"Money in the 21st century will surely prove to be as different from the money of the current century as our money is from that of the previous century. Just as fiat money replaced specie-backed paper currencies, electronically initiated debits and credits will become the dominant payment modes, creating the potential for private money to compete with government-issued currencies." Jerry L. Jordan, President and CEO, Federal Reserve Bank of Cleveland

 

Introduction

Hardly a day goes by without some mention in the financial press of new developments in "electronic money". In the emerging field of electronic commerce, novel buzzwords like smartcards, online banking, digital cash, and electronic checks are being used to discuss money. But what are these brand-new forms of payment? Who will use them? And most importantly, which of the emerging electronic money technologies will survive into the next century?

Tough questions, and no easy answers, but I will attempt to answer them nonetheless. And in the process, I will make some predictions about the future of money and currency.

What Is Electronic Money?

Electronic money, as it is often referred to, is essentially a payment or transfer of funds that is initiated and processed electronically within current interbank payment systems. Given the recent proliferation of computers, modems and modern telecommunication links, the market for electronic money products has grown immensely. Electronic money is the digital representation of money, or more accurately, the digital representation of currency. It must be noted that the words money and currency, although used interchangeably and often synonymously, do in fact mean different things. "Money" is simply a means of communicating value, while "currency" is the physical manifestation of money currency gives money visible form.

Although the term "electronic" currency is usually used in expressing the movement of currency through computer networks, "digital" currency is the more precise term, distinguishing it from "analog" electronic currency, which is theoretically possible to create. I will use electronic when referring to currency's historic development up to the present, whereas digital will refer to currency in the future.

The History of Electronic Money

Today's Fedwire funds transfer service traces its roots back to 1918 when Federal Reserve Banks first moved currency (i.e., manipulated book-entries to clear payment balances among themselves) via telegraph. However, the widespread use of electronic currency didn't begin until the automated clearinghouse (ACH) was set up by the US Federal Reserve in 1972 to provide the US Treasury and commercial banks with an electronic alternative to check processing. Similar systems emerged in Europe around the same time, so electronic currency has been widely used throughout the world on an institutional level for more than two decades. 

Payments made today in nearly all of the deposit currencies in the world's banking systems are handled electronically through a series of interbank computer networks. One of the largest of these networks is CHIPS (Clearing House Interbank Payments System), which is owned and operated by the New York Clearing House. It is used for large-value funds transfers. In 1994, CHIPS and Fedwire combined handled 117.5 million transactions for a total value of US$506.6 trillion.

Although banks have been able to move currency electronically for decades, only recently has the average consumer had the capability to use electronic transfers in any meaningful way. The increasing power and decreasing cost of computers coupled with advancements in communication technology that make global interaction available at vastly reduced costs have together made the digital transfer of funds a reality for millions of individuals around the world. As a result, we are now witnessing the early stages of development of the digital economy.

Requirements for Digital Currency

For reasons explained below, the following three requirements are necessary for a digital currency system to attain widespread recognition and use. However, none of the electronic currencies in use today fulfill all three of these requirements.

  1. Instant clearing of funds
  2. Elimination of payment risk
  3. Secure transactions using strong encryption

Instant clearing of funds

Communication technology has evolved to the point where information can be transferred around the globe in an instant. An online investor in New York City can request a stock quote from a server in Tokyo and receive it within a second over the Internet. Every day an immense amount of information circulates unceasingly around the globe through transoceanic fiberoptic cables and orbiting satellites. In the digital economy distance is invisible.

Therefore the question begs asking, why does it take 24 hours (or longer) to wire currency from Los Angeles to London? Simply because the old methods of interbank payment and settlement have been grafted onto new and advanced communication infrastructures, so the full potential of new technologies has not yet been realized. New approaches to clearing and making payments must be explored.

Currency must be able to circulate instantly worldwide. After all, money (which is the means used to provide one's view on value) is information just as stock quotes, sports scores and news articles are information. When money cannot circulate instantaneously, the free flow of information is not fully realized. Economic inefficiencies are the result, much to the detriment of the economy's participants.

Useful information is a precious commodity today and will continue to be so into the next millenium. The number of information providers not to mention providers of other goods and services is rapidly expanding as more businesses and individuals connect to the Internet. When selling information, companies want to know that the funds received in payment are good before sending their information to the requesting party. Herein lies the necessity of instant clearing and the need for the digital equivalent of cash currency. The information provider wants to know with certainty that he is being paid for his services, and the buyer wants the information immediately. Time is money, and nobody wants to waste time obtaining the information they need, including the time spent paying for it. The digital equivalent of a cash transaction allows for instantaneous payments.

The instant clearing of funds means the end of 'float', which is the time spent waiting for a fund transfer to clear. At first glance this may seem disadvantageous to those who try to "play the float" by writing checks or using credit and debit cards instead of paying cash. However in the end, float is a zero-sum gain. Alice may "earn" a few pennies by paying Bob with a check, but Alice also loses pennies waiting for checks to her to clear. More importantly, float exposes the payee to payment risk, which is the risk that the financial institution transferring the funds to the payee may default on its payment obligations.

Elimination of payment risk

In 1974, Bankhaus I.D. Herstatt of Cologne, Germany went bankrupt and set off a domino effect of payment defaults throughout the international banking community. This historic event gave rise to the term "Herstatt risk" or payment risk, which is the risk incurred by anyone who accepts any national currency now in use for payment of transactions whether or not cleared electronically.

Although "Herstatt risk" refers to one specific type of payment risk (i.e., the default in a payment obligation by one of the two or more parties involved in a spot foreign exchange transaction), without getting into the unique characteristics of each specific type of payment risk, all payment risks are essentially the same. Importantly, payment risk is inherent in all forms of currency presently in use. Though much effort has been expended in recent years to eliminate payment risk, the complete elimination of this risk is not possible. At best, the payment risk inherent in present forms of currency can be mitigated, but it cannot be eliminated because the essential nature of currency now in use precludes the complete elimination of payment risk.

Payment risk cannot be eliminated from currency today because all currency presently in use is a liability of some institution issuing that currency. Cash currency is a liability of a central bank (for example, the Federal Reserve in the case of US Dollar cash currency). Deposit currency is a liability of the bank in which the currency is deposited, and these different institutions are financially responsible for the currency on its balance sheet. Because this currency is a liability, payment risk cannot be avoided. In other words, whenever any currency used in economic activity exists only because it is a liability of some institution, regardless of the form of that currency (i.e., cash currency, deposit currency, etc.), payment risk exists.

Payment risk can be eliminated completely in only one way if the currency used is an asset, like Gold or Silver. A currency which is an asset has finality. When it is accepted as payment, the obligation to pay has been completely discharged and the transaction is extinguished. Tangible assets (i.e., currency of substance) are exchanged for tangible assets (the goods or services being purchased). Substance is exchanged for substance, in contrast to payments with liability currency, which contains the ongoing and lingering obligation of the issuer of that currency.

Both liability currencies and asset currencies can function as a medium of exchange, but only asset currency has substance. Liability currency is not money, which explains why payment risk exists. Payment risk is eliminated if the medium of exchange is an asset.

Secure transactions using strong encryption

Computer networks are essentially public in their scope of operation because the information transmitted over them can be accessed anywhere between the points of origination and destination. Even private computer networks are not immune to wiretapping and surveillance by determined infiltrators. Therefore, if the transmitted information is of a sensitive nature (e.g., financial data), then it needs to be protected so that only those authorized to read it may do so. The science of cryptography, which is the science of keeping digital data secure, makes this possible. Encryption is the process of scrambling data into ciphers or code so that it can only be unscrambled (decrypted) by individuals who have the key essential to accomplish this task. Suffice it to say, there is good encryption, and there is not-so-good encryption. That is, there is strong encryption and weak encryption. An example of each illustrates this point.

The popular email encryption program PGP (Pretty Good Privacy) uses the 128-bit IDEA cipher, which is generally regarded to be one of the best and most secure algorithms available to the public today. A brute force key search (i.e., trying every possible key to decrypt the data) would involve trying 2^128 or 3.4*10^38 possible keys. According to the PGP passphrase FAQ, if a special hardware-based key cracker for IDEA were designed that could try one billion keys per second, it would take 1.08*10^22 years to go through all possible keys. One can expect on average to randomly stumble upon most keys in about half that time which will take 5.39*10^21 years. However, it is estimated that the sun will go nova in 3*10^9 years. That's strong encryption because the key can not be brute forced in a "reasonable" amount of time. IDEA is also well regarded because it has undergone extensive analysis by cryptologists without finding any exploitable flaws within the algorithm.

A good example of weak encryption can be found in popular Internet web browser software such as Netscape Navigator and Microsoft Explorer. When an Internet user creates a secure link with a website using the Navigator browser, he is relying on the 40-bit RC4 key. This key can be successfully brute force attacked by 10 mid-range Pentium computers (attempting approximately 10 million keys per second in total) working in tandem within 30 hours. This is far less time than with a 128-bit key. Brute forcing a 40-bit key is trivial.

It stands to reason that very few people will go through the trouble of coordinating 10 computers and waiting up to 30 hours (15 hours on average) in order to steal an encrypted credit card number. However, the cost of computers is decreasing dramatically while computing power increases, doubling roughly every year. In the next year or two when the encrypted information contains the password to your online bank account with thousands or even just hundreds of dollars at stake, it may be possible and worthwhile for someone criminally inclined to attempt cracking a 40-bit key on a half dozen clustered laptops working in tandem.

How many years will it be before today's strong encryption is within the realm of a successful brute force attack? Secure digital currency transactions must use the strongest encryption available. So the development of the digital economy is not impeded, the deployment of strong cryptography must not be constrained, whether by governments or otherwise.

Digital Bearer Certificates vs. Book-Entry Money Systems

Public key cryptography has led to the development of digital bearer certificates (DBCs), or digital cash. A DBC (a term coined by Robert Hettinga) is a digital representation of a bearer certificate, such as a US Dollar or a share of stock. An entrepreneur may start a business accepting US Dollars from others and offering them DBCs representing those escrowed Dollars in return. The entrepreneur would make money by charging a small fee for his services while his customers enjoyed the benefit of Dollar denominated digital cash that can be transferred anywhere in the world by computer. In fact, a system much like this (though not truly a DBC system) already exists and is in use on the Internet. Mark Twain Bank in St. Louis, Missouri has begun using the ecash system designed by DigiCash.

What's the big advantage of DBCs? Speed. Remember the 24-hour fund wire transfer mentioned earlier? That is one of the unfortunate by-products of Book-Entry Money Systems (BEMS). When currency is wired via the bank networks, funds must pass through a series of clearing mechanisms inherent in the system of interbank payments. DBCs allow for the instant transfers of funds by avoiding the BEMS pyramid of clearing mechanisms. The 24-hour Los Angeles to London money transfer using BEMS can be reduced to a split second using DBCs.

Advocates of BEMS will defend it by saying that BEMS allow for the transfer of funds between individuals who do not share a common financial institution. For instance, in order to transfer Dollar DBCs using Mark Twain Bank ecash, both parties to the transaction must have an account relationship with Mark Twain Bank. However, this problem stems from the fact that Mark Twain Bank requires each user of its DBCs to establish an account relationship with the bank. This is not a requirement for DBC systems, which explains why Mark Twain US Dollar-denominated ecash is not a true digital cash system.

Mark Twain's account requirement is analogous to the Federal Reserve mandating that anyone who uses Dollar bills must also open an account with a bank in the US banking system. There are millions of people in the USA and around the world who use Dollars in economic transactions who do not have a US bank account, nor do they need one.

Even if a number of financial institutions were to require account relationships to use their DBCs, it is likely that intermediaries would evolve to handle the conversions of DBCs issued by different companies. For instance, assume Alice has Mark Twain Dollar DBCs which she wants to send to Bob, but is he willing to accept only Citibank Dollar DBCs (these do not currently exist) because he maintains his account with Citibank. Bob can send those Mark Twain DBCs to the XYZ Currency Exchange & Cambio who will give him Citibank DBCs in return. XYZ can do this because it has an account with both Mark Twain Bank and Citibank. Bob's DBC software (a "digital wallet" application running on his computer) can be set up in such a way that any non-Citibank DBCs he receives are automatically sent to XYZ for exchange. XYZ performs the conversion and sends Bob the Citibank DBCs. This may only take a few more seconds than a direct transfer of Mark Twain DBCs between Alice and Bob (assuming they both had Mark Twain accounts) and in an ideal world would cost significantly less than the US$15 (or more) that banks currently charge for a wire transfer.

In the above scenario, a hierarchy of clearing mechanisms as found in the BEMS is not necessary. As long as there are enough cambios (currency exchangers) like XYZ to make converting DBCs easy and competitively priced, a digital economy based on multiple DBC currencies can function efficiently.

Keep in mind that any cambio need not be limited to just US Dollars, but could also convert between a variety of national currency DBCs, private and alternative currency DBCs, and even Gold or Silver DSRs (digital storage receipts). Importantly, this freemarket system of DBCs and DSRs will result in the emergence of a few strong currencies of internationally recognized worth.

The New Technology

The rapid development of communication and computer technology is fueling a revolution in our business and personal lives. How we work, communicate and spend our leisure time are being redefined by ongoing technological advances.

Within a decade from now, many of us will spend our money differently from how we spend it today. Cash, checks and credit cards will undoubtedly still exist, but totally new payment mechanisms will evolve and slowly absorb market share from the currencies and the methods of payment familiar to us today.

The Internet and the World Wide Web

Fifty years from now when historians look back on the 1990's, they will undoubtedly recognize the expansion of the Internet as one of the period's most important achievements. Email has enhanced communication, allowing an individual to reach a wider audience than with a telephone or even a fax machine and with significantly less cost. Anyone with Internet access can publish information on the World Wide Web (WWW), which is immediately accessible to the other 50+ million individuals (and rapidly growing) who currently have Internet access. The Internet is truly the greatest global medium that mankind has ever known for providing a free marketplace of ideas and information.

One factor is largely responsible for the widespread use of the WWW it is an open system. The WWW has become ubiquitous because it was developed as a network into which anyone can connect. Any computer that is setup to follow a few common protocols can share information with other computers on the network. Developers of digital currency and commercial products should take note of this important lesson. Unlike proprietary systems which are slow to evolve, assuming they ever do, the use of a well designed open system can expand exponentially.

Internet Banking

Internet banking (one form of online banking, which is the capability to perform banking transactions with the use of a modem and a computer) allows a bank's customers to access information on their accounts and to pay bills over the WWW. Even though the bank's cost for an online transaction is less than 10% of the cost of a transaction performed at a branch by one of the bank's employees, the majority of banks offer no online banking, whether over the Internet or through a private network.

The Internet has made banking with offshore financial institutions more accessible, much to the chagrin of a few government agencies. The curiously named European Union Bank (EUB) based in Antigua offered a full range of financial services, including fully anonymous, numbered accounts. Unfortunately, EUB's owners embezzled all of the funds. As always, caveat emptor (buyer beware). Inevitably, offshore Internet banks with integrity will emerge as banking online becomes a more widely practiced means of managing one's financial affairs.

Digital Cash

Digital cash has been pioneered by DigiCash. Its founder, David Chaum, is an expert in financial cryptography and is the inventor of more than half a dozen cryptographic processes covered by US Patents. DigiCash has created and markets a software program called "ecash", which basically creates DBCs that represent units of various currencies.

Currently, US Dollars, Finnish Markkas and Australian Dollars circulate on the Internet using the ecash system, with several other currencies to be introduced in the near future. Although DigiCash is the only company with a working product that is now available for use, there are other companies and independent developers who are working on digital cash systems as well.

Digital cash is ideal for what is known as micropayments, or transactions of less than US$10 in value. Micropayments are generally not economical with credit cards or electronic fund transfers, primarily because of the high overhead costs in processing those transactions. Digital cash makes small payments of just a few cents possible and profitable for both the merchant receiving the payment and the issuer of the digital cash.

One of the interesting features of digital cash is that it allows for relative degrees of privacy in monetary transactions. DigiCash's ecash only provides privacy (anonymity) for the payer in the transaction. The payee reveals himself when he verifies the authenticity of the ecash with the issuer. Other types of digital cash involve anonymity for both parties or neither party. Ideally, individuals will be able to choose between these different systems to decide the level of privacy they wish to maintain in any transaction.

Secure Electronic Transactions (SET)

SET is the banking industry's response to ensure the safety of credit card payments made over the Internet. Its development has been spearheaded under the direction of MasterCard and Visa. SET has received a great amount of attention in the online media, but it remains to be seen whether anybody will actually use it.

In order for SET to get underway, a massive digital certificate structure needs to be implemented, the certificates being used to identify merchants and cardholders. This is no small task. Also, the technical aspects for customers to become SET-compliant are relatively burdensome, especially when considering that credit card transactions are fairly secure now when using the built-in encryption protocols available in common web browsers.

In order to use SET, the customer must download a special plug-in to run with his current web browser software and also obtain a digital certificate for identifying himself in the transaction. The merchant needs to install new software as well on his servers, and may even need to purchase additional computers to handle the load generated by the CPU-intensive cryptography inherent in SET. Because of all the requirements necessary to launch SET, it has been dubbed as "a full employment act for highly paid software engineers".

Smartcards

A smartcard resembles a credit card except that it has a microchip embedded within it, which allows the smartcard to store information and sometimes to even perform simple calculations. Common smartcard chips typically holds about 8,000 bytes (characters) of information, which enables the smartcard to perform a variety of functions such as identification, storing bank account information and holding digital cash.

A number of smartcards are on the market today, and these are used in a wide range of applications. Mondex has received a lot of recognition in the financial press, and several banks have already conducted trials with its smartcard. Wells Fargo & Co., a major California bank based in San Francisco, will issue Mondex smartcards to all of its online banking customers in 1998, a number which could reach into the hundreds of thousands. Because MasterCard International holds a 51% stake in Mondex, it could become the de facto international standard for bank-issued smartcards.

Personal Digital Assistants

One of the more exciting developments that will unfold in the future is the widespread application of the personal digital assistant (PDA). A PDA, sometimes referred to as a palm-top computer, is smaller than a laptop computer and does not have as much computing power. However, PDAs still allow their users to send email via a wireless modem, write documents in a text editor, perform calculations in a spreadsheet, store names and addresses, and perform other common business and personal tasks. As computer chips become more powerful, the functionality, speed and memory capacity of PDAs will increase substantially.

When the more robust PDAs are eventually coupled with the low-orbit satellite networks that will become available at the turn of the century, then mobile handheld computing will begin a process that will in time make them ubiquitous. The scenario where Alice and Bob pass DBCs between each other can be performed directly via an infrared link between their PDAs, or indirectly via satellite. In essence a PDA could function as a personal cambio, converting currencies on-the-fly via a satellite link to institutional cambios like XYZ mentioned earlier. PDAs can even double as digital telephones, allowing the owner to be contacted by anyone regardless of where he may be in the world. The PDA is truly a giant on the emerging technology scene.

A Cashless Society?

The 21st century will not be "cashless", as many now predict. However, it does seem clear that the currency of the 21st century will be "paperless". Paper currency and checks are gradually being supplanted by smartcards, digital cash and instant transfers of funds. The large paper bureaucracy of banks is quickly becoming redundant, burdensome, even antiquated. Some say that the evolution in digital money is happening so fast that banks cannot adopt quickly enough and will eventually collapse like top-heavy giants, blown over by the winds of financial change. Maybe, or maybe not, but one trend is already clear.

The wallet of the future will hold less paper cash, coins and magnetic stripe cards. It will hold instead smartcards containing digital cash and other financial information, updated perhaps automatically by a PDA with a satellite communication link. The question is no longer if this evolution will happen, but when.

The Inevitability of Private Currencies

As the new technologies develop into new ways of making payment, one concern naturally arises. Will this technology protect each individual's right to privacy while providing the sound money needed for the economic health of communities? The answer is simple it depends on how the new technology is used. There is nothing inherent in the technology that makes it less protective of privacy and individual rights. In fact, advancements such as PGP make individual privacy even more secure encrypted email is substantially more secure than any form of snail-mail.

As developments in electronic money gather pace, protection of individual rights must be kept in focus. Because the record of most governments so far in these early stages of electronic commerce has been seen by many to be confrontational and not protective of individual rights, it is likely that the preservation of these rights is one reason that private currencies are likely to emerge on the Internet and to eventually play an important role in global commerce.

Clearly, the field is wide open for any entrepreneurs who want to create a private currency. The technology now exists so that anyone with a few hundred thousand Dollars (maybe less) can set up a working and robust digital currency system. Slowly, but surely, private currencies will begin to emerge.

Competition between currencies, whether government or private, is beneficial to everyone in the digital economy. The currencies of substance that maintain their value over time and are implemented under a trustworthy and secure computer and communications system will be the ones that will circulate and be accepted globally.

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