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For release on delivery
11:30 a.m. EDT (10:30 a.m. CDT)
May 11, 2006

Investing in Payment Innovations: A Federal Reserve Perspective
Remarks by
Donald L. Kohn
Member
Board of Governors of the Federal Reserve System
at the
2006 Payments Conference
Federal Reserve Bank of Chicago
Chicago, Illinois
May 11, 2006

I am pleased to have the opportunity to speak at this conference on investing in payments
innovations.1 We are living in a period of rapid innovation and technological change. The
productivity of the U.S. economy accelerated in the mid-1990s and productivity has grown at an
even more rapid pace this decade, as new technologies and increasingly sophisticated capital
equipment have made it possible to produce and deliver goods and services more efficiently and
cost effectively. Technological advancements have made the payments system a very dynamic
part of the U.S. economic infrastructure. The increasing availability and convenience of
payment alternatives, along with generally lower costs, have affected how people choose to pay
for their purchases. Payments that a few years ago were being made in paper form--by checks or
in cash--are today being made electronically. Indeed, a recent Federal Reserve study found that
the number of retail electronic payments in the United States--such as credit cards, debit cards, or
automated clearinghouse (ACH) payments--exceeded check payments for the first time in 2003.
On at least one network, debit card payments have recently surpassed credit card payments,
reflecting the rapid growth in debit card use that has been evident for a number of years. Given
this changing environment, the Federal Reserve is planning to repeat its triennial retail payments
survey next year to help quantify recent trends.
The check-processing system is also evolving rapidly. The changing character of the
payments business is challenging long-held assumptions about the payments infrastructure, as
well as business relationships in the payments industry. My remarks today, which reflect my
own thoughts and not necessarily those of the Federal Reserve Board, will provide an overview
of some of the recent changes in retail payments, the challenges of innovation, and the Federal
Reserve’s role in the retail payments system.

1

Edwin J. Lucio, Helena L. Tenenholtz, and Jeffrey S. H. Yeganeh, of the Board’s staff, contributed to this speech.

-2Changes in the Retail Payments System
For many reasons, I believe the pace of change we have experienced in the retail
payments system over this past decade will continue or even accelerate. Much of the needed
electronic infrastructure is in place today, both in homes and at businesses. As new generations
grow up in the PC age and as older generations become increasingly computer literate, people
are becoming more comfortable with using electronic technology in their daily lives. At the
same time, the emergence of interstate banking has removed institutional barriers to the
development of national electronic debit systems. Innovation in payments systems has also
become a global phenomenon, and successful innovations outside the United States will likely
influence developments here. These and other factors will likely spur further changes in our
payments system in the years to come.
New technologies are at the heart of this evolution. Laws, regulations, and rules have
also been modified to remove barriers to innovation and experimentation in the payments
system. These factors are driving the changes we see today. Consumers and businesses are
increasingly using debit and credit cards instead of paper checks and cash at the point of sale,
and technology has allowed the payments industry to develop new payment instruments to meet
new business needs. For example, over the past decade, Internet-based payment options, such as
PayPal, have grown rapidly and facilitated commerce on the web. In addition, closed-network,
prepaid payment alternatives, which use chip-based technology, have been successful in
collecting tolls on the nation’s highways.
Likewise, the combination of new technologies and changes to the rules and regulations
governing the ACH network has facilitated the use of this network for one-time, nonrecurring
payments. In the past, the ACH was mainly used for recurring payments, such as payroll,

-3mortgage, and utility payments. Today, consumer purchases at stores, over the telephone, or
over the Internet can be completed using the ACH. Regulatory changes have also facilitated the
use of the ACH to convert checks that consumers mail to businesses into electronic payments.
These new uses of the ACH for one-time payments have driven continuing double-digit growth
rates of ACH transaction volume.
Legal and technological changes are also affecting how banks process checks. For
example, the Check Clearing for the 21st Century Act, or Check 21, has facilitated the ability of
banks to collect checks electronically. Depository institutions are using the authority granted
under Check 21 to apply communications and imaging technologies to long-established checkcollection processes. Ultimately, these changes will not only reduce check-processing and
transportation costs but also diminish the importance of geography in check processing.
However, banks seeking to implement a full end-to-end electronic check processing environment
must reengineer their back-office systems to integrate the more complex aspects of electronic
check receipt into their core banking and risk-management systems. We are beginning to see
evidence that depository institutions are starting this reengineering process. Generally, Check 21
volumes at the Reserve Banks are increasing rapidly, reflecting the efficiency gains that will
inexorably lead to the electronic processing of almost all checks in the not-too-distant future.
The greater use of electronic payments has not been uniform across all market segments.
A closer look at payment trends reveals that consumers and businesses may have different
perspectives on electronic payments. Businesses have been encouraging consumers to use
electronic payment alternatives and have been the driving force behind the conversion of
consumer checks into ACH payments. In turn, consumers, recognizing the convenience of

-4electronic payments, have allowed their checks to be converted into ACH payments and have
initiated an increasing number of their payments electronically.
Businesses, on the other hand, have been more cautious about having their own checks
converted into ACH payments or switching from paper to electronics. There are some obvious
reasons for this behavior. First, businesses often have cash-management processes or legacy
accounting systems in place that rely on paper checks. A payments conference hosted by the
Federal Reserve in 2003 found that businesses face organizational and technical challenges in
moving to electronics. For example, businesses may need to make significant investments in
their back-office payment, billing, and accounting systems before they can use electronic
payments more frequently. In addition, many businesses are reluctant, from a control
perspective, to allow others to debit funds electronically from their accounts. If businesses can
overcome these challenges, they should be able to make and receive a much larger portion of
their payments electronically. At the same time, the financial incentives for businesses to make
these changes will increase as the relative costs of electronic versus paper payments continue to
shift in favor of electronic payments.
Challenges of Payment System Innovation
In addition to low costs, successful innovations must satisfy at least three criteria: meet
end-user needs, address network externalities, and provide sufficient controls over risks. To be
successful, new payment instruments, and changes to existing instruments, must ultimately be
more convenient and cost-effective for end users. Consumers and businesses are not likely to
modify their payment behavior unless they are shown how they will benefit from a change. A
Federal Reserve Board staff study conducted in 2002, “The Future of Retail Electronic Payments
Systems,” highlighted this observation. The study was based on interviews with payment system

-5innovators, many of whom had experience during the years of the Internet boom. The interviews
emphasized that providers of payment services cannot assume that an innovative service will
generate significant demand simply because it provides new and creative technical capabilities.
Providing net benefits to one or more key participants in a transaction, while not materially
affecting other participants negatively, appears to be the most important requirement for any
innovation to be successful. The benefits may accrue to the providers of payment services in the
form of lower costs, but they cannot adversely affect end users. This interaction between the
preferences of payments users and the choices offered by payments providers determines which
payment instruments will become successful in the long run.
Successful electronic payment instruments, by their very nature, require large networks
with wide reach. That is, the instruments require a critical mass of both payers and payees.
Developing large networks and attaining critical mass, however, are often difficult tasks.
Consumers may be cautious about using new payment methods and will have particular concerns
about how providers protect users’ funds, security, and privacy. In complex payment systems,
users may need a significant amount of time to become familiar with and learn to trust a new
system. Moreover, potential providers of new payment services may be cautious about investing
before they understand how many consumers would want to use a new payment instrument or
system. As a result, innovators face the classic “chicken and egg” problem when assessing the
network economics of establishing new systems. In the late 1990s, attempts to establish largescale stored-value card networks in the United States faced these problems and were ultimately
not successful.
However, the likelihood of overcoming these network problems appears to be higher if a
particular innovation meets a significant need that existing instruments do not. For example, the

-6growth of Internet commerce created a new need for a payment method that would allow both
consumers and businesses to make and receive relatively low-value electronic payments. While
credit cards and debit cards have become the primary means of conducting these transactions, a
segment of the market, specifically individuals and small businesses, could not readily accept
card payments from others. This demand for an alternative way to make payments on the
Internet eventually led to the development of new payment options, such as PayPal.
The economics of networks and of scale may also interact and accelerate change in
traditional systems. For example, the clearing system for paper checks includes a high-fixedcost physical transportation system. Declines in check volumes generally, as well as declines in
the collection of checks in paper form, will likely result in higher unit costs to collect paper
checks, as the fixed costs of the network are spread over ever-decreasing volumes. The increases
in unit costs, in turn, will cause banks to examine less expensive electronic processing
alternatives, as check-collection intermediaries raise prices to recover their costs. As a result,
market dynamics will continue to lead to the greater use of electronic check processing.
Managing risk is also critical to successful payments innovation. These risks include
fraud, operational, financial, and legal risks. Understanding the relationship between innovation
and risk is particularly important in today’s evolving payment system because concerns about
risk can inhibit the adoption of innovative payment products and services. Payment innovations
can potentially reduce risk within a payment system, but in a complex environment, innovation
may also shift risks or even increase them. Both the design of payments systems and the way
participants use them can affect risk. For example, because a depository institution’s ACH and
check systems may not be integrated, stop payments on checks may not work as intended,
thereby increasing the risk that fraud may slip through the system. Innovations in the use of

-7payment networks, such as the ACH, have led to greater complexity in roles and responsibilities.
Both depository institutions and ACH operators are actively examining their risk-management
capabilities to determine whether new risks resulting from innovation are being adequately
managed. The use of Check 21 authority to process checks has altered operational, legal, and
fraud risks, which has led depository institutions to reexamine and, as necessary, modify their
processes and procedures to ensure that these risks continue to be well managed.
In this time of transition in the payment system, both providers and users of payments
systems will need to manage their risks more comprehensively. Traditionally, risk has been
managed with a segmented, payment-specific approach. This made sense when payments
systems were largely independent of one another. Today, the conversion of checks to electronic
payments, as well as the technical integration of electronic networks and systems, requires
providers and users to adopt a more strategic approach to managing products, infrastructure, and
risk across traditional payments silos. They need to consider not only the financial and business
cases for adopting a particular payments strategy but also how the risks associated with the
strategy will be managed. The payments industry has been actively discussing this issue, and I
expect that the industry will develop effective and comprehensive risk-management approaches.
The Federal Reserve’s Role in the Payments System
The Federal Reserve will continue to play an important role in fostering a smoothly
functioning payments system that is safe, efficient, and accessible. We also need to be flexible
in carrying out our traditional functions within the payments system--as a provider of payment
services, regulator, and catalyst for change--in this rapidly changing environment.
In its role as service provider, the Federal Reserve will continue to promote the efficiency
of the nation’s payments system. The Reserve Banks are now pricing their check services to

-8encourage the greater use of electronic check products relative to paper check products. The
Reserve Banks are also leaders in providing Check 21 services to encourage depository
institutions to shift to the greater use of electronics in check processing and have been working
collaboratively with the industry on electronic check standards and other technical issues. Most
importantly, the Reserve Banks will continue to compete as payment services providers on a fair
and equitable basis by pricing their services to recover their costs, including imputed profits and
taxes, as required by the Monetary Control Act of 1980.
In its role as a regulator, the Federal Reserve will need to be alert to the application of
regulations in changing circumstances. In some cases, regulations may impede the ability of
service providers and consumers to take advantage of new technology. For example, the Federal
Reserve has clarified the application of Regulation E to the new ACH services I discussed earlier
involving check conversions. In some other cases, payments innovations can expose consumers
to new risks--risks with which they may not be familiar. In addressing these situations, the
Federal Reserve must ensure that consumers have adequate protection and that regulations are
consistent with the changing technological environment. Changing payment practices can also
expose financial institutions to growing risks. Last year, for example, the Federal Reserve
modified its Regulation CC to reallocate the liability for unauthorized, remotely created checks
among depository institutions, shifting liability to institutions that are better positioned to
influence and mitigate those risks.
Finally, in its role as a catalyst for change, the Federal Reserve will work with the private
sector to identify and, when appropriate, address barriers to payments system innovation. Last
month, the Federal Reserve combined the duties of two of its internal committees that deal with
payments issues. The newly expanded Payments System Policy Advisory Committee will

-9provide the Federal Reserve with an overall view of strategic developments in both wholesale
and retail payment systems. In addition to supporting sound policy development, the committee
will sponsor research on payments issues that will help inform policymakers, the industry, and
the public. We will also promote dialogue with a wide range of participants in the retail and
wholesale payments systems to better understand a variety of perspectives on key issues. We
will continue to sponsor different types of forums as an important part of our public outreach
activities.
Conclusion
Despite the many challenges associated with the rapid evolution I have discussed today,
the United States continues to enjoy a safe, efficient, and reliable payment system. The strength
of its financial institutions, as well as its payments and settlement systems, are the bedrock of the
country’s financial infrastructure. As innovations occur in the payments system, market forces
will determine which of these innovations will ultimately best serve the needs of consumers and
businesses. We, at the Federal Reserve, need to continue to address barriers to innovation to
give the private sector scope to experiment with new payment services, while we continue to
fulfill our responsibilities to foster a robust payments system that protects and benefits its
participants. At this time of strategic change, I believe that dialogue among payments system
participants and users will help all of us identify and address issues of innovation and risk in a
balanced and thoughtful manner. This conference is a welcome and constructive element in this
important dialogue.