Payments Systems in the US

🚀 The Book in 3 Sentences

This book is an overview of how the U.S. and by extension, the world's payment systems work. It goes into detail on credit cards, debit cards, checking and other systems. It contains an overview of the how and why of each system.

🎨 Impressions

It is a small book, with short but interesting discussions and sections. Most of it is maybe a bit out of the interest sphere of everyday people, but I found it very interesting. It has useful and insightful anecdotes that make reading the book worthwhile. Checking might not be that relevant to me, but I still felt it was interesting to understand how the checking system evolved and, therefore, also led to new developments.

This comment rings true to a lot of the thoughts in the book.

How I Discovered It

A thread on hacker news, not everyone needs to read payment systems in the U. S. was a comment, so I decided to read it.

Who Should Read It?

If you are very interested in payment systems and how it works.

☘️ How the Book Changed Me

I was quite astonished at how immensely profitable the credit card industry is for Visa and Mastercard. Just free money more or less.

✍️ My Top Quotes

There are six core payments systems in the United States: Cash The checking system The credit card and charge card systems The debit card systems The ACH (Automated Clearing House) system The wire transfer systems
The earliest check clearing house was a simple meeting, each business morning, of representatives from each participating bank in a city. Clerks from each of the banks would come to the clearing house bearing bags of checks. At the clearing house, the checks would be exchanged and each clerk would depart with the checks written on accounts at his bank. (It is interesting to note that in the early phases of the card industry, paper “sales drafts” were cleared in much the same way.
The original American Express and Discover systems, and the proprietary card systems (for example, a Sears credit card accepted only at Sears) are examples of closed loop systems.
“On-us” transactions occur when the bank intermediary is the same on both sides of a transaction.
“Push” payments are fundamentally much less risky than “pull” payments. In a “push” payment, the party who has funds is sending the money, so there is essentially no risk of NSF, or nonsufficient funds—”push” payments can’t “bounce.”
“Pull” payments are inherently subject to “bouncing.”
Card networks are fundamentally “pull” payment networks. Card payments don’t bounce—but this doesn’t mean that they are push transactions.
The check payments system in the U.S., as discussed above, is a “virtual” system with no central authority. Banks do, however, join one or more check clearing houses to process checks
Visa, MasterCard, American Express and PayPal are all examples of what we call “thick model” networks. Other networks are thinly resourced, and manage only minimal interoperability issues, leaving functions such as product definition and brand to intermediaries.
Check clearing houses, the ACH, and PIN debit networks are all examples of this “thin model”.
In a “thick model”, the network enables significant profits for the funding member banks. In a “thin model”, the network exists to reduce costs (for example, in check processing), and so is operated as an efficient utility.
The word itself comes from the Arabic word şakk. There
The origins of the checking system as we know it today can be traced to medieval, and perhaps earlier, times—many economies developed some version of a document that allowed the transfer of funds from one bank to another. The word itself comes from the Arabic word şakk
In the late 1950s and early 1960s, the introduction and widespread use of MICR (magnetic ink character recognition) characters enabled high-speed check processing. MICR characters, identifying the bank and account a check is drawn on, appear at the bottom of a check.
Grounded Planes: The events of September 11, 2001, are often cited as the reason for the Fed’s actions in championing the Check 21 law. When planes didn’t fly, and checks didn’t move, for days after the attacks, the float at the Federal Reserve Bank (which technically acts as a correspondent bank in check processing:
In the abstract, float refers to a gap in the availability of funds transferred between two parties.
For funds received, prior to collecting from the paying bank. (Historically, the Fed has done this as a way to manage, on behalf of the presenting bank, uncertainties in check collection.) Often float is more a matter of perception: “disbursement float” is a term used to describe the gap between when a corporation mails a check (and presumably discharges its obligation to a vendor) and the time that the check is actually presented to its bank for payment. Float is often discussed in relative terms: if a bank has been collecting deposited checks on an average of 1.5 days after receipt, and it reduces that to an average of 1.25 days, it has improved float. If a bank makes good funds available to a depositing customer prior to receiving payment on the check in question, it is incurring a float expense—which may be theoretical, rather than actual, if the customer in question leaves the balances in the account. Confused? Here’s one thing to remember about float.
In the U.S., bank exposure to check fraud is generally believed to be less than $1 billion annually.
The third party in the example above is at extreme risk if the consumer transaction is fraudulent—e.g., if the consumer has given someone else’s bank account information. To manage this risk, PayPal early on developed a “micro deposit” scheme designed to verify account ownership. By making two small, random deposits in the consumer’s bank account, and then asking the consumer to report the amounts, PayPal can verify that the consumer is the valid owner of that bank
The third party in the example above is at extreme risk if the consumer transaction is fraudulent—e.g., if the consumer has given someone else’s bank account information. To manage this risk, PayPal early on developed a “micro deposit” scheme designed to verify account ownership. By making two small, random deposits in the consumer’s bank account, and then asking the consumer to report the amounts, PayPal can verify that the consumer is the valid owner of that bank
The card payments systems fascinate many people, within financial services and in many other industries, because they are at the heart of consumer commerce—facilitating trillions of dollars of consumer and business spending each year.
Later, the charge cards issued by Diners Club and American Express in the 1950s, primarily intended for business travel and entertainment (T&E) purposes, established the early “closed loop” card systems.
Shortly thereafter, the two organizations came together under a new company named Visa—with the international organization (IBANCO) becoming Visa International and NBI becoming Visa U.S.A., a group member of Visa International.
In the late 1960s—and in parallel with the growth of credit cards, banks began to introduce automated teller machines (ATMs) as a new channel for serving checking account customers.
Another fraud control data element, referred to as CVV2 or CVC2, is the three- or four-digit number printed on the signature panel on the back (or, for American Express, on the front) of the card, and used as the “Card Security Code” for card-not-present transactions conducted online. If a merchant captures the CVV2/CVC2 from the cardholder and forwards it in the authorization message to the issuer, the issuer will respond by indicating its validity—or lack thereof. This helps prevent fraud where a card number is known but where the fraudster hasn’t had access to the physical card.
Contactless cards use a simpler chip, based on RFID (radio frequency) technology, to pass data between the card and an RFID reader at a POS terminal. Contactless cards are implemented primarily as a customer convenience (for speed of checkout), rather than for fraud management—although they contain technology analogous to the CVV/CVC on the magnetic stripe that helps reduce counterfeit fraud at contactless acceptance locations.
Contactless acceptance devices are also important to the deployment of certain kinds of mobile payments—particularly those based on the use of near-field communication (NFC) technology.
Card volume by type looks very different if you look at transaction count vs. transaction amount. Debit transactions exceed credit transactions by count, but are less by amount due to the higher “average ticket” on credit cards vs. debit cards.
The revenue models for the card networks consist of processing fees and brand-use service fees assessed on all transactions made with a card carrying the network brand.
The credit card has been called “the most profitable product in banking history” in the United States. With industry revenues estimated at more than $140 billion annually (accruing to MasterCard and Visa bank issuers, for credit cards alone), it is clearly an attractive business.
Near-universal acceptance. Almost all retail establishments in the U.S. accept credit cards, as do many non-retail enterprises, including billers, B2B manufacturers, distributors and wholesalers, governments, nonprofits, and educational institutions. A saturated marketplace. Almost 80% of American households—more than 90 million households or about 175 million individuals—had one or more credit cards at the end of 2008. Many Americans without access to credit have debit or prepaid cards. Multiple cards. Of Americans who have a credit card, most have more than five cards each. They are used to choosing between those cards at the point of sale based on a wide variety of factors, including available credit lines, rewards, and purpose of the purchase.
In Greenback, his book about cash, Jason Goodwin notes, “There are more dollar bills in existence than any other branded object, including Coke cans”.
The failure of the German bank Herstatt in 1974, during the course of a day, caused huge losses worldwide and a cascade of bank failures. This type of risk, which became known as “Herstatt risk”,
SWIFT can be thought of as “the payments system that isn’t a payments system.” SWIFT is a global messaging network for the financial services industry, through which participating members, including banks and securities firms, can send each other secure, structured messages.
Convenience helps instill confidence and inspires frequent usage. Anything that gets in the way of convenience—call it “friction”—is likely to dramatically reduce potential consumer acceptance.
Financial gains have to be significant to matter to consumers—significant enough to overcome existing habits and preferences about ways to pay
At the end of the day, we must not forget that the actual making of a payment is not the consumer’s real focus. Rather, consumers want to own the products they’re purchasing, or experience the service, or pay off a liability incurred to another. That’s where the rewards are—not in the payment mechanism itself!
As it turns out, only some 350 major merchants are responsible for about half of all payment card transactions. Similarly, in the eCommerce world, the top 100 eRetailers account for over half the spending in their segment.
There are more than 27 million enterprises in the United States—including businesses, nonprofit organizations, educational institutions, and local governments and agencies.
*In the U.S., to start a bank, you need a charter from an issuing agency—a state or federal chartering authority. The chartering authority examines the business plan, management competency, and capital adequacy of the proposed bank. The charter, when issued, defines the capabilities of the bank. The key activity is deposit taking.
A non-bank can lend money or handle payments, but only a chartered institution can accept consumer deposits into a transaction account.
Banks make money by lending money, by holding money (in deposit accounts or investment accounts), and by moving money—moving money means payments. Although all three activities are profitable for banks, the relative profits are highest for lending, and lending activities tend to dominate a bank’s management agenda.
It’s hard to imagine, from the standpoint of the present, just how innovative and frankly amazing the ATM was. Customers who once spent their lunch hours waiting in line to deposit a paycheck and get grocery money could now take care of business on their way home from work—or after church on Sunday.
Famously, Visa and MasterCard used to require acquiring bank contracts to bind merchants to their rules—without letting the merchants see the rules! Today, both organizations make the rules available on their websites.