Why is the United States lagging behind in payments?

… is the title of a useful paper by Christian Catalini and Andrew Lilley that digs into the puzzle of why it is that one of the (if not the) key players in the global financial system seems to lagging global best practice in terms of the cost, convenience and speed of its payment system.

It has to be noted that the authors are not neutral observers in this space. Christian Catalini is the Chief Economist of the Diem Association and Diem Networks US, and Co-Creator of Diem (formerly Libra). He is also the Founder of the MIT Cryptoeconomics Lab and a Research Scientist at MIT. Andrew Lilley is an employee of Novi Financial, Inc. who contributed to the paper as part of his work with Diem Networks US. With that caveat in mind, the paper still offers a short (12 pages) and useful summary of the ways in which the US lags best practice.

They frame the US problem as follows:

The US enjoys one of the least concentrated banking systems among the G30, but this feature has also created a fragmented and expensive payments system. Transfers between major US banks incur fees ranging from $10 to $35 for same-day wires, and up to $3 for 2-day transactions. Compare this to the UK, where individuals and businesses have access to a free, 24/7 interbank payments system which settles within seconds and supports over 8M transactions per day. While the US does have a Real Time Gross Settlement (RTGS) system, the Fedwire Funds Service carries less than 1 million transactions per day, has limited 21/5 availability, and is almost exclusively used by financial institutions and large corporations. Its fees, moreover, are larger than alternative payment methods such as ACH, creating a trade-off between cost and immediacy. Private sector alternatives are limited, and while some banks have deployed real-time solutions, these come with transaction limits and little adoption, which severely reduces their usefulness.

Catalini and Lilley (2021), Why is the United States Lagging Behind in Payments?

The paper then outlines how these limitations affect individuals, business and government and concludes with suggestions of what might be done to address the problems discussed:

There are at least three ways to remove frictions in payments and rapidly expand the number of individuals and businesses that can access the financial system and cheaply transact in real time. The first is to bring deposits on a single ledger through a Central Bank Digital Currency (CBDC), so that transfers between banks are not limited by external liquidity constraints or third-party rails. The second approach is to follow countries such as India and Mexico and increase the throughput of always-on RTGS systems. This is the model the Federal Reserve is pursuing with the introduction of FedNow, targeted for 2023. FedNow, however, is expected to have an initial transfer maximum of $25,000, which would limit its usefulness to businesses. The third approach is to facilitate the growth of interoperable, stablecoin payment rails by creating the right regulatory framework for these new types of networks to safely increase competition in payments.

While each one of these approaches presents different challenges, opportunities and trade-offs in terms of complexity, development costs and ability to expand access to segments that are currently excluded, it is important to stress that they are likely to be complements, not substitutes.

Advancing the US payments infrastructure will require both regulatory and technical developments targeted at improving market structure, lowering barriers to entry, and facilitating collaboration between public and private sector efforts in digital payments.

Catalini and Lilley (2021)

I am trying to keep an open mind on the future of payment systems but find myself drawn towards the conclusion that fast payment systems that the FedNow initiative is based on seem to have worked pretty well in other countries in terms of improving cost, speed and convenience so it is not obvious to me why either a CBDC or stablecoin solution is necessary in the United States.

If you want to explore these issues further, JP Koning recently offered a nice summary of what has been achieved by fast payment systems in other countries while a speech (“CBDC: A solution in Search of a Problem?”) by Governor Waller of the US Federal Reserve neatly summarises the issues associated with whether a CBDC is necessary or desirable (at least so far as the USA is concerned). It is important to recognise however that the conclusions that Waller draws do not necessarily apply to other countries (China being the prime example) which are responding to very different types of payment systems.

Let me know what I am missing

Tony – From the Outside

Central bank digital currencies – Game On

FT Alphaville today wrote up some of the highlights they picked up from a report included in the Annual Economic Report published by Bank for International Settlements (BIS).

The highlights I picked up from the Alphaville column included:

  • Central Bank Digital Currencies (CBDCs) now seem a matter of when, not if, primarily because the BIS has concluded that they need to get ahead of Big Tech (i.e. Big Tech are pushing ahead with their own versions of digital currency in a number of jurisdictions so central banks need to respond to these initiatives)
  • The fact that China is committed to a digital currency with the potential to gain a “first-mover advantage” also seems to be a factor
  • The BIS does not however see a CBDC as adding much value if your financial system already has a well functioning, retail fast payments system with all of the safeguards required by know-your-customer regulations
  • In terms of design, the BIS seems to be opting for an account based (as opposed to token based) form of digital money
  • Two of the larger design issues associated with implementing a CBDC are privacy versus security concerns and the potential for crowding out (i.e. how the new form of digital money impacts financial systems where banks are established as the primary suppliers of digital money).

There is a lot to unpack in the BIS paper but it is worth noting one thing I found immediately curious. In responding to the concerns about privacy versus security, Alphaville noted that “The report … says CBDCs could even have a built-in layer of anonymity for very small inconsequential transactions“.

That might work from an Anti Money Laundering (AML) perspective but it is far from clear to me how you would define “very small inconsequential transactions” in a world where a relatively small number of low value payments can finance child pornography. Westpac Banking Corporation paid a high price for failing to comply with reporting requirements in this regard so it is hard to see how a CBDC could define a threshold that was inconsequential.

Alphaville is of course just one perspective. I am yet to read the BIS paper in full but these are the key takeaways that the BIS author has chosen to highlight:

. Central bank digital currencies (CBDCs) offer in digital form the unique advantages of central bank money: settlement finality, liquidity and integrity. They are an advanced representation of money for the digital economy.

• Digital money should be designed with the public interest in mind. Like the latest generation of instant retail payment systems, retail CBDCs could ensure open payment platforms and a competitive level playing field that is conducive to innovation. 

• The ultimate benefits of adopting a new payment technology will depend on the competitive structure of the underlying payment system and data governance arrangements. The same technology that can encourage a virtuous circle of greater access, lower costs and better services might equally induce a vicious circle of data silos, market power and anti-competitive practices. CBDCs and open platforms are the most conducive to a virtuous circle.

• CBDCs built on digital identification could improve cross-border payments, and limit the risks of currency substitution. Multi-CBDC arrangements could surmount the hurdles of sharing digital IDs across borders, but will require international cooperation.

“CBDCs: an opportunity for the monetary system”, BIS Annual Economic Report 2021

Tony – From the Outside