Summary Economics of Payment Systems 4.4 – Vrije Universiteit
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Summary Economics of Payment Systems 2020 – Annamarie de Ruijter – VU Amsterdam
,The payment system Chapter 1 – T. Kokkola (2010)
Money is anything that is generally accepted in payments or repayment of debt. A payment
generally delivers the good or service and transfers money, discharging a claim or repaying debt. The
payer issues the payment and agrees to transfer funds to the payee, the final recipient of these
funds. Well-designed payment systems help markets function properly and eliminate trade frictions,
benefits must exceed costs in a transaction. A payment system involves the instruments,
intermediaries, standards, procedures, processes and interbank funds transfer systems (IFTS) that
ensure money circulation. A Large-value payment system (LVPS) is the transfer system between
banks and central banks (main issues: access, liquidity, system risk, settlement), while retail payment
systems are the transfer systems between consumers, merchants and banks (main issues: pricing,
competition, regulation, innovation, fraud). A payment system serves three purposes:
1. Payment instruments or the authorization and submission of a payment.
2. Processing or exchange of the payment between accounts.
3. Settlement or compensation between banks.
Other important features are the institutions that provide payment accounts to customers, IFTS that
deals with payment, clearing and settlement services; and market arrangements and regulation that
involve laws, standards, rules, procedures and contracts.
The payment chain of non-
cash payments start with the
choice of the payment
instrument and (electronic)
submission to a bank. The
bank verifies the instrument,
checks fund availability and prepares the payment instruction. Then the payment is processed and
confirmed. The settlement asset is transferred from the sending to the receiving bank, which finalizes
the interbank transaction. Finally, the receiving bank credits the account and communicates the
receipt or invoice.
Payments can be classified on the basis of different concepts, such as the types of payer/payee
involved: wholesale or high-value time-critical payments between financial institutions, retail or
lower-value more frequently made payments between non-financial institutions and commercial or
payments between firms. Or based on the number of parties involved: a one-to-one transaction or
one payer and one payee (C2C, C2B and B2B), a one-to-many transaction or one payer and multiple
payees (business or governments to households for salary or social security) and a many-to-one
transaction or several payers to one payee (households to business or governments for tax). Finally
in an international context: clean payments of which all paperwork is exchanged directly between
the trading partners and documentary payments of which documents are handled by banks.
A payment instrument is a tool or procedure that enables the transfer of funds from payer to payee,
mostly distinguished in cash and non-cash instruments. Payments in cash (coins and banknotes) are
usually immediate or face-to-face and of lower value, while non-cash (debit and credit) transactions
are transfers of funds between accounts often of higher value. These latter can be physical (paper or
electronic instruments) or credit- and debit-based (direct credits or debits, card payments or
cheques). Credit transfers are instructions sent by a payer to its bank requesting a transfer of funds
to the account of a payee. Direct debits authorize the debiting of the payer’s bank account, initiated
by the payee with authorization (mandate) of the payer. The payment (funds) and instrument (data)
flow in the same direction in the case of credit payments, while these flow oppositely with debit
payments. Debit cards can be used by holders to pay for goods and services (at the point of sale or
remotely) or to withdraw money at ATMs. Delayed debit and credit cards are used to delay payment,
the amount is paid back fully or in parts by the end of a specific period. A cheque is a written order
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Summary Economics of Payment Systems 2020 – Annamarie de Ruijter – VU Amsterdam
,from the drawer to the drawee (credit institution), requiring the latter to pay a specified sum on
demand to the first. Electronic or e-money is a claim on the issuer stored in an electronic device and
accepted as payment, either hardware (card) or software (server) based.
In the processing of every payment, information needs to be submitted and funds exchanged
between the parties involved in the payment chain. This used to be done manually, now it is done
electronically in an automated clearing and settlement process. A well-functioning payment
communication network links parties in a cost-efficient way, ensures they meet standards to
mitigate risks and increases the reach compared to point-to-point connections. For instance, ATMs
link the device to a bank allowing the cardholder to use it or card payment services that link point-of-
sale (POS) terminals. In a proprietary network all participants transact with each other via a central
entity, while a public network has direct links between individual participants. However, the
introduction of the Internet has blurred this distinction because it allows parties to communicate
through one single IP-address.
To ensure a payment systems’ communication network is secure, it needs to have the following
features: authenticity (real users), integrity (not manipulated) and confidentiality (not viewed by
anyone) of the data. Payment processing can be done ‘in-house’ or if the payer and payee have an
account with the same institution; or between two banks. This latter is either a correspondent
banking agreement (bilateral with or without a service-providing bank) or most commonly used a
payment system (multilateral arrangement among banks for their own account and on behalf of
their customers). Direct participants must satisfy all entry conditions and can perform all activities in
the system, while indirect participants use a direct participant as intermediary to perform some of
the activities (tiered).
Netting is the agreed offsetting of mutual obligations in order to establish single net settlement
positions (received minus sent), provided by clearing houses and central counterparties. It reduces
settlement costs and liquidity or credit risk, but it also shifts counterparty risk to the central authority
providing the service. Position netting is an offsetting agreement where parties agree to pay or
receive a single net amount instead of settling individual transactions but remain responsible for
their individual delivery. Settlement is the actual transfer of funds between the payers’ and payee’s
bank, discharging obligations between two or more parties. Settlement assets are the (claims on)
assets that are accepted in order to discharge a payment obligation, either central bank money
(central banks issue liabilities which function as money) or commercial bank money (commercial
banks provide private money in the form of deposit liabilities than can be used for transaction
purposes). A payment in cash is immediately settled using the first category, while a payment in debit
creates an interbank obligation that is settled later using either of the two categories. Using central
bank money reduces credit and liquidity risks, because central banks can’t default and create
liquidity by lending money.
The use of a currency and guaranteed uniform value are ultimately determined by trust, confidence
and the conversion rate. A central bank must maintain price stability and check the convertibility of
commercial banks, these must show solvency and liquidity. Both types of money should coexist for
the financial system to operate efficient and effective. The settlement agent or institution is the one
across the books of which transfers between participants take place on order to achieve settlement
in non-cash transaction, either a central or commercial bank. Gross settlement leads to separate
payments while in net settlement payments are netted, resulting in a smaller number of claims. Real-
time settlement occurs on a continuous basis (wholesale) and designated-time settlement deferred
or only at pre-specified points in time (retail). Hybrid systems are a combination of the liquidity-
saving net settlement and finality gross settlement systems.
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Summary Economics of Payment Systems 2020 – Annamarie de Ruijter – VU Amsterdam
, A card scheme is the arrangement that enables card brands to function in an appropriate
organizational, legal and operational framework. It also states the rules, since all card transactions
needs to be performed consistently to be reliable. The card issuer is the financial institution that
makes payment cards available to cardholders and authorizes transactions at POS terminals or ATMs.
The acquirer is the entity (credit institution) that manages the account for the merchant (shop). Once
the card transaction is initiated at a terminal or over the Internet, the card and cardholder are
authenticated by reading the magnetic strip and the PIN code. If the transaction is forwarded and
authorized, it is cleared according to the contractual agreement and settled with the rules of the card
scheme. Card payment schemes will sell their services to cardholders who use their cards to buy
goods and services; and merchants who offer their customers the possibility to pay by card ( two-
sided markets). Card schemes set prices taking into account both demands and effects of changes on
both sides. Since price elasticity is lower for merchants, they pay higher prices than customers.
Interchange fees perform the function of sharing revenues between the issuer and acquirer.
Offshore systems are transactions denominated in a currency other than that of the country in which
they are established. It enables local entities to settle foreign currency transactions with cost savings,
risk reduction and efficiency maximalization. The settlement institution is usually a commercial bank,
such that liquidity has to be delivered in the country of issue of the relevant currency. Time-zone
differences and liquidity risk could lead to central bank issues regarding monetary and financial
stability of its currency. Such that central banks should be directly involved in the design and
oversight of offshore systems. Cross-border transactions involve one currency, while cross-currency
payments require a currency conversion. Because not all financial institutions operate outside their
country, another intermediary is sometimes needed to access the system and settle payments in the
local currency. Foreign participation in national payment systems and financial markets increases as
international trade and finance grows. Payment systems are becoming increasingly independent but
need to remain safe and robust. Differences in currencies and time-zones are the two greatest
challenges, causing the two payments to become unsynchronized in the form of foreign exchange
settlement risk.
European Retail Payment Systems: Cost, Pricing, Innovation and Regulation – W. Bolt, N.
Jonker & M. Plooij (2016)
Payments and recent developments in this European retail field are essential for a smooth operation
of the economy. Payment behavior changed from cash and paper to electronic payments, but
despite technological developments the first hasn’t disappeared. Retail payment instruments are
split into point-of-sale (face to face) and remote (at a distance). The first are cash, cheques, debit
and credit cards to make payments in shops while the latter are credit transfers and direct debits to
make online and bill payments. But these are not mutually exclusive! Since the introduction of the
Euro in the early 2000s and the unification of the European payments area the way consumers pay
has changed
considerably. Debit
and credit card usage
increased rapidly,
while ATM or cash
withdrawals and
cheques declined.
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Summary Economics of Payment Systems 2020 – Annamarie de Ruijter – VU Amsterdam
