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At the 2005 Payments Conference, Federal Reserve Bank of Chicago, Chicago, Illinois
May 19, 2005

The Federal Reserve in an Electronic World
Michael, thank you for your kind introduction and for the opportunity to share with you my
perspective on the forces shaping today's payments landscape. We have heard a great deal
during this conference about various innovations within the payments system and how
payments providers can take advantage of them. What I would like to focus on this morning
are some of the effects that these innovations, and market changes, in general are having on
the payments industry and to address the role of the Federal Reserve in this time of rapid
market change.
Let me begin with a review of marketplace changes. It is clear that a market-driven change
is under way within the payments system. Overall, users of the payments system are moving
away from the use of paper checks and toward much greater use of electronic payments. A
recent Federal Reserve study shows that in 2003, for the first time ever, the number of
electronic payments in the United States exceeded the number made by check. Although
checks are likely to remain an important part of the payments system for some time to come,
a long-term decline in the use of the check appears, finally, to be taking hold. Still, it is
important to remember that this changeover has been a long time in coming. After all,
electronic wire transfers have been around for most of our lives and debit cards and the
automated clearinghouse (ACH) system were developed three decades ago.
There is, of course, more to the story of increased use of--and confidence in--electronic
payments by consumers, businesses, and governments. The payments industry itself is taking
innovative steps to collect more payments electronically. Let me highlight two of the most
significant innovations. The first one, which was discussed earlier at this conference, is
electronic check conversion. Simply put, electronic check conversion amounts to using the
bank account and routing information printed on a check to debit a consumer's bank account
electronically via the ACH system or a debit card network. In 2004, more than 1 billion
checks were converted to electronic payments using the ACH system, reducing the number
of checks that would otherwise have entered the paper collection system.
Electronic check conversion is sometimes confused with innovations associated with the
Check Clearing for the 21st Century Act (commonly known as Check 21). This very
important law will ultimately bring about fundamental changes to the check-collection
system, because it facilitates the adoption of check truncation and electronic collection of
checks through the action of market forces. I would note, however, that even before Check
21 became law, one out of every five checks collected through the Federal Reserve Banks
was being presented electronically.
Check 21 contains consumer protection provisions that differ from those provided under
electronic check conversion. But the substantive rights of consumers are very similar

whether they are derived from check or electronic fund transfer law.
To date, little has changed within our national check collection system since Check 21 came
into effect a little more than six months ago. However, as banks make the investments
necessary to take advantage of Check 21 and modify their operations to make the best use
of the new technologies, the acceptance of digital check images for presentment and return
of checks will accelerate. And costly substitute checks, though they are critical to the
change allowed by Check 21, will eventually be looked back on as a transitional vehicle that
helped achieve greater electronification of payments.
Overall, a more electronic payments system will benefit society and will help improve
payments system efficiency. The need for physical transportation of paper checks will
decrease. With more channels for processing payments, the payments system infrastructure
will become more diverse and more resilient. At the same time, however, the payments
industry will have to rely more heavily on key telecommunications networks and computing
systems. Mitigating the risk associated with greater reliance on electronic processing is vital
and should be a top priority for the payments industry.
There are other challenges arising from the ongoing transition to a more electronic system.
Many payments providers are trying to determine how best to manage investments in paper
check processing as check volumes decline. Many are also trying to decide what, if any,
investments to make to take advantage of the authority provided by Check 21 to convert
checks to electronic funds transfers.
Changes within the payments system are also presenting challenges to the Federal Reserve
System. Since 1999, the number of checks collected through the Reserve Banks has fallen
nearly 20 percent, and the pace of decline is accelerating. The Reserve Banks have
undertaken a range of cost-reduction initiatives to keep pace with the declining volumes,
including an ongoing realignment of their check collection operations. Among their
restructuring efforts is a reduction of the number of offices at which checks are processed
from forty-five as of 2003 to twenty-three by early 2006. As the check market continues to
shrink beyond 2006, the number of check processing centers will almost certainly decrease
The Reserve Banks are also increasing their use of technology as part of a longer-term
business strategy to facilitate the greater use of electronics in check processing. That
strategy includes providing products and services that help banks take advantage of Check
21. To date, the adoption of those services has been slow, however. On average, only
400,000 of the 50 million checks the Reserve Banks collect each business day involve the
deposit of digital check images or the printing of substitute checks. Using Internet
technology, the Reserve Banks are improving customers' access to such core clearance and
settlement systems as ACH and Fedwire. They are also offering new services consistent with
heightened customer account activity and risk management capability.
Any discussion of the Federal Reserve's evolving role in payments would be incomplete
without a review of the Fed's role vis-à-vis its private-sector competitors. From its inception,
the Federal Reserve considered its role in payments to be an important component of its
central bank responsibility. The Fed's check and ACH services, in addition to Fedwire for
commercial transactions, have provided a consistent, reliable, and efficient payment
capability that has enhanced the performance of the U.S. economy.
While the Fed has had a significant role in payments, it has not been the only player. The

Monetary Control Act of 1980 (MCA), by requiring that the Fed explicitly price all the fee
services it offers to banks, establishes, as a matter of public policy, a competition between
the Reserve Banks and the private sector in the provision of payment services, to ensure that
the efficiencies of market competition are realized fully.
Other legal and policy limitations on the Reserve Banks also affect the Fed's competition
within the private sector in the provision of payments services. First, the Reserve Banks, as
directed by the MCA, must make their payments services available to all depository
institutions--in contrast to private-sector competitors, which may offer their services to a
limited, more profitable market segment. Second, the Reserve Banks, again as directed by
the MCA, must recover, over the long run, the full direct and imputed costs of providing
payments services to depository institutions. While the Reserve Banks' competitors also
must recover their costs, they may, in addition, offer non-payment-related services that the
Reserve Banks may not offer, thereby giving competitors greater flexibility in recovering
payment service costs.
This mix of competition and statutory obligation is highly beneficial to consumers and
businesses alike and is an important source of efficiency and innovation within the payments
system. The Reserve Banks' direct involvement in the payments system and ability to
facilitate the adoption of standards and practices through their operating circulars also helps
the Federal Reserve achieve its broader public policy goals, such as improving the efficiency
and smooth functioning of the payments system.
Unlike the Federal Reserve Bank obligations under the MCA, private-sector payment
providers have a single-sided option. That is, they can compete in any segment of payments
without the requirement to offer a full range of payment alternatives. As will be discussed
later, this competitive option for private-sector firms is good for the consumer.
There are many examples of private-sector payment providers making strategic decisions on
payments that affect competition. One example involves check-clearing services. Many
large banks with significant correspondent banking networks have historically offered
check-clearing services to downstream correspondents as a core component of their product
mix. Through consolidation, some of those banks have discontinued all or parts of their
correspondent banking services. Others have promoted their check-clearing services, as the
incremental cost of clearing checks is small relative to their existing fixed-cost structure. As
this example suggests, banks have a wide range of strategic reasons for either discontinuing
or expanding their check-clearing operations, and their pricing strategies can be as varied as
their strategic reasons for participating in the business.
Other examples of strong private-sector competition provided by the Clearing House
Interbank Payments System (CHIPS) and the Electronic Payments Network (EPN), are the
large-value funds transfers and ACH processing services to an increasing number of large
banks that originate many of these payments. A diverse mix of banks, corporate credit
unions, third-party processors, and other service providers also provide competitive payment
services in markets across the country.
An important question raised by the ongoing innovation and change in the payments system
is whether regulatory response is necessary. At this conference we have heard a variety of
opinions on this topic. Some believe that as payments are made and collected in new ways,
certain laws and regulations need to be clarified. Others suggest that the change offers a
unique opportunity to reconsider the relationships among legal and regulatory regimes that

support the payments system.
When considering the need for regulatory response, it is instructive to recall efforts by
committees of both the House and the Senate in the very tech-conscious environment
surrounding Y2K. After extensive hearings, committees concluded that caution should be
exercised in changing laws and regulations to accommodate technological innovations. This
sensible conclusion was based in part on two important realizations--first, that however well
intended, efforts to alter current laws and regulations may assume that today's technological
state of the art will also be tomorrow's and, second, that any changes based on that
assumption could have the unintended consequence of stifling innovation.
Rather than attempting to address specific technological changes, a starting point might be to
identify certain principles. One principle, for example, might be that regulation in general
(not just regulation within the payments system) should be effective and as clear as possible,
and should support market-led innovation. Another principle might be that payments laws
and regulations should be viewed holistically. As the distinctions between paper and
electronic payments become increasingly blurred, there may be opportunities to simplify
existing laws and regulations to achieve greater consistency among them.
But I would be wary of making fundamental changes to the existing regulatory regimes
without substantial study and careful consideration of the potential implications. Careful
consideration would argue for a gradual, cooperative approach to identifying regulatory
concerns and impediments to innovation and to address those concerns in a way that meets
the needs of our economy for flexibility and growth. Of course, government organizations
must carry out their specific mandates and act according to the public interest.
The development and enactment of Check 21 offers a good example of this approach. As
you may recall, the development of Check 21 began as the result of the banking industry
identifying legal barriers to clearing checks electronically--specifically, state laws governing
check collection that allow banks to demand that the original checks be physically presented
for payment. Although these laws typically allow banks to agree to alternative presentment
arrangements, the large number of banks in the United States has made the widespread
adoption of electronic check collection through agreement extremely difficult. The Federal
Reserve worked with the banking industry, consumer groups, and legal experts to analyze
these barriers to innovation and determine how best to address them. The resulting legal
innovation was the introduction of paper substitute checks that are legally equivalent to
original checks, thereby allowing banks that choose to collect checks electronically to create
and present substitute checks to paying banks that demand presentment by paper check. The
resulting proposal was then presented to Congress and formed the basis of what became
known as Check 21.
This bit of history leads me to the role of the Federal Reserve in regulating the payments
system. While the Federal Reserve has an interest in the smooth and secure functioning of
the overall payments system, our regulatory authorities are specific to only certain
operational aspects of the system, such as the interbank collection of checks, and specific
consumer rights and protections, such as consumer liability for unauthorized electronic funds
transfers. These authorities are derived from statute.
With regard to the operational aspects of the payments system, the Federal Reserve is
responsible for regulating the operations of the Reserve Banks, particularly their check
collection and wire transfer activities. The Federal Reserve also has regulatory authority,

under the Expedited Funds Availability Act and Check 21, for various aspects of the
collection and return of checks by banks.
The Federal Reserve's regulatory authority over electronic payment operations is limited to
those of the Reserve Banks. Instead, the private sector, through bank associations, card
networks, and other cooperative rule-setting bodies, establishes many of the operating rules
for electronic payments. For example, NACHA--the National Automated Clearing House
Association--sets the operating rules and establishes contractual liabilities and warranties
among the banks that participate in the ACH system. Similarly, Visa, MasterCard, various
electronic funds transfer networks, and card companies establish the particular operating
rules their members must follow in their credit and debit card operations.
A potential implication of this distribution of rulemaking authority within the payments
system is that as more payments are made by ACH or by debit and credit cards, the relative
importance of private-sector rulemaking may increase. At the same time, as checks are
increasingly collected electronically, the Federal Reserve may need to use its regulatory
authority over the interbank check collection system more actively. In particular, we will be
monitoring the banking industry's experience with the Board's regulations implementing
Check 21 and will revisit them over the next few years to determine whether any
refinements are necessary.
With regard to consumer rights and protections, the Board has a more extensive role with
both checks and electronic payments. For checks, the Federal Reserve's statutory authorities
relate to the obligations of banks to make deposited funds available to their customers and to
recredit their customers for losses suffered as a result of receiving a substitute check. We
take these responsibilities seriously. For example, we monitor developments in the checkcollection system on an ongoing basis to determine if the maximum permissible hold periods
in Regulation CC should be shortened. If we find sufficient improvement in check-collection
and return times, particularly as more banks make use of Check 21, we will reduce the funds
availability schedule accordingly.
For electronic payments, specifically debit cards and ACH, the Federal Reserve has equally
important responsibilities. They include establishing the rules that help protect consumers
from unauthorized transactions and the various reporting and notice requirements associated
with electronic funds transfers that must be made to consumers.
The card associations and private-sector rulemaking organizations complement these
regulatory protections and disclosure requirements by offering additional rights, protections,
and notices. For example, the card associations provide consumers with "zero liability" for
certain unauthorized credit and debit card transactions that are processed on their networks.
While the private sector plays an important supplemental role in the area of consumer
protections and notices, the Federal Reserve has become increasingly active in this area. For
example, we have clarified that consumers have the same general rights under Regulation E
(Electronic Funds Transfers) when their payments are made via electronic check conversion
as they do when they pay their mortgage automatically each month.
We also are considering how to address concerns about the notices that consumers receive
when their checks are converted to electronic payments. We have found that the quality of
these notices varies tremendously, creating some confusion among consumers about what
they are authorizing. The Board is considering whether to revise the commentary to
Regulation E to include model language that could be used in these consumer notices. We

are also considering whether to require, along the lines of current industry rules, a written
authorization signed by the consumer when the check is converted at a merchant location.
I expect that the need for further clarification of regulations by the Federal Reserve will only
grow as more innovation occurs within the payments system.
An important conclusion from this discussion is that the role of the private sector is growing.
This is happening in all segments of the payments system, from providing payments services,
to setting industry rules or establishing industry technical and operational standards, to
providing consumer rights and protections.
Nevertheless, the Federal Reserve will continue to have an important role within a
more-electronic payments system. We will continue to monitor developments within the
payments system to better understand their implications. As a policymaking body, we will
continue to promote the integrity and safety of the payments system while also supporting
improvements in efficiency and accessibility. We will facilitate private-sector efforts to
improve the payments system through a combination of dialogue and leadership. Where
appropriate, we will work cooperatively with the private sector to identify and remove
regulatory barriers to innovation and efficiency within the payments system. And, finally,
when necessary, the Federal Reserve will act as a catalyst to greater efficiency, safety, and
accessibility within the payments system.
I would be happy to answer any questions you may have.

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Last update: May 19, 2005