Rethinking Access to the Payments System

Financial Services & E-Commerce Newsletter - Volume 1, Issue 2, Spring 1997

July 1, 1997

Eugene M. Katz, Robert H. Rosenblum

Once upon a time, there was no concept of money. People ate what they grew or hunted, lived in a structure they built or found, and generally did not engage in commercial transactions. As civilization and economies developed, the practice of barter, or trade, developed, so that a farmer could trade fruits and vegetables for the clothing made by someone else. Eventually, this system grew too cumbersome, and people began trading on symbols of value -- sea shells, coins and pieces of paper that we call money, and evidences of indebtedness coupled with a promise to pay, such as what we now call checks and credit card payments. These symbols have little or no inherent value (the piece of paper on which a $100 dollar bill, along with the ink on that piece of paper, is not worth pennies, much less $100). We value them, however, because we are confident that other people will value them. We believe that our local grocery store will accept cash in payment for the food we buy there so we are willing to accept cash in payment for the products we produce or the services we provide. We also believe that we will receive cash (perhaps in the form of a credit to our bank accounts) when we accept a check or a credit card payment in return for our products or services, provided the person purchasing those products or services by check has adequate money in her checking account.

The basis for our confidence in our monetary symbols is well founded. A complicated

but well functioning set of statutes, regulations and practices assures that a merchant can deposit a check in a local bank that was drawn on a bank account from across the country or on the other side of the world, and that her bank account will receive the money promised to be paid on the face of the check. Similarly, the merchant can accept as payment an IOU in the form of a credit card and, except for the payment by the merchant of certain fees to the appropriate credit card company, that IOU will be converted into cash and deposited in her bank account. As a result of current and developing technology, many new forms of payment instruments are becoming available, including prepaid or stored-value cards, electronic purses and Internet-based and other electronic payment mechanisms. Integral to these and a number of other commercial and financial transactions that occur each day is the "payments system."

The "payments system" is a term that does not have a precise definition, although most industry observers and participants have a fairly consistent idea of what it covers. Generally, it refers to the clearing and settlement services that are provided by the Federal Reserve System ("FRS") through the regional Federal Reserve Banks, and by other clearing an settling organizations that interact with the FRS and carry on their activities under the guidance of the operating rules and policies established by the Board of Governors of the FRS (the "Board"). Among the many significant functions performed by the payments system are the traditional clearing and settlement of paper checks through the FRS and regional clearinghouses, and the electronic clearance and settlement of the transfer of funds (principally large dollar transfers) through automated clearinghouses and electronic funds transfer services such as the FRS's FedWire and private networks such as CHIPS and SWIFT.1

Traditionally, direct access to the payments system has been limited to depository institutions (referred to herein for ease of reference as "banks"), whether or not they are members of the Federal Reserve System. Institutions other than banks generally are not permitted to have direct access to the payments system.

The reason for this limitation of access to the payments system probably arose partly from commercial practice, and partly from legitimate regulatory concerns. Among the legitimate regulatory concerns were (and are) limiting access to the payments system to financial institutions that would conduct their activities in such a manner as to assure the proper functioning and safety and soundness of that system. As discussed earlier, confidence in receiving cash in a timely manner is a critical component in our willingness to accept checks, credit cards and other instruments in lieu of cash. This confidence could be severely shaken by an interruption in the smooth functioning of the payments system, such as might occur if one or more of the significant participants in that system defaulted on their obligations, or if there was a significant breach of the security of the payments system (such as by a computer hacker). Such a loss of confidence, in turn, could cause severe disruptions in the normal flow of commerce and finance if , for example, merchants began refusing to accept checks or credit cards and instead insisted on receiving only cash.

These reasons, however, do not explain why only banks are permitted access to the payments system. No doubt, as a general rule banks are credit worthy participants in the payment system, due in large measure to the regulatory oversight of state and federal banking regulators. It might be tempting to also assume that the federal government's insurance of the deposits of banking customers also provides significant comfort to the financial integrity of the payments system, although on reflection this is not necessarily the case. First, deposit insurance is available only to deposits, and only to deposits of up to $100,000. Many of the electronic transfers, large checks and other items processed by the payments system simply are not eligible for deposit insurance, either because the underlying funds are not drawn from bank deposits, or because the transactions greatly exceed $100,000. Second, even if the federal government were to pay depositors of a failed bank (or, as is more often the case, arranges for that failed bank and its deposits to be acquired by another bank), this process takes significant time, and the payments system would be significantly disrupted if the settlement of transactions in which such a failed bank was involved had to await final payment by the FDIC on deposits (or the final acquisition of the failed bank by another bank).

Nonetheless, while banks generally are credit-worthy participants in the payments system, there are other financial and other institutions that potentially also are credit-worthy participants. As an example, many major brokerage houses, insurance companies, diversified financial holding companies and others are as a group at least as credit worthy as banks, and certainly in general are more credit worthy than, say, financially troubled banks with large portfolios of bad loans (which, despite their financial difficulties still may have access to the payments system). The reason that these types of institutions do not have access to the payments system probably rests less on any overarching regulatory policy considerations than it does on a simple fact of history: Until recently, these financial institutions did not particularly want access to the payments system.

Not so long ago, banks offered a relatively well-defined and relatively unique set of products and services. Among these, for example, were check writing privileges, and as a necessary corollary, a mechanism for clearing and settling checks (that is, assuring that when person A wrote a check to person B, person A's checking account was debited by the appropriate amount and person B's checking account was credited by the appropriate amount). This clearance and settlement function, and related services, were and are handled by the bank through its direct access to the payments system.

As long as financial institutions other than banks did not offer check writing and other services that required access to the payments system, there really was no need for those institutions to have access to that system. But recently, competition and technology have permitted non-bank financial institutions to offer products and services that do require access to the payments system. For example, brokerage firms offer the functional equivalent of check writing privileges from money market and wrap fee accounts, and permit electronic transfers of money from investment accounts. Many non-bank institutions offer various other types of sophisticated and not so sophisticated products and services that permit or facilitate the transfer of money from one person to another. One increasingly important example of this are computer companies that are developing and refining computer systems and programs that permit individuals and companies to transfer money electronically, directly from their home or business computers. As a result, many non-bank financial and other companies now have a legitimate interest in having direct access to the payments system, rather than having to access that system indirectly through a bank.

Fundamentally, there does not appear to be anything unique to the deposit-taking or any other core functions of a bank that should cause banks, and banks alone, to have direct access to the system that clears and settles checks, electronic transfers and the like. The reason that banks need direct access to the payment system -- to assist them in transferring money from one person to another -- is now equally compelling in the case of other financial institutions and companies that offer products and services that involve the transfer of money. Moreover, securities and commodities firms have long been participants in the securities and commodities clearance and settlement systems (such as National Securities Clearance Corporation, or NSCC), which conceptually function in manner quite similar to the payments system. It is difficult to conceive of a legitimate danger to the payments system if securities firms were to be permitted direct access to that system, when securities firms already have direct access to the systems that clear and settle stocks, bonds, futures contracts and the like.

Currently, Congress, the Administration, banking regulators and the financial services industry in general are considering how to regulate financial services providers in the United States. It is widely accepted that banks, securities firms, insurance companies and other financial services providers are offering products and services that directly or closely compete with products and services offered by the others. In this environment, laws that were written with the assumption that banks offer distinct products and services from those products and services offered by securities firms, insurance companies and other financial services providers are being reevaluated. As part of this reevaluation, the concept of who should have access to the payments system also should be considered. Indeed, Senator D'Amato (R-NY), Chairman of the Senate Banking Committee, has on several occasions suggested that access to the payments system should be considered as part of broader legislation to modernize the financial services industry.

While providing non-banks access to the payments system would raise a number of issues, it is likely that a regulatory structure providing such access could be developed around the following three key principles.

1) Does the proposed participant in the payments system have a genuine need to have direct access to that system? For example, a bank that offered solely trust services to its customers might not actually need access to the payments system, while a securities firm that offered check writing privileges to wrap fee account customers might well have a legitimate need to have direct access to that system (such as in the form of being able to offer lower costs or better services to its customers due to the direct access).

2) Does the proposed participant have sufficient financial resources to justify permitting it to have direct access to that system? As discussed above, confidence in the safety and soundness of the payments system is critical to our commercial and financial world. Presumably, entities with direct access to the payments system should have adequate capital, and should be subject to legitimate rules that govern access to that system. In this regard, it is not at all clear that any particular class of financial institutions should have automatic access to the payments system. For example, it might be appropriate if banks that do not meet certain minimum capital requirements lose their ability to directly access the payments system, and instead must access the payments system through a correspondent relationship (i.e., through a financial institution that does have access to the financial system, much the way non-bank financial services providers access the payments system today).

3) Does the proposed participant have sufficient safeguards in place to prevent unauthorized access to the payments system? Such safeguards presumably would include appropriate policies and procedures governing employees and supervisors, and appropriate computer and technological safeguards.

Any efforts to permit additional access to the payments system also should attempt to strengthen that system. While that system works well, the increasing number, value and complexity of transactions that the payments system must handle will at some point test that system. Permitting access to the payments system to well capitalized institutions with a legitimate need to access that system, while simultaneously denying access to that system to other institutions, should decrease costs to (and arguably increase competition among) financial services providers, while at the same time strengthening that system.

*Mr. Katz, a member of Womble Carlyle Sandridge & Rice PLLC, was formerly Director of the Litigation Division of the Office of the Comptroller of the Currency and Senior Deputy Chief Counsel, of the Office of Trift Supervision. Mr. Rosenblum, a lawyer with Fulbright & Jaworski LLP, previously was counsel to a commissioner of the Securities and Exchange Commission, and is the author of a forthcoming book on the Investment Company Act. Womble Carlyle and Fulbright & Jaworski represent a number of clients which may have an interest in the subject matter of this article, although this article expresses only the views of the authors, and not necessarily the views of Womble Caryle, Fulbright & Jaworski, or their clients.

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1 Section 11(a) of the Federal Reserve Act contains a list of the clearing and settlement services provided by the FRS for which full cost pricing is mandated. This list provides a relatively good picture of what the payment system consists of : (1) currency and coin services; (2) check clearing and collection services; (3) wire transfer services; (4) automated clearinghouse services; (5) settlement services; (6) securities safekeeping services; (7) Federal Reserve float; and (8) any new services which the Federal Reserve System offers, including but not limited to payment services to effectuate the electronic transfer of funds.