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Op-Ed

Why don’t checks clear instantly? Ask the Fed.

Aaron Klein and

Whenever you make a payment—with a credit card, a check, a wave of your iPhone—you’re piggybacking on a system built during a time of punch-card computing, a time when billions of paper checks were flown across the country to be physically sorted one by one. Today, living in a land of smartphones and click-to-same-day delivery, one would think the payment system would have evolved. It has not.

Financial technology firms—or fintech—are gunning to change that. Payment transactions are one of the biggest targets for fintech firms, which want to revolutionize how you make payments, how fast they clear, and who profits from them. Nearly $20 billion in new venture capital dedicated to fintech in 2015 is betting that it will. Banks are aggressively partnering with fintech firms and launching payment systems of their own, not wanting to be the taxicabs in this Uberization story.

In the middle of it all stands the Federal Reserve, which lies at the center of America’s payment system but hasn’t made the core changes the system needs. Its failure to do so is particularly costly for Americans living paycheck to paycheck, trying to manage their money in real time. As a direct result of the Fed’s failure to achieve real-time payments, people are overdrafting their accounts and experiencing costly fees, all while their deposits are stuck in payment limbo.

Whether the Fed leads, follows or gets leapfrogged depends on how quickly the Fed can move. The recent results are not encouraging.

As the nation’s central bank, the Fed operates a major payment system, the Automated Clearinghouse (ACH), the black box that converts things like your debit-card swipes and direct-deposit paycheck into credits and deductions from your bank account. It also writes the regulations for other payment systems, like bank-to-bank clearinghouses. This dual role as both operator and regulator can create a conflict of interest, especially given the Fed’s additional responsibility to ensure that the banking system is safe and secure.

The stakes are high: Losing their role in the payment industry would cost the banks a significant source of profit; colonizing it would represent an opportunity for fintech startups. Yet the Fed’s own attempt to speed up ACH payments has been slow and not terribly successful. Despite advances in technology, payments clear very slowly; debit-card transactions are processed in a batch just once at the end of each day, and deposits like checks take multiple days. The Fed has been trying to speed up the system so that it clears transactions twice a day, a marginal advance that would not fundamentally address the problems consumers face. In a smartphone world, the goal of real-time payments ought to be much closer at hand.

To speed things up, the Fed has named a Faster Payments Task Force—a group with a remarkable 331 individuals who represent all imaginable aspects of the payment system, and that has spent almost two years working on the problem. The Fed announced earlier this year that it’s hiring McKinsey & Company to help “assess faster payments solution proposals from various providers” across the payments industry. Despite (or perhaps because of) having a 331-member task force and the almost unlimited resources of the Federal Reserve System, the Fed still needs help deciding what to do.

Right now, the payment system is actually contributing to income inequality, helping the rich and harming the working class. Most people don’t think of the existing payment system as regressive and falling harder on the poor, but that’s exactly its effect. When you purchase something on a card, the associated fees range from dimes to 4 percent to 5 percent taken from the merchant and distributed among banks, issuers, processors and consumers. Wealthier people get rebates every time they use their cards in the form of points, miles and cash. The more you spend, the better your perks. These add up. Consider someone who spends $50,000 a year on credit cards and earns 1 percent cash back. Their savings come to $500 a year in tax-free money as a result of the payment system.

Lower-income Americans, who disproportionately use cash, prepaid cards or debit cards, get little to nothing and are in effect subsidizing the wealthy through the payment system. They also deal with a slow clearing and settlement system that causes additional expensive overdraft fees. It seems remarkable that in a world in which you can deposit a check from your bedroom or use PayPal or Venmo to send money across the world in seconds, it can still take two to five days to clear a check, or that debit-card transactions are processed only once a day. The result is that people who are living paycheck to paycheck run up overdraft fees thinking that their check cleared when in fact the money isn’t there and the debit card keeps working.

Speeding up check processing is a clear example of how the Fed both moved the ball forward and failed to fully follow through for consumers. The Fed even sent Congress a draft version of what ultimately became the Check 21 Act of 2003, which allows all of us to use our smartphones to deposit checks. Yet the Fed hasn’t used its regulatory authority to make those checks clear as quickly as they are deposited. Hence the confusion when a consumer gets an email saying that a mobile check deposit has been approved—which many assume to mean the money is in their account. But in reality the money isn’t there, as the Fed doesn’t require the money to settle that quickly and the payment industry enjoys the float. As a result, the Consumer Financial Protection Bureau recently reported that: “The availability of funds deposited via check or through direct deposit is a major concern for consumers. Consumers are often frustrated by bank check holding policies and by the length of time it takes for various negotiable instruments to clear and become available.”

Checks, however we deposit them, are quickly becoming a thing of the past; plastic cards may soon follow. Despite a myriad of new ways for banks to issue magnetic stripe cards—credit, debit and prepaid—the basic technology is old, expensive, and, as a result of the widespread adoption of so-called “Chip and Sign,” less convenient and more time-consuming. Does anyone enjoy waiting extra time for an inserted card to be read? Or waiting behind that person?

Fintech is already engaged with new payment systems, using smartphones to simulate cards through new services such as ApplePay, Square and Andriod Pay, which offer the easier, faster and more secure interface of thumb-print technology. But this is also just a marginal advance. These systems are simply replacing your card with your phone. After all, while many consumers think of their cards as Visa or MasterCard, they are all tied to a bank. Payment transactions are bank-to-bank settlements that take days to play through, cost merchants substantial sums, and support an entire ecosystem of payment processors and intermediaries.

The potential for fintech to disintermediate banks from the payment system and create a totally alternative payment system is real and would have serious consequences. It does not necessarily have to be a world of Bitcoins; the change could come through any app that allows people to clear and settle payments in real time, saving merchants money and providing the security, speed and incentives that consumers demand.

Moving to this alternative world would come at a real and not fully appreciated cost. Consumers would lose a myriad of legal protections built into the existing payment system that are triggered through banks. Specifically, consumers are protected against fraud, stolen cards and unauthorized transactions by the Electronic Funds Transfer Act, which flows through their bank accounts—but do not cover fintech payment systems that avoid banks altogether. When your debit card is stolen or phony online transactions occur, the law limits your liability and holds the bank financially responsible. But if your PayPal balance is hacked or you fat finger a payment to the wrong person that never touches the banking system, these legal protections do not apply.

The Fed has an opportunity to improve the payment system in a way that would benefit banks, fintech firms and, most importantly, working Americans who are trying to manage their money in real time. But if they can not find a way to act and act quickly, then the result is a slow, fragmented system that reduces economic growth and hurts millions of Americans who suffer as a result of slow payments. It doesn’t have to be this way. A better payment system awaits everyone from working Americans to small businesses to fintech firms. If the Fed can’t lead, it should follow or get out of the way—and allow fintechs and banks to innovate and solve this problem.

Klein has served as an unpaid member of the Clinton campaign’s Infrastructure Finance Working Group; he has not served as an advisor on any banking or finance issues.

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