by Kaz Nejatian
It was this growth in Boston that caused a shortage of currency. People wanted to buy and sell things — but they didn’t have enough gold and silver coins.
To remedy this situation, in September 1681 a group of Boston businessmen got together and crated The Fund at Boston in New England. These businessmen mortgaged their land to this Fund, received credits for the value of the land and then drew checks against this fund to buy and sell things.
As The Fund at Boston in New England grew in popularity, other similar funds were started in other cities and towns in the United States.
These funds bought checks from local merchants without charging any fees; local checks, therefore, were cleared at par. In other words the funds paid the check holder the full amount of the check.
The funds, however, did charge a fee for checks that were mailed to them from out of town for settlement. This fee originally was meant to cover the costs of sending gold coins, frequently via horse carriage, to the fund or the bank that had received the check from one of its customers.
As US merchants began to travel more and more, these out of town check fees became more and more common.
To gain a competitive edge in the local market and to receive more business from local merchants, many local banks developed a network of relationships with out-of-town banks. These networks would allow banks to cash checks between each other without any fees.
Frequently meeting in local restaurants or train stations, employees from these banks would simply batch a week’s worth of checks and exchange them at pre-set meeting destinations, so-called clearing houses. These clearing houses were frequently placed close to train stations so that travel by rail would be easier for those making the trips every week. (Interestingly, to this day in an homage to the early days the term “payment rails” is used to refer to a system over which payments can be settled.)
At the meetings in the clearing houses, the banks would simply exchange checks and settle the difference in gold coin or letters of credit.
Under this ad hoc system, banks began sending checks to their network partners rather than the original bank. For example, if Bank A in Boston had a relationship with Bank B in Philadelphia, and was presented with a check from the Bank C in Philadelphia, Bank A would send the check to Bank B , and an employee from Bank B would then simply physically walk up to a branch of Bank C in Philadelphia and clear the check at par.
As these networks became more complicated, the routing of checks became more complicated as well. Checks would frequently travel hundreds of miles more than they needed to in order to be cleared at par.
While banks reduced the fees they paid using this clearance method, they did not reduce the fees they charged to their customers. This meant that starting in the 1700s, banks were making a significant amount of money from check interchange.
This created some very odd incentives for banks. Obviously reducing the cost of clearance led to an increase in time of settlement. A check that had to exchange hands 10 or 12 times would likely land in an account weeks after it was written. This meant that by the time the check was ultimately settled, the customer might no longer have sufficient funds in their account.
In one example, a check drawn from a Sag Harbor, New York bank travelled more than 1,200 miles through nearly ten cities before being deposited in Hoboken, New Jersey, which is less than 100 miles away from Sag Harbor.
In another example, a check deposited in an Alabama bank that was written from a bank merely a few city blocks away was routed nearly 2,500 miles, through Jacksonville and Philadelphia before returning to Alabama a week later.
In addition to increasing the credit risk, this system increased the risk of error. A check traveling 2000 miles might be lost, might be recorded incorrectly, or might be stolen by bandits along the way — a non-trivial risk in those days.
Spike in Popularity
For much of the two centuries between 1681 and the Civil War in 1861, checks lagged in usage behind government backed currency and private bank currency (the type that were taxed out of existence by the National Bank Act in 1870s).
By the 1850s, however, as private banks flourished and as free banks spread across the United States, checks became more and more popular. By the end of the Civil War, given all the trouble with the devaluation of greenbacks and shortage of gold and silver, checks were the most popular method of payment in the United States. This growth, incidentally, did not slow down until the late 1990s.
By the early 1940s, Americans were writing nearly four billion checks each year. That means that each American was writing on average a check every 11 days. By the 1950s, Americans were writing nearly eight billion checks each year. This works out to each American writing at least one check every week.
By 1979, nearly 90% of all payments in the United States were made by check. Americans wrote checks for nearly every purchase - writing a total of 33 billion checks in 1979. That’s one check written every other day by each man, woman and child in the United States.
Interestingly, as the usage of checks in every day life grew the shape and the design of checks did not change much. The only major difference between a check written in 1860 and a check written in 1960 would have been the introduction of the magnetic ink character recognition code (MICR Code) at the bottom of the check in 1959.
Federal Reserve to the Rescue - Again
The system developed in 1681 for clearing a few dozen checks was collapsing by the late 1800s.
As checks became more popular and more fees were incurred, the US merchant population began lobbying Congress to fix what the merchants considered a banking racket.
The merchants, and some banks, began lobbying Congress to create a central bank. The US. Congress was skeptical. Two previous efforts to create a central bank (in 1791 and in 1816) had not ended well. Thomas Jefferson and Andrew Jackson had both spent a significant part of their political lives opposing such banks, arguing that they were unconstitutional and unnecessary.
But in 1913, spurred by the Panic of 1907 as discussed in the previous chapter, Congress finally relented and passed the Federal Reserve Act, giving the new Federal Reserve Board the specific task of getting rid of expensive check fees.
The Federal Reserve took up this task with gusto, and began toforce — frequently by threat of forcing a bank into effective insolvency — an at-par check clearance system on US banks. By 1920, nearly 20,000 banks in the United States had signed up for the “voluntary” at-par clearance system. A few hold-outs sued the Federal Reserve. In the famous Am. Bank & Trust Co. v. Fed. Res. Bank of Atlanta case, the Supreme Court ruled in favor of the bank, and against the Federal Reserve.
The Supreme Court ruled that the Federal Reserve had been acting unconstitutionally and illegally by forcing banks to join its at-par clearance system.
“Congress did not in terms confer upon the Federal Reserve Board or the federal reserve banks a duty to establish universal par clearance and collection of checks; and there is nothing in the original act or in any amendment from which such duty to compel its adoption may be inferred. ”
Immediately after this decision, the number of banks charging check interchange went up. In the long run, however, the damage had been done. So many merchants had found banks willing to clear their transactions at par that the remaining banks wanting to charge interchange gave up their fight and waived their fees as well.
3 Automated Clearing House
As checks grew in popularity, more and more employees began requesting that their employers pay them in check rather than cash.
By the late 1950s, virtually every single salaried employee in the United States was being paid by check. Every two weeks, payroll teams across America would gather their records and begin the process of paying their employees. Once these checks were written, they were handed to the employees, many of whom would immediately drive to the nearest bank to deposit their salary into their bank account.
This traffic of payrol
l clerks writing checks, managers signing them and employees depositing them became particularly problematic in California where thanks to intense expansion of Bank of America the percentage of employees with bank accounts was higher than elsewhere in the country.
SCOPE
The increased travel to their branches and the delays associated with writing and depositing checks every two weeks for the exact same amount drove many bankers in San Francisco to the edge. Thus, more out of frustration than anything else, in 1968 a group of San Francisco bankers invited some Los Angeles bankers to form the Special Committee on Paperless Entries (SCOPE).
The people running SCOPE didn’t have any great national plans. They didn’t want to form a new method of payment. They just wanted to find a way to free their bank clerks from the drudgery of having to spend hours upon hours every two weeks reviewing and depositing paychecks.
This task became more difficult during Christmas season. A New Jersey banker, from this period, claimed once in an interview that during the Christmas season the paperwork required to settle all transactions, including all the checks, would reach the ceiling of the bank’s main branch and that it would take the bank’s employees up to four months to clear such transactions. During this four month period, the bank would not know whether it had been defrauded or whether it had cashed a bad check.
The task of SCOPE, therefore, while a thankless one was a necessary one. Left with the processes from the 1960s, banks would not be able to fit all the paper required to track all transactions in the back offices of their branches by the 1980s.
The amount of paper piling up in bank offices was especially problematic in California. By 1968, many Californians were using the then popular BankAmericard cards (covered in a later chapter) for their purchases and these transactions would need to be settled and paid for by many of the same clerks that were responsible for maintaining the checking system for many banks.
In order to deal with the increasing flow of transactions from all the checks being written, SCOPE used a relatively recent innovation from the world of checks.
Starting in 1959, banks had begun printing magnetic ink character recognition codes, or MICR codes, at the bottom of their checks. This ink was meant to be used in conjunction with the relatively new optical character recognition, or OCR, technology to lessen the work of manually looking up and writing account information on the back of checks so they could be proceed.
Against this backdrop, starting in 1968, the SCOPE committee started to solve the problem at hand. Early on the committee decided that its goal was to create an exchange called “Automatic Payments and Deposit Exchange” to enable “preauthorized paperless entry” of transactions.
As they navigated the legalities, the lawyers in the room advised the group to not call their final organization an exchange but a clearing house. Thus, with the help of the Federal Reserve of San Francisco, SCOPE formed the California Automated Clearing House Network (CACH).
The system called on the member banks to send CACH two transmissions on a daily basis either on magnetic tapes or punch card, though preferably magnetic tape. The first transmission involved all the debit transactions that a bank wished to originate – in effect pulling funds from another bank. The second transmission involved all the credit transactions. Banks were forbidden from sending their “on us” transactions, transactions where the debit and the credit accounts are held at the same bank, to CACH.
One may ask, why are banks required to send two separate transmissions to the clearing house? This is an odd feature of the Automated Clearing House (“ACH”) system that persists to this day.
The reasons were simple.
First, the debit and the credit features of the system were built on two fundamentally different procedures. A debit transfer was very similar to a check clearing process. All that changed was the lack of a paper check. The credit transfer, however, was built on top of the already existing pre-authorized payroll deposit system where some employers required that their employees open up bank accounts at the employer’s bank in order to facilitate payroll. These two systems were fundamentally different systems within banks.
Second, and more practically, the magnetic tapes available in 1968 did not have enough storage for both outgoing and incoming transactions. This meant that even if banks were willing to change their internal procedures, they could not find storage tapes with enough capacity for their needs.
For comparison, the most sophisticated magnetic drum memory in the late 1950s had a capacity of around 10 Kilobytes. A Kilobyte is 1,024 Bytes. A Kilobyte can hold about 2 paragraphs of text. A Gigabyte is 1,073,741,824 Bytes or 1,048,576 Kilobytes. A Gigabyte can hold every song ever recorded by Miley Cyrus. It can hold Party In The USA about 256 times over. The least expensive iPhone 7 in 2017 has a capacity of 32 Gigabytes.
Another challenge facing SCOPE in 1968 was the fact that what its ultimate goal had recently been made illegal.
For over 100 years, the law governing payments of checks in the United States was the egotiable Instruments Law of 1896. It had very broad structures around what was allowed and what wasn’t, but it gave banks and clearing houses a great deal of flexibility.
In 1951, however, the Negotiable Instruments Law was replaced by the Uniform Commercial Code. The old rules were modified and became Article 3 within the Uniform Commercial Code, called “Negotiable Instruments”. The rest of the old rules were included in Article 4 of the new Uniform Commercial Code called “Bank Deposits and Collections”.
Under the new rules, a check was a negotiable instruments and thus covered by Article 3; but Article 4 governed the specific rules that banks must abide by when handling checks.
Article 3, among other things, required that a negotiable instrument contain a signature and a promise to pay. It is difficult to imagine how a magnetic tape or a punch card could contain either a signature or a promise to pay. In fact, the file system envisioned by SCOPE would only contain account numbers and debit or credit amounts.
This meant that any law that could permit SCOPE to do what it wanted to do must be based either on Article 4 or a sophisticated contract between all the banks specifically nullifying provisions of the Uniform Commercial Code. It is easy to imagine how negotiating such a contract would be difficult and expensive.
Luckily for SCOPE, Article 4 did allow for payments of “any instrument for the payment of money even though it is not negotiable.” However, even here the banks were not clear.
Article 4 clearly governed rules of an “instrument”; and the term instrument is defined within the Uniform Commercial Code as a “writing”.
SCOPE’s legal advisors brazenly argued that since a writing means “an intentional reduction to tangible form” then holes in a punch card or data on a magnetic tape would also constitute a “writing”. No one apparently asked how 1s and 0s stored on a digital tape themselves were “tangible”. Fewer people seemed to argue that a hole is not something tangible but by definition the lack of something tangible.
To make the legal case murkier, Article 4 imposed on the banks to use reasonable care to discover “unauthorized signature or any alternation of an item” and to send to the customer “a statement of account accompanied by items paid in good faith.”
Obviously, under SCOPE’s plan the bank could not take reasonable care to review unauthorized signatures on every debit and credit entry. SCOPE’s lawyers reasoned that the bank could review the signature on the original instruction for the repeat transactions and that this would be enough despite the fact that court cases had leaned towards interpreting the law to mean that this duty applied to every transaction.
The lawyers also argued that the simply printing what was on the magnetic tape and attaching it to the monthly statement would be enough to comply with the “statement” requirement of Article 4. This is peculiar, of course, since the information on the magnetic tape and the information on the statement would be drawn from the exact same source. They would not all
ow the customer to see any mistakes with the underlying instructions.
Despite the legal objections, SCOPE’s lawyers consented to its plans. The pain felt by California banks from paper checks piling up in their branches was too strong to be stopped by mere legalities that would take years to litigate through the courts.
The same thing, however, could not be said about the California labor laws. Unlike the Uniform Commercial Code, California labor laws are not optional. Even if the banks wanted to spend years negotiating contracts between themselves, they could not opt out of California labor laws. More importantly, there was no ambiguity in California’s labor laws. They required, in black and white, that no company “shall issue in payment of wages due … any order, check, draft, note … , unless it is negotiable and payable in cash, on demand.”
Virtually none of these conditions were met by the system envisions by SCOPE. The payments would not be “negotiable” since they clearly did not meet requirements set out in Article 3 of Uniform Commercial Code. The payments would not be in payable in cash or on demand. A payment made on Monday would show up in the customer’s bank account later in the week and even then it may not be payable in cash since the customer may have other obligations to the bank. The money would simply be added on top of the customer’s existing balance and if that balance were negative the payment would be reduced.