Issues and Prospects for

The check clearing and electronic payments systems market are regulated and dominated to various degrees by the Federal Reserve System. This article examines the theoretical and empirical implications of a potential deregulation of this market within the context of three broad effects: price discrimination, network externalities, and anticompetitive pricing. While these are all legitimate concerns, both the theoretical literature and empirical examples from other industries show that it is probable that deregulation would significantly improve the market’s allocative and technological efficiency. Thus, deregulation of the payments systems market should be investigated further. Introduction It is a surprising empirical fact that despite the rapid technological change of the last decade, checks are still the dominant retail payments instrument. Their continued dominance has led researchers to speculate that the Federal Reserve System could increase access and efficiency to the payments systems market by modifying incentives for both paper-based and electronic payments. To generate such incentives, one option that the Federal Reserve Board of Governors could consider is deregulating parts of the payments services. In this paper, I focus on the potential deregulation of check clearing and automated clearinghouse (ACH) services. To understand the possible impacts of deregulation, it is useful to summarize the current market structure. Payments systems are currently organized as a regulated industry. As regulator, the Federal Reserve Board has authority over the competitive conduct of the 12 Reserve Banks. While the Board is a federal agency, the Federal Reserve Banks themselves are private, independently chartered, not-for-profit corporations. Accordingly, there are two ways to deregulate payments services: by eliminating some or all regulations imposed on the Federal Reserve Banks for their provision of payments services or by eliminating entirely the Banks’ mandate to perform these services. Because this article’s sole purpose is to explore some of the potential economic consequences of changes in the payments systems, I do not distinguish between these two alternatives, but instead apply the broad term “deregulation” to both of them. 1 See Green (1997) for more details. Why should the Federal Reserve Board consider deregulating check clearing and ACH services? The simple answer is that rapid technological change has enhanced the market’s ability to develop payments systems that are better in both a technological and an allocative sense. Centralized organizations may lack the knowledge or incentives to develop efficient systems and pricing mechanisms, but the profit motive of the market will encourage innovators who have the necessary knowledge and capability. A marketbased payments system that broadens the scope for competitive pricing therefore has the potential to develop widely useful electronic banking services and to lower check clearing prices, changes that might not occur within the retail payments system. Despite the general notion that markets can achieve efficient outcomes, this is not always the case. In particular, there is evidence that payments systems are characterized by both network externalities and increasing returns to scale. Economic theories predict that either of these conditions may lead to a market failure, in which a deregulated industry may underprovide and/or overcharge for certain services, which would produce an inefficient outcome. While it is certainly possible that some deregulation could increase the allocative and technological efficiency of payments systems, it is not a