The Economics of E-Cash
Electronic cash may end government monopolies on the lucrative business of minting money
For all the hype over electronic cash, one point is usually left out: it may never come to pass. It all depends on the economics of e-cash, and that's a complicated mix of issues--including whether producers can find an opportunity for profit, whether consumers will accept it as money, and whether governments will allow it to flourish. If all the stars don't line up, it could go the way of the geodesic dome--just another big idea with few important applications.
Electronic cash includes electronically stored value designed for use either in a single transaction or in many. E-cash meant for repeated use is also called electronic currency. Currency and other kinds of e-cash store and convey value in and of themselves rather than merely representing value residing elsewhere, such as a deposit account. By contrast, electronic checks and debit cards do not store intrinsic value and thus are not considered e-cash, which can be used in transactions off-line and with no transfer of physical material.
Making a buck by making currency
The business of making money can be lucrative--one reason national governments around the world have kept the action to themselves for most of this century. The world's largest issuer of currency is the U.S. Federal Reserve System (the "Fed"), which has more than US $400 billion in paper bills outstanding, two-thirds of it circulating outside the United States. When issuing new currency, the Fed trades it for interest-bearing U.S. Treasury securities. The resulting interest accruing to the Fed--in effect, the "float" on outstanding dollar bills--amounts to some $20 billion a year. The government saves this money in interest charges because it can print cash that it uses to buy back a part of the federal debt.
These earnings are the modern-day equivalent of what used to be called seignorage: the sums monarchs of old would clear for minting coins. Seignorage is the difference between the selling price of currency--its face value--and the printing costs, which today are pretty small compared to the face value. One of the major incentives for banks and other private institutions to issue electronic cash would be the chance to earn seignorage by selling e-cash. E-cash would be sold to customers for old-fashioned paper dollars or something else of value, such as money transferred from a deposit account. It would then be used in transactions before being returned to the issuer, at which point it would be exchanged back into paper dollars or an account balance.
Earnings for the issuer would come in the form of interest on investment of the money that would be paid for e-cash. These interest earnings, accumulating while the e-cash remained outstanding, would be the issuers' incentive to produce and sell e-cash products so useful to the economy that they would remain in circulation for a long time before being redeemed. To turn a net profit, an issuer would have to keep in circulation enough e-cash to pay the costs of developing and managing the product. For a number of reasons, that's easier said than done.
First of all, the development costs can be enormous. Firms like Mondex in the UK, DigiCash in the Netherlands, Danmont in Denmark, and MasterCard, Visa, and Citibank in the United States have invested huge amounts developing electronic payment systems intended to act as cash substitutes.
Managing the product could also turn out to be expensive. Consider what would happen to seignorage earnings if currency issuers had to pay interest on their e-cash--that's right, interest on cash. It will certainly be technically feasible in the future, and if there is competition among various issuers of e-cash, market forces may demand that interest be paid. Consumers would love to get it, but if it were payable at rates comparable to those of other investments, seignorage profits to issuers would be completely wiped out, and with it much of the incentive to develop e-cash systems.
A further incentive for e-cash producers, retailers, and others forming links in the transaction chain is the possibility of reducing the costs of processing transactions that now involve paper currency [Fig. 1]. Because these costs would be so low, one major use of e-cash--the so-called killer application--may be Internet transactions involving small amounts of money. Such small transactions have never been economically feasible with more expensive, paper-based systems. But in the future, small purchases of information or entertainment (for instance, financial statistics, movie reviews, and photographs) may become commercially viable. Whole new industries could be spawned by coupling this new transaction capability to the Internet's new content-delivery system. Those with a stake in delivering this kind of content will have great incentives to develop and deploy e-cash systems.
Perhaps the most compelling argument for e-cash is the potential for improved service. Banks compete hard for deposits by offering services that are typically more important than interest rates: check processing, statement services, and ATM (automated teller machine) access, for example. Similarly, the customer of the future may expect stored-value cards and other products that use e-cash, so the bank of the future may have to provide them whether or not these services can pay for themselves. This may sound far fetched, but it is a little-known fact that ATM services are provided by banks today at a significant loss.
Nonfinancial firms also have incentives to issue e-cash as a service to their retail customers. For example, telephone companies are issuing prepaid cards to assist consumers as they travel; convenience stores are offering prepaid cards to build customer loyalty; and transit authorities are issuing prepaid cards to help customers enter and exit their systems more expeditiously.
Stages of e-cash development
The examples of prepaid phone cards and convenience store cards represent the first stage of e-cash development: two-party stored-value systems [Fig. 2, top]. Customers can use this type of product only to pay for services rendered or goods sold by the stored-value issuer itself. Because the only parties involved are the issuer and the customer, such products are viable only for issuers with something to sell at the retail level.
The next stage of e-cash development would involve three-party stored-value (or closed-loop) systems in which customers can pay for goods or services sold by retailers other than the issuer of the card [Fig. 2, center]. This makes e-cash practical for a broader range of issuers, including those with no retail goods or services to sell.
Widespread acceptance among retailers will be essential for the success of three-party stored-value products. Banks, with their strong merchant relationships and government regulation for safety and soundness, may be among the few kinds of firms capable of issuing such products commercially. While other major institutions may be able to offer these products, their customers would have to monitor the financial safety and soundness of the issuer in some way. A three-party stored-value system is to be tested jointly this year in New York City by Chase Manhattan, Citibank, MasterCard, and Visa. Transit authorities and universities that are attempting to broaden their existing two-party systems to include local vendors are also issuing such products.
As with two-party stored-value systems, the float would be earned in the interval between issuance of the e-cash and its return to the issuer. In this case, the stored value would be presented to the issuer by a retail vendor for legal-tender cash or credit to an account. And as with two-party stored value, too, this period is likely to be relatively brief, since the product could be used in only one retail transaction, which is why the system is referred to as "closed loop."
The final stage of e-cash development will involve the creation of a currency-like system in which stored value circulates through several transactions. Such open-loop stored-value systems [Fig. 2, bottom], would allow customers to pay not only participating retail vendors but also individuals willing to accept the e-cash as payment. Because open-loop e-cash would not have to be returned to the issuer after just one transaction, it would circulate for longer periods, boosting both the amount outstanding and its profitability.
The product would be designed without linkage to a bank account and could therefore be traded off-line among all individuals with the appropriate hardware. As compared with closed-loop three-party systems, open-loop ones would likely require issuers with even more household recognition and credibility. This requirement may effectively limit successful issuers to banks and perhaps certain other government-regulated organizations.
As in the case of closed-loop systems, the float would be earned from the time the stored value was issued until the point when the value was returned to the issuer either by individuals or retailers. In an open-loop system, this period is potentially indefinite and apt to be quite long in practice. Indeed, some people speculate that once such a system has been established and accepted, e-cash could even survive the financial failure of its issuer.
Consumer acceptance is shown as a function of investment in point-of-sale (POS) equipment [blue curve]. A certain number of merchants must have it before any acceptance by consumers can be expected. And no matter how pervasive merchant POS gear becomes, total consumer acceptance is virtually impossible.
Merchant investment in POS e-cash equipment is shown as a function of consumer e-cash acceptance [red curve]. Any merchant investment presupposes at the least some preexisting consumer acceptance, and total merchant acceptance is never achievable.
The critical mass needed for market development needs a certain level of consumer and merchant acceptance [lower-left intersection of the two curves]. Lower levels ofc onsumer or merchant acceptance will not produce a sustained market [depicted by path of arrow A]. Any level of consumer or merchant acceptance that is above the critical mass will result in market growth [path of arrow B].
The market will eventually reach its equilibrium size [upper-right intersection of the two curves].
The leading developer of a currency-like stored-value product is the British firm Mondex, International Ltd., London, which grew out of a project at National Westminster Bank. Franchising participation rights throughout Europe and North America, Mondex has signed up several banks plus AT&T. The Dutch firm DigiCash BV, Amdsterdam, and the U.S. firm CyberCash Inc., Reston, Va., are also developing stored-value products to act as cash substitutes, though their main focus has been Internet deployment. Mondex would also be card-based.
Issuers of e-cash can expect it to have a life cycle similar to that of most new products [Fig. 3, left]. During the early stages of development, large investments may be necessary before any returns are forthcoming. If the product is to be successful, at some point customer acceptance and product development both become sufficient to accelerate returns on investment. As products reach full maturity, additional investment brings little additional return. This is the position of most paper-based payment systems today. Such "legacy" systems have reached high levels of efficiency and typically cannot yield significant improvements no matter how much new investment they consume.
Before any market dependent upon consumer acceptance can take off, a large number of them must be convinced that the product is worthwhile. But they will only be interested in acquiring e-cash if they can use it in transactions--a lot of transactions. That means that retailers will have to be willing to accept e-cash and to invest in hardware and software at the point of sale (POS), as they did for credit card payment systems. Retailers will not be willing to make those investments until they see that consumers are willing to use e-cash--so there is a "chicken-and-egg" problem. Which comes first, consumer acceptance or merchant investment? The answer, of course, is both, which means that a critical mass of consumer and merchant participation must be established before an e-cash system can take off. When that finally happens, if it ever does, new consumers and merchants will be drawn to the system by its success [Fig. 3, right].
The key to any monetary regime is the confidence of the consumers and participating institutions. Holders of currency need to know that it will be acceptable to others and keep its value over time--and their confidence can be undermined by any number of apprehensions.
One is the fear of inflation. In the modern era, where local money has lost the confidence of the public it has been mainly as a result of high inflation caused by over-issuance of currency. The ability to earn seignorage creates an incentive for issuers to circulate increasing amounts of currency, leading to greater levels of inflation. When this happens to local currency, foreign currencies are often brought in and adopted by local consumers and merchants to conduct transactions and provide a store of value. The foreign currencies of choice are issued by governments that have learned the lesson that controlling inflation yields the long-term benefits of economic stability. Consumers contemplating whether to accept e-cash issued by either a government or private institution should wonder if the issuer has learned this lesson.
Another consumer concern is the fear of a financial failure. In most advanced nations, bank deposits are insured by the government against loss in the event of a bank's failure. The government agency providing that insurance in the United States, the Federal Deposit Insurance Corp., recently announced its belief that e-cash will not be similarly insurable, because it is not tied to a deposit account. Consumers must therefore consider the possibility that the issuer of their e-cash might collapse. The collapse of an issuer would beg the question of whether anyone would continue to accept the e-cash. Would other financial institutions redeem it?
Because banks are the most likely issuers of e-cash, one question is whether the safety-and-soundness regulation to which they are subject is sufficient to put consumers' minds at ease. Given the likelihood that only small amounts of money will be stored electronically for any one consumer, this protection may well be enough. In the past, currency was routinely issued by the private sector; consumer acceptance varied widely [see "Private currency: brief examples"].
Consumer acceptance can also be undermined by the fear of fraud. The currency issuer requires protection from the age-old problem of counterfeiting. If e-cash issued by either a government or a private institution could be replicated illegally, it might be extremely difficult to detect and stop because counterfeit e-cash could be impossible to differentiate from the genuine article. Since e-cash would be cheap to reproduce, counterfeiting may give rise to an enormous amount of phony money. That could destroy the financial soundness of the currency's true issuer, which might have to redeem the counterfeit currency. Because such a meltdown could completely undermine consumer confidence in the system, experts in cryptology, including government agencies, are working with potential issuers of e-cash to find ways to prevent counterfeiting.
The wild card in the future of e-cash is the important role played by governments. The Federal Reserve and other regulators of the U.S. payment system have stated their intention to stay out of these markets to the greatest possible extent, thereby allowing products to develop in an unbiased and unencumbered fashion. However earnest such statements may be, certain issues can be settled only by governments, and when they are markets will be affected in unpredictable ways. These issues include requirements for consumer disclosure and liability, as well as ways of dealing with transactions that are attempted but not completed. Indeed, whole areas of commercial and consumer law in all countries will have to be rewritten to accommodate developments that were not even contemplated when most existing laws were drafted.
The most contentious issue of all may be deciding which firms should be allowed to issue e-cash. While the market might be made most competitive by allowing anyone to do so, the possibility that an issuer might fail and therefore be unable to redeem its currency poses risks to all participants in the system. These risks can be largely mitigated by subjecting issuers to the type of safety-and-soundness regulation that most countries impose only on banks. However, many regulators believe that such supervision can be conducted only by requiring issuers to actually be banks. The European Monetary Institute (EMI)--representing the central banks of the European Community--has recommended that nonbanking organizations should be allowed to issue stored-value cards only on an exceptional, case-by-case basis.
Governments can also influence the development of the market by taking the lead in using e-cash itself. The U.S. Congress, for example, has required the Treasury Department to conduct all transactions--except tax refunds--electronically by 1999. As a result, thousands of firms will be forced to install systems to handle the transition from paper-based payments.
Millions of individuals receiving government entitlements will also be brought up to speed through the U.S. government's Electronic Benefits Transfer (EBT) program, which will require recipients to use stored-value cards carrying an array of benefits, including cash and food stamps. Through EBT, a demographic group that has not been effectively reached by many other payment technologies will be propelled directly into the 21st century.
Finally, most national governments today claim a monopoly over the issuance of currency. Giving up that status may be costly in terms of seignorage, yet this may be the only way to make markets as competitive as they can be. Private markets, for example, are more likely than governments to develop interest-bearing e-cash, as private issuers competing for balances may need to pay interest to keep customers.
Before merchants invest in POS equipment they will have to know what to buy. If e-cash is not standardized, they will be acquiring equipment that might be rendered obsolete when changes are made to e-cash itself, the business protocols involved in using it, or the hardware necessary to process it. As for consumers, they will not want to carry more than one e-cash wallet or keep different types of e-cash in their PCs to conduct transactions with different merchants.v For these and other reasons, institutions with interests in seeing the e-cash market develop will have to work together to standardize many processes involved in electronic commerce. MasterCard and Visa have demonstrated their willingness to cooperate by creating the Secure Electronic Transactions (SET) protocol for transmitting credit card data over the Internet [See "Locking the e-safe"]. If this is a sign of things to come there is reason to be optimistic.
Nonetheless, if different firms or groups of firms develop incompatible systems, users may have to choose one over another. After those choices have been made, they may be difficult or expensive to reverse. In other words, such systems will in effect have "captured" their customers. This would retard technological progress because products and services with a captive customer base do not have to sustain the level of innovation normally seen in competitive markets. All systems should therefore be compatible, allowing them to compete for merchants and consumers without forcing the market to make irreversible decisions.
For example, home PC electronic-commerce software developed by one vendor should be easy to replace with software developed by any other vendor, as well as compatible with the software used by all financial service providers. Otherwise, there will be a risk that a software provider with a large market share might try to impose universal compatibility by forcing everyone to switch to its system. The dominant firm could control many aspects of home-based electronic commerce, slow down the pace of innovation, and even charge monopolistic prices.
To provide a competitive environment, e-cash systems should be designed to encourage a large number of institutions to compete head-to-head on a level playing field. This goal will probably mean that potential issuers of e-cash will have to be allowed to plug into fully developed support systems even after they are already up and running, thus permitting latecomers to save money by avoiding the development costs incurred by early players. This may mean that early players will have to be motivated solely by the opportunity to establish an advantage in consumer acceptance.
What if e-cash never happens?
Many futurists bullish on e-cash are afraid to ask a simple question: how much worse off would we be without e-cash? The alternative is not necessarily a permanent paper-based system but, rather, an electronic-payment system capable of replacing paper currency in whole or in part, but without acting as currency itself.
On the Internet, for example, electronic commerce may develop quite efficiently simply by using credit card or bank account numbers that represent each customer's account. Because these systems are quickly developing an ability to work reasonably well off-line, they could have tremendous cost advantages over on-line credit or debit card systems. In off-line systems settlement orders instructing the payer's bank to transfer funds to the payee's bank are batched and processed at a later time; in on-line systems, settlement takes place immediately, before the transaction is consummated, requiring more expensive electronic communications.
With the development of the SET protocol, the implementation of off-line Internet systems may accelerate over the next few years. In POS transactions, off-line debit cards are bringing costs down below the levels associated with credit card transactions [Fig. 1]. As for convenience, there may be little difference to consumers between e-cash and off-line debit cards.
About the Author
Mike ter Maat, an engineer at heart and by academic training, is a senior economist with the American Bankers Association, Washington, D.C., where he has worked on a wide range of issues, including electronic payment systems. Earlier he served as a commercial loan officer at the Goldome Bank for Savings, New York City, and at Carteret Savings Bank, Morristown, N. J. He has consulted on financial operations and economics to the World Bank, the International Finance Corp., the Overseas Private Investment Corp., and the U.S. Office of Management and Budget. He subsequently worked on federal budget issues at the Office of Management and Budget and was a communications specialist for the Bush reelection campaign in 1992.
To Probe Further
Report of the Payment System Task Force, a publication of the American Bankers Association, Washington, D.C., discusses various recommendations on the major competitive and public policy issues that will affect future payment systems. Call 202-663-5000 for a copy.
"Increasing Returns and the New World of Business," by W. Brian Arthur, Harvard Business Review, JulyAugust 1996, explains the modern economics of standardization and scale applicable to high-technology markets.
Emerging Electronic Methods for Making Retail Payments (Congressional Budget Office, Washington, D.C., June 1996) discusses the economic and public policy issues created by emerging payment technologies. Contact Linda Schimmel at 202-226-2809.
Creating the Value Network: Fifth Annual Special Report on Technology in Banking, published by Ernst & Young LLP, 1996, describes the state of technology and the pace of change in retail banking service-delivery systems. The person to call is Tonya Brooks-Taylor at 617-859-6346.
Banking and Technology Issues, published by Fried, Frank, Harris, Shriver & Jacobson (Washington, D.C., 1996), is a collection of papers discussing the legal and regulatory issues being introduced by new payment technologies. To get in touch with Thomas P. Vartanian, the editor and managing partner, call 202-639-7200.
"How Would the Invisible Hand Handle Money?" by George A. Selgin and Lawrence H. White, in the Journal of Economic Literature, Vol. XXXII (December 1994), pp. 17181749), examines the literature on the lessons that historical markets offer for private currency.
Michael A. ter Maat's "A Cross-Sectional Analysis of the Development of Corporate Equity Securities Markets," a doctoral dissertation at George Washington University (1991), analyzes the need for a critical mass in the development of financial markets. Contact the author at 202-663-5354.