A recurring theme for Bits about Money is that financial infrastructure is heavily path dependent. We’re (oft unknowingly) standing atop decades and centuries of work which came before. Sometimes, the specific contours of that work, and of decisions made decades ago, is a roadmap to what continues to work today and what doesn’t.
Let’s talk checks.
A brief programming note: We're fast approaching the end of the year, and I still owe you all a few issues of Bits about Money, so you might be getting three issues or so prior to Christmas rather than the more typical publishing pace around here.
A brief digression for people who use functioning payment forms
Checks are the oldest form of widely deployed non-cash payments instruments. As we’ve covered previously, all a “payment” is in the payments industry is a message about the status of a debt. While almost all checks are pre-printed these days, the earliest ones were simply a handwritten letter to one’s banker, instructing him to pay money the bank owed to you to the party you named.
Checks became central to payment systems through a property called “negotiability.” The earliest checks look like a three-way transaction: buyer of a good or service (who wrote the check), seller (who turned the check into money), and the banker (who facilitated the transaction). It fairly quickly developed that checks were much more useful than this transaction appears on the surface: the person accepting the check could sell it, because the notion of a debt owed to you has value. This would allow them faster access to their cash and allow someone else an opportunity to profit from transactional friction, by reducing it.
There is a fascinating history of the negotiability of checks, of the deposits at different banks trading at varying (and constantly changing) discounts to par, and of checks being the primary form of paper money for more than a century in the United States. We’ll elide most of it here. Let’s focus on the most boring possible implication of negotiability: your bank should be willing to accept that other bank’s check.
That is an interesting usage of the word “should”, right? Should they, because it would be convenient to you? Or should they, because it is good business? Or should they, because other stakeholders in the financial system, like say the government, mandate it? Yes, in all these senses of the word “should.”
Check settlement in the pre-computer era
One of the most important standardizations that you’ve probably never thought of is the Uniform Commercial Code, which dates to the late 1800s. It was an early and extremely successful implementation of “model language” for statutes: each of the several United States was convinced to change local state law to match a change being made effectively simultaneously in every other state, without an explicit federal coordination mechanism.
The most lastingly important thing in the UCC is that it standardized checks. Instead of them being creatures of state contract law, dragging decades of precedent and complex bespoke negotiations behind every specimen, they became almost exactly describable by recounting a short description of the face of the check. We (very intentionally!) made checks “dumb” to allow the system around them to be much smarter.
The UCC facilitated banks clearing each others’ checks. (“Clearing” is a magic finance word. Clearing a check refers to completing the process which the check agrees to: the writer sees money leave their account and the person depositing the check sees it enter theirs. This is much more complicated than it sounds in this quick gloss.)
Note that “facilitated” does not imply “this then became very easy.” One infelicity which became increasingly stressed as improved transportation and communication technologies caused more commerce in the U.S. to be other-than-local: you had to physically move checks between banks to clear them. If there are two banks, then you need two messengers, each carrying a bag of checks once a day. If there are four banks, you need twelve messengers, because Bank A needs one each for B, C, and D, and each other bank needs the same. If there are thousands of banks, then each bank needs to… oh dear.
More than a century before we invented the computer science to describe what would have happened, we invented the solution to it: centralized clearinghouses. New York’s first was in the 1850s; London had already pioneered the mechanism a century earlier. Instead of your bank sending the check to the originating bank to clear it, it would send it to the central clearinghouse. Each bank thus only needs one messenger a day, not thousands. (As you can imagine, in the real world, there were actually multiple messengers carrying multiple bags. Still, the stylized truth of this is important.)
And thus we come to an important fact about the U.S. payments ecosystem: every way of moving money between banks was designed in relation to the capabilities necessary to facilitate nationwide clearing of paper checks. The most common method of interbank payments in the U.S. wears this history in its name: ACH stands for “Automated Clearing House.”
The historical timeline for interbank payment settlement in the U.S. comes to us, in a direct and at-times maddening fashion, from “How long did it take to move data between New York and San Francisco when the best available technology for this was rail networks, the transport protocol was handwritten paper, and the cloud computing was floors full of clerks doing repetitive mathematics using mechanical adding machines and AI (artisanal intelligence)?”
Some funny consequences of checks underpinning everything
Credit underlies much more than people generally believe it to. Checks are an unusually direct example of this. The capability to write checks requires a credit extension. The capability to accept checks requires a credit extension. Checks, by existing, promiscuously distribute credit. Promiscuously distributing credit has some knock-on consequences.
Consider the case where you pay for a basket of groceries with a check. (This probably strikes many in the audience as anachronistic. Work with me here because it’s actually terrifyingly relevant to modern payments systems.) At the point which you check out, you owe the grocery something, and promise to make good upon this debt. Retailers historically did a direct extension of credit at that point; users would settle up weeks or months later.
Checks move the extension of credit (in part!), from the store to the banking system. At the point which you write the check, the grocery has to make a decision whether to release your chicken, with extremely imperfect information. Your account may or may not have good funds in it presently; the store cannot know. More importantly, the store cannot know whether your account will have sufficient funds when the check is presented a few days in the future.
Why did we do this?! Why accept mere promises, promises conditional on unobservable future events? Because systematically taking relatively small amounts of risk created immense value. Groceries prefer selling more groceries to selling less. Extending consumers credit tends to increase the number of chicken breasts they consume at the margin. Consumers prefer to eat chicken versus going hungry. Chicken do not get a vote.
Note that the extension of credit is recursive and systemic here. The grocery store will issue paychecks; those paychecks each embody credit risk. (We will return to the fascinating topic of credit risk in payroll systems in a later issue.) That credit risk in part comes from the uncertainty as to whether your check for the chicken was good. The credit risk there comes from factors like your general capitalization, degree of conscientiousness regarding financial management, and whether your most recent paycheck is good. It is credit risk all the way down.
One control which we made for checks to reduce systemic risk continues to have consequences more than a century later. Most disagreements between you and a grocery store are beneath the notice of the law. If you and your grocery store have a disagreement about a check specifically, you can go to jail. The crime is sometimes called “uttering”, for charming historical reasons.
It is well within the norms of checking accounts for them to become overdrawn as e.g. users miscalculate the amount of money they have on deposit, timing issues with the posting of checks break in ways that are not perfectly predictable in advance, and users make mistakes. This is something that product managers at banks design into the unit economics of checking account. NSF (insufficient funds) fees were for at least two decades or so an important part of the revenue mix.
We arrested and jailed, and continue to arrest and jail, at least some people for something which looks very, very similar to what earns other people a $30 NSF fee. (And, of course, if you’re a desirable banking customer, they’ll waive that fee because the waiver is simply good business.) In theory, uttering is distinguished from simple overdrafting by there being an element of intent to defraud. In practice, uttering is when you’re a poor person using a checking account and a string of people reviewing your behavior view it unsympathetically. If a grocery store loss prevention employee, a police officer, and a prosecutor each refuse to stop the process, NSF means you’re Now Somebody's Felon.
Sometimes your behavior will look unsympathetic because you are a poor person. Sometimes your behavior will look unsympathetic because you definitely were trying to pull one over on the grocery store. Sometimes your behavior will look unsympathetic because you have done this many, many times before. Sometimes these are all the same picture.
Phrased that way, it sounds almost fantastically unjust. And… it’s complicated. Many people, of all social classes, consumed many chickens obtained on credit because certain specially-formatted pieces of paper were believed to be money. That belief relied, in material part, on a state guarantee that they were money. That guarantee was backed by the state expressing substantial displeasure about the abuse of certain specially-formatted pieces of paper.
And from this follows an underappreciated consequence of modern financial infrastructure: credit cards and debit transactions make the economy more efficient. One way you can measure that efficiency gain is that their users rarely go to jail. Partly that is because you can do a near real-time prediction of whether the transaction has good funds behind it at the point-of-sale. Partly it is because we more fully move credit risk from the grocery store to the bank.
Society frequently considers the sophistication of different participants in determining their level of legal recourse. We consider grocery stores presumptively worthy of a relatively high degree of protection; we will jail someone over $20 of chicken. We consider banks usually capable of doing their own risk analyses, and if they make an underwriting decision that costs them $2,000, well, society assumes banks have people who are good at math. Part of that math is “credit card issuance is fantastically lucrative, in part because you can charge the grocery store when it sells chicken to someone using a credit card.” And so part of the cost of accepting credit cards is the cash rewards, part is for computers, and part pays for “not jailing poor people.”
Money in transit
It’s useful to understand the historical physical reality of check clearing because we loved this model so much we re-used it for most later forms of payments. Banks which routinely cleared checks from particular other banks, due to geographic proximity or because they were large institutions in e.g. New York, would open correspondent account relationships with each other. A correspondent relationship is simply a bank having a bank account inside another bank. Bankers historically use Latin to make this sound more complicated than it is. (For shibboleth value: nostro is “our account at your bank”, vostro is “your account at our bank.”)
This made collecting payment more efficient: instead of frequently having money move between banks, you could total up all of the incoming payments (checks presented by your customers drawn against the other bank today), total up all of the previous period’s outgoing payments (checks presented by the other bank’s customers drawn against you a while ago), “net” those against each other, and then make a single internal accounting entry against your correspondent’s vostro. Your two banks would then only periodically rebalance where they held their money, which in the old days involved sometimes literally sending a stagecoach over with gold or silver and in more recent days would typically take the form of a wire transfer.
This relationship decreases the amount of money in transit at any given time, which has important operational efficiencies and decreases credit risk. We have made many, many more improvements over the years.
One intellectually interesting one: the Check 21 Act was designed to bring check clearing into the 21st century. The most important part of it was bulldozing a coordination problem: banks were split on whether the paper part of paper checks actually mattered or not. Check 21 said definitively “Your opinion as a bank is irrelevant: an electronic reproduction of a check is the same as a check. If you absolutely need physical paper, your counterparties are allowed to write that electronic reproduction onto completely new physical paper then send it to you.”
Why did we do this? Because it greatly speeds up presenting checks for payment. They get scanned in at one institution then transmitted electronically and not physically to the clearinghouse. The clearinghouse then will generally electronically send it to the institution the check is drawn on. This can save literally days. It is another step in making checks dumber to make the surrounding system smarter: the check is almost entirely vestigial at this point.
So how could anyone have been against this? In a recurring theme for this column, many small banks didn’t believe that they had the prompt technical capacity to receive their checks reliably electronically. It was 2003, a surprising portion of small banks still had immaterial usage of the Internet in their operations. Most of them did not own their technical destiny but rather are at the mercy of various vendors. (Plus ça change.)
Check 21 said “OK, the rest of the industry hears that explanation, and we actually sympathize a bit, but we won’t let you block an industry-wide improvement. We will instead give you a carve-out: you and you alone will still get the daily delivery of a lot of paper. It will just be new paper, with substitute checks printed on it, from a printer we have arranged to locate very close to your check processing address. We will legally compel you to treat that paper exactly like the special magically formatted check paper. You are very good at processing that sort of paper, because you’ve done so for decades; even though you are small, you are still a bank and still operationally competent.”
More interestingly to most readers of this column, Check 21 also paved the way for remote check deposit as a product. Your bank’s mobile app very likely allows you to take a picture of a check to deposit it. This desirable user experience would be much less possible if the mobile app had to, after you had taken a photo, read the routing number and tell you “Actually, sorry about this: that bank needs the check presented physically to pay it. We understand you’re angry at us, because we’re your bank, but this is out of our hands.”
That sounds crazy, right? But you’re dealing with that exact argument today for why you mostly can’t do instantaneous payments between U.S. banks. The system which would allow it (FedNow) is opt-in for both sending institutions and receiving institutions. There are legitimate and heady reasons why some financial institutions think operational and risk issues would make supporting FedNow very difficult for them to tackle. With those institutions as holdouts, the network graph of “Who could you send money to from your current bank account?” is currently very sparse. This makes it less likely for your bank to both a) decide to join as a sender and b) actually expose that sending capability in the app, because they know it will generate annoyed customers and little else. Instead, they’ll continue pushing you to (slower) ACH payments and (broadly worse) Zelle payments. (An in-depth description of why Zelle is not a particularly good product qua bank payments will probably have to wait for another day.)
Deposit accounts and their discontents
A final funny wrinkle for the moment: the “standard” bank account in the United States is a checking account. (This is not true internationally; checking accounts are sufficiently weird in e.g. Japan that if you have one you’re assumed to be much closer to Toyota than to a natural human. Having a checking account is considered weird because Japan has its own quite path-dependent history in the coevolution of bank accounts and business practices. Back home, checks are used almost exclusively for large commercial transactions and routine person-to-business or business-to-person payments happen via e.g. instantaneous bank transfers.)
Since the standard U.S. bank account is a checking account, even if it cannot write checks, it is necessarily a credit product. Banks must manage credit risk. This makes opening up standard bank accounts far higher ceremony than it is in many peer nations. You can (easily) be declined services, for example because your previous use of bank accounts landed you in ChexSystems, an industry-wide niche credit reporting agency which basically exists solely to blacklist people from accessing checking accounts in the future.
This is not simply because banks hate poor people and want them to suffer. Routine use of a bank account in the United States will not infrequently cause a credit loss. Margins on small bank accounts are very thin; credit losses can easily be larger than several years of them. Some people will walk away from that credit loss, in which case the bank (basically) eats it. One choice which keeps bank accounts broadly available to people, including people who do not have demonstrable assets or credit history, is defaulting to not handing out bank accounts to people who demonstrably cause credit losses and then walk away from them.
And so people, including in the financial industry, who want to provide financial services to people in economic precarity run headlong into this. "Creditworthy" sounds like a value judgement but is, simultaneously, just a prediction about the weather. Some places see more rain; some customers see more credit losses. Frequently advocates who want to bank the un- or underbanked are also simultaneously furious at the banking industry for improvidently extending credit.
How have we dealt with this? We have seen a fascinating boom in products which exist along a spectrum from “definitely not a bank account but has some characteristics you’d associate with one” to “a full, traditional checking account.” We’ll cover that another day.
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