Making a payment – what does actually take place?
Payments today are almost exclusively electronic payments where funds are transferred from one bank account to another. What does actually happen when someone makes a payment? Are any physical assets transferred (bags of coins?), or, is it all just bookkeeping?
As a starting point, money in a bank account is nothing more than a contract with a promise to pay (the bank being the debtor/payer and the account holder the creditor/payee); it is a claim against the bank (an IOU issued by the bank, Norwegian: enkelt krav) held by the account holder.
By creating bank IOUs called “demand deposit accounts“, the bank promises to:
- Convert deposits into cash (coins and notes) on demand;
- Accept bank IOUs (deposits), both its own and those of other banks, in payment of debts owed to the bank, and as deposits to accounts with the bank.
Thus, in essence, the modern banking system operates as a national clearing facility where each bank accepts IOUs on all other banks in the country. This allows anyone with a debt due to any bank in the country to pay this debt with an IOU issued by any other bank in the country. Banks, in turn, clear accounts among themselves using their holdings of reserves with the central bank (electronic central bank money, i.e., IOUs issued by the central bank). (Historically, when notes were issued by various banks to document deposits made to bank accounts, notes issued by one bank were not necessarily accepted at par by another bank. As an example, if you tried to pay down your loan from Boston Savings Bank using notes issued by First Bank of Kentucky, they might only be worth only 70 cents on the dollar. The Federal Reserve System in the US was created in part to ensure par clearing: the banks that were members of the Federal Reserve System would clear accounts among themselves using the Federal Reserve’s IOUs, called central bank reserves. A bank would accept another bank’s IOU at par trusting it would be settled at par by the issuing bank by the deliverance of an IOUs issued by the government, i.e., the Federal Reserve. This type of payment & clearing system is used around the world today, with commercial banks using central bank reserves to clear accounts among themselves.)
Let us examine what is described above in more detail by way of an example:
- A keeps a deposit account with Bank 1. A holds NOK 1000 on this account.
- B keeps a deposit account with Bank 2. B holds NOK 500 on this account.
- Both Bank 1 and Bank 2 have accounts with the central bank where they hold central bank reserves. They each hold reserves of NOK 1000 with the central bank.
- A buys a bicycle from B, agreeing to pay B NOK 500 for it.
- A agrees to settle the purchase price by transferring NOK 500 to B‘s bank account at Bank 2.
- A instructs Bank 1 to transfer NOK 500 to B‘s account with Bank 2.
- What actually takes place then, legally, is that part of the IOU issued by Bank 1 to A (NOK 1000), an IOU in the amount of NOK 500, is transferred from A to B, i.e., B becomes the holder/owner of this IOU (in the amount of NOK 500) on Bank 1.
- Thus, B, for a short period of time, holds an IOU issued by Bank 1 in the amount of NOK 500.
- A‘s claim on Bank 1 is reduced to NOK 500 as a result of the transfer of the IOU in the amount of NOK 500 to B.
- B’s IOU on Bank 1 in the amount of NOK 500 is then transferred to Bank 2, and as settlement for this IOU, Bank 2 credits the deposit account of B with the same amount (at par), i.e., it issues an IOU to B in the amount of NOK 500.
- A, as a consequence of the above, ends up with NOK 500 in his deposit account with Bank 1, and B ends up with NOK 1000 in his deposit account with Bank 2.
- However, Bank 2 has no intention of permanently holding an IOU of NOK 500 on Bank 1, and thus requires that Bank 1 settle the IOU of NOK 500 by transferring a corresponding amount to Bank 2’s reserve account with the central bank. (The expectation of being able to exchange the claim on Bank 1 with a claim on the central bank at par, is the reason that Bank 2 accepts to credit the bank account of B at par with the nominal value of the claim on Bank 1.)
- Bank 2 offsets its claim against Bank 1 upon central bank reserves in the amount of NOK 500 being credited to its account with the central bank; i.e., upon receiving a claim against the central bank in the amount of NOK 500.
- Subsequent to the transfer of central bank reserves, Bank 1 holds NOK 500 in its reserve account with the central bank and Bank 2 holds 1500 in its reserve account with the central bank.
- However, neither bank is richer or poorer as a result of the transaction. All that has happened is that Bank 1′ balance sheet has shrunk (by NOK 500 on both the asset side and liability side) and Bank 2’s balance sheet has expanded (by NOK 500 on both the asset side and the liability side). The equity value of each bank remains the same.
Thus, as the above makes clear, modern-day payments move no physical assets. Instead, they are merely an exercise in the transfer and cancellation (set-off) of claims on banks and the central bank. The national payment system (in Norway, Bits and NICS) is a clearing system that ensures the orderly and secure clearing of claims among the banks (commercial bank money) and claims on the central bank (central bank reserves).
Payment card schemes (such as Visa and Mastercard) are messaging systems that ensure secure and orderly communication between the payers, payees, and banks in connection with electronic payments where funds are transferred from one bank account to another. The payment card schemes do not move any assets, neither physical or digital, nor do they at any point “hold any money”, i.e., the payment schemes do not at any point hold or own any of the claims that are being transferred (IOUs issued by the banks). They merely convey messages.
On a related note, utilizing blockchain technology (distributed ledger technology) in connection with payments has been a much talked about proposition over the last few years. Assuming this relates to electronic payments where funds are transferred from one bank account to another (IOUs on banks), this merely means using blockchain technology as a messenger system – a system that, directly and without any middlemen, quickly and securely transfers messages (instructions) from the payer’s bank to the payee’s bank, such that the payer’s bank account more or less instantaneously may be debited and the payee’s bank account, correspondingly swiftly, may be credited. The blockchain would not move any physical assets, nor would it at any point hold any of the claims that are being transferred (IOUs against the banks). The blockchain technology would only facilitate the transfer of messages pertaining to the fiat currency in question (in the form of commerical bank money or central bank reserves). Such blockchain-based payment platforms already exist in relation to cross-border payments, e.g., Santander’s app for international payments using Ripple Labs’ blockchain technology. In November 2022, J.P. Morgan Chase & Co executed its first live trade on a public blockchain (the Polygon blockchain), exploring the use of decentralized finance. J.P. Morgan Chase also processes intraday repo transactions using their private blockchain platform (a permissioned blockchain) called Onyx Digital Assets.
The implementation of the second EU payment service directive (PSD2) has raised several questions pertaining to payments and payment services. One interesting question is whether the so-called “Payment Initiation Service Providers” (PISPs) will render the payment systems and card schemes (such as BankAxept, Visa and Mastercard) obsolete by directly communicating with the banks (and only use the bank infrastructure when transferring funds, e.g., Baltus 2.0 in Norway). However, to date it seems the payment card systems have been able to navigate the new terrain rather deftly, and thus, that their current strategic position is actually stronger than before the implementation of PSD2.
As is evident from the above, when analyzing what takes place when making a payment, it is helpful to bear in mind that payment transactions are mere bookkeeping exercises; all that takes place in connection with the electronic transfer of money is that the ownership positions to claims are transferred and set off against each other.