Happy Brief Friday!
As I mentioned last week, I will start the Payment Series. Here comes the first post on Payment 101.
But before we begin the Payment Series, I just need to share the tweet:
Featured Article: Payment 101
The original meaning of “pay” is to “pacify and satisfy.” Whenever you make a payment, there is likely, if not always, a debtor-creditor relationship between you and the recipient. The payor is obligated to pay the payor for the service or goods or for paying for their debts due arising from previous transactions or events.
Thus, the preliminary question is, how can we erase the debt we owe to the other party? How can two people who don’t even know each other be willing to settle and complete the transaction? What, to the bottom line of the question, is money?
This is the fundamental question preliminary to what the payment is. As such, at the beginning of the U.S. Department of the Treasury report, The Future of Money and Payment, it highlighted money’s three core functions: (1) a unit of account, (2) a medium of exchange, and (3) a store of value. Thus, a critical part of money is consensus formation among people. It could be stipulated by the power that be, or it could be voluntarily accepted by people from all walks of life, or just by a group of prisoners.
I won’t cover the history of money here. You can refer to the traditional view of money history by Investopedia or see a non-tradition picture of money in the book Debt: The First 5,000 Years by David Graeber.
Now that we have a good understanding of what money is, we can discuss what payment is. Because money is a store of value used to exchange goods or services, we can use it to pay off our debt or taxes. Generally speaking, the payment consists of three steps: Execution, Clearing, and Settlement.
Execution/transaction: the payor initiates the payment, including the recipient’s information and the amount of money to be transferred.
Clearing: all necessary activities between transaction initiation and settlement.
Settlement: the transfer of value is finalized, the payment is confirmed, and the debt is paid off.
A cash payment process can simplify these three steps. I would initiate the payment by counting my bills and coins and passing them to the payee. Upon confirming the payment amount and the payee’s acceptance, my debt has been paid off—it is settled within a few finger clicks.
In contrast, credit card payment is much more complicated. When I use my credit card to pay, I start by typing the credentials (or swiping my card). Then I confirm the amount of payment and the information about the recipient. After that, the card issuer (usually a bank) checks whether my credential is correct. If so, it responds to the merchant’s bank via the network service provider, such as Visa and Mastercard. The merchant will receive confirmation of my payment authorization. Thereafter, the merchant can rely on such confirmation to proceed with its service or good delivery.
Then everything between this moment and the final settlement of our payment is clearing. That is, the merchant requests the funds, I get my credit card statement, pay the bill, and my bank transfers my money to the merchant’s bank, which releases the payment to the merchant.
You can see the simplified process in the two flowcharts below:
That’s way more finger clicks in the process behind the scene than the cash payment, although intuitively, we think credit card payment is much more convenient. As you can imagine, despite the automation technology implemented, the non-cash process takes considerable time and human resources. When the payment involves cross-border payment (or, more precisely, cross-currency payment), in that case, it is even more expensive and complicated because the central banks in two jurisdictions will come into the payment picture.
That’s why governments and the payment industry have been tackling numerous challenges. These challenges for an enhanced payment system include global regulatory harmonization, improvement, and technology innovation. Also, these participants want to maintain their monetary policy sovereignty or business interests. That’s human nature, which makes our lives colorful and miserable simultaneously.
Before I conclude today’s Brief, there is a vast difference between the retail and wholesale payment systems. The retail payment system processes high volumes of lower-value transactions and does not need real-time settlement, like the example above. On the other hand, the wholesale payment system addresses larger-value transactions and usually requires a “real-time settlement or continuous settlement” to mitigate risk. Thus, banks and financial markets usually settle their payment through the wholesale payment system.
In short, built upon a clear understanding of money, this Brief covers the payment process in both cash and non-cash scenarios. As the previous Brief highlights, we can better comprehend the convoluting payment ecosystem through the lens of the participants: payor & payee, financial institutions, network service providers, and central banks.
I hope you enjoy Payment 101. I will see you next Friday.
One Question This Week:
What is your least favorite part of the current payment system?
Stay safe and sharp,
Jason Lai
Disclaimer: Not legal advice. You can see the full disclaimer & disclosure here.