Network economies versus innovation in the transition to Check 21

Checks were the last major noncash payment instrument to be converted to electronic payment and settlement. Under state laws based on U.C.C. standards, payment was only required upon presentation of the original check, thus hindering the adoption of electronic check presentment. The Check Clearing for the Twenty-First Century Act (Check 21), which took effect on October 28, 2004, allows a collecting bank to present a legally equivalent paper copy of an original check—called a “substitute check”. Banks can now replace their own internal paper-based processes with electronic processes from the initial receipt of the original check up to the actual presentment of the check to the paying bank. Although slow to start, once the legal framework was in place, the transition to electronic presentment occurred faster than expected. Many factors likely played a role but in this paper we focus on estimating how much of this transition was driven by network economies and how much was driven by innovation. A straightforward theoretical model predicts a role for network economies (the benefits of participating in a network grow as the size of the network increases), however innovation (primarily technological progress and learning-by-doing) likely also plays a role. We can estimate the magnitude of the two effects by looking at the 47 Federal Reserve check regions from 2005 to 2012. The key to separating the two effects is that innovation would affect all the regions equally, whereas the effects of any network economies would be larger in regions with early adopters. Our empirical findings support an important role for network economies.