Over the past few years the topic
of electronic commerce and banking has moved from the laboratory
into the mainstream of our public discourse. This afternoon our
panel has been asked to discuss the subject of alternative
financial delivery systems. I would like to broaden this
discussion a bit. The theme of my remarks will be that three types
of variables--convenience, confidence, and complexity--are helping
to shape the ongoing changes in electronic commerce and banking. I
would then like to apply this theme briefly to the historical
development of retail payment systems, in order to provide some
insights into the changes in products and delivery systems that
are now taking place. Finally, I would like to touch on the role
of the central bank in addressing these developments and provide
some information on the work of the Federal Reserve's Payments
System Development Committee.
Convenience, Confidence, and
Complexity
Electronic commerce is growing rapidly as our technologies for
processing, analyzing, and transmitting vast quantities of data
continue their extraordinary development. Consumer and business
practices across a number of markets are changing, in some cases
dramatically. In the end, there may be far-reaching and positive
implications for the structure and efficiency of many of our
markets.
Three key sets of variables that
are shaping electronic transactions and electronic commerce can be
summarized under the headings of convenience, confidence, and
complexity. Convenience refers to the capital, labor, time, and
other real resources needed to conduct a transaction. Obviously,
consumers and businesses wish to optimize the resources expended
in conducting a transaction. Confidence refers to the trust that
parties have in the elements of a transaction that generate risk
to them. Financial, operational, security, and legal risks are
relevant here as in many other contexts. Particular attention is
currently being paid to the complex of "trust variables"
relating to the authentication of transactions and parties, as
well as to issues of privacy. Complexity is a shorthand reference
to the ease with which the key features of a transaction can be
standardized and automated and, ultimately, understood by the
parties to the transaction. As we have now learned, however, it is
not the good or service itself, sometimes called content, that
necessarily has to be standardized in order to participate in
electronic commerce. Rather it is the sales transaction and key
related services that need to be standardized.
There appear to be important
tradeoffs among the convenience, confidence, and complexity
variables that shape choices about electronic as well as other
transactions. Greater convenience in transacting through open data
communication networks, for example, may increase security and
privacy risks and reduce user confidence. Greater complexity, in
turn, may reduce the convenience of transacting electronically
through data networks. One fundamental point, however, is that
ongoing changes in technology are improving the terms of these
tradeoffs, sometimes in several dimensions at the same time.
For example, traditional
constraints on the timing and location of economic transactions
are being relaxed simultaneously and rapidly in a number of
markets, leading to large potential gains in convenience. Through
the use of the Internet and automated business systems, many
markets can now be open twenty-four hours per day at very low
marginal costs. Transactions can take place at much more
convenient times tailored to the specific needs of individuals and
businesses, with either immediate delivery of services in some
cases or with later delivery in others.
New technologies are also
reducing the need for buyers and sellers to meet at one location
as well as the need for computers and telephones to be tied to
traditional wire networks. The result is that even some
traditional retail markets increasingly seem ubiquitous and
global.
In addition, as convenience
factors such as time and location are changing, significant
efforts are being made to strengthen confidence in electronic
transactions. Various encryption systems have been deployed.
Developments in public key infrastructure are being closely
followed. Considerable attention continues to be paid to
strengthening the law governing electronic transactions. And
privacy has reemerged as a crucial commercial and legal issue.
Electronic Banking
Electronic commerce involving banks is subject to the same forces
as those affecting many other industries. New communications
channels and devices, coupled with automated systems, allow a bank
and its customers to transact an expanding range of business at
virtually any time. According to recent statistics, nearly 40
percent of all U.S. banks now provide some form of web site
through which they can communicate with customers, and nearly 15
percent provide web sites that can be used to conduct banking
transactions. These numbers are growing rapidly. Of the banks with
more than $500 million in assets, nearly 50 percent now provide
web sites that can be used to conduct transactions.
In parallel with the development
of new transaction systems, there is an ongoing trend toward
standardizing and automating banking products, including loan
products, which traditionally required special attention and
approvals along with thick files of documents. As in other
industries, this combination of developments is calling into
question the size of investments in traditional delivery
mechanisms, which are now disparaged as "legacy systems"
and "brick and mortar" investments. As in other
industries, banks are increasingly examining both the relative
importance of their various delivery channels and the degree to
which their products and services are integrated across the
channels.
In this environment, banks are
continuing to experiment with new technologies, services, and
business models. It is natural that there is both uncertainty and
intense market competition surrounding promising innovations.
Because of the rapidly changing nature of electronic commerce,
some of these innovations will undoubtedly press the very
definitions of banking. Of course there are also risks, along with
the new business opportunities. These risks will continue to
require careful monitoring and management. To do otherwise would
undermine the hard-won confidence that once lost is not easily
regained.
Payments
Turning to payments, traditional payment mechanisms such as
currency and checks have held the field against many challengers
for more than a century. Undoubtedly the confidence that has been
built up in traditional payment instruments has played a major
role in their continuing success. Very interesting innovations,
however, are being announced almost every day. Many of these
innovations are being driven by efforts to improve the convenience
of payment instruments and systems, including the timing and
availability of electronic payments. It might be instructive to
review briefly the history of retail payments to understand how
the tradeoff among convenience, confidence, and complexity has
worked.
Looking back, the check was used
in North America as long ago as colonial times. Businesses, in
particular, were early users. The widespread use of the check by
consumers did not occur in the United States until after World War
II. Rising levels of income and restored confidence in the banking
system led to the growth of deposit banking. Checks were used
increasingly to make purchases over the counter as well as to pay
bills. Checks allowed users to make payments for small as well as
very large amounts at any time of the day, without needing to
visit a banking office to obtain cash. Checks also allowed users
to pay bills without visiting physical locations designated by
service providers such as utility companies and other major
billers. Thus checks offered more choices regarding the time and
location for making payments and, at the same time, reduced the
risk of theft and loss associated with cash payments.
Ironically, innovations such as
automated teller machines, which are not payment instruments but
delivery mechanisms for cash, may well have supported the use of
cash relative to checks or newer forms of electronic payments.
ATMs initially offered a key banking service--cash
withdrawals--around the clock. With the latest surge in
deployments, ATMs seem now to be located on nearly every street
corner.
Over the longer term, the
expansion of ATM networks and their integration into broad
"point-of-sale" networks may ultimately improve the
convenience of and increase the demand for on-line debit cards. In
countries such as Canada and the United Kingdom, 20 percent or
more of noncash transactions are now made by debit card over
nationwide networks.
Credit cards offer another
interesting example. Credit cards began more than 75 years ago as
store charge cards. These cards received a boost in the 1960s with
the creation of branded bank cards and have since grown in
popularity. The cards can be used on a 24-hour basis. Initially,
the locations where they could be used were limited, but these
have grown significantly along with overall credit card use in
recent years. Consumers and merchants have now widely adopted
credit cards to make payments arising from electronic commerce.
There have also been efforts to make the use of credit cards over
open networks more secure and to increase protections to
cardholders.
Other attempts at payment
innovations also suggest that convenience, confidence, and
complexity are important. The automated clearinghouse, designed to
provide a very low cost electronic payment mechanism, has been
very successful in automating many types of recurring payments.
Early uses of the ACH, however, did not generally provide for
flexible interfaces with consumers and businesses. To make an ad
hoc electronic payment over the ACH, for example, would generally
have required a special trip to a full-service banking office
during regular business hours. From the standpoint of timing and
location for making such types of payments, the check was clearly
a superior instrument for consumers and many types of businesses.
Some recent innovations such as point-of-sale check truncation and
electronic bill payment systems now provide interfaces between the
ACH and consumers and businesses that may significantly stimulate
the use of the ACH over the longer term.
In pilot tests of stored-value
products, consumers have been able to use innovations such as
stored-value cards only at very limited numbers of locations.
There have been no real market tests yet of cards that can be
reloaded at home computers or telephones. In theory, this
capability could be equivalent to placing an ATM in every
household. On balance, because consumers have not perceived the
characteristics of stored-value cards to yet equal or improve on
those of cash, it is no wonder that the cards have not done well
commercially in early trials. However, providers of stored-value
products have an incentive to make the use of those cards more
attractive than cash in terms of the tradeoff among convenience,
confidence and complexity. If they do that, it is quite possible
that future tests will be more successful.
Potential Lessons and
Innovations
Our experience with innovations in the payment system suggests
several lessons. First and foremost, an innovation should have a
"value proposition" that works for both providers and
users. Providers must be able to earn a competitive return on the
product, otherwise they will have no incentive to supply the
innovation to the marketplace. For users, innovative products will
need to offer combinations of convenience, confidence, and
complexity in making payments that provide advantages over
existing payment instruments and systems and to be competitively
priced. Innovations that simply offer greater convenience but
lower confidence may not be successful. Conversely, innovations
that offer somewhat less convenience but improve confidence
factors such as security and privacy may also be less than
successful, at least initially. The final judgments in these
cases, however, will have to be made by consumers and businesses
in the marketplace as they weigh different variables against each
other.
Second, innovations in payment
systems may provide new ways of doing business for providers and
users that go beyond the process of payment itself. Electronic
payment mechanisms, in particular, may lead to the combination of
financial, payment, and other activities in new ways, particularly
if data are brought together at one time and location for users.
Indeed, new software offers low-cost opportunities to combine data
and activities in ways that may not even have seemed practical a
few years ago. Current electronic bill payment services and
projects are one example. It is becoming increasingly convenient
not only to make on-line bill payments but also to combine this
activity electronically with financial analysis, cash and
investment management, record management, and related functions.
Third, electronic payment
systems typically require a communications infrastructure along
with technical, business, and legal rules in order to function
effectively. The advent of the Internet and other types of network
services may reduce the cost and complexity of putting such
infrastructure in place. Relatively little new infrastructure was
required to use the Internet and existing credit card networks as
communication tools for making credit card payments to support
electronic commerce, and growth has been rapid. Other innovations
may also be able to build on the Internet and established payment
networks, such as the ATM and ACH networks, in order to expand the
range of payment options in electronic commerce.
Fourth, economic "network
effects" may be important in determining which innovations
succeed or fail, at least in the short run. In general, one aspect
of a network effect is that the value of a network to its users
increases as more users join. We are familiar with this effect in
the telephone and other communications markets. In payments, if
too few consumers or merchants use a payment network or a new
instrument, the system may not be sufficiently valuable to its
users for it to become economically viable. To date, some
innovations such as stored-value products may have been less than
successful in part because of these effects.
The Role of Government and
the Federal Reserve
Despite some of the challenges in shifting from a paper-based to a
more electronic payment system, it is clear that the United States
fundamentally has a safe and reliable retail payment system. As
that system continues to evolve, the private sector will play the
pivotal role in most innovations, while the Federal Reserve will
also continue to play a strong and important role.
In general, government,
including the Federal Reserve, must continue to foster the safety
and soundness of the payment and financial system, promote
competitive markets, and ensure adequate levels of consumer
protection. The Federal Reserve can also continue to modernize its
existing payment services and work with the private sector to
identify and, when appropriate, address barriers to payment-system
innovation.
Last July, the Board announced
the formation of the Payments System Development Committee, which
I co-chair with Cathy Minehan, the President of the Federal
Reserve Bank of Boston. This new group is focusing on key medium-
and long-term public policy issues surrounding the development of
the retail payment system. In particular, the Committee is seeking
to work with the public to identify barriers to the future
development of the payment system and to recommend solutions to
the Board and other authorities.
During this year, the Committee
is focusing on four important areas relating to retail and
low-value commercial payments. First, we are attempting to learn
from both Federal Reserve and private-sector experience with
truncation and electronic check presentment, and to identify
barriers to greater use of electronic technologies to collect
checks. Second, we are assessing gaps in standards that may be
inhibiting payment system innovation. Third, we are reviewing
legal and regulatory issues, with an emphasis this year on the
legal underpinnings for converting checks to electronic payments.
Finally, we are examining the long-run strengths and weaknesses of
the clearing and settlement systems for electronic payments.
In addition, the Committee is
following with great interest the many payment innovations that
are currently taking place in the market. Most importantly, the
Payments System Development Committee is seeking to foster
communication with the public about the development of the retail
payment system through meetings, workshops, and other forums.
Conclusion
Overall, a number of innovations are taking place in the retail
payment system, along with very creative thinking by both
traditional and nontraditional participants. Many of these
innovations closely mirror much broader developments in electronic
commerce and banking. Payment system innovations that improve
efficiency and confidence are welcome developments. Because of the
complex nature of our economy and the fundamental role of the
market, many of these innovations will necessarily come from the
private sector. A particularly important challenge for the Federal
Reserve is to find effective ways to work with the private sector
to identify and address genuine obstacles to innovation so that
today's promise can give rise to tomorrow's achievements.
