Payment systems have evolved through several stages: coins, paper and electronic. The next stage of evolution is digital payment systems like bitcoin.
The first generation of payment systems was coins. They represented the first quantum leap in payment systems. Made of precious metals like gold and silver, coins were portable, durable and valuable. Their weight and content were standardized by the entities that made them. For example, if you trusted the government mint, you could have confidence that the coin was worth what its face value was.
What made coins such a good payment system was that value could easily be transferred from the buyer to the seller. Once the goods or services were chosen, the buyer simply had to give the appropriate number of coins to the seller. The transaction was secure (assuming that a robber did not interrupt the transaction) and was instantly verifiable. Coins were especially convenient for individual and local transactions.
The second generation of payment systems was the development of paper instruments. Like representative money, these paper instruments represented value stored in a financial institution like a bank. The earliest paper instruments were checks. This innovation made high value transactions a lot easier: instead of bringing a large amount of precious metal coins to the transaction, a buyer need only a check or currency notes equivalent to the purchase value.
While being able to transfer value from the buyer to seller, the transaction was a little more secure. If a robber or burglar stole the check, the buyer could void the check at their bank.
However, verification proved to be a little trickier. If the buyer and seller were customers of the same bank, verification was relatively fast. But if they were customers of different banks, verification was more complex. The check-clearing process between banks was cumbersome, especially if one of the banks was outside of its service area. As a result, the banks would charge the seller fees for clearing, transportation costs and taking on credit risk. These early issues inspired alternatives like money orders, which were considered less costly and more trusted but also more inconvenient.
One of the reasons why Congress authorized the Federal Reserve System was the need for a national payment system. The Fed’s national check clearing services were free to any bank joining the Federal Reserve System. As more banks joined and the Fed’s process proved more reliable, consumers began having more confidence using checks. Eventually, checks became the dominant form of non-cash payments until the 1990s.
The third generation of payment systems was electronic payments. Banks collaborated on the development of the credit card in the 1950s and creating the electronic highways for these transactions to travel. Credit cards grew at a steady pace but then skyrocketed when the tech boom in the 1990s made data processing easier and less costly.
Debit cards are a relatively new electronic payment system, originating in the 1980s. They began as an Automated Teller Machine card that would debit the user’s bank account immediately and quickly expanded into becoming an electronic payment system itself. The growth of debit cards has been dramatic.
Interestingly, credit card transaction growth has not come at the expense of coins but instead have eroded checking’s market share. And debit cards’ growth has come mostly at the expense of credit cards. Only recently has cash, both bills and coin, begun to shrink noticeably.
Electronic payments are a more effective method of transferring value than are paper instruments and they are more quickly verifiable, but they are less secure. Hackers and other cyber criminals have figured out the Achilles’ heel of electronic transactions: the centralization of data. Hack into the choke point and voila, you can get all sorts of personal data including credit card and Social Security numbers.
Digital payment systems like bitcoin are the next stage of evolution for payment systems. These transactions use the Internet instead of a proprietary financial transaction infrastructure. By using the Internet, financial transactions can be done at a fraction of the cost just like phone calls on Skype or FaceTime or mail on Google or Yahoo.
These transactions are also decentralized, which means they are more secure. Instead of traveling a centralized financial transaction highway, digital payment systems are one-time individual transactions between the buyer and seller. Instead of the target-rich environment of electronic transactions, a hacker would have to cost-ineffectively breach each individual transaction. And if they were successful, they could steal bitcoin like cash but there would be no personal data at stake.
Further, each Bitcoin transaction is also verified and then recorded on a public ledger in a block of data. New transactions are recorded on top of prior transactions (hence the public ledger’s name, the Blockchain) and become easily verifiable and immutable.
Bitcoin has all the elements of an optimal payment system: easy transfer of value, secure and verifiable. But consumers’ payment system habits change slowly. Only when they trust a payment system will a consumer start using it. And they will use whatever payment system is best for a specific transaction. So expect that coin, paper and electronic will be with us for a while. But also expect that digital payment systems will gain market share over time while others fight over a shrinking piece of the pie.
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