The Future of Money

By Kelley Holland and Amy Cortese
BusinessWeek
Monday, June 12, 1995

http://www.businessweek.com/1995/24/b3428001.htm

E-cash could transform the world's financial life

In his pinstriped suit and wire-rimmed glasses, Timothy L. Jones looks every bit the traditional British banker. Sure enough, he has spent a dozen years at National Westminster Bank PLC. But ask Jones what he is doing now, and he responds with an intensity worthy of a Silicon Valley entrepreneur. Leaning across a table, he waxes eloquent about his new enterprise, Mondex, and the future of the product he's selling: a new kind of electronic money.

Mondex, which was launched by NatWest, is not alone:
A raft of companies are developing their own forms of electronic money, known as E-cash. E-cash is money that moves along multiple channels largely outside the established network of banks, checks, and paper currency overseen by the Federal Reserve. These channels enable consumers and businesses to send money to each other more cheaply, conveniently, and quickly than through the banking system.

Some of the E-cash players are faceless, dubious outfits that exist in cyberspace and can be traced only to a post-office box--in the physical world. But there are plenty of others, ranging from techno-savvy startups with names such as DigiCash and CyberCash, to corporate icons including Microsoft, Xerox, and Visa. Citicorp is even developing what it calls the Electronic Monetary System, an entire infrastructure for using electronic money to be issued by Citi and other banks.

These companies are part of a mass experiment that could transform the way we think about money. In the process, it could change consumers' financial lives and shake the foundations of global financial systems and even governments.

Digital money is the ultimate--and inevitable--medium of exchange for an increasingly wired world. With E-cash, you'll no longer need to carry a wad of bills in your pocket or fumble for exact change. Instead, you might carry a credit-card-size piece of plastic with an embedded microchip that you will ''load'' up with E-money you buy with traditional currency. Or, you might store your digital coins and dollars--downloaded over phone lines from your bank or other issuer of E-money--on your PC or in an electronic ''wallet,'' a palm-size device used to store and transmit E-money.

This digital money will let you shop online, zapping money to a merchant over the Internet, or perhaps paying for a movie on demand over an interactive-TV network. It also has the potential to replace cash and checks for everyday purchases--in stores, restaurants, or taxis that accept E-cash. Businesses could also keep a stash of E-cash on hand for buying office supplies, or use it to transact directly with each other instead of going through banks and electronic funds transfers.

THE START OF A REVOLUTION. In many ways, E-cash, which can be backed by any currency or other asset, represents the biggest revolution in currency since gold replaced cowrie shells. Its diversity and pluralism is perfectly suited to the anarchic culture of the Internet and the evolving web of networks known as the Information Superhighway. ''Electronic commerce will literally change the way business is done worldwide,'' says James G. Cosgrove, vice-president and general manager for business multimedia services at AT&T. ''We're about to see another revolution similar to the Industrial Revolution.'' Adds Richard K. Crone, senior manager in the financial-services group at KPMG Peat Marwick: ''We're in the beginning stages of the cash-replacement cycle.''

But the advent of E-cash raises all sorts of questions, most of which remain unanswered: Who should be allowed to issue E-cash, and who will regulate those issuers? How will taxes be applied in cyberspace, which transcends physical boundaries? Who will set the standards? How do you ensure that payments made over the Net will be secure? How will consumers be protected? How will regulators police money laundering and counterfeiting on private networks?

While regulators wrestle with these questions, technology is remaking the monetary system. That's what Microsoft CEO William H. Gates III had in mind when he bid for personal-finance software maker Intuit Inc. He saw programs such as Intuit's as the gateway that would draw millions of consumers onto his online network where they could pay bills, get financial advice, or shop, perhaps paying him for access. But the Justice Dept. worried about Microsoft's reach, and he abandoned the deal on May 20.

Tough break, but it will hardly slow Gates down. Microsoft is working with Visa on a system for securing credit-card transactions over the Net. But that's just one piece of a much bigger problem Microsoft is trying to solve. Gates has dozens of programmers busy devising a sweeping system, Microsoft Network, to help people do business safely in cyberspace--or more specifically, in Microsoft's own network and interactive-TV systems--using a range of payment options. Microsoft won't reveal much about its E-cash plans, but, says Nathan P. Myhrvold, Microsoft's top advanced-technology expert, ''we're very interested in the area.''

They should be. The stakes are enormous. Seamus McMahon, a vice-president at Booz, Allen & Hamilton, sees as much as 20% of total household expenditures taking place on the I-way just 10 years from now. If any operation, whether Citicorp or a startup such as Mondex, gained control of a new medium for even part of those exchanges, it would have the opportunity to charge royalties or fees for its use and earn interest on the E-money sitting in its accounts. Even a tiny charge, when applied to millions of transactions, would be highly lucrative.

E-cash could also create a competitive free-for-all. Because the Internet knows no boundaries, a company offering E-money can gain direct access to millions of consumers and businesses--no matter what state or country they are in. ''The retail banking market will collapse and give way to global competition,'' says Eric Hughes, president of Open Financial Networks, a Berkeley (Calif.) consulting firm. ''Those [regional] separations don't work on the Internet.''

WINNING CONSUMERS' TRUST. Governments' and central banks' control of money flows has already been loosened, as shown by recent currency and market crises in Mexico and elsewhere. But with the growth of E-cash, money could flow in and out of countries at lightning speed without being traced, weakening governments' ability to monitor and tax. ''Over the long haul, this is going to lead to the separation of economy and state,'' declares Bill A. Frezza, president of Wireless Computing Associates and co-founder of the advocacy group DigitaLiberty.

The growth of E-money could also be bad news for banks. If other companies successfully offer their own brand of digital cash, they could bypass banks as primary providers of consumer financial services. The companies, not the banks, might be consumers' first contact when they wanted to obtain some digital money. ''Banking is essential to the modern economy, but banks are not,'' says J. Richard Fredericks, senior managing director at Montgomery Securities.

Commercial banks are, of course, entrusted with the creation of money through the fractional reserve system. They lend out more than they have on deposit, and they are the only companies authorized to do so. If each unit of E-cash had to be backed by a corresponding unit of traditional currency, that would mean that lending out E-cash wouldn't create new money. But if nonbank money suppliers started backing just a fraction of their digital cash with traditional money--just as commercial banks today keep on hand only a fraction of the deposits on their books--nonbanks, which are largely unregulated, could create money just as commercial banks do now.

Bankers must move fast to keep up. Ronald A. Braco, head of electronic banking at Chemical Bank, estimates that banks have less than five years to come up with viable E-money products before other players carve out the biggest chunks of the market for themselves. ''No question, it's for real,'' says Richard M. Rosenberg, chairman and CEO of BankAmerica Corp. In a couple of years, ''it will take off fairly dramatically.'' The issues now: winning consumers' trust and getting them to change their buying habits.

The first step in that direction could be to get consumers used to using credit cards for purchases on the Internet. Once that happens, the thinking goes, they may be willing to start using E-cash systems.

One of the first purveyors of a Net credit-card system is First Virtual Holdings, run by onetime celebrity manager Lee Stein. Stein has 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 I.D. numbers in exchange for their card numbers. When they want to buy something electronically, they simply supply their I.D. number to the merchant.

First Virtual, which became the first secure payment system on the Net when it handled its first transaction last October, is growing fast. Stein won't disclose activity levels, but he says volumes are increasing by 16% a week. ''If you make it simple and safe, people will use it,'' he says. First Virtual has enlisted such merchants as Apple Computer, Reuters, and National Public Radio--which sells transcripts of programs.

Most electronic extensions of the credit-card system, though, are built around encryption--scrambling card numbers so they can pass safely on electronic networks. For example, CyberCash Inc., a Reston (Va.) startup, is cutting its teeth on a deal with Wells Fargo & Co. for encrypted credit-card transactions over the Internet.

Visa and MasterCard, not surprisingly, are also working to make credit cards usable on the I-way. Visa is, among other things, developing with Microsoft a system using encryption technology that they hope will become an industry model. ''We want to be sure that the industry as a whole has certain standards,'' says Carl F. Pascarella, president and CEO of Visa USA. Meanwhile, MasterCard has teamed with Netscape Inc., a maker of security and browsing software for the Internet, to pursue a similar goal.

WILTSHIRE EXPERIMENT. Credit-card-based systems have the advantage of seeming familiar to consumers. But the card systems don't do everything cash can: They're not anonymous, they do not work person-to-person, and they have credit limits. They're also not suited for the grassroots economy the Internet makes possible, where any outfit or individual can sell its wares, whether a newsletter or a stock tip.

That's where E-cash comes in. But E-cash needs to be just as secure as credit cards for people to use it. David Chaum, CEO of pioneer DigiCash in Amsterdam, has done the most to solve this problem. He has devised a clever system that uses so-called public-key cryptography that, like encryption, makes it possible to send sensitive information over the Net. But Chaum's big breakthrough was ''blinding'' technology, which lets the issuing bank certify an electronic note without tracing whom it was issued to. The result: Your E-cash, unlike an encrypted credit-card transaction, is as anonymous as paper cash.

Chaum has yet to announce firm deals with companies to issue his E-money. But in a pilot, some 5,000 consumers are part of a DigiCash marketplace, using the equivalent of $1 million in E-money to do business with 50 companies, from Encyclopaedia Britannica Inc. to Ricky's Junk Shop. Chaum's technology is also at the heart of CAFE, a European Commission-sponsored project to develop an electronic wallet for pan-European use.

CAFE's setup is similar to Jones's Mondex system. ''Imagine it's the same as physical money, and you won't be far off,'' says Jones. Mondex money will be created initially by NatWest and a partner, Midland Bank PLC, which will then ''sell'' it to customers. The E-money is loaded onto credit-card-size ''smart'' cards with embedded microchips. The cards can be used in point-of-sale terminals or fit into electronic wallets that can transmit money to merchants or--just as with traditional cash but not with credit cards--to other consumers. Mondex money is still in pilot form, but the company has signed up 40,000 consumers and over 1,000 retailers in the Wiltshire town of Swindon to test Mondex money beginning in July.

CyberCash, too, is experimenting with E-cash in addition to its credit-card-based system. In the E-cash system, consumers will set up E-money accounts at their banks. Then, using proprietary software provided free of charge by CyberCash, they can go about their business on the Net. At the end of the day, CyberCash will clear all the E-money transactions and convert E-cash balances back to dollars.

No matter who develops the best E-cash, consumers and businesses alike stand to reap sizable benefits. No longer will consumers have to wait for change or scurry to automated teller machines for cash--out of sight, they hope, of the nearest mugger. E-cash will let businesses carry out transactions around the world without transferring bank funds--and they will be better able to reach a large population of technologically savvy, often affluent consumers.

Moreover, because E-money is basically software, it can be programmed to do things that paper money could never do. Microsoft's Myhrvold explains that electronic money could be earmarked for special purposes, with conditions on where it can be spent. For example, a business could have an electronic version of petty cash to be used for supplies at an Office Depot--but not a beer at the local tavern. Or parents could wire to a college student E-money that is designated for rent or books. ''There will be new forms of smart money and payment systems that can only be done online,'' says Myhrvold.

Along with the opportunities, though, comes huge uncertainty. Existing monetary regulations don't cover all of the potential uses of E-cash. Nathaniel S. Borenstein, a computer scientist and co-founder of First Virtual, says: ''One of the hardest questions merchants ask us is, 'When do we owe taxes?''' That's not a trivial question: With E-money, the merchant could be in Guam and the buyer in Canada, while First Virtual's computers are located in Ohio. So whose sales tax do you pay? Borenstein's advice to merchants: ''I tell them to consult a lawyer.''

There's also a major potential for crime (page 78). E-money can be easily sent in and out of a country undetected, facilitating money laundering on a grand scale. Tax evasion could become a matter of pushing a button. And without foolproof cryptography, counterfeiters could replicate the series of digits that constitutes E-money. Governments would be hard pressed to monitor or control stateless E-money. ''Digital cash is a threat to every government on the planet that wants to manage its currency,'' says David E. Saxton, executive vice-president of Net1, a startup that has developed a secure way to send electronic checks across the Internet.

BATTLE OF THE LOGOS. Even law-abiding citizens and companies using E-money could be victims of sophisticated hacker attacks. Says Colin Crook, senior technology officer for Citicorp: ''We have to assume electronic money will be the subject of sustained attack from all kinds of people.''

Another open question--and a large one--is the role of banks in the new electronic world. ''E-cash will be offered by both banks and nonbanks,'' says Chaum. Sure enough, DigiCash or CyberCash could join forces with AT&T or Microsoft just as easily as with Citibank. Having one of those companies dispensing E-cash directly to consumers could do serious damage to banks' main link with their customers.

Even if banks are involved, they could find other players taking center stage. Early entrants to the E-money business could set the operating standards for digital cash. And the nonbanks could even devise systems that would make their logos the first thing people see. William M. Randle, senior vice-president at Huntington Bancshares, warns that banks could become ''buttons on a network operated by other entities.''

Improbable? Not really. Take a look at credit-card processing. Twenty years ago, banks owned the card-transaction-processing business. Now, close to 80% of card transactions are processed by nonbanks such as First Data Resources Inc., says KPMG's Crone.

A similar erosion has occurred in wholesale banking, where banks have ceded to such outfits as General Electric Information Services and Electronic Data Systems Corp. nearly the entire market for transferring payment data to corporations, leaving themselves the mundane, low-margin service of transferring money between corporations. Today, says banking consultant Edward E. Furash, although the situation is improving, fewer than 100 banks offer full-service electronic data interchange, as the data part of payments transmission is known. ''We should do more of that,'' says Richard Matteis, head of Chemical Banking Corp.'s Geoserve unit.

Banks have one key advantage: a near lock on consumers' trust when it comes to depositing money. For that reason, many bankers tend to dismiss the threat implicit in E-money. ''The reason financial institutions are going to win in the long run is trust,'' says Kawika Daguio, the American Bankers Assn.'s federal representative on operations and banking. Indeed, many E-cash makers are choosing to partner with banks because of that consumer trust. ''We've positioned ourselves to work with the banking industry and make sure that if there are heroes in this, it is the banks,'' says William N. Melton, CEO of CyberCash.

But Microsoft's bid for Intuit last fall gave bankers a collective scare. And even though the deal did not work out, banks worry that Microsoft could hook its 70 million Windows customers into the electronic-commerce networks that it is developing--with or without banks' help. If Microsoft becomes a utility, ''it will take a lot of business from the banks,'' says Montgomery's Fredericks.

Now several of the biggest banks are pushing hard to develop E-money. Citibank's Electronic Monetary System is one of the most advanced bank offerings, although officials there stress that it is still in development. It would allow retail and business customers of Citi--or any other bank that paid to use Citi's system--to convert money in their accounts to electronic cash. Citi customers would also have access to a credit line they could draw down in E-money, just as they would use a credit card. Banks ''should be experimenting,'' says Sholom Rosen, vice-president for electronic commerce at Citi. ''That's what we're doing.''

Beside NatWest and Midland, Bankers Trust Co. has a group dedicated to electronic commerce. And even some regional banks see opportunities. There is Wells Fargo's work with CyberCash. First Union Corp., based in Charlotte, N.C., has created an electronic mall for Internet transactions. Even Cardinal Bankshares Inc., a $607 million Lexington (Ky.) bank, on May 24 formed a new subsidiary, Security First Network Bank, which aims to grow into a full-service interactive bank on the Internet. ''We'll be a one-branch bank in Kentucky with potential customers all over the U.S.,'' says CEO James S. Mahan III.

While it's not clear who the players will be 10 or even 5 years from now, it is inevitable that much E-money will originate outside the purview of central banks such as the Federal Reserve or the Bank of England, which are largely responsible for traditional monetary regulation. And that has major policy implications.

To begin with, consumers using the stuff could be extremely vulnerable. When consumers lose their credit cards, they are only liable for the first $50 of charges on the card. But for now at least, if a consumer misplaced, say, a Mondex card, it would be like losing cash. Similarly, if your digital coins are stored on the hard drive of your PC, a system crash could wipe out your electronic savings.

Electronic money also creates vast opportunities for tax evasion, money laundering, and other financial crime. ''There is an imaginable potential for a serious challenge to the whole political and social order,'' says First Virtual's Borenstein. ''I am not all that sanguine that the government has the control they think they do.'' For people trying to avoid paying taxes to a national government, the lure of a stateless currency would be powerful indeed. Already, ''virtual currencies'' serving electronic communities of people are springing up on the Internet.

Then there's the issue of the volatility of money. The effects of high-speed electronic trading have been painfully apparent in market crises over the past several years. Market swings could be magnified if consumers and businesses could send their money around the globe with the touch of a button on a PC.

The monitoring of national money supplies will also change. While some regulators dismiss the issue, arguing that E-money will inevitably convert back to traditional money and get counted, other experts disagree. Martin Mayer, a guest scholar at the Brookings Institution, says that he expects the Fed to lose control of a significant portion of the money supply.

One of the most pitched debates is likely to be over privacy. As a society, we have relied on a system that allows us to keep some transactions private by using cash, while others, such as big-ticket purchases, are entrusted to a credit-card company or a bank. Competing forms of E-cash offer wildly differing degrees of privacy: DigiCash's E-money offers virtually complete anonymity, while every dollar you spend using the credit-card-based systems would leave a trail. The problem will be balancing individuals' rights to privacy with government's need to monitor money flow and trace criminal activity.

BREAKING INTO THE E-MINT. More dire is the possibility of major break-ins to E-money systems--the electronic equivalent of penetrating the U.S. Mint. If someone were to crack the sophisticated code of, say, the DigiCash system, he could start minting unlimited amounts of his own DigiCash money.

That's why it is all the more alarming that some regulators and even some central bankers still seem unconcerned with the advent of E-cash. After a breakfast speech to several hundred business leaders in San Francisco last March, Fed Vice-Chairman Alan Blinder was asked whether the Fed is studying the regulatory issues surrounding digital cash. His answer: ''Digital what?'' Then, after pausing a moment, he added: ''It's literally at the thinking stage.''

Slowly, though, some regulators are beginning to explore the concept of E-money so they can set policies. The Federal Reserve's payment-systems committee is meeting with Chaum of DigiCash and other E-money pioneers. State tax collectors are looking at the issue of taxing electronic commerce. The Financial Crimes Enforcement Network is also weighing in. Even the White House technology office is taking a big interest.

It's not a moment too soon. ''There's no going back,'' says DigitaLiberty's Frezza. ''The genie's out of the bottle. The Internet doesn't have an off switch.'' And no amount of wishing by regulators will change that.

The New World Of E-Cash

THE GOOD
E-cash is more convenient and flexible than traditional money. It can be used by consumers and businesses, and for everything from buying wares on the Internet to lending a pal five bucks.

Banks that issue E-cash could find it much cheaper than handling checks and the paper records that accompany traditional money.

Consumers doing business on the Internet will find some forms of electronic money afford much greater privacy than using ordinary credit cards.

THE BAD
Uncontrolled growth of E-cash systems could undermine bank- and government-controlled money systems, giving rise to a confusing and inefficient Babel of competing systems.

E-cash may be less secure than bank money: Money stored on a PC could be lost forever if the system crashes.

E-cash could foster a have and have-not society: Those with PCs would have ready access to the stuff, while those without, many of them low-income consumers, would not.

AND THE UGLY
Money laundering and tax evasion could proliferate in stateless E-money systems as criminals use untraceable cyberdollars to hide assets offshore.

Counterfeiters could create their own personal mints of E-cash that would be indistinguishable from real money.

If computer hackers or other criminals were to break into E-cash systems, they could instantaneously filch the electronic wealth of thousands or even millions of innocent consumers.

DATA: BUSINESS WEEK

EARLY MONEY
Seashells, odd rough-hewn coins--the first money was flexible, highly distinctive, and exchanged in multifarious ways. Objects were gradually replaced by standardized commodities such as gold and silver, and these in turn by paper money. Yet even early currency was at first issued by private banks, local governments, and others--usually backed by gold and silver. Diversity abounded.

E-CASH
E-cash may be technologically light-years ahead of early money. But in many ways, it is closer to seashells than greenbacks. E-cash is digital money that moves through a multiplicity of networks instead of the current bank system. It comes in lots of guises, is created by lots of individual parties, and is backed by anything constituents demand as an accepted medium of exchange: gold, dollars, yen, whatever. It is the ultimate, and inevitable, currency for the wired world. Competition is intense, producing rapid innovations. Using money downloaded to your PC or a palm-size electronic ''wallet,'' you'll be able to zap money to merchants on the Net--or buy a newspaper faster than you can grab a greenback. If you're a business owner, you can bypass banks and move E-cash directly to customers and suppliers. The advantages: convenience, speed, cost savings. The technology is complex, but to the user, E-cash is as easy as pushing a button.

BANK MONEY
The current money system is largely monolithic. Nearly all major countries have a single system of national currencies and bank checks. Most have elaborate infrastructures built around commercial banks and a central governing body such as the Federal Reserve Board. That entity is usually the only facility allowed to issue money. Perhaps because of their monopoly structures, money systems tend to resist change and innovation. Traders can move millions of dollars around the globe at the touch of a button. But the small check-based transactions of consumers can take days to clear. And chartered airplanes physically transport billions of checks around the country every workday.