Thursday, February 12, 2015

Slow greenbacks, fast loonies

Canada trails the U.S. is a common refrain, but not when it comes to payments. Courtesy of the Interac e-transfer service, Canadians have been able to make person-to-person (P2P) payments in real-time as early as 2002. By person-to-person, think email or mobile phone payments to friends, family, or your landlord, and by real-time, the receiver of a payment can immediately turn around and use those funds to buy something. By contrast, most Americans are still stuck in the nebula of three day delays when it comes to P2P. 

Why this incredible lag? I think it's for the same reason why the U.S. banking system is so much more unstable than the Canadian banking system. Whereas Canada has a small number of strong national banks, the U.S. has a large population of weak undiversified regionals. This lack of size and strength renders U.S. banks prone to failure. It also makes it difficult for them to coordinate together in order to create shared-use systems. 

Part of the problem in providing a real time P2P solution to consumers is that U.S. banks can't use the Federal Reserve's existing small payment network, ACH, to do the job. ACH is a forty year old system that transfers funds with delays sometimes lasting as long as 3-4 days. That being said, the Canadian equivalent small payment system, the ACSS (run by the Canadian Payments Association) isn't much better, with settlement occurring the next business day. Yet somehow we Canadians enjoy real time P2P. 

Over a decade ago, Canadian banks decided to avoid ACSS altogether and set up their own proprietary network to provide real time P2P capability. Run by Interac, a bank-governed non-profit, the e-transfer network processes P2P payments, nets them out across all banks, and provides instant communications among participants. At the end of the day, the banks settle balances owing and owed by trading Bank of Canada clearing deposits via the CPA's Large Value Transfer System (LVTS). 

As a rule, the e-transfer system requires banks to provide customers with instant access to the funds they have received either via email or their smart phone (or, if they have been debited, lose access to these funds). Heck, Royal Bank even has real-time payments via Facebook. [1] Since banks make the funds available before they settle among each other, they are in essence temporarily lending to their customers. Rules about maximum payment size keeps these intraday loans to a small size.

As anyone who has read the free banking literature knows, the U.S. has an awful history of bank regulation. Until recently, law makers forbade banks from setting up national branch systems, with unit banking being the norm. (Here is George Selgin on the topic). As a result, the U.S. is characterized by a patchwork quilt of banks, 6,891 in fact, with the top five banks accounting for only 56% of all deposits. Canadian law, on the other hand, never discouraged national branch banking. As a result, Canada has five dominant banks with broad exposure to all provinces and maybe two dozen smaller banks, the "big 5" accounting for at least 80% of Canadian deposits. 

You can understand now why it would be difficult for U.S banks to set up their own real-time payments system. In Canada, only a handful of bankers needed to be convinced that the time and effort to build a mutually beneficial system was worthwhile before the remaining minority followed. A much larger expense must be incurred in herding U.S. banks towards that same equilibrium. It's sort of like fax machine adoption. A single fax machine is useless, but the value of every fax machine increases as the installed base of fax machines grows, since the total number of people with whom each user can send/receive faxes rises. Ideally, everyone just agrees ahead of time to get a fax, or in the case of P2P, all bank decide to jointly build a shared network. Tough to do when you're a thousand squabbling voices. Enlightened cooperation among a few large banks, the Canadian solution, gets you there quicker.

The result is that in the U.S. most of the P2P solutions haven't been developed by banks, but by technology companies. Finance tech giants Fiserv and Fidelity National Information Services have developed their own networks; Popmoney and People Pay. Upstart Dwolla is trying to convince financial institutions to adopt its FiSync real-time service. This plethora of competing networks reminds me of what I've read about the early days of electrical utilities in the U.S., with multiple competing wire systems running down the streets. To avoid this sort of redundancy, some might say that the best option is to have a regulated monopoly like the Fed take the baton, say by upgrading ACH to real time. And with so many different competing systems, I can't help but wonder how they 'talk' to each other. If there were three or four brands of fax machines, and each brand could only receive its own faxes, how much less useful is the fax network?

So we Canadians have ubiquitous real time P2P and the Americans don't. However, the dark side to the Canadian system is that cooperation among the few needn't always be so enlightened. Just as the chiefs of the big 5 banks can get together in a back room and cobble together a mutually beneficial shared network, it's just as easy for them to set up a mutually beneficial pricing schemeat the expense of consumers. It costs $1.50 to do an Interac e-transfer. Sounds suspiciously high to me. 

[1] My source for information on the Interac e-payments system is the CD Howe's Mati Dubrovinsky, who briefly describes how the system works here.  


  1. My kids taught me how to use the e-transfer service to email money. To them.

  2. Australia has a similar bank structure to Canada (small number of large national banks) and whilst we don't yet have real time P2P payments, we at least have 5 intra-day settlements between banks ( behind our online bank transfers.

    The US banking fragmentation may account for why they see such things like bitcoin as so revolutionary. I think in countries with efficient P2P payment system bitcoin is unlikely to offer any value to the average person from a payment's point of view. If the US banks ever got themselves organised, there would go a major use case for bitcoin. I wonder if that was in the Winklevoss bitcoin ETF risk disclosures?

    1. You make a great point about the US and bitcoin. Once a real-time system is up and running in the US, whether it be the banks of the Fed who implement it, then who really needs domestic bitcoin P2P? Although that still leaves the door open for international bitcoin P2P, since the existing correspondent banking system is awfully slow and expensive.

    2. Bitcoin is not only about speed. It is about transaction costs in general, such as the risk of identity theft, censorship resistance or independent dispute resolution.

  3. > And with so many different competing systems,
    > I can't help but wonder how they 'talk' to each other.
    With great effort I'd imagine. I worked in payments in Ireland. You have a bunch of batch files in different formats, being tranferred by different protocols. Everything has undocumented quirks and if something breaks, it needs to be fixed manually.

    1. I was hoping you'd comment, I remember you telling me you'd worked in payments.

      Do you think its fair to say that the countries with the best payments systems are the ones that are least interested in bitcoin? Am I wrong in thinking that the U.S. is pretty far behind relative to Canada and Europe? Which countries are considered to have the best payments systems?

      My feeling is that the Swedes must be pretty good because of this:

      How do you think things play out in the U.S. in terms of P2P payments?

  4. the history of banking in the US, Canada, Brazil, Mexico and Japan is reviewed in the book, Fragile By Design. There are many quirks of the US system derived from the land rush era and then the post civil war structure. Canada does have an impressively stable system. The book explains the design of banks legal and by extension structural evolution as a trade off between politicians, populace and bankers. These trade offs driven by history and relative political power explain a lot of the structure and crisis response the respective systems experience. It is a really interesting thesis and top-notch book.

  5. Would you say the tradeoffs between having a dispersed banking system like the US (pros-competition & con- lack of stability) more appealing than the close knit canadian banking system (pro- strong banks & con- collusion is more possible)

    1. I don't think that having plenty of competition and a strong banking system are necessarily mutually exclusive. The Canadian banking system would be much better off if it allowed US banks to move in, for instance, since the competition would drive fees down without sacrificing any stability. As for the U.S., deregulation will slowly undo the damage of unit banking laws as banks merge and expand.