Why the Fed needs to get its act together on payments

By Felix Salmon
March 12, 2011

I’ve known Josh Reich, BankSimple’s CEO, for a while now, but it’s only today that I managed to sit down and have a serious conversation with CFO Shamir Karkal. He’s a very interesting guy — go check out his latest blog entry on the rise of Credits and you’ll see what I mean. Our discussion today was largely about payments, an area where BankSimple stands out starkly from the mass of banks and credit unions by being in favor of lower debit interchange fees.

The debit interchange debate is at full volume right now, as banks try to lobby Congress to weaken the part of the Dodd-Frank law which essentially forces the Fed to bring interchange fees down to a very low level. And both sides — banks vs merchants — are putting a lot of money and effort into noisily pushing their side of the story. It was only when I sat down with Shamir that I finally found someone with a considered middle-ground view. And he makes a lot of sense.

The big picture here starts with the fact that there are very good public-policy reasons for central banks to assiduously regulate payments mechanisms and ensure that they clear at par. Paper checks are very expensive to process, for instance, but if I write you a check, the amount of money that I spend and the amount of money that you receive are identical.

In much of the world, bank transfers work the same way. If you give me your bank account details, I can transfer money straight from my account to yours, and you will receive the exact amount of money that I sent. In Scandinavia, this happens in real time: I can transfer money to you now, and you can see that money appear in your bank account minutes later.

The US is far behind on this front; bank transfers are so cumbersome, time-consuming, and expensive that a huge company called PayPal has grown up to try to make money out of providing an easier way of doing things. But people have a tendency to send money via PayPal by typing in their credit-card number, and in that case the amount of money received is significantly less than the amount of money sent. In other words, PayPal does not always clear at par, and that’s both a weakness of the system and an explanation of how come it was sold for well over a billion dollars.

Right now, debit cards can’t be used for person-to-person payments. There are companies like Square popping up to try to change that, but again they take their cut, with the effect that debit does not clear at par. If you pay me $100 with Square, I’ll receive $97.50.

This is a problem, because it makes payments difficult and inefficient. We’re at a restaurant, and we don’t want to burden the waiter with two different cards. So I pick up the check and you transfer half the total bill directly from your account to mine. That should be easy, but it isn’t. And if one of use has to pay a fee for doing that kind of thing, it’s never going to happen.

The next important realization is that payment mechanisms are fragmenting, but are also subject to enormous network effects. The cash-and-checks duopoly over payments lasted a long time, but is long gone now, and there’s a huge push towards lots of other payments systems, from mobile to debit to things like Facebook Credits. And what all of them want is ubiquity and scale. There’s no point in me signing up for PayPal if you aren’t signed up too. But if everybody’s signed up, it’s great.

Once a payments system gets enormous, it then has the ability to start extracting rents. This is exactly what happened with debit cards: in the beginning, they were very cheap, as banks encouraged merchants to accept them. Once substantially all merchants did start accepting debit cards, the banks then embarked on a process of extracting rents by steadily increasing debit interchange fees. And left to their own devices, they will continue to raise those fees steadily and inexorably. This goes against the public interest, and it’s an abuse of the banks’ monopoly position.

Enter the central bank. In a sensible system, the central bank should constantly be keeping a close eye on what’s happening in the payments space, and trying to maximize the ease with which people can transfer money to one another while at the same time being able to keep an eye on money laundering.

This is not uncommon in much of the world, especially in Scandinavia. Payments systems there don’t make lots of money for the banks, but they do help the economy as a whole run much more smoothly.

In the US, however, this doesn’t happen at all, for two main reasons. Firstly, the banks are far too big, too powerful, and too important to the economy as a whole. As such, they’ve effectively captured their regulators, to the point at which the Fed considers its main job to be to safeguard the health of the financial system rather than to minimize inefficiencies in the economy as a whole.

On top of that, the US has a rigid rules-based system rather than a more flexible principles-based system. As a result, no matter how much the Fed looked into the system of debit interchange, it was effectively powerless to prevent massive fee inflation unless and until Congress gave it a mandate to do so. That mandate arrived with Dodd-Frank, but again the Fed’s pretty powerless to do anything intelligent or inventive: it has no choice but to implement the Durbin amendment exactly as it’s written. So the whole battle is being played out in front of Congress. What should be a matter for technocrats is instead being decided by politicians, and it’s rare that ever results in an improvement.

In a sensible system, we wouldn’t need the Durbin amendment at all, because the Fed would have been on top of the debit interchange situation all along, and would have pushed hard on the banks to ensure that they didn’t start extracting rents from what is at heart an extremely cheap and efficient payments utility. But because of the way the Fed’s set up, they couldn’t or didn’t do that.

What this means is that as payments go mobile, we’re going to have exactly the same problem all over again. The banks will coalesce around some kind of mobile-payments solution, they will support it until it becomes broadly adopted, and then they’ll start extracting as much money from it as they can get away with. And the Fed will look on, powerless, until someone like Durbin comes along to legislate a one-off solution which will almost certainly not be optimal.

All of which is to say, we desperately need the Fed to move to smart principles-based regulation with real teeth, at least when it comes to payments. But I fear there’s precious little chance of that.


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“If you pay me $100 with Square, I’ll receive $97.50. This is a problem, because it makes payments difficult and inefficient.”

Square taking a cut is a problem because you find it difficult and inefficient? I feel the same way about my grocery store checkout line… should I just skip the line and walk out the door with my trolley?

“…banks then embarked on a process of extracting rents by steadily increasing debit interchange fees. And left to their own devices, they will continue to raise those fees steadily and inexorably. This goes against the public interest, and it’s an abuse of the banks’ monopoly position.”

The banks are a monopoly? Plural? I would suggest that if there is a problem, it is precisely the fact that it looks to the consumer as if payments clear at par. If the retailer added the charge explicitly, I think you might see some different market dynamics emerge.

Posted by markmthomson | Report as abusive

Debit card fees should be regulated, because it looks obvious there is collusion among the banks. If there was true competition, the fees for debit cards would drop to somewhere close to their actual cost, and the only way the cost of processing electronic debits could be anywhere near what the bank industry claims it is if Bernie Madoff is doing the accounting.

That said, the Fed is not the right body to regulate prices. Their responsibility should be to ensure a reliable and equitable monetary system. Enforcement of anti-trust laws, which the banks regularly ignore, should be the responsibility of the executive branch. The laws are usually created by Congress, and we can count on that not happening any time soon, as the last thing Congress would want to do is piss off the banking industry.

And speaking of collusion, is there a law that demands banks charge $29 or $35 when credit card payments are late? If not, why does every bank charge that (often usurious) fee? Where’s the competition in that?

Posted by KenG_CA | Report as abusive

It’s time the government got back into managing the currency. The currency is electronic nowadays As usual, the private sector has screwed it up. Let’s get the government back to doing its job.

Posted by spiffy76 | Report as abusive

The real issue that Congress should be looking at is the situation with state money transmitter licenses. The price of a debit transaction keeps increasing because no one is allowed to enter the market to compete without going through absurd regulatory hurdles. I have written more about this issue here:

http://www.huffingtonpost.com/aaron-gree nspan/a-public-comment-on-the-d_b_812525 .html

Posted by aarongreenspan | Report as abusive

FaceCash huh?

It seems like everyone and their mom is starting a new payments system.

Bring it on. I’ll adopt any and all systems.

Whatever fosters competition is good. Line em up, let the market decide.

And, yes, I’ll still take actual cash too.

Posted by bryanX | Report as abusive

A technical advantage that most of the new mobile solutions have over the classic card scenario is that they are inherently more secure.

Handing a card over to a store clerk or waiter is essentially a security breach every single time.

ATMs are no more secure. Card skimmers and micro-cameras or keypad overlays can easily breach the debit pathway. The ATM itself can be a fake, set up to skim you’re info.

With mobile payments you typically “push” money to the merchant without revealing any key info. With credit/debit cards you’re ALWAYS revealing critical info so the merchant can “pull” your money.

Heightened security should lead to less fraud and therefore lower fees.


Posted by bryanX | Report as abusive

Your comments reflect what is a common global issue with the incumbent banks and the regulators. Whether it is the recent spate between the EPC and the European Commission on SEPA end dates or creation of Faster Payments in the UK, there is one common theme. The business case for innovation within incumbents versus the new players is inherently different. Improving the overall efficiency of the financial supply chain will remain a pipe dream.

Posted by AussieBanker | Report as abusive