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.

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