Some interesting ideas have been floated recently about what the electronic payments system of the future might look like, particularly by Hal Finney and by Steven Levy.¹ To their discussions of the technical problems of cryptographically securing electronic payments methods against counterfeiting and theft, and of the prospects for preserving the privacy of transactions, I want to add some thoughts on the economics of possible future payments systems.

Most of the electronic payment methods under discussion involve transferring balances from one bank account to another.² The practice of making payments by account transfer has been around since at least 1200 AD, and correspondingly so has intangible or “digital” money. A bank account transferable by any method can serve as money (i.e. as a widely accepted as a medium of exchange), and any account balance is an intangible claim represented by digits on the bank’s balance sheet. Whether those digits are displayed by means of pixels or ink hardly matters. Electronic funds transfer is just the newest method (going to the bank in person was the first, writing a check came later) for authorizing a bank (or pair of banks) to shift balances from one account to another.

At the financial wholesale level, the practice of wiring money has been around for decades. Point-of-sale electronic funds transfer, initiated by swiping a “debit card” through a retailer’s card-reader and keying in a PIN (personal identification number), brings wire transfer to the retail level. Debit cards have now arrived at U. S. supermarkets and service stations. (Credit cards, with transaction approvals obtained electronically in seconds, are also now accepted at many supermarkets.) Soon just about every point of sale that has a cash register will take both

Thoughts on the Economics of “Digital Currency”

by Lawrence H. White

credit cards and debit cards. Home banking — including account transfer authorization by home computer — has been around for a decade, and has begun to grow in popularity.³ A decade from now, it may be common to shop on-line and pay on-line by mouse-clicking an on-screen “buy” button to authorize a transfer to the seller’s account. The authorization method will have changed from the days of writing a check, but not the event (transfer of account balances) taking place behind the scenes.

An alternative to the deposit-transfer and credit-card models of payments has appeared on the horizon. Developments in cryptography are said to make “digital currency” possible, that is, payment by means of a “smart card” that carries a spendable balance written to and from its implanted microchip, or by means of a personal computer that has the same kind of balance written to its hard drive or RAM. If we are to understand smart-card and PC payment systems clearly, such terms as “digital currency” and “electronic cash” should not be used loosely. “Currency,” strictly speaking, is the subset of money (the set of widely accepted media of exchange) that circulates from transactor to transactor.⁴ (“Cash” is either synonymous with currency or means a specific kind of currency, issued outside the banking system, for which bank li-

abilities are redeemable.) Some have suggested that the currently available type of plastic prepaid card, which carries a balance written to a magnetic strip on its back, offers a pro-

totype of smart-card currency. The balance on a typical prepaid card, however, is neither currency (the spent balance is not re-spent by the recipient, but simply disappears) nor money of any other sort (the balance is not widely accepted, but can only be spent at vending machines owned by the card issuer, such as the photocopy machines in a university library).

Smart card balances are money when the same card is widely accepted by vending machines and cash registers. The truly smart card can also have its balance “topped up” at an ATM (or even at a home computer) by downloading funds from the cardholder’s bank account. But is the smart-card balance more like currency than like an account balance? The fact that the card balance would be a claim on a private commercial bank (or other financial firm), rather than the nominal liability of a government central bank, does not disqualify it from currency status. Private banknotes have been the predominant form of currency when and where (everywhere in the nineteenth century; Scotland, Northern Ireland, and Hong Kong today) governments do not arrogate a monopoly of paper currency issue to themselves.

A smart-card- or PC-carried balance is like banknote currency, and unlike a deposit claim, if the balance is not “in” a particular account, being continuously tracked by the bank, but is instead held “on the card” (or “on the hard drive”), by

Continued from p.15

NOTES

1. Hal Finney, “Protecting Privacy With Electronic Cash”, Extropy #10 (4:2), Winter/Spring 1993.

2. Though this is changing as the quality of color photocopies improve.

3. See, for example, Stefan Brands, “An Efficient Off-Line Electronic Cash System Based On The Representation Problem”, or Niels Ferguson, “Single Term Off-Line Coins” for examples of systems using off-line verification. Both papers are available on the Internet by ftp from ftp.cwl.nl.

4. David Chaum, “Achieving Electronic Privacy”, Scientific American, August 1992. Also available by WWW on the DigiCash site at http://www.digicash.com/

5. See Wired, Dec 1994, for a demonstration of the Ecash user interface.

6. Those who would like to experiment with digital cash will find the Magic Money software by ftp on the Internet at ftp.dsi.unimi.it in Italy as /pub/security/crypt/code/MagicMoney.tar.gz, or on ftp.csn.net in the US. Note that US ITAR regulations make exporting this software from the US a serious crime, so if outside the US get it from a non-US site.

7. See http://www.fv.com/ on the WWW for details of their credit-card based payment system.

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whomever owns the card (or the PC). A smart-card balance deserves to be called “digital currency” if and only if it circulates, i.e. Alice can transfer it to Bob, and Bob can transfer it to someone else, in transactions that are untracked by any financial institution. A currency smart card could thus have its balance augmented by a transfer from another card, perhaps via a pocket device for reading and writing to smart cards (a “digital wallet”), unmediated by the banking system.

I do not know whether the encryption technology exists to allow smart cards to carry such truly circulating balances, secure from counterfeiting. But then there may not be much demand for currency smart cards. The anonymity of currency would seem to be equally available through encrypted deposit transfer (see below). One major use of the circulability feature of paper currency — making change — is never needed with smart card payments.

The type of smart cards Finney and Levy describe do not follow the currency model. They are better be characterized as “digital cashier’s checks” than as digital currency, because the balances do not circulate party-to-party. Instead, like cashier’s checks today, Alice would always obtain her card balances directly from her bank (probably by transferring funds out of her regular bank account). Bob, receiving Alice’s payment, would always immediately redeem it by electronically depositing the payment into Bob’s account. With that kind of transactions technology, unlike with banknote currency, the bank is tracking which card has what outstanding balance at every moment. (The identity of the card-holder might be unknown to the bank, if anonymity is desired, but this does not make the card balance currency: a numbered Swiss bank account provides the same kind of anonymity.) Thus the card balance is functionally equivalent to a bank deposit, and smart-card payments are just another form of deposit transfer. Furthermore, every payment recipient must be wired to the payment network (to immediately confirm and covert the claim into the recipient’s deposit balances).

It seems to me that digital cashier’s checks, acceptable only to wired sellers, lack an obvious niche in the payment system. Immediate confirmation, which eliminates the risk of a payment bouncing, is already available on deposit transfers

fers via debit card. If every recipient of smart-card payments needs to be wired to the payment network, there is no apparent reason for any set of sellers to accept payments via smart card but not via debit card. Why then bother with the smart card? A conceivable way to make smart cards acceptable to non-wired sellers would be the development of a “digital safe”, a device allowing a seller to receive and to store smart-card payments until the end of the business day, when the payments would be electronically deposited. It is not clear that having a digital safe would ever be cheaper for the seller than being wired.

When debit- and smart-card readers become near-universal, paying by debit

by a third party that purchased and collated the information held by all the vendors from whom you bought. This list is potentially available to the IRS or to other government agencies who may want to commandeer it, and (if you don’t have a contract with your bank and vendors expressly forbidding it) to credit bureaus or junk-mail firms. Cryptography, as I understand it, offers a solution to this problem by making anonymous electronic payments possible.

One set of methods for anonymous payment uses the “smart card” model (the funds to be transferred have already been downloaded onto a smart card or personal computer); an alternative set uses electronic deposit transfer either by debit card

If an offshore bank were linked to the clearing system and to an onshore ATM network, more of us could begin enjoying the advantages of offshore banking that big-money players and large firms have enjoyed for years.

card or smart card will usually be more convenient than paying with paper currency or coins. A debit card is better than cash or a dumb prepaid card in at least two more respects: using a debit card keeps your money in your bank account, where it is both more secure from the hand earns interest, right up to the moment it is spent. A smart card could be made as secure as a debit card by requiring a PIN (known only to the rightful owner) to be entered before the card balance can be spent. I imagine that a smart card could also be made to pay interest, namely by programming the card’s microchip to augment the unspent card balance automatically over time. If such programming can be developed and cheaply copied to smart cards, competition will force the banks that issue smart cards to pay interest on card balances.$^{5}$

A potential privacy problem arises with electronic payments because a credit-card transaction or an electronic funds transfer (whether initiated in person or via computer), like writing a check (but unlike a paper-money or prepaid-card transaction), generates a trail. Your bank’s or card company’s computer ends up with a list of how much you’ve spent and where. The same list could be constructed

or by personal computer. I imagine that a privacy-preserving deposit transfer could work the following way. Suppose Alice wishes to pay Bob $100. Alice might be standing at Bob’s cash register, or she might be home at her computer looking at Bob’s invoice or advertisement on her screen. By merely typing in her PIN, or clicking on a “pay” button on my computer screen (after logging on with an ID code known only to her), Alice sends a cryptographically “signed” (or PIN-authorized) and numbered (Bob has assigned the number) message to Alice’s bank that instructs the bank to transfer $100 to an account (whose name is encoded) at Bob’s bank. Alice’s bank reads the “signature”, and knows the message is genuine. Alice’s bank can’t read the recipient account name, so it doesn’t know to whom the money’s going (only to which bank). Bob’s bank can’t read Alice’s signature (which Alice’s bank may have removed), so it doesn’t know from whom the money came (only from which bank, and in favor of which account). Bob reads the transaction number to know the payment came from Alice (though Bob might not know Alice’s real name).$^{6}$ Bob then hands Alice the goods, or ships them to Alice’s private post office box.

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Are bank customers actually eager to pay cost-covering prices for privacy features of this sort? Encryption entrepreneur David Chaum of DigiCash thinks so. I don’t know. The market profit-or-loss test will tell us, assuming that the government does not interfere.7

Assuming that security and privacy can be assured, what implications do the new payment methods have for individual liberty? I have read a transcript of postings to the Extropians e-mail list discussing many of the relevant issues. Let me add my comments here.

One major potential advantage of electronic funds transfer via personal computer is that it may give ordinary consumers affordable access to off-shore bank-

vacy should also find an offshore foreign bank attractive for its lesser propensity to surrender its records to domestic authorities.

When Prodigy, CompuServe, and commercial Internet sites begin offering offshore banking services, the retail banking market should become very interesting. An exodus of retail banking business from the regulated onshore sector to an untaxed and unregulated offshore sector will shrink the domain of federal banking authorities. It is probably unlikely that the authorities will gracefully allow this to happen, though it should be noted that the Federal Reserve has since 1981 allowed U. S. banks and licensed foreign banks to do some “off-shore” banking (no reserve requirements,

the standard type of units that everyone else wants to be paid in. New methods of transferring payment do not change any seller’s rational preference for being paid in units of the currently dominant money.

Notes

1. See especially Steven Levy, “E-Money (That’s What I Want),” Wired 2.12 (December 1994), pp. 174ff. (surveys electronic payment methods and privacy issues), and Hal Finney, “Protecting Privacy with Electronic Cash,” Extropy #10 (Winter/Spring 1993), pp. 8-14 (explains the encryption methods that enable anonymous electronic payment). See also “So Much for the Cashless Society,” The Economist, 26 November 1994, pp. 21-23 (speculates about payments over the Internet).
2. In what follows I will use the terms “bank” and “deposit” to cover any sort of financial institution issuing any sort of claim with a transferable account balance, including a money-market mutual fund account (which strictly speaking is not a bank deposit).
3. See David C. Churbuck, “Let Your Fingers do the Banking,” Forbes (19 August 1991), pp. 122-24;
4. A “medium of exchange” is an asset acquired in one trade in order to be spent (or converted into another asset to be spent) in a later trade.
5. Paper currency has traditionally not paid interest, even when issued by competing banks, because small amounts of interest are at stake (a week’s interest on a $20 bill amounts to less than 2 cents when the annual interest rate is 5 per cent), and collecting it is cumbersome (one would have to stop to ascertain in each transaction the current value of a note whose value is rising over time). Interest on paper currency (or token coins) is thus not worth the trouble. A currency smart card that updates its own balance would make the cost of collecting interest on currency negligible for the first time in history.
6. This method preserves privacy by using the two banks as semi-anonymous “remailers” of different parts of the payment message. Privacy could be increased even further by having a clearinghouse relay the message so that neither bank knows the identity of the other bank.

Continued on p.19

Lawrence White’s Free Banking in Britain will come back into print in a paperback second edition to be published by the Institute of Economic Affairs, late this year or early 1996. His Competition and Currency is available from Laissez Faire Books in paperback for $14.95. LFB also offers a The Crisis in American Banking (NYU Press), edited by Prof. White, in hardcover for $27.95.

ing. With direct deposit of paychecks, and with old-fashioned cash available at ATMs whenever we want it, many of us already no longer need to visit a bank office in person. Why not keep your account at a reputable foreign bank (perhaps a branch of a major Swiss bank) in the Bahamas or the Cayman Islands? Such an offshore account is perfectly legal today (though a U. S. bank’s offshore branch is prohibited from directly doing business with American citizens or firms), but is simply not worth the trouble (the expense of wiring money back and forth) for most individuals or small businesses. If an offshore bank were linked to the clearing system and to an onshore ATM network (the ATM link would be unnecessary if all cash-like payments could be made by debit card or smart card), more of us could begin enjoying the advantages of offshore banking that big-money players and large firms have enjoyed for years. Offshore banks pay higher interest on deposits because they are free from the taxes on deposit balances that the U. S. government levies in the form of reserve requirements, deposit insurance “premiums,” and taxes on bank earnings. Desktop electronic funds transfer, in other words, may bring offshore banking to the small player. Individuals who are concerned about pri-

no deposit insurance) with foreign customers onshore in the U. S., through separate balance sheets known as International Banking Facilities.8

Would currency smart cards, bearing a new privately issued form of money, undermine the Federal Reserve’s control over the quantity of money in the economy? If the authorities thought so, it would be very easy for the Fed to impose the same reserve requirements against the total of a bank’s outstanding smart-card balances that the Fed currently imposes against deposit balances. Even without Fed-imposed reserve requirements, however, a bank’s obligation to convert card-balance dollars to scarce reserve dollars (physical currency or account balances at the clearinghouse) on demand naturally limits the number of card-balance dollars a bank will find it prudent to create given the size of its reserves.9

Finally, will desktop electronic funds transfer and smart cards promote the use of some monetary unit better than the currently predominant government fiat unit (the Federal Reserve dollar, in the United States)? Unfortunately, no. The fiat dollar has a great deal of inertia behind it because of a network effect: each individual normally wants to be paid in the units that he or she can most easily spend, which means

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