The Checking System and the Importance of Financial Intermediation

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.