Financial Update (Third Quarter 2002)
Payment Systems and How They Work
ayment finality is critical to decentralized exchange. By specifying how the transfer of one type of claim extinguishes another, the rules governing finality minimize opportunities for default along credit chains and allocate other risks.
An article in the Atlanta Fed’s Economic Review (Second Quarter 2002) provides a basic analysis of finality and its role in facilitating exchange. Authors Charles M. Kahn and William Roberds first present a simple, historically based model of transferable debt and finality. The discussion demonstrates the desirability of transferable debt and why rules governing payment finality are needed to sort out who will bear the losses in the event of default. Over time, the introduction of such rules helped establish the concept of negotiability, which greatly increased the efficiency of trade.
A second model shows how a more modern payment system works. The large volume and scope of payments in modern systems have resulted in disparate sets of finality rules. For example, the finality of check payments is generally tentative, and the risks are often concentrated on a single party. Credit and debit card payments are generally more final, and the liability for potential losses tends to be shared among participants.
Choosing the degree of finality for a given situation involves a trade-off between the benefits of finality and the costs of an erroneous or fraudulent transfer. Kahn and Roberds predict that the introduction of new technologies for payments may improve these trade-offs, but finality will remain the essential service provided. Visit www.frbatlanta.org and go to Publications for the full text of the article.