The Fed performs a variety of other tasks, including providing financial services to banks. One such service is a role in operating and overseeing the nation’s payments systems, including the mundane task of clearing checks. When someone receives a check and deposits it into an account, his bank must clear the check with the bank upon which it was written to ensure there are sufficient funds and then transfer the money into the recipient’s account. Nowadays, it typically takes a day or two for the Fed to clear a check.

But the market does not need the Fed to clear checks. Back in the 1850s, the largest commercial banks created an entity called The Clearing House (TCH) to handle the task. It still operates today and clears about half of all checks written.

In late 2017, TCH began offering banks a service that can clear payments (including checks) within seconds, which offers a myriad of advantages both to depositors and banks. The service has proven popular and fully half of all depositors now have access to real‐​time payments. At the time it began the service’s roll out, TCH anticipated that nearly all depositors would have access to real‐​time clearing by the end of 2020.

This past August the Fed announced that it would begin taking steps to offer a real‐​time clearing service of its own, FedNow. While a competitor in this nascent market may seem at first blush to be a potential benefit to banks and depositors, the reality is otherwise: the service is a natural monopoly best served by a single, private‐​sector entity. The Fed’s costly and delayed entrance into the market will delay bank customer access to the service and likely scuttle any hope of ubiquity with such a service, negating most of the potential gains from real‐​time clearing.

To understand why this is, it is necessary to understand who will benefit from the service, as well as the Fed’s historical role in clearing checks.

History of check clearing / A consortium of a dozen large New York banks created TCH to expedite the clearing of checks between institutions. The process of bringing all issued checks to a central location and settling the amounts owed between banks simplified operations and reduced the average time to clear a check. TCH operates essentially as a utility.

Until a few years ago, clearing checks necessitated physically transferring a check from the bank that received it to the bank from which it was issued — a labor‐​intensive and costly exercise. These days, check‐​clearing can largely be done electronically; many people deposit checks via a phone app and no bank ever takes physical possession of the check.

Until the creation of the Federal Reserve in 1913, TCH had no real competition — which made sense, as having a single entity collecting and returning checks to each bank reduced complexity and eliminated redundancy. That it was (and still is today) wholly owned by the commercial banks that benefit the most from its service obviates concerns about monopoly pricing; it does not price‐​discriminate, which means that smaller banks that do not have a stake in TCH are not at risk of being disadvantaged.

In 1972, at the behest of the U.S. Treasury, the Federal Reserve began offering electronic direct payment facilities to the federal government. At the time, the number of people employed by the government or receiving government support had dramatically increased, which increased the number of checks issued by the government, along with its costs of issuing and administering checks.

The Fed initially provided its Automated Clearing House (ACH) services to the government for free. After a few years, it began offering the service to banks as well, at a price well below the cost of providing the service. That made it difficult for TCH to effectively compete in the market.

Having the Federal Reserve compete against the private sector — especially in markets that it regulates — created some unease in Congress, especially given that the Fed was effectively subsidizing its ACH services for no good reason. One provision of the 1980 Monetary Control Act specified that the Fed needed to charge a price sufficient to cover costs for any services it provided. The act also directed the Fed to consider whether the private sector has the ability to offer a service before the Fed enters that market.

Not surprisingly, the Fed has failed to see any reason for it to withdraw from the check‐​clearing market. Over the years it has offered various rationales for remaining. Even Alan Greenspan — perhaps the most famous libertarian in U.S. history — averred after becoming chair of the Federal Reserve that having it perform this service gave it useful data on financial markets. The changing rationales manifest the fact that there is simply no good reason for the Fed to compete against the private sector in this market.

Potential gains / A system that clears checks in a short period of time would benefit banks, but the real beneficiaries are low‐​income workers.

About 7% of the population does not have a bank account, according to the Federal Deposit Insurance Corporation. These “unbanked” forgo accounts either because they cannot get one — banks generally cannot give checking accounts to people who have unresolved bounced checks — or because it does not make financial sense for them to have one. For most of this cohort, depositing a check and waiting for even a short time to access that money is impractical. People without a bank account invariably rely on payday lenders, pawn shops, or title loan companies, which charge for their services and can be quite expensive relative to the money being exchanged and the customers’ income.

Another 18% of the population have bank accounts but sometimes find it necessary to avail themselves of the services of payday lenders and the like because they are capital‐​constrained in some way. That banks cannot quickly clear checks is a primary reason that these “underbanked” must resort to costly nonbank services. For a fee, payday lenders can immediately make funds available to people.

Brookings Institute economist Aaron Klein estimates that the unbanked and underbanked paid about $24 billion last year in various fees to payday lenders. The status quo does not work for these cohorts.

Natural monopoly / Commercial banks in the United States have belatedly come to realize that clearing checks immediately would not only benefit their customers but also improve the banks’ bottom line. They can take business from payday lenders and expand their services to existing depositors. This would also simplify their business processes. Hence, TCH’s entry into real‐​time check‐​clearing. But when the Federal Reserve announced in 2018 that it was considering entering the market, that effectively froze TCH’s expansion plans, with few banks subsequently signing up for the service.

While it may seem logical to presume that two competing services would be better than one, that is not the case for this market. Each system necessitates a substantial fixed cost from each participating bank in order to clear checks in real time, along with a per‐​check clearance fee that would be somewhat higher than the current system.

The Fed’s current, slower check‐​clearing system, which processes checks in batches intermittently, allows the Fed and TCH’s system to be interoperable. However, competing real‐​time check‐​clearing systems would almost surely not be interoperable; the robust messaging functionality used by TCH’s system would be lost even if it did become possible to bridge payments between two real‐​time systems. In Europe, where a private utility competes with the European Central Bank to provide real‐​time check clearing, interoperability between the two systems was promised but never achieved.

Having two competitors would require banks to either invest in each system or else force each bank to choose one provider. In the latter case, the bank could offer to clear checks in real time only if the payer’s account is with a bank that uses the same system, which would negate most of the benefits. In other words, this market is effectively a natural monopoly, which means that the market would be more efficient with a single seller.

Some community banks aver that the Fed may be more amenable to their needs and possibly offer them a lower price. However, if the Fed hews to the Monetary Control Act by not providing an explicit or implicit subsidy to any customer, it is hard to see how that could be the case, especially given that TCH has already committed to charging all banks the same per‐​check clearance fee.

It is also worth noting that the Fed’s summer 2019 announcement stated that it would need at least four years to roll out its system, further delaying the widespread adoption of real‐​time payment processing. If such a system does have the potential to substantially increase the number of bank customers and improve efficiency, then this delay in the market will reduce potential short‐​term bank profits — not to mention consumer welfare.

Benefit–cost analysis / Until recently, independent agencies like the Federal Reserve had not been subject to regulatory oversight of their activities. However, a memo issued earlier in 2019 from acting Office of Management and Budget director Russ Vought clarified that the Congressional Review Act (CRA) requires all agencies — even independent agencies like the Consumer Financial Protection Bureau, the Securities and Exchange Commission, and the Fed — to submit major regulations to Congress and the Government Accountability Office. (See “What Does the OMB Memo Mean for Review of Independent Agency Actions?” Fall 2019.)

The Office of Information and Regulatory Affairs (OIRA) is tasked with determining what is a major rule, defined as having an annual economic effect of $100 million, increasing the costs of doing business, or affecting competition. Vought’s April memo requested that independent agencies work more closely with OIRA to ensure CRA compliance. The Fed argues that expansion into real‐​time check clearing isn’t subject to Vought’s memo because the service is merely a new product line that it plans to offer various customers. However, this distinction doesn’t seem sufficient to exempt the service from the CRA or the memo.

The real‐​time clearing market is effectively a natural monopoly, which means that it would be more efficient with a single seller.

As part of its review, OIRA may want to discern how a regulator acting as a competitor will affect this nascent market, whether small banks will be disadvantaged if the Fed decides to offer steep volume discounts for check‐​clearing as it currently does for its ACH business, and what might be the broader economic costs of the Fed’s action given that its delayed entry will force millions of Americans to continue paying check‐​cashers and leave the U.S. economy lagging behind other nations in real‐​time payments adoption.

OIRA should immediately signal that the Fed’s final rule on real‐​time check clearing is subject to oversight under the CRA. OIRA and Congress should insist upon the completion of a benefit–cost analysis of the Fed’s creation of a real‐​time payments system that passes muster with OIRA, the same as the actions of other agencies.

Distortions / One of the intentions of the Monetary Control Act was to provide guardrails for the sorts of activities the Federal Reserve should and should not undertake. High up in the latter category were activities that the private sector could provide efficiently. Clearing payments in real time is one such activity. If the Fed does follow through and offer this service, it would ultimately distort the market and increase the overall costs to banks of real‐​time clearing.

The rationales the Fed has offered thus far for entering this market simply do not hold water given that the market is a natural monopoly. Even if competition were necessary to drive economic profits down to zero, the fact that bank costs would essentially double in order to cover both systems means that no one will save money from the Fed’s participation.

The Federal Reserve’s 2019 announcement estimated that it would cost at least $800 million and require four to five years of planning and investment before it will be able to offer its competing service. It also forecast that the Fed would not be able to recoup its investment in at least a decade, which seems to put it clearly at odds with the intent — if not the letter — of the Monetary Control Act.

The government — and the Federal Reserve most emphatically is a part of the government, regardless of its ostensible independence from the executive and legislative branches — should strive to be a referee and not a participant in banking services. Its announced intention to offer real‐​time payment services to banks not only is at odds with this idea, but its ultimate effect on the market would be counterproductive, serving to delay TCH’s expansion of this service and actually reduce the ubiquity of real‐​time check clearing. Ultimately, the Fed’s entry will only increase banks’ costs, impeding tangible benefits for low‐​income workers living paycheck to paycheck.