Subcommittee on Domestic and International Monetary Policy of the Committee on Banking and Financial Services
U.S. House of Representatives
Tuesday, September 19, 2000
http://financialservices.house.gov/banking/91900var.htm
Mr. Chairman, ladies and gentlemen of the Subcommittee. I appreciate the opportunity to be here to discuss electronic payment systems.
In March of 1996, I experienced first hand the Mondex smart card pilot program in Swindon, England.(1) It initially characterized itself as "money." The card contained a microprocessor chip that could hold and transfer electronic value, as well as record the last ten transactions involving that value. In addition, the electronic wallet that accompanied the card allowed the value on the card to be transferred from person-to-person in a manner that was both immediate and final. The product was crisp, clean, efficient and easy to use. As my wife and I experimented with the Mondex-enabled phones in the city and dipped the card in Mondex point of sale ("POS") terminals throughout the city, we concluded that this form of money would revolutionize payments systems and would be immediately embraced by the consuming public. Four years later, neither has occurred.
Since then, I have represented banks, diversified financial services companies, payments systems participants, governmental entities and trade groups in a variety of matters involving the development of alternative payment instruments and systems. Based on these experiences, I offer the following views for the Subcommittee's consideration.
Since the debut of Mondex, there have been dozens of electronic payment products and systems introduced to the public, such as VisaCash, Digicash, CyberCash, Millicent, Proton, PayPal, eMoneyMail, BillPoint, Payme.com, PayTrust and Propay. While each of these products are efficient and innovative, to date, most have attracted customers only in limited consumer and business applications. At the same time, electronic bill presentment and payment products and systems are beginning to infiltrate the payments landscape. There are significant and traditional reasons for the relatively glacial evolution of electronic payment instruments and systems in a world that is eager to adopt any new technological product that comes along.
1. The current money and payments infrastructure is well-established, reliable, and businesses and consumers understand it and feel comfortable with it.
2. New products and systems usually require the creation or adoption of standards so that every machine and network is speaking the same language.
3. Businesses and consumers are slow to change their financial habits without compelling reasons.
4. The value proposition for businesses and consumers to shift to new electronic value systems is not yet clear and may not come into focus sharply until there is a supporting infrastructure and a critical mass of users.
5. The online movement of money may not yet be as reliable, convenient, safe and easy as it needs to be.(2)
6. Unfamiliarity with new payment instruments and systems, concerns over the potential loss of funds in accounts, increasing apprehensiveness about the loss of privacy, and the temptation to offer new payment products before they are perfected create an environment that makes both businesses and consumers wary.
7. There is significant market competition and controversy concerning what entities can control the point of customer entry for these products.
8. Current laws are often ill-suited to, or incompatible with the way that electronic payment instruments and systems work.
As I discuss electronic money and payments systems today, I use the term loosely to include a wide array of electronic money (card, chip and PC-based), electronic checks, new credit card and electronically based person-to-person money products.
The Comfort Factor
There is one immutable and daunting truth that affects the acceptance of all new financial products and systems: every human being has an emotional attachment to his or her money. That usually means their use, investment and transfer of money fall into behavioral patterns that they are comfortable with and that change only when the cost, convenience and confidence factors related to these products become overwhelming. When I was in Swindon, I asked a woman in a drug store why she wasn't using a Mondex card. She told me that she didn't need it; she had real money and it worked just fine, thank you. She also said that she was not interested in becoming addicted to a form of money that she would actually have to pay to use.
The lesson here is clear. Just because technology provides a new, glitzy product to the public does not necessarily mean that consumer and business acceptance will automatically follow. Many will not use it until they fully understand it or absolutely need it.(3) Looking back at periods where other financial services evolved at a much slower pace, we see that even with a clearly worthwhile product, staying power is essential since it may take a generation in order to reach a loyal audience.
Examples of this in the financial services history are numerous. In September 1958, the Bank of America introduced the BankAmericard, the predecessor of the Visa card. Some very bright people in the bank developed the revolving credit card idea and a way of marketing it to a generation of post-depression consumers who were emerging from the dominant pay-as-you-go economic memories of that era.(4) Bank of America made a bold move. It printed and mailed 60,000 credit cards to every customer in the Fresno, California market. This event, known as the "Fresno Drop," primed the credit card pump. While consumer and business acceptance eventually followed, economic success was slow in coming. Within fifteen months, the BankAmericard lost $8.8 million, a huge sum of money at that time.(5) Nine years later, the predecessor to MasterCard was formed and the rest, as they say, is history. Today, the credit card is one of the most successful financial products ever created. That might suggest that the pioneers of the credit card probably had their names enshrined in the financial services hall of fame. Hardly. At Bank of America, many were reassigned or quietly left their jobs because of the enormous losses the bank suffered, since it distributed the card indiscriminately without underwriting the creditworthiness of its users. Initially, the BankAmericard was considered a failure.(6)
This story is important and may suggest some lessons for the future of electronic payment instruments. Consumers, businesses and governments will eventually become comfortable with new forms of money and payments systems, but it will take time to build both the physical and emotional infrastructure. Perhaps not the time it took for credit cards and ATMs to be accepted. But, history teaches us that some fraction of a generation must mature with a new financial product in order for it to find its way into the lexicon of consumer financial markets.
Cost
For new electronic payment instruments and systems to be attractive to consumers and businesses, they should save money and reduce the costs in the current systems. In short, if consumers can spend their money more cheaply, they will be more likely to adopt the new electronic products that let them do so. It appears that the savings are there for the picking in the electronic money and payments area. The cost of dipping a smart card, which requires no closed proprietary or open network to transmit its electrons from chip to chip, is less than $0.01. An ATM transaction costs about $0.27, while a teller generated transaction in a financial institution costs about $1.07.(7) The average cost of swiping a credit card ranges from $0.08 to $0.15.(8) Squeezing as much as $1.06 out of the trillions of financial services transactions that occur each year is a very meaningful reason why electronic payment instruments and systems will change.
The instantaneous movement of money is a phenomena that will change many of the conventions to which we are currently accustomed. For example, new payments systems could challenge and disenfranchise the sponsors and owners of the current system, including the banking industry and governmental entities like the Federal Reserve. They will also change revenue and expense models to the extent that payments systems are connected from the current overnight or several day batch processing and netting systems to real time finance. Gone will be traditional money-making strategies that have relied upon the float in the system and the incompatibility of parallel payments networks. At the same time, the government could lose the profit it makes on seigniorage.(9)
Convenience
As the speed at which transactions increase with the pace of life in a technologically charged environment, new financial products will have to be easy to use and save businesses and consumers time, computing space and resources. But the fact that they are quicker won't necessarily make them viable. They will have to fit naturally into the current structure of financial services, as the logical outgrowth of where businesses and consumers would go, left to their own devices.
In Crossing the Chasm, Geoffrey Moore refers to this issue, drawing distinctions between what he calls "discontinuous innovations" -- changes that require the consumer to change a behavioral pattern -- and "continuous innovations."(10) While it does not require disruption of one's traditional behavioral patterns to buy the new and improved Tide, for example, -- it's in the same spot on the shelf that the old unimproved Tide was -- it may require a shift in consumer behavior to begin banking online or to pay bills electronically. Electronic payment instruments and systems will become a part of the financial environment, but it will take time, and it will require the confluence of the needs of all of the constituents in the financial marketplace.
Confidence
No payment instrument or system can work without the trust and confidence of its users. The money that we have in our pockets is no more and no less than a symbol of a trusted system that works. Green dollars could as easily be pink pineapples, as long as people trusted the underlying value of those pineapples.
Interestingly enough, because of the trust factor, which forms the backbone of money and payments systems, governments and quasi-governmental entities play a critical role in making them work. In the final analysis, businesses and consumers have to know that the form of value that they are using will be accepted and that the system that handles it does so without delays, disruptions or challenges.
This necessary confidence factor translates into governments playing a more prominent role in the development of new electronic payment instruments and systems. For example, if the federal government required the 30 million Americans who receive some form of financial assistance to use smart cards to receive and transfer that value, smart card technology would be more readily salable to the public by private businesses for a wide variety of purposes. When federal and state governments require the use of digital signatures for governmental transactions (e.g., to apply for a license, pay taxes or receive a student loan), the use of digital signatures will become more widely accepted by the public, and private sector businesses will be able to more easily market other electronic signature applications to them.
Money and payments systems, therefore, require a unique blend of governmental, business and consumer participation in order for them to succeed. Until those factors are all aligned at the right time and in the right place, what may seem to be significant developments in financial services products may limp along, garnering market acceptance on an evolutionary rather than a revolutionary pace.
Current Electronic Payments Institutions
Let's fast forward from Fresno in 1958, to the Upper West Side of New York City in 1998. In the Upper West Side pilot, two of the city's largest banks teamed up to experiment with the deployment of electronic value cards. The project followed the Atlanta Olympic pilot of 1995, as another attempt to achieve consumer and merchant acceptance of card-based electronic value. In the Upper West Side pilot, consumers reportedly found modest value in placing value on a card that could only be used a limited number of locations. Merchants encountered operational and training difficulties.
On the other hand, consumers have shown much more enthusiasm for a wave of person-to-person, Internet-based, money transfer services. These services, which vary widely in their structure, have apparently found a niche that is attractive to buyers and sellers in online auctions and to individuals who are looking for an online-based method to send funds to other individuals.
The Future of Electronic Money and Online Payments Systems
There are, in my view, critical reasons why electronic payment instruments and systems will eventually be accepted and find their niche in the payments environment.
1. The cost savings are substantial, and businesses and consumers will not be able to ignore that fact once other issues are resolved.
2. The exponential growth of electronic commerce, online financial services, electronic bill presentment and payment products, and new financial communication networks will demand greater velocity in the movement of value which are efficient and instantaneous.
3. The proliferation of business-to-business ("B2B") electronic commerce will force payments systems to adapt to even greater speeds and standards of efficiency.
4. The adults of the future will not be wed to bricks and mortar, checkbooks or passbooks or even ATM cards.
But we should not be fooled into thinking that 21st century electronic payments products will totally replace checks, credit and debit cards, or cash. They will simply find their niche in the financial products landscape like very other product did in the 20th century.
Legal Considerations
There are a variety of policy, operational and legal considerations confronting any entrepreneur who attempts to tackle the challenge of creating a new form of value or a new way to transmit it. Because most current banking and payments systems laws and regulations have been constructed to deal with more traditional payment mechanisms, they often do not provide a clear picture of whether and how they apply to new payment vehicles or systems. That creates a sense of uncertainty that is not helpful to developing markets. If the government does anything in the near future, it should foster legal predictability in this area.
Jurisdictional Considerations
Money and payments systems are by their vary nature, multi-jurisdictional products. If there is one thing that is meant to be in commerce, it is money. Thus the creation of new global electronic payment instruments and systems raises a threshold issue - whose laws apply? While today, there is a well worn path of understanding regarding the application of check clearing, ACH, credit card, Fed Wire and other traditional payments systems rules, the development of new forms of money and new payments systems that are based in Cyberspace necessarily raise jurisdictional questions. Which state or country will regulate the activities of the entity or the movement of the electronic value it creates?
This, among other things, has been the subject of a two-year study and Report issued by the American Bar Association, which I chaired.(11) To the extent that new forms of money and payments systems are to succeed, a certain level of predictability and certainty is necessary so that the sponsors and participants can fairly evaluate the rules that will apply and estimate their obligations and liabilities.
State Banking Laws
The creation of a new electronic payment product raises the possibility that it may unknowingly conflict with banking laws in one of the fifty states. To the extent that a non-bank creates a payment product that is linked to an "account," that entity may be engaging in the business of banking without a license under state law. It may also have established an illegal deposit relationship with its customers that subjects it to criminal penalties under federal law.(12) When Florida State University issued a smart card to its students, which could be used in a variety of ways at a variety of places, it probably did not anticipate that it would be considered to be improperly engaging in the business of banking without a license to do so.(13) But the State of Florida thought so. The "account" issue also raises interesting questions in this regard in relation to the status of certain person-to-person money transfer services.
State Money Transmitter Laws
Most of the states have money transmitter laws and regulations that require licenses and impose regulatory burdens, obligations and rights upon non-banking entities that are involved in the movement, distribution or clearing of payments.(14) Conformity with these laws on a nationwide basis creates a significant regulatory consideration for anyone contemplating the development of electronic payment products and networks. State regulators have recognized that their laws were not designed to address this new range of Internet and card-based payment instruments that have begun to emerge. They are seeking a uniform law that will establish a consistent nationwide approach for dealing with such payment mechanisms.(15)
FDIC Insurance Considerations
The extent to which funds are insured is generally a question of whether they are a "deposit" as that term is defined by the Federal Deposit Insurance Act. There are two different considerations in this regard: (1) some sponsors of new products may not want their products to be insured, so that they can create their product outside the purview of federal banking regulators; (2) others may want their product to be insured so that they can market that feature to the public. The extent to which an electronic payment product is insured by the FDIC is generally a question of "where the money actually is."(16) If it resides in an account, notwithstanding the transmission of a representative digital equivalent of that value, it is likely that the value remains insured.(17) Like most other situations in which "old economy" banking laws are applied to new electronic products, they may not translate well, and there may be confusion as to the application of those laws. Another important issue in this regard is the extent to which consumers and businesses appreciate the relationships they have established, who holds their money, how it moves to other parties and the risks that they face based on the conduct and solvency of those parties.
Regulation E
Another significant issue presented in connection with electronic money and payment systems is the application of the Federal Reserve Board's Regulation E, which implements the Electronic Funds Transfer Act. In circumstances where Regulation E applies, consumers are entitled to certain disclosures and protections, financial institutions and other parties are subject to certain responsibilities and obligations. In many areas of electronic financial services, the application of Regulation E remains unresolved or open to dispute. For example, no final action has yet been taken with respect to this on the Federal Reserve Board's ("FRB") 1996 proposal regarding the treatment of various types of stored value systems for purposes of Regulation E. Similarly, it is unclear how Regulation E may apply to various types of Internet-based payment services. At the same time, the FRB is currently considering how Regulation E may apply to data aggregation services that permit consumers to execute transactions in their financial institutions accounts.
State Escheat Laws
Electronic payments, like other forms of money, may be subject to the escheat laws of the various states. However, the application of such abandoned property laws to electronic assets raises interesting questions, such as how one knows when a non-traceable electronic asset, like an electronic dollar, is subject to escheat, when it is not possible to tell where it is, where it's been or if it has been abandoned?(18)
Law Enforcement
While the issue of anonymous, non-traceable economic value in the form of electronic money and payments systems may raise complex questions concerning the application of network rules, significant concerns have also been expressed by law enforcement agencies, which conceivably could hinder the development of new payment products.(19) Clearly, law enforcement agencies that are responsible, for example, to monitor money laundering, are very concerned about the development and proliferation of anonymous, non-traceable electronic payment products. To the extent that organized crime figures can merely email electronic money around the globe or load it on to a smart card or a piece of jewelry containing a microprocessor chip, their jobs get significantly more difficult. In this regard, one of the most difficult decisions that Congress and the agencies responsible for combatting money laundering will have to make is how to balance the interests of the private sector in developing more efficient money and payments systems, and the interests of law enforcement agencies who are charged with protecting the public.
Who Should Facilitate Electronic Payments?
In a similar vein, there are intriguing legal, regulatory and policy questions that must be answered when it comes to the question of who may mint, distribute, circulate and transmit electronic payments? While most systems really aren't creating money in the technical legal sense, in the economic and practical sense, they may be. If the medium of exchange is trusted and the scale of acceptability is large, several critical questions arise:
1. Do electronic payment products affect the money supply?
2. Should non-regulated companies be permitted to mint, distribute, circulate and transmit electronic money?
3. What protections should be constructed to deal with the failure of companies that create, distribute or clear electronic money and liquidity crises in the resulting electronic payments markets?
4. How should new electronic payments systems be protected, regulated and made safe and secure?
5. Who provides the ultimate liquidity and stability that makes these new money and payments systems work?
Most governments do not generally allow anyone but governmental entities to create money. While private entities are able to create and distribute substitute money products such as travelers checks, generally, they are viewed as special purpose instruments and are not used in the same frequency, volume or scale as traditional money. Indeed, if one form of electronic money offered by a private company or consortium of companies, became ubiquitous, there would be economic downsides to consider alongside the economic benefits it might confer. For example, if most Americans used electronic money on smart cards, any hint that the sponsor of the system was in financial difficulty or that the security of the system had been broken could result in a "run" on that form of money. Merchants might refuse to accept the card. Card holders would rapidly retreat to the bank whose name was co-branded on the smart card and demand "real money" in exchange for their electronic money. If on the way to their bank, they passed an off-line vending machine that accepted the card, they might use it to purchase a car load of sodas to wipe out the value on the card, thus shifting the risk of loss to the owner of the vending machine. Such monetary crises have not occurred in this country. While regulators are well equipped to handle bank failures, the collapse of a form of currency is another matter altogether.
Similarly, the emerging area of electronic bill payment and presentment raises new issues for payments systems. Today, a growing number of consumers pay their bills electronically (electronic bill payment) without writing a check, finding an envelope or licking a stamp. They may also receive their bills electronically (electronic bill presentment) without ever receiving a paper bill in the mail. This system potentially offers enormous cost savings to both consumers and billers. Yet, it also raises new issues as to who bears responsibility should payments not be made. As the system has evolved to date, the third party processors that facilitate electronic bill payment and presentment, and through which a consumer's funds may travel, typically are not insured financial institutions. Once value leaves the insured banking system and becomes the property of such processor, even overnight, the failure of such entity raises significant financial issues for businesses and consumers, each of whom would assert a claim to the funds. In short, new products, players and systems implicate new rules of management and risk.
The Stamp Payments Act of 1862
The Stamp Payments Act of 1862 declared it to be a felony for anyone to create or circulate any coin, token or obligation in a denomination of less than one dollar if it is meant to circulate as "money."(20) This statute is still on the books. It was referenced by the Department of Treasury in its 1996 review of electronic money,(21) but was not considered when the Comptroller of the Currency approved the acquisition of an electronic money business by several national banks in December 1996.(22) To the extent that the statute raises questions that may discourage the development of electronic payments instruments and systems, its status and application should be considered and/or clarified.(23)
* * * * *
Recommendations
We are at the beginning of perhaps the most radical revolution in the adoption of electronic payment instruments and systems. The government plays a critical role in this process, as does the private sector.
1. Governmental agencies and instrumentalities should do whatever they can to facilitate and encourage the private sector to develop cost effective electronic payment instruments and systems that correlate to the movement of financial services on to the Internet.(24)
2. Regulators should seek to clarify the law and create greater predictability regarding the application of financial services laws to new financial products.
3. Financial regulators should be encouraged to meet with their counterparts around the world and agree upon the manner in which jurisdiction will be determined.
4. Laws and regulations should enable the development of electronic payment instruments and systems, rather than establish regulatory bureaucracies before there is an industry or accepted product to regulate.
5. Governments and regulators should thoroughly explore the new risks and security challenges that electronic payment instruments and systems create and address the economic, political and legal risks that are suggested.
Again, I appreciate the invitation to appear before you today and look forward to your questions.
Thank you.
Notes:
1. Thomas P. Vartanian, Mondex's Swindon Test Points to Future of Electronic Cash, Am. Banker Future Banking, April 15, 1996, at 14A.
2. See, e.g., Fried, Frank & Peter Wayner, The Management of Risks Created by Internet-initiated Value Transfers (NACHA 1997).
3. Businesses should not make the mistake of confusing the enthusiasm of "Early Adaptors" with the much more conservative approach displayed by the market segments one expert labels as the "Late Majority" and the "Laggards." See Geoffrey A. Moore, Crossing the Chasm 46 (Harper Business 1995).
4. Joseph Noscera, A Piece of the Action 20-21 (Simon & Schuster 1994).
5. Id. at 31.
6. Id.
7. Loretta J. Mester, The Changing Nature of the Payments System: Should New Players Mean New Rules, Bus. Rev. (Fed. Res. Bank of Philadelphia), March/April 2000, at 3. See also Thomas P. Vartanian, Robert H. Ledig, & Lynn Bruneau, 21st Century Money, Banking & Commerce 286 (1998).
8. Kevin P. Sheehan, Electronic Cash, Banking Rev. (FDIC) 1 (Vol. II, No. 2 1998).
9. The Department of the Treasury defines seigniorage as the difference between the face value of a coin and the coin's cost of production. See H.R. 534, One Dollar Coin Act of 1995: Hearing Before the Subcomm. on Domestic and International Monetary Policy of the House Comm. on Banking and Financial Services, 104th Cong. (1995) (testimony of L. Nye Stevens, General Accounting Office). Of course, if traceable electronic payments become the norm and replace cash, the government should see increased tax revenues from the sudden appearance of cash income that has often been "off the books."
10. See Moore, Crossing the Chasm, supra note 3, at 10.
11. American Bar Association, Achieving Legal and Business Order in Cyberspace: Jurisdictional Issues Created by the Internet (July 2000), available at
12. See 12 U.S.C. § 378. Section 21a of the Glass-Steagall Act, which states:
[I]t shall be unlawful -
(1) For any person, firm, corporation, . . . to engage at the same time to any extent whatever in the business of receiving deposits subject to check or to repayment upon presentation of a passbook, certificate of deposit, or other evidence of debt, or upon request of the depositor . . . .
13. See Inter-Office Communication from J. Ashley Peacock, Assistant General Counsel to Terry Straub, Director, Division of Banking (Nov. 16, 1990); see also Thomas P. Vartanian & Robert H. Ledig, The Business of Banking in the Age of the Internet: Fortress or Prison, Banking Pol'y Rep., March 4-18, 1999, at 6.
14. See State Legislation: Sales of Checks/Money Transmitter Statutes - Part I - Alabama to Kentucky, Electronic Banking L. & Com. Rep., Nov. 1996, at 13; State Legislation: Sales of Checks/Money Transmitter Statutes - Part II - Missouri to Wyoming, Electronic Banking L. & Com. Rep., Jan. 1997, at 12.
15. See Unif. Money Services Business Act (2000 Annual Meeting Draft) (July/Aug. 2000), available at
16. Thomas P. Vartanian, Key Questions for Emerging Systems: Where is the Money?, Am. Banker Future Banking, June 17, 1996, at 6A.
17. General Counsel's Opinion No. 8; Stored Value Cards, 61 Fed. Reg. 40490 (1996) (indicating that some stored value products would be eligible for deposit insurance while others would not).
18. Unif. Unclaimed Property Act (1995), available at
19. See Internet Fraud; Illegal False Identification Web Sites: Hearing Before Subcomm. on Investigations of the Senate Comm. on Governmental Affairs, 106th Cong. (2000) (testimony of Brian L. Stafford, Department of the Treasury, Secret Service).
20. Act of July 17, 1862, ch. 196, sec. 2, 12 Stat. 592 (codified at 18 U.S.C. § 336):
Whoever makes, issues, circulates, or pays out any note, check, memorandum, token, or other obligation, for a less sum than $1, intended to circulate as money or to be received or used in lieu of lawful money of the United States, shall be fined under this title or imprisoned not more than six months, or both.
21. See U.S. Department of The Treasury, An Introduction to Electronic Money Issues (Sept. 1996).
22. See OCC Corp. Decision, Conditional Approval No. 220 (Dec. 2, 1996).
23. Thomas P. Vartanian, Robert H. Ledig, & Yolanda Demianczuk, Echoes of the Past with Implications for the Future: The Stamp Payments Act of 1862 And Electronic Commerce, Banking Rep. (BNA), Sept. 23, 1996, at 465.
24. Organizations such as the National Automated Clearing House (www.nacha.org) and the Financial Services Technology Consortium (www.fstc.org) have conducted important pilot programs dealing with digital signatures, electronic checks etc. Such pilot programs are vital to the efficient modernization of payments systems.
Thomas P. Vartanian is the Chairman of the Electronic Commerce & Financial Services Transactions practice in the Washington, D.C. office of the law firm of Fried, Frank, Harris, Shriver & Jacobson. He is the Chairman of the American Bar Association’s Cyberspace Law Committee and its Transnational Jurisdiction Project, which produced a report on global jurisdictional principles entitled Achieving Legal and Business Order in Cyberspace: A Report on Global Jurisdiction Issues Created by the Internet. He is an Adjunct Professor of Law at Georgetown University Law Center and Boston University Law School and is the author of numerous books and articles, including his latest technology book entitled 21st Century Money, Banking and Commerce.
Mr. Vartanian is testifying on his own behalf as an electronic commerce expert and attorney and represents no entity for this purpose.
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