Plastic Takes Over
Using cards as payment started with credit cards, and this occurred well prior to the digital age, where transactions had to be verified with the credit card company over the phone. Many smaller transactions were not verified, but with larger ones, the merchant had to call the credit card company and get an authorization code.
To keep these calls within reason, the credit card had to agree to honor transactions below a certain amount, even though the cardholder may not have available credit for the purchase, because it simply was not efficient to take calls for nominal amounts.
Once the digital age hit, these authorizations became automated, through a computer system. This also brought forth the bank card, similar to a credit card other than the payments aren’t extended by way of credit, but instead by debiting the cardholder’s account, the same way a check would.
Bank cards virtually put an end to using checks as payments for point of sale purchases, once bank cards became ubiquitous. They were optional when they were first introduced, but eventually they became mandatory, and if one could write a check to debit one’s bank account, one could also use their debit card as payment, as long as they had the money in their account to cover it.
The instant verification of plastic cards brought a new level of efficiency to making payments. While the transfer of funds is not instant, the authorization of the payment is, and now merchants can be as assured with non cash transactions as they can be with cash ones, save for counterfeiting with cash and fraud with cards, both of which are uncommon enough to not represent an unacceptable risk to the merchant.
What makes these payments so efficient is that everything is automated now, and neither customers nor merchants have to handle cash with these transactions, which involves both a burden and greater risk to both parties.
Many people still prefer to transact in cash though, and this remains a personal preference, at least so far. Cash is still legal tender, which means people are obligated to take it as payments for goods or services received or for payment of debts, but more and more people are moving away from cash each year and embracing the easier form of making digital payments.
How Banks Transfer Funds Between Payor and Payee
Banks are involved in all forms of payment, whether this be by cash or check or by digital means. People tend to understand how cash works at the banking level, as money is given to someone and they deposit it at their bank and their bank account gets credited with the funds.
The way banks process non cash transactions is much less known. Some wonder what digital cash consists of, or whether or not actual cash changes hands with these transactions, and the answer is that it does not, nor does it need to.
If you make a non cash payment to someone, using a bank account as payment, money does not go directly from your bank account to the bank account of whoever receives the payment. This is possible but it would be way too inefficient, and account charges would be much, much higher than they are if this were the case.
Digital money like Bitcoin does process direct transactions like this, but digital currency is much more efficient by nature and the fact that this is all done on the internet and occurs directly between the parties, peer to peer payments as it is called, makes this possible.
Banks on the other hand process payments in bulk, exchanging money between each other on a net basis. If a payment is between two clients of the same bank, it’s just a matter of debiting one account and crediting the other. Often though these are between institutions, so at the end of the day the banks calculate how much one owes another and either credits or debits the accounts that each have at the other bank or at a third party institution, and most commonly settle these payments through the central bank, where they both have accounts at.
How Bank Deposits Really Work
To understand this properly, we need to realize that money on account at a bank isn’t just money in the bank that we have, but a debt the bank owes to us. Even when we deposit cash, the bank keeps the cash for itself and simply owes us the money, a debt to be paid to us at a future date.
So let’s say you make a purchase at a store for $20, and you bank at Bank A and the merchant banks at Bank B. Bank A does not simply take $20 out of your account and send the cash to Bank B, that would be ridiculously inefficient, and the transaction costs may even exceed the original $20.
Instead, what the banks do is exchange these debts. Let’s say someone else at Bank B made a payment to a store which uses Bank A, your bank, for $20 as well. So for your transaction, your bank no longer owes you the $20, it owes it to Bank B, who in turn owes it to the merchant you spent the $20 at.
Bank B owes Bank A $20 for this other transaction though, so these transactions balance out, and no money ends up being transferred to one or the other bank as a result of these two transactions, as this scenario allows for both transactions to be processed internally. At the end of the day settlement, the banks figure out what the net amount is for all the transactions between all of their parties and transfer the net amount to one another to “settle” their transactions.
This is why, even in this day and age of instant digital processing, bank transactions still do not settle until the next business day, and why people see the processing date and the posted date, when it is settled, as not occuring on the same day. It’s not that banks could not process them instantly, but they wait and do these in bulk, with net amounts, to make the system much more efficient and cheaper to manage.
So digital money isn’t cash, it’s debts between banks and depositors, which is money in a real sense, as it is part of the money supply.
The money supply though is much more than all the cash in circulation though, it’s mostly these bank debts to people and businesses. People may wonder whether digital payments use real money, and the answer is that they do but not money as people normally think of it, but it is all legitimate but simply a bank’s promise to pay someone rather than cold hard cash sitting somewhere.
So this is how banks process payments, by shifting around the debts that they owe people to clients within their banks and to other banks as well.
Editor, MarketReview.com
Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.
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