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Checking System and the Importance of Financial Intermediaries

In this video, we’ll explore what the checking system is and the importance of financial intermediaries.
In this module, we’ll deep-dive into the FinTech innovations in the money transfer industry. Our journey into the space actually starts with the writing of a paper check. The goal of the next two videos is to understand how “legacy” money transfer systems work and identify their key inefficiencies. After this, we’ll be in a much more informed position to better understand the specific value propositions that the new innovations such as digital wallets have in addressing these inefficiencies. So think about the last time you wrote a check, maybe to pay your rent, make a donation, or to pay a contractor for some work they did.
You probably didn’t think of it too much, but what happens afterwards actually serves as the backbone upon which many new innovations are built. So let’s take a look at these technical underpinnings in a graphical setting. You, the sender, is writing a check to someone, the receiver. In order to do that, you need to have a checking account with the bank. After the check is sent and the receiver gets it, they’re going to either deposit it at their bank or they go to a check cashing business to catch it, which will in turn deposit the check in his bank. So either way, the check ends up into possession of a bank on the receiving end.
Here’s when the interesting actions start to happen. The receiving bank is going to scan the check and identify the sender using the two numbers
printed on the check: the routing number, which identifies the sender’s bank, and the account number that the sender has with the bank. Based on them, the check is going to be routed back to the sender’s bank through a centralized check routing system operated usually by the central bank. In the case of the United States, the systems are operated by the Federal Reserve with their 12 branch banks located across the country. So to quickly recap, the checking system has
five important players: the sender, the receiver, their respective banks, and the Fed routing system, which serves as the central conduit along which the information embedded in the check flows. After this comes the settlement process where money actually changes hands. The sender’s bank receives the information. They will do some verification task to make sure that the sender does have an account there and there’s enough money in the account to cover the amount of the check. Once verified, they will send the money to the receiver’s bank,again, routed through the Federal Reserve System. Settlement finally occurs once the money is in the receiver’s bank account and that’s when we label the check as cleared.
If everything is done using the paper, then this could take up to two weeks because the paper checks have to be physically moved through the system. So overall, this sounds rather complicated. Let’s pause a little bit and think about its key advantages relative to the cash payments. Notice we have two types of arrows here in this graph. The solid arrows represent the flow of information, in this case, information physically embedded in the check. The dashed arrows represent the actual flow of money during the settlement process. The crucial innovation here compared to cash is that the flow of information is not synchronous with the flow of money.
Essentially, by getting a check, you’re getting information that you’ll be paid before you’re actually paid at settlement sometime later. This time separation is a critical development in a financial system because if you have some trust in the system, then as a seller, you can deliver the goods once you get the information and trust that your money will come later. This enables transaction to happen much faster in a much higher volumes. How do you have trust in the system? That’s where the financial intermediaries like banks come in because the very same lack between the information flow and the money flow is also a critical limitation of the checking system, and there will be crooks trying to take advantage of the slack.
For instance, when the checks were still physically routed through the mail, it was very possible to write multiple checks to buy stuff with more money than you have in your bank account and hope that the seller will deliver the products before the settlement fails in two weeks time due to the lack of funds. The movie “Catch Me If You Can” shows a real-time case like this. This type of fraud really shows the importance of financial intermediaries like banks. To combat this fraud, banks have put in many layers of safeguards such as reversibility of payments, pre-authorization of funds, electronic routing, etc. These measures all serve to enhance people’s trust in the checking system.
Now we can see why financial intermediaries are a critical part of a well-functioning financial system because most transactions in our modern economy rely on dealing with untrusted parties that you have never met before. Every time you’re buying something from someone that you don’t know, say some online seller, you’re not really sure about whether or not they’re going to actually deliver the promised product. At the same time, they’re not really sure about you, about whether or not you can actually pay them either. This is a classic case of information asymmetry, and a Nobel Prize winning research has demonstrated that if flips unchecked, this lack of trust could easily lead to market collapse.
So formally, the financial intermediaries like banks exist because they provide safeguards that alleviate the problems introduced by asymmetric information. The services they provide like monitoring fund transfers, advanced encryption are all mechanism designed to enhance people’s trust in dealing with people that they don’t know. That if something goes wrong, the intermediaries like the banks will have their backs, and for that they will be compensated with transaction fees like those you pay to your bank or your broker. The more trust is needed, the higher the costs are going to be. So in the PayTech space, what is essentially happening is that the tech companies are trying to disintermediate the system.
They’re trying to take on some of the intermediation roles that financial incumbents provide, such as authentication, secure transfer, identity management, which they believe they can do better with more advanced technology. Consequently, the PayTech business model is usually about capturing a piece of the pie of the transaction fees. Well, it says how well they’re able to do so and in what areas, in our next video of this course.
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