The Future of Electronic Money: A Regulator's Perspective

In the long history of how things get paid for, is electronic money the next step? If the issue is how money is transferred, that question is settled--it is happening now. But if it is the creation and acceptability of new forms of money, the jury is out.

Like so many other tools of civilization, money has evolved tremendously over the centuries. While change was glacially slow at first, the pace of evolution has recently been accelerating, and there is no reason at all to think that will stop. But what new forms might money assume? Will electronics take over, and if so, how soon will it do so?

Money has three functions in society, and how well electronics serves these functions will determine its future. First, money is a unit of account, or a way to measure and record value: a pig is worth X dollars. Second, it is a way to store value conveniently for future use; possession of a pig is replaced by possession of a bank account recorded in, and retrievable in, money. Finally, it is a medium of exchange; instead of having first to find a pig to trade for cloth, money buys cloth or a pig.

For money to fulfill these three functions, it must satisfy certain requirements. It should be easily and broadly recognizable and hard to fake (counterfeit), its value should be reasonably stable (a major matter, indeed!), and it should be durable and not deteriorate (electronic pulses are potentially wonderful). Finally and crucially, it should be convenient and inexpensive to use (vital for its acceptance in daily commerce).

The history of money illustrates these points. It began, of course, with barter. In a primitive society a pig might be traded for a bolt of cloth. The obvious limitations of this kind of exchange led to the use of proxies for value. In societies near oceans, sea shells served; in other places, special stones; and later on, pieces of metal, often gold or silver, did duty and came to be shaped into coins. The development of printing spurred the use of paper notes. From this came checks, with which payments could easily be made over a distance, a major breakthrough. When the telegraph was invented, the technology for making remote payments developed further, as transfers became virtually instantaneous. Then a natural extension was the use of modern electronics and computers.

Today, money is transferred in a wide variety of ways. Most of the value moves nearly invisibly to consumers and businesses through what may be termed wholesale payment systems, such as the Federal Reserve's Fedwire, and these systems are almost entirely electronic already. But most of the products under development are designed to serve the vast "retail" channels, which encompass the infinity of smaller transactions occurring daily throughout the economy.

How will electronics fit into this matrix of functions and requirements? The products being developed today fall into two groups, and it is important to distinguish between them because only one of them is a new form of money. Those referred to as electronic banking do not represent a new kind of money, but rather offer a new way to access a number of traditional bank services with traditional money. Such activities as bill paying and shifting funds among accounts over a telephone or computer connection belong here, and development is well along in this field. The many emerging types of stored-value cards and other media, however, do create a new money, as they represent an alternative to government-issued or -guaranteed instruments.

In stored-value systems, the liability of the issuer is recorded directly on the card, and a corresponding deposit account is not necessarily maintained for the individual card holder. Innovations of this type are coming along a bit more slowly. To be sure, some systems may involve both stored value and a deposit balance transfer capability, thus integrating the two types of products.

Predictions of an electronics-based cashless society have been around since the 1960s and, at least to date, it has not emerged. Consumers and businesses have proven quite conservative in their money management, relying heavily on tried and true methods even after more advanced techniques have become available. To one degree or another, this conservatism will likely be the case in the future as well. That said, why should the course of events be different now?

The characteristics of e-money and the speed of its advent will depend in large measure upon whether it serves the historic functions of money better than do its existing forms--whether electronic cash does better as a unit of account, a store of value, and a medium of exchange. How acceptable the new products are will be determined by the market and the classic economic factors of basic supply and demand characteristics. Suppliers will have to deliver a product that consumers want to use at a price that they are willing to pay, and that merchants see as a desirable additional way to conduct business.

In determining product prices, the cost factor is always crucial, and engineers designing the product's technical characteristics will have an important influence on these costs. Components will include the costs of cards themselves, of terminals, of creating and maintaining software, of obtaining funds and of settlement, and (lest we forget) a profit margin. It is likely that the advance of technology will lower all of these costs continuously.

A long list of features, some essential and others only desirable, will determine the demand for the product. The degree to which these features are incorporated in new products will determine whether e-money does, in point of fact, represent an improvement.

Convenience will be key for everyone. For consumers, this will consist, among other things, of ease in obtaining cards and replenishing them, as well as plenty of opportunity to use them. Merchants will want to see fast and easy service requirements on the part of their staff and fast settlement of the amounts due to them. Privacy may be a tricky issue as consumers will want to keep the details of their transactions private, whereas merchants and issuers will want to ensure they capture an appropriate record of their transactions.

Then there is the all-important issue of safety for the store-of-value devices. Both consumers and merchants will want their stored-value systems to be simple in operation and error free, because neither will favor a device at all likely to somehow eliminate its own value through electronic malfunctioning.

Both consumers and merchants will also demand a high degree of financial stability on the part of the issuer. Otherwise an insolvency may leave the holder with a worthless asset.

All the items on that laundry list have significant technical dimensions, and these technical problems are well on the way to being solved. For instance, engineers have made solid progress in solving the hardware and software issues posed by stored-value cards. Chip cards can now be mass produced, and advanced cryptography techniques are incorporated into the operating systems stored in the chips.

Meanwhile, issuers are confronting the managerial, financial, and legal issues, which could prove far more difficult in many cases. For example, potential issuers are looking into the financial and legal structures that will provide their product with the greatest financial stability while at the same time avoiding the need for regulation, or at least minimizing their costs of complying with regulation.

Governments are keeping a watchful eye on all of this activity, chiefly through their finance ministers and central banks. The Federal Reserve, the central bank of the United States, is closely following several issues. First of all, the safety and soundness of the financial system, especially the banking system, are major concerns, as instabilities there can disrupt the economy at large. On this point, the Federal Reserve is unalarmed by developments to date, because market forces should help ensure sound financial practices. After all, consumers and merchants will be most inclined to purchase stored-value products from those issuers who have implemented prudent financial structures and have taken steps to minimize the possibility of fraud.

Furthermore, the stored-value industry appears unlikely to be large enough to threaten the financial system.

Then there is the need to protect against crimes such as fraud and money laundering, as well as to ensure the privacy and security of the financial activity of society. The Federal law-enforcement community is looking closely at those issues.

Over the longer term, there could be implications for the control of monetary policy, but I am confident that central banks will be able to adapt their monetary policy procedures to the growth of stored-value products, if the necessity arises. Perhaps most controversial in this context is who should be permitted to issue stored value and under what conditions. While all these issues require resolution, none seems to present insoluble concerns, and the Fed sees no present reason to jump in with preemptive regulations before any clear public policy requirements have been demonstrated. To do that could disrupt the socially beneficial entrepreneurial processes of the private sector, and would imply that market forces could not do the job. We believe that they can.

How all this will evolve as time goes along is hard to predict. The large-value wholesale systems are fully electronic already, and while they will no doubt evolve over time, they are not the focus of creative energies in the private sector today. The electronic banking products designed to improve access to existing retail banking functions will almost certainly soon find a place in our financial activities. The stored-value or e-money products could at the least evolve to serve a special niche in small transactions. For larger purchases, the financial incentives may continue to lead consumers to use other means of payment, such as checks and credit cards. It seems unlikely that e-money will make major inroads in the existing order of the financial system for the foreseeable future, but innovation in this area may well lead to noteworthy new efficiencies for the payment system.

One thing I will predict with confidence: the forms of money will continue to evolve, as scientists and engineers continue to advance the applicable technologies.