutionary, over the next few years. Second, I will summarize the Federal Reserve's key responsibilities for oversight of the U.S. payments system and how we approach the uncertainties of change. Third, in terms of the three payment mechanisms where we have a significant operational presence—Fedwire, ACH [Automated Clearing House] and Check—I will offer some examples of how we put our policy objectives into action and how we are responding to the major payment trends of the day.

Photo: Check writing Significant changes are under way in the U.S. payments system. Whether this process of change is evolutionary or revolutionary, the Federal Reserve is committed to fostering market-based outcomes that result in a more efficient and effective electronic payments system.

Major U.S. payment trends

Forecasting the direction and pace of change is never an easy process, and this is certainly true with respect to payments. Change is continuous and it is often easiest to answer questions like "evolution or revolution" with the benefit of hindsight. But despite these difficulties, there are some key dynamics regarding the U.S. payments system at present that seem relatively unmistakable in their direction, if not necessarily in their timing. There are, I think, two broad trends in particular that are generally agreed on by observers of the U.S. payments system. The first is the accelerating movement from paper-based to electronic payments. The second is the blurring of existing payment mechanism boundaries as payments system providers and users strive to meet new business requirements and gain competitive advantage. Let me say a little about each of these in turn.

Paper-based to electronic payments
While it is arguably long overdue and certainly long anticipated, the big news in the United States in terms of retail payments is the accelerating growth of electronics and the absolute decline in check volumes. It has only been in the last few years, due in part to Federal Reserve-sponsored research, that these trends have been clearly documented. We believe that an important ongoing responsibility of the Federal Reserve is to foster greater understanding of payments system trends through market research and dialogue among payments system stakeholders.

As you know, for many years analysts predicted absolute declines in check volumes and for years the marketplace refused to cooperate. In 1979, checks made up around 90 percent of all noncash retail payments. Fifteen years later, checks still made up around 80 percent of the total. However, more current data have shown a decline in check volume beginning at some point between 1995 and 2000. By 2000, electronic retail payments were estimated to constitute 40 percent of total noncash payments, up from 15 percent just a decade before.

The bulk of this growth, in absolute terms, has come from debit and credit cards. Card payments have grown from 18 percent to 33 percent of the total. The growth of debit cards has been particularly noteworthy. In 1995, debit card volumes were 1.4 billion, and by 2000 they had grown to 8.3 billion and represented 12 percent of the total noncash retail payments volume. During this same period retail ACH also grew significantly from 2.8 billion items to 5.6 billion items, and its share of the total expanded from 4 percent to 8 percent. Similarly, recent data show a 13 percent increase in ACH transactions in the third quarter of 2003 over the same period a year earlier.

Simple, and perhaps conservative, extrapolation of these trends suggests a noteworthy change is occurring in the composition of noncash retail payments. Let me illustrate what I mean. For argument's sake, let's assume that from 2000 to 2005, total noncash retail payments grow at a level roughly equal to the historical growth rate of real GDP (3 percent). This seems like a reasonable assumption, given that this was the growth rate for noncash retail payments from 1979 to 2000. If we also assume that check volume falls 2 percent per year—which is 100 basis points less than the rate it fell from 1995 to 2000—then by the end of 2005, check volume will constitute only 46 percent of total noncash retail payments volume. In other words, the mix of paper and electronics will be nearly the reverse of the composition today. Check will have roughly the share in 2005 that the noncheck portion-credit/debit cards and ACH—has today. Other observers of current trends are forecasting even more rapid declines in the prominence of checks. Obviously, any forecasting based on such limited data is necessarily accompanied by significant uncertainty, but the quickening pace of change from paper to electronics seems fairly clear.

In a similar vein, data from our consumer finance survey highlight significant growth in the acceptance and use of electronic payment options, particularly debit cards. In 1995, about 18 percent of households used debit cards. By 2001, nearly 50 percent used them. During this period, acceptance of automatic bill payment also grew considerably. Interestingly, these types of trends are present across various age and income groups.

While many commentators have stressed the significant changes evidenced by these data, one needs to be careful not to overstate the magnitude of the changes or imply that we fully understand their underlying causes and future direction. On a comparative basis, our use of checks in the United States is still extremely high. We also know that consumers tend to adopt technological change gradually. Even when new technologies start to gain widespread acceptance, old ones are abandoned fairly slowly. Research conducted by the Federal Reserve staff reinforces the notion that the adoption of technological change is a highly complex process with a large number of factors determining a household's willingness to adopt new technologies for the consumption of financial services.

Blurring of payment mechanism boundaries
A second key trend concerns the many ways in which the boundaries between individual payment mechanisms are blurring and in some cases breaking down. Let me provide some examples drawn from our experiences with ACH use in the United States. As you know, the ACH network in the United States is heavily dominated by bulk, recurring credits and debits, such as salary and utility payments. But the ACH mechanism is increasingly being used for other types of payments, including individual payment transactions initiated over the Internet or the telephone. Telephone- and Internet-related transactions made up 10 percent of total ACH transactions for the third quarter of last year. In contrast, at the end of 2001 these types of payments represented only 1 percent of total ACH transactions. The growing conversion of check payments to ACH items is another example. About 5 percent of ACH volume for the third quarter of last year reflects this conversion process, up from about 1 percent less than two years earlier.

Central bank oversight of payment systems

The Federal Reserve has a long-standing interest in the effective operation of the U.S. payments system due to the critical role that a well-functioning payments system plays in the country's overall economy. This interest manifests itself in a number of ways, including, but not limited to, research and analysis, regulation and supervision, and even direct provision of payment services. Let me now turn to recent Federal Reserve efforts to gather information on current payment dynamics.

Assessing changes in payments
I have already mentioned the retail payments research that we sponsored in 2001, which documented the decline in aggregate check volume. We recently announced that we will be conducting similar studies this year to allow us to further assess the pace of change in retail payments. Specifically, we will be repeating two of the three studies that we conducted in 2001. This year we will be examining the number and value of checks written in the United States and the number and value of electronic payments. We anticipate releasing the results of both studies later this year. It is our expectation that this research will shed additional light on the key question of the pace and specifics of the trend from paper to electronic payments in the United States.

In addition to this type of market survey research, we also believe that continuing dialogue with other payments system stakeholders, both providers and users, is vitally important. In that vein, the Federal Reserve, through its Payments System Development Committee, last October sponsored a major conference on transition in the payments system. This conference brought together end users, financial institutions and other payment providers. The conference was unusual in the variety of viewpoints represented, including large retailers like Wal-Mart, financial institutions of all sizes, government agencies and payment processors and networks.

As you might imagine, there were many points of view about the adequacy of current payment mechanisms and the likely direction and pace of change. Despite the range of opinions expressed, there were several main themes that [Fed] Vice Chairman Roger Ferguson highlighted in his concluding remarks, which I think accurately summarize the current dynamics in payments:

  • From a public policy perspective, the payments system is not currently facing serious or fundamental problems. The pace of change in the payments system, however, is accelerating due to a number of factors including changing payment preferences, technological advances, business practice innovation and evolving regulatory frameworks.
  • There is general agreement on the need to address barriers to innovation in payments, but there is significant variation in what participants believe constitutes a barrier and only limited consensus on the appropriate steps to address specific barriers.
  • While many speakers identified opportunities to improve the payments system in various regards, there was less agreement on how the costs of these enhancements should be borne and how the inevitable operational transitions that would be required should be managed.
  • Given the diversity of stakeholders in the payments system and the resulting diversity of views on the needed direction and pace of change, it is clear that continuing dialogue among all of the interested parties will be an essential ingredient to real progress.

In the view of conference participants, three areas for continued attention and action seemed particularly important: risk management, Internet payment alternatives and standards. In terms of risk management, there was general agreement that the ability to maintain a sound payments system without excessive fraud or other sources of loss will remain a challenge requiring attention from many payments system participants. The growth of electronic commerce over the Internet was seen as increasing the need for low-cost, real-time alternatives for interbank funds transfers related to this activity. The goal of straight-through processing—linking payments with transaction information in a way that businesses' internal systems are linked seamlessly with payment mechanisms—was seen as an area of considerable opportunity, but also challenge. Progress in this area is likely to be dependent on the establishment of common information processing standards, which will require effective collaboration across a diverse group of payments system stakeholders.

Within the Federal Reserve, we are engaged in research and planning efforts to consider the characteristics of the potential "next generation" of our payment mechanisms. As part of this process, we are analyzing the major attributes of current and future types of payments. In this vein, our ongoing discussions with a variety of payments system stakeholders, both providers and users, regarding the strengths and limitations of existing payment mechanisms is an invaluable source of information. While this initiative is still quite preliminary, we hope it will help us assess far-reaching questions, including the desirability of developing new payment mechanisms that combine features of current retail and wholesale offerings.

The Fed's operational role in payments

After gathering the available data on payments system trends, Federal Reserve policymakers need a framework to guide their decision making, particularly as it relates to the question of the direct provision of services. We believe that the central bank's overriding concern when considering its financial services role should be on improving the welfare of society as a whole, rather than advancing more narrow interests. This broad focus reflects the overall mission of the Federal Reserve. We do not try to maximize market share for ourselves or to advance the interests of one group of payments system participants over others.

This emphasis on broad social benefits means that we tend to look first to market forces to shape payments system developments. One key role that we strive to play is to facilitate change in legal and regulatory frameworks where necessary to remove impediments to innovation. Our sponsorship of the Check 21 legislation, which I will summarize in a few minutes, is one recent example of these efforts.

Having recapped the major trends evident in U.S. payment activities and summarized some of our key activities with regard to the oversight of U.S. payments from a policy perspective, I want to conclude by spending a few minutes summarizing some of the key operational initiatives we are pursuing in our major wholesale and retail businesses.

Operational initiatives of the Fed

I will focus today on just a few key initiatives, many of which link to the more general trends in payments we already discussed and the framework guiding our payment decisions that I just articulated. I will begin with a discussion of initiatives under way with Fedwire and conclude with a discussion of our major retail businesses—ACH and Check. For each of these businesses, I will begin by providing an overview of current volume levels and trends.

On a preliminary basis, Fedwire funds transaction volume last year was 123 million, up 7.2 percent from the prior year. The aggregate value of these transactions was $447 trillion, up 10.1 percent from the 2002 level. Operationally, there are three initiatives under way in Fedwire that I want to discuss briefly: expanded hours, interoperability and resiliency.

A proposal to expand Fedwire funds service hours was published for public comment in December 2002. Based on the positive response, we moved forward last year with plans to expand Fedwire hours of operation from an 18-hour day to a 21.5-hour day. These new hours go into effect this May. This expansion of Fedwire hours was made in response to industry demand. It will provide greater overlap with the Asian markets and will reduce existing constraints on managing settlement and operational risk.

Recognizing the importance of interoperability to reducing operational risk, improving operational resilience and improving payments system efficiency, we have been actively exploring avenues to make payment message formats and networks more seamless. This year we will be continuing to work with SWIFT [Society for Worldwide Interbank Financial Telecommunications] to increase network interoperability between SWIFTNet and the Fedwire network. We will also be collaborating with SWIFT, industry standards groups and other market infrastructures to develop next-generation message formats. In explorations such as this, we place a high priority on feedback from our customers and other key payments system stakeholders. This input will play a critical role in deciding if, and how, we proceed.

Given the vital importance of our wholesale payments infrastructure to financial markets, operational resilience has always been a key priority. As resilient as our infrastructure was before 9/11, and I believe it was second to none, we have made it even better, and our efforts in this regard are ongoing. Since 9/11, we have made important enhancements to the resilience of our services in three areas: data processing, operations support and data communications. In terms of the three mainframe data processing sites supporting Fedwire, we have brought the third site to a higher state of backup readiness and developed the processing flexibility to permit the swapping of production and backup processing between the first and second sites on a relatively routine basis. We have reviewed all operations support activities to ensure adequate local as well as remote site backup of all critical functions. And we have worked with major customers to ensure the diversity and resilience of their connections to us.

On a preliminary basis ACH volume in the United States last year was about 9.9 billion items, up roughly 10.5 percent from 2002. The aggregate value of the ACH items processed last year was $26.2 trillion, an increase of about 7.2 percent from the prior year. The Federal Reserve is the dominant ACH processor, with recent data indicating our market share is around 70 percent. We are working to enhance the functionality of the ACH mechanism, and there are three more important initiatives under way in ACH that I want to highlight. The first concerns our international efforts, the second relates to enhanced fraud detection and the third involves check-to-ACH conversion.

To promote payments system efficiency, we have developed a suite of FedACH international services, which are designed to encourage the use of FedACH for international transactions by accelerating the clearing time and reducing the cost associated with these transactions. Service to Canada has been in place since 2001. Last year we introduced a transatlantic service covering Austria, Germany, The Netherlands, Switzerland and the United Kingdom. We plan to begin service to Mexico later this year. One of benefits of the Mexican service is that it will provide a lower-cost option for sending remittances—the money that immigrants earn and then send back home. [In mid-January] the Bush administration announced an initiative to lower the cost of remittances in the Americas by half by 2008. The impetus behind this initiative is the fact that remittances have tripled in the last six years and totaled more than $32 billion in the Western Hemisphere in 2002. Moreover, remittances have become the main source of foreign capital for some countries. According to White House data, remittances account for more than 10 percent of the gross domestic product of Nicaragua, Haiti, Guyana, El Salvador, Jamaica and Honduras. Losses to the region due to the high transfer fees for remittances have been estimated at more than $4 billion annually.

As I noted earlier in talking about the broad payment trends in the United States, growth in ACH volume has been fueled in part by new forms of ACH transactions including Internet-authorized payments, debits authorized over the telephone and check to ACH conversions at the point-of-purchase or the lockbox. With these new ACH transactions has come the need to carefully identify and effectively manage risk related to the potential for fraudulent transactions. Without effective risk mitigation, there is a potential for financial loss to originating institutions and reputational harm to the ACH system as a whole. The Federal Reserve has taken several steps to respond to these developments. First, last summer we sent financial institutions guidance outlining these risk issues and the risk control measures they should consider taking. After consultation with our industry advisory group and others on the nature of the problem and how best to address it, we are piloting a program that manages debit and credit file submissions against caps and suspends files when caps are breached, at the direction of the financial institution. Information on levels of unauthorized ACH returns could also play a role in identifying sources of fraud, and we will continue to explore these and other means of addressing the fraud concern.

With changes to the NACHA [a not-for-profit banking trade association] rules in 2002 allowing banks to create account receivable (ARC) entries, these items have become the fastest growing of NACHA's eCheck applications. At present, the market is still in a great deal of flux, but some industry studies estimate that ARC volume could grow to over 6 billion items annually. At present, the largest ARC originators are large credit card issuers and others with national customer bases. Given the potential efficiencies to be gained from this product and the fairly significant technological barriers to entry confronting regional and community financial institutions, we have recently decided to provide such a service on at least a limited basis.

Check initiatives
Along with the industry as a whole, we are grappling with the need to reduce the size and cost of our check processing infrastructure as check volumes and revenues decline. On a preliminary basis, Federal Reserve check volume last year declined about 3 percent to about 18.1 billion items. In contrast, our check volume in 2001 was 19 billion items. Since we process about 40 percent of all interbank checks, the transition from paper to electronic payments has significant implications for us. Equally significant, the recent passage of the Check Clearing for the 21st Century Act, or "Check 21" as it is commonly known, will, we hope, serve as an additional catalyst to the adoption of electronic processing efficiencies in retail payments.

Perhaps the most pressing issue for our payment services today is how we respond to the decline in check volumes and the pressure that decline puts on our ability to recover our operating costs. Like others in the industry, we are reducing our check processing infrastructure. We have announced plans to close 13 of our 45 offices, taken steps to streamline our adjustments infrastructure and been actively pursuing other cost-saving opportunities across the full range of our check business. We have made considerable progress, but a significant ongoing challenge remains. One of the realities of the situation confronting all of us in the check processing business is that while the volume of checks being written has begun to decline, the volume of checks processed is likely to decline significantly faster, fueled by the potential for check-to-ACH conversion and image-enabled processing.

The outlook for image-enabled processing received a significant boost with the recent passage of Check 21. The Act, which was signed into law on Oct. 28 of last year, will become effective this October. Check 21 authorizes the use of a new negotiable instrument called a substitute check and provides the legal framework for the creation and collection of these instruments in place of the original paper instrument. A substitute check is a paper reproduction of the original check suitable for automated processing in the same manner as the original. Check 21 requires financial institutions to accept substitute checks from a presenting institution and grant them equivalent status as the original checks.

The use of substitute checks will allow a bank that receives a paper check drawn on a bank across the country, for example, to send information gathered from that check electronically to the payor bank's location, where a substitute check with the same information will be generated and presented for payment. By facilitating the elimination of the need to physically transport paper checks, Check 21 may reduce the costs of check processing and potentially increase the resiliency of the financial system in cases where physical transportation is disrupted. More generally, the ability to use electronic means to effectuate what amounts to the transport of checks could act as a catalyst for other electronic check processing tools such as image exchange.

The enactment of Check 21 creates considerable opportunities and challenges. There is, at present, considerable uncertainty about the direction and pace of change in the check processing business. We are committed to working with the industry to foster the payments system innovation that Check 21 should bring. In this regard, we are committed to providing products and services that will help financial institutions take advantage of the efficiencies of Check 21 and pass these benefits along to their customers.

Finally, let me mention one of our highest priority initiatives that encompasses all of our payment businesses including Fedwire, FedACH and checks. Currently, about 9,000 financial institutions use our DOS-based FedLine product as a secure service delivery channel for our financial services including high-risk transactions such as Fedwire and FedACH. We are closing in on our goal of replacing this channel with our FedLine for the Web product which will utilize a tiered Web security architecture for the delivery of financial services and information. This tiered architecture will allow us to support different applications and services according to their risk, while retaining the ability of customers to access financial services and information using a common portal.

As my comments this morning suggest, significant changes are under way in the U.S. payments system. While there are considerable uncertainties regarding the implications of these changes for various payments system stakeholders, there is real potential for improvements in efficiency and resiliency that will benefit everyone. Whether this process of change that is under way is evolutionary or revolutionary, the Federal Reserve is committed to fostering market-based outcomes that result in a more efficient and effective electronic payments system.