How money used to move (not well)
This is the third post in our series "From old money to Smart Money." If you haven't read the first two, we recommend you start here.
Have you ever wondered why we can only send bank transfers during
business hours on business days? Why it takes days for money to
get from one place to another? Why every app and product you use
has limits on how much of your own money you can send? Why you
only get paid twice a month?
We’ll take a quick tour of some of those — but there’s an endless
rabbit hole you can go down here (and we have!) of esoteric
regulations, unwritten rules, banking “best practices,” and
skeletons in closets.
The simple answer to all these questions is identical: financial
institutions use the same processes to move money today that they
did in the 1970s. Most every “upgrade” or “innovation” since then
has been a matter of building on the same, broken foundations.
It’s frankly impressive how long those foundations have remained
standing — but the cracks are starting to show.
To really understand how "modern" money movement works, we first have to go back in time.
The Pony Express
Founded in 1860, the Pony Express was a network of 186 stations
positioned about 10 miles apart from each other so that bags of
letters and checks could be sprinted across the country. For
example:
- Someone in California might deposit a check, originally sent from St. Louis, at their local bank
- That check would then be sent (with any others from that day) to a large regional bank in, say, Sacramento
- The bank in Sacramento would then put this check in the next batch headed for the biggest St. Louis bank
- If the original sender wasn’t a customer of that exact bank, the check would then go to a local clearing house
-
At the clearing house, they’d hand the check to the recipient’s
actual bank, which would debit the sender’s account
At each hop in that process (the California local bank to the
Sacramento regional bank to the St. Louis bank to the final bank),
the bank opened up an IOU with the bank before it.
At the end of each day, a bunch of banks owed each other money
from their customers’ checks going back and forth. Ultimately, a
clearing house would keep track of all these debts and tell every
bank at the end of the day if they owed money (a “net debit”)
position and needed to hand over more money, or if they had a “net
credit” position and could withdraw money. This is called a
“net-settlement system.”
Finally, when the check cleared, there would be a chain reaction
that cleaned up all the debts.
All of this is true, except for the last part: while in theory
confirming a payment should be a key part of this process, the
Pony Express had limited capacity and was expensive. So in
reality, the payor’s bank never sent confirmation to the payee’s
bank.
The only time the payee's bank in California would get any
news is if the check didn’t clear. But there was no
deadline for them to hear this news — which meant there was no
fixed amount of time after which the bank in California could be
confident the money was good. No news, as far as these banks were
concerned, was good news. Can you see how this could become a
problem?
The bank in California needed to give its customer access to their
funds right away, but at the same time, the bankers had no
specific time when they knew they weren’t liable for a bad check.
No bank really knew what the state of everyone’s accounts was at
any given moment. You’ve heard stories about “check kiting” and
other scams back in the day — the brokenness of this system is
what allowed that.