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Changing E-Payment
Payment Networks in the U.S.:
The Strategic, Competitive &
Innovative Implications
Brian Mantel
Manager
Emerging Payment Studies Dept.
Federal Reserve Bank of Chicago
and
Tim McHugh
Senior Analyst
Emerging Payment Studies Dept.
Federal Reserve Bank of Chicago
10
Through their common control of both Visa and MasterCard, the largest banks have stifled competition.
U.S. Department of Justice vs. Visa and MasterCard Complaint
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First Data Net [referring to First Data Corporations acquisition of the NYCE ATM network] will be
able to bypass the major credit card companies because when you own the point of sale devices, you
have a lot of control of the routing of the transactions.
Charles T. Fote, President, First Data
Corporation
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Amazon.comhas joined forces with Citigroup, Inc.s Citibank unit and is offering an online payment
service that doesnt require a credit cardAnalysts said the payment service is a sign that Amazon is
using its influence as the largest online retailer to find lower-cost alternatives to credit cards.
Wall Street
Journal
13

10
This article represents the views of the authors alone and does not necessarily represent the views of the Federal
Reserve Bank of Chicago or the Federal Reserve System.
11
U.S. Department of Justice. United States versus Visa U.S.A., Visa International, and MasterCard International,
Inc. [Accessed at http://www.usdoj.gov/atr/cases/f1900/1973.htm on November 5, 2001].
12
Breitkopf, David (2001). First Data Taking Major NYCE Stake, American Banker, June 15, 2001, p. 1.
13
Wingfield and Merrick. Amazon Sets Citibank Deal. The Wall Street Journal, November 6, 2001.p. B8.
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Change has continually engulfed the payments industry, perhaps more so than ever in the past
decade. In the last few years, a number of payment innovations such as smart cards, person-to-
person payments, check conversion and mobile payments have gained increased attention and
could hinder future innovation. Yet, competition and public policy decisions are still based on
assumptions and ideas about networks made several decades ago. In the midst of continuous
change it has been difficult to gauge the level and importance of some of these changes. This
article sets out to re-evaluate our fundamental ideas about networks and competition. It
documents how these networks have changed and the implications of these changes for payment
innovations for government and private sector providers.
Central to this change has been increasing use of payment networks for new or alternative
payment uses. When competition and innovation policy in the credit card market was just beginning to be
explored several decades ago, there was essentially just one productthe credit cardand one type of
network for non-recurring consumer paymentsthe credit card network (with several competing
providers of credit card networks). However, over the last two decades the use of payment networks in
the United States has drastically changed, evolving into what we term product-independent payment
networks. Payment networks have evolved and expanded beyond their initial product-driven focus.
Examples include the following:
Credit Card Networks. The banking industry and national credit card associations have expanded
the use of the credit card network to include signature-based debit cards. These networks are also being
utilized to conduct electronic person-to-person payments.
ATM Networks. Another example of the evolution to product-independent payment networks
can be seen in the evolution of ATM/EFT networks. EFT networks, which were previously regionally-
based, now extend across the country both through direct ownership and through sharing arrangements.
Like credit cards, their use is evolving beyond their initial product design. A significant amount of
electronic bill payments are processed through these networks. A P2P provider in Canada plans to use
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the EFT networks to process P2P payments and has expressed interest in extending its business model
internationally. Meanwhile, the largest credit card processor in the U. S. has taken an equity interest in
one network and plans to use the network to bypass the Visa and MasterCard authorization networks for
some transactions.
ACH Network. End users have also expanded and changed the primary uses of the ACH
network, which was initially developed to handle direct deposits. For instance, several merchants have
introduced retailer-debit card programs that leverage the ACH network, bypassing the online (ATM
networks) and offline (credit card networks) debit card networks. Pre-authorized debits, electronic check
conversions and PC bill payments are already being processed through the ACH network. At the same
time, industry groups are looking into ways to use the ACH network to convert and truncate check
payments at lockbox locations. As a result, it is increasingly clear that the clearing and settlement
business is becoming a commodity business that can be transacted over a variety of networks and clearing
arrangements.
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Figure 1. Evolution of Product-independent Payment Networks
1970s 2000
Network
Uses
Ubiquity Network Uses Ubiquity Percent of use
outside of
original intent
for network
ACH
Network
Direct
Deposits
National
but
modest
Direct Deposit
Pre-authorized debits
PC Bill Payment
Check converted to EFT
Retailer debit cards
National and
broad
52.1%
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ATM
Networks
ATM
withdrawals
Regional
but
modest
PIN-based debit
Credit cards
P2P payments
PC Bill Payment
Increasingly
national and
broad
(selectively
international)
19.0%
15
Credit
Card
Networks
Credit cards National
but
modest
Credit card
Debit Card w/ signature
P2P payments
Smart cards
Purchasing Cards
International
and broad
26.1%
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14
This represents the share on total ACH payments, as reported by NACHA, used for any means other than direct
deposit in 2000.
15
This represents the percentage of EFT transactions conducted at the point of sale as reported by Faulkner and
Gray
and the Federal Reserves recent benchmarking study.
16
This reflects the percent of offline debit card payments as a fraction of total volume on credit card networks
(offline debit card transactions plus credit card transactions).
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Increasing Innovation & Competition: Some Evidence
Given the changing use of payment networks and innovations by stakeholders, a significantbut
not fully appreciatedamount of competition may have emerged in this market. In particular,
competition within the credit card industry has been a focus on continuous speculation and debate. This
section outlines how significant competitive pressure exists at the point of sale for credit cards, checks
and cash.
Proliferation of New Potential Substitutes
The increase in alternative uses for payment and telecommunications networks to develop a number
of key payment substitutes provides the first example of the changing competition.
Recently online debit cards have emerged as suitable and widely accepted alternatives for merchants
and consumers at the point of sale. Consolidation amongst EFT networks has led to the formation of
national EFT point of sale networks for the first time. During 2000, PIN-based transaction levels actually
grew at a rate of 35%.
Offline debit cards are also becoming increasingly popular amongst consumers and financial
institutions, with transaction volume growing 31% in 2000. Visa and MasterCard have launched
aggressive national advertising campaigns in support of this product.
Though less publicized, several merchants throughout the country have successfully launched ACH-
based debit programs. Similarly, large retailers, such as Wal-Mart, have introduced check truncation at
the point of sale with some level of success. In 2001, NACHA reported there were 88.7 million of these
e-checks at the point of sale.
In addition, third party providers have expanded the use of credit card and ACH networks to small
merchants through P2P payments. Since these fees are typically far below the average fee incurred by a
small merchant online, these networks could compete with credit cards on the Internet. Thus, while this
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market, characterized by high fixed costs, has not seen a significant number of completely new entrants, it
has seen important entry by suppliers and other third partiesfirms in an ideal location to evaluate when
market conditions will support profitable entry.
Meanwhile, telecommunication providers, especially in Europe, have also stepped forward recently to
offer payment capabilities over mobile phones.
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In many cases, providers are attempting to adapt their
networks to process payment transactions either in conjunction with financial institutions or separately
from them. These two cases are examples of clear and important increases in choice being offered to
consumers and merchants alike.
Forward Integration by Third Party Suppliers to Financial Institutions
The second example of change can be illustrated through forward integration by third party
suppliers. While forward integration by third party providers clearly did not occur in the 1980s and early
1990s, the enormous take-off of credit and debit cards is now providing fertile ground for suppliers of
payment processing services to banks and credit card associations to enter these markets. For instance,
First Data has recently unveiled aggressive plans to offer comprehensive consumer payment card services
which in some cases will not only compete with but also disintermediate incumbent credit card
associations and banks.
2
Several telecommunication providers have also investigated the possibility of bypassing the credit
card networks to process micro-payments. Though some wireless payment solutions do involve the use
of the credit card networks, several providers have looked into solutions that would utilize their own
billing and network capabilities to process micro-payments. These initiatives have grown more slowly in
the United States than in Europe.

1
See Power, Carol (2001). Bank-Telecom Alliance Trend Said on Way to U. S., American Banker, April 27,
2001, p. 10.
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Backward Integration by Retailers
Third, several retailers have developed innovative means through which they could decrease the
cost of payment services. For years some merchants have been offering retailer-sponsored debit cards
that are cleared via the ACH network for certain segments of their customers. In these cases, merchants
integrate backwards into the payments marketplace, as they offer the payment card, customer service, and
risk mediation services that were beforehand provided by banks and/or credit card associations. On the
Internet, building on the experience of large retailers offerings of store-based credit cards, Amazon.com
has pledged to develop its own credit-based payment option, again internalizing a service previously
provided by financial institutions or payment associations.
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As another example of this trend, there have also been pledges by retailers to work with card
associations to co-develop new risk management products that allow merchants to take on some risk-
mitigation services in exchange for lower fees. Specifically, Internet-based retailers have both made
investments to reduce fraud if the investments would result in lower discount rates.
4
Risk mitigation is a
valuable service provided by banks and credit card associations and is now increasingly being provided
by merchants or at least being bargained for by merchants as part of fee negotiations. In some cases,
merchants may be in a superior position to provide these risk mediation services. To the degree this trend
continues, it may have a very significant impact on the negotiating position of credit card associations.
Active Retailers and Retailer-led Coalitions

2
See Breitkopf (2001). First Data Taking Major NYCE Stake, American Banker, June 15, 2001, p. 1.
3
See Wingfield amd Merrick (2001). Amazon Sets Citibank deal. The Wall Street Journal, November 6, 2001, p.
B8.
4
For instance, consider eBays development of consumer buyer and seller feedback rating systems.
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Fourth, active retailers and retailer coalitions have stepped forward to encourage the growth of
cheaper payment alternatives. Merchants have also taken a more proactive role in encouraging the
entrance of new market competition and the negotiation of pricing terms. In August 1999, retailers and
trade associations selected Concord EFS to develop a means of accepting non-cash payments using the
ACH network. In turn, Concord worked to develop electronic check initiatives and the development of
debit cards that are processed over the ACH network.
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Also, Wal-Mart has stepped forward to lead a
fight against Visas and MasterCards honor all cards rules. Perhaps equally important, the discount
retailer also became the first merchant to switch from Visas Interlink EFT network, after Visa threatened
to double its interchange fees. In addition, merchants, government agencies collecting taxes from
consumers and other firms are increasingly finding ways of bundling value-added services around the
acceptance of credit cards and instituting fees for accepting this form of payment.
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Increasing Innovation and Competition: Forward Looking Changes
While significant change has occurred in the use of payment networks, a number of innovations
are currently under discussion or development that would continue to leverage existing payment networks
new ways.
International ACH
The Federal Reserve has already expanded the scope of the ACH network to send payments to
Canada. Currently, a number of different associations, government agencies and private corporations are
discussing further extension of this payment system to other countries. In particular, discussions are

5
See Stock, Helen (1999). Supermarkets Looking for Ways to Skirt Bank Transaction Fees, American Banker,
August 31, 1999, p. 1.
6
Source: authors discussions with industry.
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already under way to investigate the feasibility of expanding ACH payments to Mexico and Europe.
Given the large amount of money transfers sent each year from the U.S. to Mexico, a low-cost means of
transferring funds internationally would potentially be in very high demand.
P2P Payments
Third party payment providers are leveraging existing networks to provide electronic person-to-
person payments on the Internet and at ATMs. Companies such as PayPal, Citibank and eBay are
utilizing the ACH, credit card and EFT networks to provide electronic P2P payments over the Internet.
While each of these companies is a network in itself, the clearing and settling of funds mainly takes place
over traditional payment networks. These networks also allow small merchants to access the credit card
networks.
At ATMs, Concord EFS and Money Gram are teaming up to offer electronic person-to-person
payments via the electronic funds transfer network. Using a special access card and one-time PIN-
number, consumers will be able to send payments from person to person. In addition to domestic person-
to-person payments, this application could be expanded to include international P2P payments.
Mobile Payments
Significant investment and research has gone into investigating the creation of mobile payment
applications. In addition to leveraging telecommunications networks, these innovations typically utilize
existing payment and banking networks. In particular, Visa and MasterCard have worked closely with
third party providers and telecommunications firms. While these applications achieved marginal success
in Europe and Asia, the United States has been slow to adopt mobile payments.
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It should also be noted that several merchants have utilized new wireless technology and the
credit card networks to offer innovative new services to customers. For example, McDonalds has used
ExxonMobils Speedpass technology to make paying for small-value purchases with credit cards quicker
and more convenient at the point of sale.
ACH and Online Debit over Internet
Recently, NACHA has spearheaded an effort by several financial institutions to promote ACH
payments over the Internet. If successful, Project Action could make ACH a viable alternative to credit
cards for Internet purchases. The project is still in the proposal stage.
Several companies and network operators are also testing the feasibility of making payments on
the Internet using PIN-based debit cards. NYCE gained significant attention the past few years for its
SafeDebit project. While no definitive solution has emerged, future innovation in this area is certainly
anticipated.
Lessons Learned for Innovation
This review of recent changes in the use of existing clearing and settlement networks highlights
three important lessons for payments innovation. First, in recent years, the majority of successful
payment innovations appear to make use of the existing payments infrastructure and networksrather
than creating entirely new ones. Second, payments innovation and consumer adoption must overcome
significant resistance to change. Third, a systematic unbundling of networks and specialization is
occurring within the payments industry. Let us look at each of these lessons.
1) Leveraging existing networks. A review of recent payment innovations illustrates that the
majority of successful payment innovations rely heavily on the existing payment networks and
infrastructure. For instance, P2P payments initially succeeded by meeting the needs of online auctions
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through increased convenience, customer service, dispute resolution and insurance against fraud. Here,
innovations are leveraging current payment systems, such as credit cards, debit cards, ACH and checks, to
offer consumers increased convenience, customer service, resource and incentives.
While past e-cash implementations perhaps lacked the compelling business case
7
and many times
required entirely new and expensive payment infrastructures to be built ,
8
newer forms of online payments
are appearing to make significant inroads by increasingly leveraging installed payment infrastructures.
This is perhaps best illustrated in recent pilots of mobile payments in Europe where consumers are able to
pay for merchandise via their cell phone and where payment is charged either to a bank account or to the
telephone operators billing system. In this case, providers are able to leverage an installed base of
telephones in retail locations along with the installed accounting systems of telephone operators and/or
financial institutions.
2) Networks, switching costs and the limitations of customer preferences in motivating change.
Second, many analysts fail to recognize the hidden efficiencies in existing payments and customers
reluctance to change. Several studies have noted the importance of network externalities in the adoption
of emerging forms of e-payments. Yet we argue that, for many forms of emerging payments, it is not the
network nature of these markets that is limiting adoption, but rather the presence of significant,
irreversible and interconnected investments leading to an installed base where firms do not see a business
case for change.
9
As a result, new innovations, such as stored value cards or micro-payments, while
potentially ground breaking, may need to not only be better than current products, but overwhelmingly
better than current solutions.

7
Forrester Research Analyst David Weisman noted that one reason electronic coins have not come to fruition is that
many low dollar products are given away for free on the Internet or are bundled in other monthly service charges
that consequently make the business case for e-coins smaller. See Federal Reserve Bank of Chicago (1999),
Proceedings from the Workshop on Promoting the Use of Electronic Payments: Assessing the Business,
Technological and Legal Infrastructures.
8
Charles Schwab Security SVP Eddie Zeitler also noted that past e-cash innovations many times required building
entirely new and sophisticated electronic payments infrastructures. See Federal Reserve Bank of Chicago (1999),
Proceedings from the Workshop on Promoting the Use of Electronic Payments: Assessing the Business,
Technological and Legal Infrastructures.
9
We argue here that there are several critical and viable alternative electronic payment networks that are
increasingly allowing for easier entry into this market. A particularly critical network is the ACH network. While
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When these innovations do occur, they will likely succeed at the margins of commercial
relationships, be pioneered by non-traditional firms and/or gain acceptance by leaping the current
generation of technology several years into the future.
10
For example, some successes have occurred:
Stored value cards have proven effective for some unattended locations, mobile payments have leveraged
the telecommunications network infrastructure to offer improved convenience and retailer-based debit
card systems have been introduced that leverage the ACH network. In these cases, new solutions have
leveraged core infrastructure or focused on small niche needs rather than attempting to be broad-based,
independent solutions.
3) The unbundling of networks, on-us transactions and payment utilities. An analysis of recent
innovations also highlights an important trend in the manner in which payment networks operate. In the
past, a handful of payment networks handled the majority of clearing and settling functions for one type
of payment. Today, an increasingly large amount of payments innovation involves an unbundling of
the network and specialization (see Figure 1). Third party providers are handling many of the functions
previously handled by payment networks. A number of firms are specializing in performing one aspect of
the clearing and settlement process. Through innovation and scale economies, these providers are able to
typically offer cheaper and/or more effective alternatives. The following three examples illustrate this
change.
PayPal and other P2P providers have taken over the responsibility of consumer authorization,
customer service and merchant enrollment for its transactions. Existing payment networks are used for
the physical clearing and settlement functions. When customers do retain funds in PayPal accounts, the
company can completely process the transaction as an on-us transaction.
11
Within the check processing industry, several companies have focused on the authentication

the ACH network has clear and well-documented limitations, its low cost and open access make it an ideal platform
for some early innovation.
10
For instance, see Mantel, Brian (2001). E-money and E-Commerce: Two Alternative Views of Future
Innovation. Federal Reserve Bank of Chicago Fed Letter. March 2001.
11
See McHugh, Timothy (2002). The State of Person-to-Person Payments. Federal Reserve Bank of Chicago Fed
Letter, July 2002.
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of check writers. Several companies, such as Telecheck and Verifone, provide authorization and
verification services to merchants for a small fee. According to statistics published by The Nilson Report
and the most recent Federal Reserve check study, more than 75% of checks written at the point of sale are
verified by a third party provider.
12
Within the credit card industry, First Data Corporation and others are now responsible for
processing a large share of card transactions on behalf of both merchants and financial
institutions.
13
Lastly, several large banks have eliminated the use of networks for on-us transactions.
Though this practice has been around for several decades, rapid consolidation within the
banking industry appears to be pushing the number of transactions processed this way to new
highs.
While the majority of payment innovators are concentrating on providing one aspect of the
clearing and settlement networks, a few payment utilities that offer to serve as an entire
network have emerged. One example of this trend is the creation of the Continuous Linked
Settlement (CLS) Bank for clearing and settling foreign exchange transactions.
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Conclusion
Contrary to popular speculation, we believe that significant innovation and change has occurred
in the clearing and settlement networks of the United States during the past few decades, and that
innovation is still ongoing. Existing payment networks are continually being utilized for new and
innovative means, while third party providers are utilizing these networks to move electronic payments
into new territories. Furthermore, this change can be expected to continue into the future as a new series
of innovations are already under discussion or development.

12
See The Nilson Report , June 2001, Issue 742, p. 1.
13
Breitkopf, David (2002). Cardservicer Hopes to Wedge into U.S. Processing, American Banker, January 24,
2002, p. 8.
14
De Feo, J. (2001), CLS Bank: Settlement Risk to End in Forex Transactions, American Banker, June 22, p. 8.
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This study also highlights three critical lessons on the use of payment innovations and network
effects. First, it is absolutely imperative to consider electronic payment innovations in the context of the
developing commercial environment's needs. For instance, while some e-cash implementations did not
reach commercial success, they were pioneered at a point in time when consumer Internet adoption
remained in its infancy and at a time when it was reasonable to presume that information providers might
want to sell access to content using micro-payments.
In contrast, recent person-to-person payment innovations have succeeded and filled emerging
commercial needs in the online auction environment. It is not clear which product had "better"
technology or functionality, but what is clear is that fuller development of the online market brought
about new product needs which were not readily apparent in the early 1990s.
Second, even products that do not reach commercial success may be absolutely critical in
building the case for new innovations. These products may have pioneered technology that was in its
infancy and raised broader customer awareness. As Nathan Rosenberg notes, technology innovations are
better thought of in terms of the hundreds of small improvements and innovations that, in sum, led to the
innovation rather than as one discrete innovation.
Third, customer preferences alone may not always motivate adoption, particularly when an
installed base of products exist and where the switching costs for change do not warrant investment by
customers or providers. For instance, consider the case of the QWERTY personal computer keyboard,
where superior keyboard designs have been available for decades, yet a variety of factors including a
broadly installed base of users and keyboards exist which would require significant transition costs to be
born by a significant customer population.
The result of all of this change is that competition and innovation are increasingly occurring
across payment networks, rather than just within networks. This change requires policy makers and
payment providers to re-think how competition policy is evaluated. Furthermore, we argue that
competition and public policy should focus on promoting an environment for healthier
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competition through the single-minded focus on removing barriers to competition rather than
attempting to influence market outcomes to produce lower prices or more innovation. As in past
decades and in other markets, we see continued evidence that promoting innovation and lowering
the cost of services continue to be functions best provided by market forces.
Single Purpose
Clearinghouses
Unbundling and
Specialization
Increasing On-us
transactions
Payment Utilities
Figure 2: e-Payment Network Trends
1970-2000 1990s and Beyond Selected Examples
Equifax, First Data
ACH & Check On-Us
First DataNet
CLS Bank, NYCHs
UPIC Project