They say that money is the root of all evil. Over the centuries money has been tainted by greed, crime and wars. A different type of war is about to be staged. The factions are not kingdoms but commercial empires, the scene is not a battlefield but the global market, and the prize is nothing less than the license to control money. This paper examines the commercial enterprises, the consumers, the regulators and the race for the digital cash standard.
It is a popular misconception that the disadvantages of barter provided the main impetus for the development of money. But archaeological, literary and linguistic evidence of the ancient world, and the tangible evidence of actual types of primitive money from many countries demonstrate that barter was not the main factor in the origins and early development of money. Many societies had laws requiring compensation in some form for crimes of violence. The word to "pay" is derived from the Latin "pacare" which means pacify, appease or make peace with - through the appropriate unit and amount of value agreeable to both sides. A similar widespread custom was payment for brides to compensate the head of the family for the loss of a daughter's services. These tokens created for one purpose soon found use in general trading and also began to supplement barter. The problems with the barter system provided the push towards a monetary system. Early money was in the form of cowrie shells and disc shaped stones. The early money was flexible, very distinctive and exchanged in many ways. Objects were gradually replaced by standardized commodities like gold and silver and these in turn were replaced by paper money. This currency was first issued by private banks and later by local governments, and it is usually backed by gold and silver.
The current monetary system is largely monolithic. Almost every country has a single currency system and bank checks. The system is normally made up of an elaborate infrastructure in the form of commercial banks and a central controlling body like the Federal Reserve Board. Only the Federal Reserve Board has the authority to issue money. The tight conservative monopolistic monetary system is resistant to any form of change or innovation. While large transactions worth trillions of dollars handled each day by banks, other financial institutions, and government clearinghouses is already carried out electronically, chartered airplanes physically transport billions of checks around the country every workday. Digitizing the last mile of electronic money, where the coin and dollar bill go the way of the vinyl LP, will make all the difference in the world. Electronic money will not only change the way people spend money but also will impact the economic and social fabric of the society.
Hard currency has been useful for a few millennia but it may be time for change. The advent of high-quality copiers makes counterfeiting easier. The demands for guarding paper currency are making it very expensive. The hassles of handling it in vending and ATM machines make it undesirable. According to Donald Gleason, president of the Smart Card Enterprise unit of Electronic Payment Services Inc. it costs money handlers in US alone approximately $60 billion a year to conduct transactions under the current monetary system. Electronic money in the form of credit cards is already in use. But this system lacks adequate privacy and is not secure against fraud. The technology and the market are ripe for a more efficient, secure and fast system for conducting monetary transactions.
The advantages of electronic money over conventional hard currency would demand that the governments get together and implement something in a systematic fashion. However, governments have been slow in moving into this issue. Private enterprises responsive to the needs of the market and in tune with the possibilities offered by technologies are at the helm of this movement. At stake is the mother of all markets- the market for money. In the fray are banks, financial institutions, software companies and cryptographers. Parties with complementary assets are formulating strategic alliances to be the first to market. Time to market seems to be the name of the game. Each company or alliance has its own scheme. Each scheme works in a slightly different way and offers something unique.
CyberCash offers a system where the customer can have money transferred from his normal bank account to an electronic money account. The customer can then avail the services of CyberCash to use this money and pay for internet transactions. Visa has teamed up to form a financial Consortium to design "Electronic Purse", for low-cost purchases at gas stations, convenience stores, grocery stores, fast food restaurants, and school cafeterias etc. Mondex, a consortium led by two British banks, is envisioning a system of cash on electronic cards to conduct cash-like, tamper-proof transactions, even across borders. Digicash is a company founded by David Chaum which offers completely anonymous digital cash. There are many other players in this game including Microsoft. A more comprehensive list of various payment schemes is given in . Most of these schemes use some form of encryption to secure transactions and prevent problems like double spending. The details of how cryptography can be used to address the variety of problems encountered with electronic cash can be found in  and .
The route electronic money is headed for right now appears to be in the direction of privatization of money. In some sense we may be regressing to a decentralized set of private monetary subsystems similar in spirit to the cowrie shell and round stone money. Electronic cash moves through a multiplicity of networks instead of the traditional banking channels, comes in a lot of guises, is created by lots of individual parties, and is backed by anything markets demand as an acceptable medium of exchange: gold, dollars, yens etc.
This paper looks at various factors that favor electronic cash and also some hard problems that have to be solved before digital cash can blossom into a full-blown monetary system. In particular the factors have been divided into three sections
The evolution of digital cash will very much dependent on the business forces and competition. Technology offers us a variety of options and various institutions in United States and abroad are backing schemes which promote their personal interest. There are
Microsoft realizing the potential for electronic commerce was willing to pay two billion dollars to acquire Intuit, which has carved out a niche in the consumer financial services market. The deal fell through because of Justice department's intervention. Nevertheless Microsoft is trying to aggressively move into this market in collaboration with Visa. Its ability to hook into its seventy million Windows customers scares the banks and other players. There are quite a few alliances between the financial institutions and the software companies to jump quickly into market by exploiting cross synergies. Mastercard is partnering with Netscape communications and Cybercash is allying with Wells Fargo bank.
In 1994, purchases of content, goods, and services on the Internet amounted to a grand total of $13 million according to market researcher SIMBA information. Net commerce is young and SIMBA predicts that it will grow by an astounding 6,000 percent to become a $1 billion industry by 1998. Electronic cash has enormous potential to become the currency of exchange for this market. This is apart from the market using cards like Mondex which store cash and can be used for payment at point of sale.
In United States, check clearing uses the Federal Reserve, at regional check processing centers, which provide floats and processing. The price of these services is hence very high. This makes electronic cash very attractive to banks. For the high tech companies this is a gold mine. It is the next logical extension to electronic commerce. Money and defense are the only major government controlled systems today. In some sense electronic money can be viewed as privatization of money. Since money is exchanged in every commercial transaction there are enormous rewards for institutions which can control even small parts of it.
Since there are huge incentives to become dominant supplier of electronic cash institutions are working at breakneck pace to be the first to market with standards. Seamus McMahon, a vice-president at Booz, Allen and Hamilton, sees as much as twenty percent of total household expenditure taking place through the internet about ten years from now. If Cititcorp, Cybercash or any one of the systems gained control of even a part of those exchanges, it would have the opportunity to charge royalties for the use of its system and also earn interest on the money sitting in its accounts. Even a small charge, when applied to millions of transaction would be highly lucrative.
Since the internet knows no boundaries, a company offering electronic cash could gain direct access to a huge number of consumers and businesses across different states and even across different countries. The entire retail banking system can collapse and give way to global competition.
The proliferation of electronic cash could be bad news for the banks. Private companies can offer their own brand of digital cash. If they succeed, they could bypass the banks as the primary providers of financial services to consumers and businesses. The companies will be the first contact point of the consumers when they want to obtain money. J. Richard Fredricks, senior managing director at Montgomery Securities says "Banking is essential to the modern economy, but banks are not".
Even if the banks are involved, other players could capture the center stage. Early entrants into this business might set the standards for digital cash. The non banks can just make their logos the first thing people see when they bring up the software. The banks will be nothing more than icon and buttons to be clicked for transactions. This is similar to what has happened in the credit card processing industry. Twenty years ago, banks owned almost the whole business of transaction processing. Now, about eighty percent of card transactions are processed by non banking entities such as First Data Resource Inc.
The banks have a very key advantage. Consumers trust them more than anybody else when it comes to depositing money. That is the reason a lot of bankers dismiss the threats to banks due to electronic money. They believe that in the long run, the trust the consumers have on the current banking institutions will enable them to win. Some of the private companies believe this too and are partnering with the banks to get a competitive edge over other electronic money systems. Dan Lynch the CEO of CyberCash said in a seminar at MIT "Political systems may control the world, but the banks control the political systems". Even if Dan Lynch was exaggerating, banks have powerful lobbyists in their pockets and will try everything from fair competition to regulation to prevent other institutions from stripping them of their source of power.
Citibank is at the forefront of the banking effort to develop a alternative to the private companies. Citibank's Electronic Monetary System is a very advanced system. It allows retail and business customers of Citbank, and other banks that pay for the system usage, to convert money in their account to electronic cash. The customers will also have access to a credit line which could be used to draw electronic money, similar to the usage of a credit card.
It is not clear who the players will be about five to ten years from now. Not every one sees issues the same way. Since the technologies are very much similar marketing and promotions will play a heavy role in deciding who wins. Banks will try to exploit their reputation and knowledge of customers while Microsoft will probably try to use Microsoft Network to aggressively penetrate the market. At this stage it seems very likely that electronic money will originate outside the purview of central banks such as the Federal Reserve which have largely been responsible for traditional monetary regulation.
All the fancy encryption technology and the various options for using electronic money will be useless if the companies promoting digital cash cannot convince consumers to use it. Consumers using this stuff feel that they are vulnerable. People are concerned about privacy issues that electronic cash raises. With certain types of electronic cash schemes, it is very easy for the suppliers of cash to construct portfolios of individuals in terms of buying patterns.
When consumers lose their credit cards, they are only liable for the first fifty dollars of charges on the card. But right now if a consumer misplaced, say a mondex card, it is equivalent to losing cash. Similarly if your digital coins were stored on the hard drive of you PC, a system crash could make your cash disappear. There are schemes which permit you to recover cash in case of the above two occurrences but they invariably compromise privacy.
Even if the system is secure there is a psychological barrier for consumers. It is not easy to create a perception of safety. There are definitely network effects at play here. The electronic money vendors need to convince a critical mass of consumers to use this system. Once the number of consumers cross that threshold, more people automatically will start using the system and from then on, barring any major system crashes, the system will be self sustaining.
A first step in this direction could be to target consumers using credit cards for purchases on the Internet. They are the more adventurous folks likely to experiment with the new system. One of the first enablers of the Net credit-card system was the First Virtual Holdings. They launched a relatively simple system using E-mail that lets consumers use credit cards on the Internet without fear that their account numbers will be misappropriated. The card numbers are stored away on a protected computer system and never pass over the network. Instead, consumers register with First Virtual by phone and receive ID numbers in exchange for their card numbers. When they need to purchase something via the net they give the ID numbers to the vendors. First Virtual says the volume of transactions it is involved in is growing at 16% a week. This scheme does not offer tamper proof security but it goes to show that there are consumers willing to give it a chance if they can be assured a reasonable amount of security. Encrypted transactions are perhaps more secure and hence marketing can play a big role in the final form in which electronic money will be used. Companies like CyberCash are already matching the up to fifty dollar liability offered by credit cards. Some companies are even giving away free hundred dollars of electronic cash to potential consumers-- a strategy similar to the one used by the Las Vegas casinos that offer free coupons for casino tokens, to draw people in. The companies hope that a large percentage of people will like it and become customers.
The other pressing social issue concerning electronic cash is privacy. Every dollar spent using a credit card leaves a trail of your purchases and preferences. People who want to keep transactions anonymous have to use cash for those purchases. Certainly it is in the interest of the consumers to let organizations like banks have some information on them if you are applying for a loan. If you have never defaulted on your previous payments it will enable the banks to give you a loan more easily and at a lower rate. In the absence of such a credit history the bank may be forced to pass the costs due to defaulters on to it customers with impeccable records. But David Chaum argues that the same information in the hands of the wrong people can ruin an individual. Thieves routinely use a stolen credit card number to trade on their victim's good payment record; murderers have tracked down their targets by consulting government-maintained records. Competing forms of electronic cash offer a wide range of privacy. CyberCash offers a version of electronic cash which is completely traceable while Digicash's electronic money offers virtually complete anonymity. Perfect anonymity will not make the government happy because of the criminal and security implications.
While security has been a big issue there have been vast differences in estimates of how much privacy the consumers will demand. While David Chaum says consumers consider privacy to be important Dan Lynch, the chairman of CyberCash does not agree. At a recent presentation by McKinsey Consultancy Services at Sloan School of Management- MIT, on Direct Marketing, the presenter was asked about privacy issues relating to Direct Marketing. He replied ".. people will give out a lot of information about themselves when questions are asked in the right way". It is not easy to reconcile these differing opinions. Moreover customer rating of the importance of privacy can drastically change once electronic money goes into increased circulation.
The government is far behind on the electronic money issue but it is catching up. David Chaum testified before congress recently. Regulation and lobbying may finally decide the route we take in electronic money. The government has been able to control the economy through fiscal instruments like interest rates. Electronic cash poses threat to government control of money. Money laundering and counterfeiting are other issues government is worried about.
One of the big issues with electronic cash is duplication. Most systems designed are secure enough to detect double payment. In the non anonymous case double payment can be checked by serial numbers and in Digicash's anonymous scheme detection of double payment and the spenders is built into the scheme. The other issue is hackers breaking the codes. Companies say that use of strong cryptography will take care of this issue. CyberCash has permission from the government to use public key cryptography with 768 bit keys for digital signatures on its electronic money. The biggest risk by far is the key falling into wrong hands. If someone manages to get hold of the private keys of Digicash, he or she can turn into a mint and literally create money. In the short time between the hackers stealing the keys and Digicash realizing it the hackers can wreak havoc. It is like printing counterfeit currency but only more dangerous, now you have access to fast channels to distribute it and no way for anybody to distinguish it from real money.
Electronic money creates vast opportunities for money laundering and financial crime. The ease with which money can be transferred across the wire makes it easy for criminals to move money out of the country. There are two main laws which have addressed the money laundering issues. The 1970 Bank Secrecy Act(BSA) required that financial institutions report currency transactions of over $10,000 to the federal law enforcement agencies for possible investigation. The 1986 Money Laundering Control Act made money laundering illegal for the first time. Money launderers have responded by dividing up larger deposits into several deposits of under $10,000. This is called "structuring". The banks have in the last decade put in place policies and procedures, generally described under the rubric of "know your customer", to protect themselves from federal investigation for negligence. Criminals can respond to this by smuggling cash across the borders and wiring it back into the U.S. banks.
While non-anonymous money can be more easily traced anonymous money poses severe problems for the detection of money laundering. David Chaum in his congressional speech argues that there is no legitimate basis for these allegations about anonymous money. He says ecash is considerably less dangerous to society than automatic teller machines because the amount goes on record. He fails to recognize that ecash makes money laundering much easier compared to ATM. Money launderers have been trying to deposit money without arousing suspicions of the bank. One way to do it was to "structure" the deposit and withdrawal through ATMs and avoid the hassle of facing the teller. The physical limitations on the ATM deposits and the monetary limitations on withdrawals made laundering through ATM machines difficult. But with anonymous electronic cash "structuring" should be easy and there are no physical limitations. In fact since most of this is done in software, each piece of the laundered money can easily follow different routes and meet at the one final destination or different destinations. All this can be done in minutes by sitting down at a PC. Chaum also says that ecash is better than paper cash because privacy is "one way" which means that an extortionist, a seller on a black market, or the acceptor of a bribe is forever vulnerable to being irrefutably incriminated by the party that paid them. Again this argument discounts the fact that the extortionists can play a lot of tricks like converting the cash to different types, and pass it through different transactions, and mix it with other flows to make the track of anonymous cash virtually untraceable. This creative routing will be easy since it can be done in software without any physical involvement.
The other issue is the loss of monetary control faced by the government. Currently the commercial banks are entrusted with the creation of money through the fractional reserve system. They can lend out more money than they have on deposit. They are the only ones authorized to do so. If electronic cash suppliers back each of unit of their digital cash with a corresponding unit of traditional currency, then no new money is created. However if the non-bank money suppliers started backing fraction of their digital cash with traditional money, non-banks, which are mostly unregulated, could create money just as commercial banks do. This combined with the high speed electronic trading can amplify market swings and create market failures within minutes. The stock market crash of 1987 which was primarily due to electronic trading should serve to illustrate this point.
Traceable electronic cash has its benefits from the government's perspective. The IRS can very easily keep track of what each person sends. In fact in a economy run completely by electronic cash one does not even have to file a income tax return. You directly get a bill from the IRS describing the amount due. Some economists even believe that electronic cash with non-bank suppliers will lead to monetary freedom which is essential to the preservation of free-market economy. They believe that robust economic commerce depends on a flexible, responsive monetary system which can best be provided by unbridled market competition. This implies unrestrained competition among issuers of electronic cash. As attractive as free market for money sounds it removes complete government regulation of money, the life blood of commerce. This can be dangerous to markets plagued by unstable equilibriums, one slip and the entire economy can nose dive into anarchy.
Electronic cash is definitely going to manifest itself in some form in the due course of time given its various advantages. The big question is when and in what form will it eventually settle down. In all likelihood there will be more than one form of money, each suitable for particular markets and particular transaction sizes. They will all be seamlessly inter-convertible. But there are hurdles to overcome before electronic money becomes widely available and accepted.
The major issue still seems to be the security issue. Companies are planning to use strong cryptography based on solid mathematical foundations but only the market can be the final proof. Though public key cryptography was invented in 1976 and has been accepted as secure the recent incident of a Stanford University graduate pointing out that the information about private keys could be extracted by monitoring the time it takes to decrypt a message sent a scare through the cryptology community. Turns out that this is not a serious problem and encryption schemes can be designed to get around this issue. The million dollar question is : are there problems which can compromise the security of the system lurking below the veil of rigorous mathematical proofs as innocuous assumptions? Though encryption has been around for about twenty years now it has never been rigorously tested in large scale commercial systems to be accepted without question as a safe security route for electronic money. Probably the best way to alleviate this problem is by starting electronic cash in smaller markets and expanding it in a controlled manner.
We will probably hear a lot from the regulators about this issue in the coming months as government is now sitting up and taking notice of digital cash. If government lets privatization occur, it must still regulate by setting up some overall controls which can act as circuit breakers for market failures. Money laundering is still a difficult problem to solve. One possible solution could be the use of sophisticated autonomous agents on the net which detect patterns in money transfers and report it to the authorities. Maybe these agents can follow some of the suspicious transactions around and report anomalous behaviors. The technology for this is probably not ready yet but it should be available by the time electronic money become common place.
Perhaps the biggest impact of electronic money on society will be micropayments. A ten year old will probably be able to set up a gallery of pictures and charge a cent to anyone who wants a peek. The "Virtual Lemonade Stand" is not far away. There will be fourteen year old millionaires and teenage startup companies. In general electronic money will in all likelihood have a significant impact on the way society is evolving because digital cash will effect commerce and there is a heavy interplay between commerce and social structure. How it will all play out, only time will tell.
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2. Achieving Electronic Privacy, by David Chaum, Scientific American, August 1992
3. The Future of Money, Businessweek June 12, 1995, pp. 66-78.
4. Information Technologies for the Control of Money Laundering , 1995 study by the Office of Technology Assesment(OTA)
5. Digital Cash and Monetary Freedom by Jon Matonis; Verisign, April 1995
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7. E-Money(That's what I want), Steven Levy, Wired 2.12
8. Electronic Payment Schemes, Phillip Hallam-Baker, World Wide Web Consortium.
9. Bibiliograhy of David Chaum's publication
10. Applied Crptography, Bruce Scheier, John Wiley & Sons, Inc.
11. David Chaum's U.S. Congressional Testimony