Chapter THE PAYMENTS SYSTEM: AN OVERVIEW Expected Learning Outcomes After studying the chapter, you should be able to 1 2 Distinguish between commodity and fiat money Explain the importance of checks Enumerate and explain the desirable outcomes of a payments system Explain how a bank client can use automated teller machines (ATMs) Explain how e-money, bitcoin and blockchain are used in the payments system RUBYCHAPTER 3 INTRODUCING THE PAYMENTS SYSTEM: AN OVERVIEW INTRODUCTION Money facilitates transactions in the economy. The mechanism for conducting such transactions is called a payments system. The payments system has evolved ‘over time from relying on payments made in gold and silver coins, to payments made with paper currency and checks written on deposits in banks, to payments made by electronic funds transfers, The Transition from Commodity Money to Fiat Money Commodity money refers to a good used as money that has value independent of its use as money. Fiat money refers to money, such as paper currency that has no value apart from its use as money. People accept paper currency in exchange for goods and services partly because the government has designed it to be legal tender, which means the government accepts paper currency in payment of taxes and requires that individuals and firms accept it in payment of debts Money is also useful because of its ability 10 serve as a standard of deferred payment. Money can facilitate exchange at a given point in time by providing a ‘medium of exchange and unit of account Historians disagree about precisely when people began using metallic coins Evidence suggests that people in China were using metallic coins in the year 100 # c.and people in Greece were using them in 700 y « For centuries, buyers and sellers used coins minted from precious metals, such as gold, silver, and copper, ‘as money. Gold and silver coins suffer from some drawbacks, however. An economy's reliance on gold and silver coins alone makes for a cumbersome payments system. People had difficulty transporting large number of gold coins to settle transactions and also ran the risk of being robbed. To get around this problem, beginning around the year ,y 1500 in Europe, governments and private firms - early banks ~ began to store gold coins in safe places and issue paper centificates, Anyone receiving @ paper certificate could claim the equivalent amount of gold. As long as people had confidence that the gold was available ifThe Payments Sytem: An Over 8 they demanded it, the paper certificates would circulate as a medium of exchange. In effect, paper currency had been invented. In modern economies, the central bank (Bangko Sentral ng Pilipinas), issues paper currency. The modern BSP payments system is a fiat money system because the BSP does not exchange paper currency for gold or any other commodity money. The BSP issues paper currency and holds deposits from banks and the national government. Banks can use these deposits to settle transactions with one another. Today, the BSP has a legal monopoly on the right to issue currency. Although in the nineteenth century private banks issued their own currency, they can no longer do so. In fact, it is not the government's designation of currency as legal tender that explains why paper currency circulates as a medium of exchange Rather, paper currency circulates because of the confidence of consumers and firms that if they accept paper currency, they will be able to pass it along to someone else when they need to buy goods and services. Basically, it is a case of self-fulfilling expectations: You value something as money only if you believe that others will accept it from you as payment, Our society's willingness to use pieces of paper issued by the BSP ay money makes them an acceptable medium of exchange. ‘The Importance of Checks Paper money hay drawbacks. Another major innovation in the payments system came in the early twentieth century, with the increasing use of checks, Checks are promises to pay on demand money deposited with a bank of other financial institution. They can be written for any amount, and using them is a convenient way to settle transactions. Settling transactions with checks does, however, require more steps than settling transactions with currency. Processing the enormous flow of checks worldwide costs the economy several billion dollars cach year. There are also information costs to using checks ~ the time and effort required for the seller to verify whether the check writer (the buyer) has sufficient amount of money in her checking account to cover the amount of the check. Accepting checks requires more trust on the part of the seller than does accepting peso bills,34 Chapter 3 New Technology and the Payments System The Bangko Sentral ng Pilipinas supervises the payments system but doesn’t secon it because many payments are processed by banks and other private firms. The BSP has listed what it believes to be the five most desirable outcomes for a payments system: 1. Security. Episodes in which criminals have hacked into retail credit card systems and other parts of the payments system have raised concerns about security. Better security increases consumers’ and businesses” confidence that funds will not be stolen electronically. 2. Efficiency. Resources devoted to processing paper checks or other aspects of processing payments are diverted from producing other goods and services. Increasing the efficiency of the payments system allows it to function using fewer workers and computers, or other capital, which benefits the economy. 3. Speed. Fast settlement of payments facilitates transactions by both households and businesses. 4, Smooth international transactions. The increasing amount of business that takes place across borders can be facilitated if payments can be made quickly and conveniently. 5. Effective collaboration among participants in the system. The payments system needs to efficiently involve governments, financial firms such as banks, and other businesses around the world. Such involvement ensures smooth transfers of funds in transactions. Debit cards can be used like checks: Cash registers in supermarkets and retail stores are linked to bank computers, so when you use a debit card to buy groceries or other products, your bank instantly credits the store's account with the amount and deducts it from your account. Such a system eliminates the problem of trust between the buyer and seller that is associated with checks because the bank’ computer authorizes the transaction. In recent years, many consumers have begun using apps on their smart-phones or smart-watches that are linked to credit or debit cards. For example, Apple Pay and Android Pay allow consumers to buy goods at any store with a compatible register at the checkout counter by waving their phone or watch. Apple Pay and Android Pay are examples of proximity mobile payments. While the total volume of transactions using such payments is relatively small, it has been increasing rapidly.The Payments System: An Overview _ 35 Automated Clearing House (ACH) transactions include direct deposits of payroll checks into the checking accounts of workers and electronic payments on car loans and mortgages, where the payments are sent electronically from the borrower's account and deposited in the lender's account. ACH transactions reduce the transactions costs associated with processing checks, reduce the likelihood of missed payments, and reduce the costs lenders incur in notifying borrowers of missed payments. Forty years ago, Automated Teller Machines (ATMs) did not exist. To deposit or ‘withdraw money from your checking account, you needed to fill out a deposit or withdrawal slip and wait in line a bank teller’s window. Adding to the inconvenience was the fact that many banks were open only between the hours of 10 ane and 4 p94 (Which were called bankers’ hours). Today, ATMs allow you to carry out the same transactions at your bank whenever it is most convenient for you. Moreover, ATMs are connected to networks (such as BANCNET, Megalink, so you can withdraw cash from the ATMs of banks other than your own. E-Money, Bitcoin, and Blockehain The boundaries of electronic funds transfers have expanded to include e-money or electronic money, which is digital cash people use to buy goods and services. One of the best-known forms of e-money is the PayPal service, An individual or a firm can set up a PayPal account by linking to a checking account or credit card. As long as sellers are willing to accept funds transferred from a buyer's PayPal (or other e-money) account e-money functions as if it were conventional, government-issued money. The central bank does not control e-money, though, so it is essentially a private payments system. Recently, journalists, economists, and policymakers have been debating the merits of bitcoin, a new form of e-money. Unlike PayPal, biteoin is not owned by a firm is instead the product of a decentralized system of linked computers. Bitcoins are produced by people performing the complicated calculations necessary to ensure that online purchases made with bitcoins are legitimate—that is, that someone doesn't try to spend the same bitcoin multiple times, People who successfully complete these calculations are awarded a fixed number of bitcoins—typically 25. This process of biteoin “mining” will continue until a maximum of 21 million bitcoins has been produced—a total expected to be reached in 2030.36 Chapter 3 Because people can buy and sell bitcoins in exchange for dollars and other Currencies on web sites, some people refer to it as a "cryptocurrency." You can buy bitcoins and store them in a "digital wallet" on a smartphone. You can then buy something in a store that accepts bitcoins by scanning a bar code with your phone. A number of web sites, such as BitPay, which is based in Atlanta, allow merchants to process purchases made with bitcoins in a way similar to how they process credit card payments. Despite these possible benefits to using bitcoin, it has not yet been widely adopted. The introduction of Apple Pay and Android Pay provided consumers with a way to use their smartphones linked to a credit card to make payments, which undercut one of bitcoins advantages. Some firms also question whether the software underlying bitcoin is capable of dealing with a large number of transactions. The most popular online bitcoin exchange, Japan-based Mt. Gox, closed in 2015, further reducing confidence in the crytocurrency. Despite the problems with bitcoin, the underlying technology behind it, known as blockchain, has attracted interest from both firms and governments as they attempt to increase the speed, efficiency, and security of the payments system. Blockchain is technically a distributed ledger, or an online network that registers ownership of funds, securities, or any other good, including movies and songs. Blockchain allows individuals and businesses around the world to settle transactions instantly and securely on encrypted sites. The ability to direct transactions through blockchain could eliminate banks and other intermediaries, potentially greatly reducing costs. The greatest stumbling block to businesses adopting blockchain is the complexity if the technology and its resulting high cost. If the cost declines over time, blockchain may become a key part of the payments system. CASHLESS SOCIETY Blockchain and other new payment technologies are exciting and lead some commentators to predict a “cashless society.” A Federal Reserve study found that noncash payments continue to increase as @ fraction of all payments, and tlectronic payments now make up more than two-thirds of all noncash payments. Not surprisingly, the number of checks written has been dropping by more than 2 billion per year. In reality, though, an entirely cashless (or checkless) society may be difficult to attain in the near future for two key reasons: