2003 Annual Report

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Shifting to New Payment System Standards

New payment technologies generate tremendous benefits for consumers and firms. Incentives abound for payments markets to embrace new technological standards, as the prospects of reduced costs and higher profits drive innovation across the industry. But obstacles to coordination can stall migration toward new technologies. Amid all of this, the Fed can re-evaluate its policy role.

Financial institutions nationwide are considering the possibilities - and pitfalls - of a new law taking effect later this year requiring banks to begin accepting substitute paper images in place of original paper checks. Passage of the law, commonly known as Check 21, required cooperation from legislators, the Federal Reserve System, and industry participants throughout the payment system. A further benefit of the law, and one that may have been underemphasized, is the flexibility banks will have in choosing how they shift from paper-based to electronic payments. Read more about Check 21.

This flexibility calls attention to the Fed's preference to avoid overtly dictating technological change in payments markets. The view exemplified by Check 21 embraces the belief that it's beneficial to provide market participants with freedom in determining the future of payments technology. Such freedom fosters creativity and innovation in the development and marketing of new technologies. Ultimately, this flexibility should spur development of a more efficient payment system.

As this migration unfolds, the Fed can position itself in a new light: as a facilitator in fostering coordination, as a clearinghouse for valuable information about costs and benefits of new technologies, and as a careful observer alert to the danger that anti-competitive abuses might either accompany technological innovation or else hinder the pace of innovation.

Critical Juncture for Payments Systems
Payment systems find themselves at a critical juncture. While the "information revolution" brings a dizzying array of new technologies to payment markets, consumers and businesses must decide whether to commit resources to new payment technologies. They do so in volatile and uncertain markets with no assurance as to which technology will ultimately "win." And those in declining payment markets, most notably the market for check clearing, face a difficult question as well: What is the most efficient way of phasing out operations where uncertainty exists about how quickly the decline will occur?

For the Federal Reserve System, the questions are equally difficult:

• Are markets "getting it right" when they choose new technologies? Can they "stall" on older, inefficient technologies?
• What are the tradeoffs between market-based and more tightly managed policy approaches to achieving technological change in the payment system?
• How can the Fed best articulate policy that advances its goal - the smooth transition to the next-generation payment system?

These are some of the fundamental questions for the Federal Reserve and the payments industry today.

New Technologies: Innovation and Adoption
Before discussing what drives innovation and adoption of standards in payments systems, it's helpful to consider lessons learned from other cases where markets face the possibility of movement to new technological standards.

Consider the QWERTY computer keyboard system (so named for the first six letters on the top left of a computer keyboard). The QWERTY keyboard became the standard in the days of manual typewriters because its configuration minimized the risk that manual keys would get stuck when two letters were struck in succession. While this unusual key arrangement might have decreased typing speed, more importantly it reduced down time from sticking keys.

Computer keyboards today still use the QWERTY configuration. But why? There is no risk of key sticking on a PC keyboard. And other designs might be more intuitive to learn or lead to higher maximum typing speeds. There are two possible answers: One is that the market has "locked in" to an inferior technology. From a policy perspective, this raises the possibility that government intervention to move the market toward a superior standard might be beneficial. On the other hand, perhaps there has simply been no clearly superior new technology.

Networks and Coordination
The QWERTY system exemplifies the key issues surrounding technological change because the QWERTY keyboard, along with many other technological standards, is a network good. Its production and consumption occur in an environment where many individuals must make adoption decisions - and where each one's decision impacts the others. In such an environment, the transition to a new technological standard can require an exceptional degree of coordination.

Payment networks face similar issues. Payment technologies are generally network goods, often involving diffuse and heterogeneous participants. Consider the coordination involved in setting up a debit card network. Consumers must adopt cards. Merchants must purchase card readers and subscribe to electronic networks. The networks themselves must develop and adopt technical standards allowing interoperability. And, banks must subscribe to common networks. Each of these groups has multiple decision-makers with diverse and possibly conflicting interests. How can the market overcome these barriers? Or suppose we start in an environment where checks are the dominant payment standard. Can a superior standard take over? And what about competition from other new technologies, such as credit cards?

One answer is that markets have proven to succeed even in the face of strong network effects. Of course this simplifies the issue a bit, but it is unambiguously true that there has been tremendous change in the payment system over the last two decades, even where new payment technologies have strong network effects. Debit cards, indeed, penetrated the market, and quite rapidly. Read more about the growth in electronic payments volumes. It seems clear that markets can provide incentives for innovation and successful transitions between technological standards.

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