Payments are the payment of money for goods and services. This is how money moves through the financial system. The payments system is the range of methods that are used for payments and the infrastructure to support these payments. Technology has been rapidly changing the payments system. In recent years, there have been significant increases in speed, security, and efficiency. However, we still take many of these conveniences for granted.
Electronic funds transfer has become a central part of the payments system. Many of make electronic payments every day. Although this is a “cashless” form of payment, it is important to understand that most of these electronic payments still flow through the banking system. Banks operate as financial intermediaries in electronic transactions, which means that they operate as a third party in these transactions. This is a major difference from physical cash. Financial intermediation always involves transaction fees.
Here are some parts of the U.S. payments system:
- Automated Teller Machine (ATM)
- Debit card and credit card
- PayPal
- Apple Pay
- Venmo
- Zelle
The most basic form of payment is cash. There is no transaction fee associated with payment in cash. It is also an anonymous transaction. Many retail merchants require payment in cash for transactions less than $5.00. In the U.S., some gas stations have begun offering lower gas prices with payment in cash. During the COVID-19 crisis, the U.S. experienced a coin shortage. The slowdown in economic activity resulted in limited circulation.
The paper check has been around for hundreds of years as a form of IOU (“I owe you.”). This makes the check a form of liability, which is not as immediate as cash. Checks must be verified. The innovation of the debit card made it possible to pay with a plastic card that is linked to a checking account. Originally, credit cards were a form of paying on credit, but now they are a common means of payment, especially due to rewards. Physical debit cards and credit cards began to replace cash and checks as the means of payment in retail locations. Physical plastic is referred to as “card present.”
PayPal was created in 1998 as a way to buy things on the internet. Originally, it was part of EBay, one of the early internet sites for buying and selling (used) goods. PayPal introduced an alternative to sending cash or checks through the mail. In this way, it moved beyond the physical delivery of paper for payment. PayPal created a means for electronic peer-to-peer payment. This was a significant evolution of the payments system that coincided with the “dot com” boom in the late 1990s.
More recently, electronic peer-to-peer payment has moved toward Venmo and Zelle. Venmo is owned by PayPal and Zelle is owned by a consortium of banks. These two financial services products provide a means for peer-to-peer money transfer that is especially suited to mobile devices. Venmo tends to be more popular with younger people due to its additional social component (public, messages, emojis). Zelle is connected to banking apps, which makes it more attractive for non-social purposes like paying rent. Both Venmo and Zelle operate as platforms connected to checking accounts or credit card accounts.
Mobile payments are the future of the payments system. Debit cards and credit cards can now be loaded in phones, so that physical card is not necessary. This also allows for contactless payment, which has become even more attractive in the age of COVID. Younger generations are continuing to think more and more of their phones as a means of payment. Companies have imbedded payment methods into their apps as an especially appealing form of payment. Starbucks has been very successful at this. (It is almost as though you are buying coffee for free and earnings rewards for future free coffee).
Money transfer is highly regulated area due to concerns about criminal activity. Know Your Customer (KYC) is an important compliance requirement for money transfer businesses to avoid identity fraud. The Bank Secrecy Act (BSA) also has a number of requirements to prevent terrorist activity in the payments system.
There is a fundamental tradeoff between speed and security in the payments system. Payments that are faster are typically less secure (more fraud, more error). Alternatively, payments that are slower are typically more secure (less fraud, less error). One of the goals right now is “real time payments.” In other words, a peer-to-peer funds transfer that is instantaneous. However, this raises concerns that there may be more room for fraud and error in the push for speed.
Different societies have taken different approaches to innovation in the payments system. In China, electronic payment using AliPay and WeChat has become ubiquitous. There seems to be a cultural acceptance of these changes and somewhat lighter regulation. In the U.S., the adoption of electronic payment (like ApplePay) has been slower than some would have expected. This suggests a slightly slower rate of technological adoption among the U.S. consumer. Also, U.S. regulators have been somewhat cautious about approving more recent innovations in payments due to concerns about security.
Glossary
Payments system. The range of methods that are used for payments and the infrastructure to support these payments