The Internet is experiencing rapid growth which is being largely driven by new commercial users of the network. Other commercial on-line services provided by companies such as CompuServe, America On-line and Prodigy are also expanding rapidly. The Internet is estimated to already have in excess of 40 million users, and according to figures published by NSFnet, the network has seen more than a doubling of users over the 12 months to January 1995. The Internet and other global on-line networks are creating new commercial opportunities for networked commerce. However, to date development has been limited by the lack of a payment infrastructure. In the past 9 months, a number of initiatives have been made public for developing secure payment systems on the Internet. This paper examines these recent developments which could permit the creation of a new cost-effective global payment system for low value payments.
The paper suggests that the creation of an Internet electronic payment system will provide opportunities for the creation of completely new sets of global and national trading relationships. The Internet offers the possibility of an 'open systems' payment and settlement system which operates in parallel to existing, more traditional bank-based networks, and which is particularly suited to meet the currently unsatisfied requirements for processing low value payments electronically. However, the institutional framework to exploit these opportunities does not yet exist. Regulatory and policy issues will need to be addressed in order that full advantage can be taken of the new types of commerce which could emerge.
The paper is split into five sections. Section 2 examines the role of payment systems in the economy and their role in respect to global trade and investment. Section 3 reviews the various existing payments systems and concludes that a cost effective and efficient electronic means for small value payments has yet to be established on a universal global basis, in particular for cross-border payments. Section 4 examines current developments in the expansion of the Internet as well as other broadly based on-line services and the efforts which have been made to create an environment for electronic commerce. Section 5 examines some of the policy and regulatory issues while Section 6 provides concluding remarks and comments on future prospects.
Money and monetary systems have also been strongly linked to the role of the state. In the medieval period, money largely meant gold or silver coins whose weight and fitness were guaranteed by the ruler under whose authority they were issued. For a long period of history, official mints were established which would convert bullion into an equivalent weight of coins, minus a fee. In the 20th century, issuance of currency has been jealously guarded by the nation state and economic policy increasingly has been exercised indirectly through the monetary system using interest rates. However, over the past 40 years, growth in international trade, which has exceeded the expansion of GDP at the national level, has resulted in a global economy which increasingly has no place for economic and monetary policies which are pursued purely at the national level. Similarly, while the Bretton Woods monetary system established after 1945 reserved special status for the US Dollar, the number of currencies having 'global' status has expanded in number, thereby removing the linkage to their respective political masters.
The increasing emphasis on non-trade-related settlement has created an agenda of concerns which are increasingly divorced from the issues faced by businesses and individuals seeking to make lower value transfers. The huge values created by the foreign exchange and securities businesses operating on a global scale create separate agendas as concerns to mitigate the ever-increasing risks associated with settlement grows. Discussions revolve around reducing systemic failure of the settlement system by either 'netting' and/or real time gross settlement (RTGS). However, these issues remain remote for the millions of individual businesses operating at national and increasingly international levels who remain locked into inefficient and time-consuming paper-based payment and settlement systems, particularly when trading is across national borders and involves different banking systems.
The past 25 years has seen a progressive globalization of world securities markets. While the speculative flow of funds into the world's emerging equity markets has declined from their peak in 1994, commentators identify them as a key source of future growth in the late 1990s. Standard Chartered Bank estimates that the size of emerging markets in terms of market capitalization is set to double to 4 trillion US dollars within the next five years, whereas others estimate that if present growth rates continue, these new markets could account for around half the world's equity market capitalization by 2015 (Financial Times, 1994b). McKinsey & Company suggest that world capital markets are being integrated more rapidly than was generally expected. The acceleration of this trend has led to a consequent expansion of the international payment system and a consequent boom in financial assets. McKinsey estimates that the value of world financial assets will rise from Dollars 35 trillion in 1992 to Dollars 83 trillion (Dollars 53 trillion in 1992 prices) by the year 2000 (Economist, 1994a).
Attempts to establish universal international payment systems which can be used cost- effectively for the full range of transactions have to date been unsuccessful. A failure to agree on common standards has meant that a major proportion of the instructions which are sent by banks follow a free messaging format. When messages are on free format (unrecognized universally) recipients have to interpret and to rekey them, involving higher levels of cost, more time and making the systems much more prone to the introduction of errors. At the same time there is a countervailing pressure to settle transactions, particularly those relating to securities, more quickly.
The large investment institutions, be they United Kingdom investment trusts, US pension funds or Japanese life insurance companies, are pushing for more rapid settlement periods. Global settlement is increasingly moving towards three-day settlement. Citicorp estimates that by the year 2000, 50-60 per cent of trades will be settled on the day of trade, and the rest within three days. The ISITC (Industry Standardization for Institutional Trade Communication), which is an independent forum of representatives in the US and Europe, is working with the principal electronic payment system providers to extend the use of payment messaging formats which can be used across a range of networks throughout the banking and securities industry. However, there are fears that attempts to create a universal messaging system are being delayed by the lack of a perceived need for consensus (Financial Times, 1994c). The major global securities clearers are Euroclear and Cedel.
This section discusses the various payment systems which are in use and the types of payment transaction for which they are used. As already identified, the issues which concern the operators of the large value payment systems are often different from those which are the focus of smaller traders. Banks which operate the former are increasingly concerned with the systemic risks which are associated with the huge monetary values which are involved. There is a move to more elaborate real time settlement systems which would be inappropriate for the much smaller denominations involved in trading on a cross-border basis by small and medium-sized enterprises (SMEs). Similarly, the degree of direct central bank supervision required for the large value payment systems is much greater and will be at variance with the objective of minimizing cost by achieving automation for low value payments. Companies involved in making trade-related transfers are likely to require less direct supervision in order to achieve the lowest transaction costs and timeliness of transfer. This would suggest that there will be an increasing divergence between large value payment and settlement systems used for a relatively small number of individual transactions. Large value payment systems will focus on the global foreign exchange and financial securities markets that are growing rapidly in size and complexity. These networks can be expected to remain proprietary and closed with close supervision exercised by central monetary authorities. Trade and commerce-related settlement systems, on the other hand, will need to move to a more open systems environment, minimizing transaction costs and opening up the opportunities which follow when smaller scale transactions can be settled on a cost-effective basis.
According to UNCTAD (the UN Conference on Trade and Development), the costs of paperwork and other complex formalities associated with cross-border trade flows can amount to about 10 per cent of the final value of goods. A typical trade transaction may involve several different parties and different documents, all of which have to be checked, transmitted, re-entered into various information systems, processed and filed. UNCTAD believes that this represents a major impediment to the growth of world trade, particularly for the industrialized countries. UNCTAD believes that unnecessary transaction costs amount to more than US dollars 400 billion a year, which could be reduced by 25 per cent or more by streamlining procedures and extending the use of paperless trading (Financial Times, 1994d). Providing automated low value payment settlement is likely to be at the center of such changes, although to be effective, other major regulatory and institutional changes will have to follow in due course.
Difficulties which have been identified with the present system include the fact that banks run up large and unmonitored overdrafts during the day, exposing members of the system to the risk that one might fail before payments had been completed with a dependence on 'unwinding' payments as the remedy for failure. The collapse of Herstatt Bank in Germany in 1974 revealed the knock-on effects which can result from such unwinding. In the United Kingdom, the Bank of England is proposing real-time gross settlement (RTGS) as the solution with payments made in full throughout the day rather than netted against each other at the end of the day (Economist, 1992a). A major bank failure in the UK would cause currency markets to halt, because 45 per cent of the money passing through CHAPS is the sterling half of foreign exchange contracts (Financial Times, 1994e).
International large value payments are increasingly intertwined. In Switzerland the proportion of large value payments which are one end of a foreign exchange transaction is already 90%. Expectations are that as finance becomes even more global in scope, then similar proportions will exist in some of the other major financial centers. This creates a push for real time settlement, ultimately on a global scale linking all the national large payment systems together (Economist, 1993).
Correspondent banking operates on the principle that a bank initiating a payment should be able to select its routing. A payment from an importer to an exporter will be routed through the importer's local bank who will then select its foreign banking correspondent. This bank in turn will contact the bank of the exporter or, in certain cases a further local intermediary payment bank. The system was originally devised to eliminate the need for medieval merchants to settle transactions in gold currency, given the risks involved in transporting valuables through hostile territories. Correspondent banking arrangements have survived and until the 1980s, correspondent banking was an important source of profit for the small number of banks in each country which have historically handled the majority of cross-border transactions. However, in an age of electronic messaging correspondent banking is rapidly becoming a costly anachronism which simply adds to the costs of each payment transfer and is one of the principal obstacles to implementing effective low value cross-border electronic payment networks. International payment systems like SWIFT remain based on the principles of correspondent banking relationships.
The correspondent banking system remains widely in use throughout the world. It is also used where banking systems are fragmented, for example the United States, where it is used to facilitate payments between local regional banks by using large money center or payment banks. The correspondent banking system, although now ingrained after centuries of established practice, has becoming increasingly outdated. Its principal disadvantage lies in the requirement to involve three and sometimes even more parties to carry out the transfer of a single payment.
The inability to establish cost effective cross-border payment systems has become a major political issue in the European Commission (EC) given the aspirations for the creation of a 'single market'. It is estimated that every year individuals and small businesses make more than 200 million cross-border payments within the European Community. A recent study commissioned by the EC has revealed that costs and service levels are very poor. The study was based on a sample of 176 transfers (some by banker's draft and some by telegraphic transfer), each equivalent to 130 ECUs (Dollars 162), made through 22 banks in the EC. The study found that banks required time-consuming bureaucratic paperwork, frequently over-charged payment transfers and took as long as 3 weeks to effect payment. Charges in a number of cases were equivalent to 20% of the value of the ECU 130 payment. Telegraphic transfers frequently proved no faster than bankers' drafts sent by post. The EC is presently preparing recommendations for legislation which would force community banks to reduce costs and improve service levels (Economist, 1992b). The Maastricht Treaty signed by the EC partners in November, 1993 makes a commitment in principle to moving towards European monetary union. The movement to monetary union will involve large-scale technical changes as funding arrangements and payment systems are overhauled, and the introduction of new bilateral or multilateral payment arrangements in place of the current arcane cross-border payment arrangements (Financial Times, 1994f).
SWIFT has more recently has been examining other opportunities to provide 'value-added' services including messaging associated with the global securities markets. SWIFT estimates that as a result of the growth in global investment there will be 1 billion securities messages exchanged annually by 1997. There is increasing pressure to use messaging as a result of falling settlement times. These have meant that it is increasingly difficult to trade confirmations in paper form. It is generally accepted that a point will soon be reached where more traditional means of settlement using telex and facsimile will no longer be able to cope (Financial Times, 1994h). SWIFT is therefore focusing its attention on the requirements for global settlement of large value payments. Its existing proprietary network and charging structure is simply not cost effective when making lower value payments. For example, although the large UK commercial banks are SWIFT's major customers and are capable of effecting SWIFT payments to virtually anywhere in the world, the service is priced at around US 30 dollars per individual payment. Smaller value transactions are generally processed by telegraphic transfer or by mail (bankers order).
In recent years, other competing cross-border electronic payment systems have been established. The Royal Bank of Scotland joined forces with a number of European banks to launch the Interbank Online System (IBOS) in 1991. IBOS attempts to break with the correspondent banking architecture still predominant in international payment transfers. It aims instead to create a virtual banking association, which links the customer networks of the participating banks without reference to existing financial infrastructures. Significantly, IBOS used expertise from British Telecom, Digital Equipment and more recently the US computer services giant Electronic Data Systems (EDS) to establish the system (Financial Times, 1995a). Other payment networks which are being established include the Financial Network Association (FNA) and the UK-based company Scitor, set up in 1991 by Sita, the airline reservation system co-operative. Although SWIFT has broadened its user base, it has not offered its services directly to major non-bank corporations in order to retain the exclusivity of the payment system for its shareholders. Both IBOS and FNA are attempts to utilize more up-to-date technological solutions for implementing electronic payments. In both cases, significant technical support is being provided by companies with established expertise in information and communication technologies (ICT).
The same inverse relationship between payment volume (in terms of transaction volume) and aggregate payment value is mirrored in all the other industrialized countries where the percentage of business-to-business payments made electronically is frequently even lower than the 12.5% in the US. Paper-based payment systems are an increasingly costly anachronism in an age which permits cost effective global electronic communications systems. Nevertheless, important institutional barriers stand in the way of reforming existing payment systems. For example, many European countries including the United Kingdom still do not permit cheque truncation (removing the need for cheques to be physically returned to the bank branch on which they were drawn). Individual businesses have also been reluctant to move to electronic methods, preferring instead to focus on automating internal administrative processes and in some cases capitalizing on the float benefits which accrue as a result of payments in transit. In the UK it is possible to send payments electronically using CHAPS. However, the cost will be similar to making payments using SWIFT and will be priced at around US dollars 30 for each transaction and first requiring the customer to provide original written payment instructions.
The experience in the United States is mirrored in Europe and Japan. In Europe, regular users of EDI have only recently increased to 40,000 companies,compared to 20,000 in 1990, and it is now acknowledged that in order for electronic commerce to happen, a whole series of changes both technical and organizational have to be implemented (PFA European EDI Survey, 1994). Actual implementation rates vary significantly from country to country and are further constrained by the fact that currently only 50% of European EDI traffic is based on the international United Nations-based EDIFACT standard (Financial Times, 1994j). Successful EDI implementations remain largely the preserve of major retailers such as Sears Roebuck in the US and Marks & Spencer in the UK. Other examples include General Motors, which in 1993 collected US dollars 12 billion from its US auto dealers using an ACH based financial EDI system. In Europe, EDI service providers like IBM, BT, AT&T as well as INS/General Electric Information Services (Geis) are gearing up for substantial future growth. Low take-up rates to date have been explained in terms of high start-up costs, lack of familiarity, as well as overall low take-up rates, which frequently require businesses to maintain dual paper-based and electronic remittance systems in parallel.
Credit and debit cards are rapidly growing in significance as the preferred method of settling small value payments associated with the purchase of specific goods and services. Separate electronic clearing and settlement systems have been established by the major credit card companies. Both MasterCard and Visa have established their own networks which are used for verifying transactions world-wide. Electronic point of sale terminals permit card details to be verified in less than 15 seconds with networks linking the merchant, the credit card processor and the card issuer world-wide. For example, Visa's system, VisaNet, operates out of three super-computer centers, one in the UK at Basingstoke and two in the USA, including San Mateo in California. Extensive communications networks link the centers and merchants using the system. These networks are growing rapidly as the trend for consumers to make payments by credit card in place of writing a cheque continues to grow.
The number of credit cards in use is growing rapidly world-wide. In Europe, credit card ownership stood at around 200 million at the end of 1990. The figure will have increased to 350 million by the end of 1995, according to Battelle, a London-based consultancy. In addition, credit card-holders will use their cards more frequently in place of more traditional payment means such as cash and cheques. Battelle predicts that the number of payment card transactions will rise to 8 billion by the end of 1995, representing a 300% increase over 1990. The number of Visa cards in Italy doubled in 1990; in Spain and France it rose by half. Eurocheque and Eurocard (Visa's smaller rival, which is also owned by banks) are launching a joint electronic debit card to compete with Visa's growing debit business in Europe (Economist, 1991). Despite increasing volumes, the credit card business has become increasingly competitive with fees being driven down by new, often non-bank entrants.
The growth in credit card usage confirms the basic demand which exists for more efficient electronically based payment systems. However, there are certain constraints which are likely to prevent credit cards from becoming the comprehensive solution to a global electronic system for making low value payments. Credit cards developed from oil company, restaurant and department store charging accounts which predated the present electronic systems by several decades. In the 1960s and 1970s their use expanded as consumer finance was made more readily available and became an important source of revenues for banks (Lindsey, 1994).
Credit cards are distinguished from debit cards by having access to a line of credit made available to the card holder by the card issuer. They generally require four separate parties to each transaction, the card holder, the merchant selling the goods or services, the merchant acquirer processing the credit card payment and the card issuer. In certain cases the merchant acquirer and credit card issuer will be the same company although generally trading under a different legal entity.
Credit card payment systems have proved to be highly vulnerable to fraud. Credit cards can be stolen from their owners and then misused, and merchants accepting credit card payments can fraudulently fail to deliver goods (e.g., when placing orders over the telephone). In either case, credit card issuers or merchant acquirers effectively stand the loss. Losses from credit card fraud by merchants have been significant. As a result merchant acquirers are highly selective in which merchants they are prepared to authorize to receive credit card payments. Similarly, issuance of credit cards has become much more controlled to curtail misuse and fraud by card holders.
Despite these limitations, credit card companies like Visa and MasterCard are currently most active in developing secure payment systems using the Internet. Secure methods of transferring credit details and ensuring effective authorization will be represent a major improvement over the off-line systems presently in use for making sales of consumer goods and services by phone or by fax. However, credit and also debit cards were designed at a time when the emphasis in the financial services industry was on transaction-based automation. Credit cards may represent too cumbersome and restrictive a system for achieving the possibilities presented by truly global low value electronic payment systems.
A number of companies, including NatWest in the UK, are developing smart card technologies, which may ultimately bridge the gap between ATM networks for delivering cash and the requirement to make electronic payments. NatWest are leading a consortium to develop smart card technology to develop an 'electronic purse' which with suitable equipment could also be used to transact payments on the Internet.
The Internet is acknowledged as the ultimate global system of computer networks. Based on figures provided by NSFnet, as of January, 1995, the Internet linked more than 4.85 million computers and over 36.4 million users in 85 countries. In the past 12 months, new users have been hooking up at the rate of one every 1.6 seconds.
The Internet has already advanced a long way since the late 1960s when it started life as a US government-funded program to electronically link researchers at US universities and government laboratories. Commercial activities were formally excluded until only two years ago. Companies such as IBM, Digital Equipment and Apple have become major users of the Internet. Digital alone is estimated to exchange more than 1.7 million e-mail messages per month with contacts outside the company. While commercial activities to date have been limited and companies have been reluctant to trust sensitive business data, purchase orders or credit information to an unregulated network, commercially-based activity is on the increase. For example, a group of Silicon Valley companies and organizations has joined forces in an attempt to pioneer the use of the Internet as a new medium for trade among high technology companies by creating an electronic marketplace called CommerceNet. Marty Tenenbaum, chief executive of Enterprise Integration Technologies (EIT), a research firm leading the development of CommerceNet together with Stanford University, anticipates that the Internet could have a major impact on both regional and foreign trade. Tenenbaum believes that in two to three years there will be as many as 100,000 companies using the Internet as a principal sales and service channel. CommerceNet itself is projected to be handling business transactions for as many as 3,000 companies by the turn of the century ( Financial Times, 1994k).
To date commerce on the Internet has suffered from the fact that there are no readily available means for payment. Payment to date has generally been made by credit card but concerns about the security of e-mail has meant that this information is often sent by fax or conveyed over the telephone. CommerceNet and others are working on secure 'web browsers.' Lee Stein, the founder of First Virtual Holdings, one of a group of new entrepreneurs developing electronic payment systems for the Internet, has observed "Unless the Internet embraces commerce, it runs the risk of going the way of CB radio. If people aren't making money, they won't add value and this won't work" (Economist, 1994b).
Nevertheless, commentators within the financial services industry recognize that changes are taking place. On March 25th, 1994, Unipalm, a small British software firm, became the first company to make the prospectus for its forthcoming flotation available to subscribers of Internet. This may be indicative of a future which will see increasing volumes of investor-relevant information made available to end users which was previously restricted to financial intermediaries. Charles Sanford, the Chairman of Banker Trust, anticipates that by 2020, individuals will be in a position to buy and manipulate staggering amounts of information before they make decisions about their investments. The role of intermediary will increasingly be taken by electronic bulletin boards which will match buyers with sellers, borrowers with lenders. Payment and settlement systems will permit transactions to be instantly verified and settled through a global payments system (Economist, 1994c).
Another measure of future developments is the level of spending on computer & telecommunications hardware and software. After some years of reduction, investments are again growing. According to the consultants Ernst & Young, financial institutions in the United States are estimated to have spent US dollars 16.35 billion in 1994, with projections that this figure will increase to US dollars 19.8 billion in 1997 (Financial Times,1994l). Other indicators also point to change. According to a survey by the Electronic Messaging Association (EMA), a trade group based in Arlington, Virginia, commerce in the US is becoming increasingly networked. The number of e-mail sites at head offices and branches of North America's 2,000 biggest companies exploded from 94,000 in 1991 to 180,000 in 1994. The number of users is rising by 17-19 per cent a year. A growing number of companies are extending their e-mail systems to customers and suppliers.
At present Internet customers have a limited set of options for making payments. The simplest option is to provide details of a credit card number and transmit this information to the merchant vendor usually using an alternative to electronic mail, either the telephone or fax. A number of enterprises currently trading on the Internet have opted for this payment method. However, this method has a number of limitations. It requires the buyer to incur the additional expense and inconvenience of conveying credit card details and requires that the seller is accredited by a merchant acquirer/credit card processor. It is also relatively costly since credit card merchant acquirers generally charge premiums for handling telephone-based sales. A simpler method would be to provide credit card details using e-mail. However, given the open structure of the Internet with messages routed through the network, there is a general unwillingness to make personal credit card details available in this form, since both buyer and seller are exposed to fraud.
The Internet is now acquiring a more commercial character and therefore there is pressure to develop and market a form of electronic payment system which will be as fast, flexible and global as the Internet itself. In general terms, this is one of several instances where advances in communications technology have already moved ahead of the technology presently incorporated into proprietary payments networks. Innovation appears to be led by non-bank, often start-up software-based companies. As well as small entrepreneurial companies, the major credit card companies, Visa and MasterCard are presently leading the race to establish secure payment systems on the Internet.
There are at present four separate approaches to achieving a secure payments solution. Most involve some form of encryption to protect the confidentiality of the sensitive elements of the message. Firstly, there are efforts to develop new digitized forms of electronic money or e-cash. A second line of approach is for a payment service provider to act as a messaging intermediary, often using other established security clearance procedures. Thirdly, efforts are being concentrated on establishing forms of encryption which will permit credit card information to be sent to Internet-based goods and service providers who will then seek separate credit card authorization using the proprietary networks, including those established by Visa and MasterCard. Finally, there is a fourth approach which involves the use of 'smart cards.' Several schemes are presently at the experimental stage, while others such as First Virtual have already declared themselves as open to do business on the Internet. It is worthwhile noting that nearly all the announcements date back less than 9 months. This paper sets out some of the current schemes but developments are moving increasingly rapidly and there are new announcements taking place almost weekly.
One of the leading firms which is developing an 'e-cash' system is DigiCash, which has previously been involved in developing smart card technologies. DigiCash is a Dutch company based in Amsterdam. It has been running trials since November, 1994, involving the transmission of what is effectively electronic money using more than thirty sellers linked to the Internet. Test sites include the Encyclopaedia Britannica. Payments consist of uniquely coded digital tokens which are established in such a way as to prevent duplication or fraud. Under the DigiCash scheme, customers would use local currency to buy an equivalent amount of digital cash from a bank. Instructions would then be sent from the bank's to the DigiCash user's personal computer, enabling payment instructions to be sent directly to sellers of goods and services on the Internet.
The key to the DigiCash system is anonymity. A person who spends one of its electronic tokens does not need to reveal his or her identity to the buyer nor to any third party except when there is an attempt at fraud, i.e., when the same piece of digital money is presented twice for payment. At this point it is possible to unravel the digital token to reveal the entity to which it was originally issued. DigiCash is attempting to license its e-cash system to banks and other financial institutions. One of its key attractions is that it avoid the time and expense associated with becoming an approved credit card accepting merchant. Anyone will be able to set up a business and receive e-cash once the system is operating fully. However, DigiCash will require the direct involvement of a bank for its system of digital cash issuance and this may yet prove to be a significant obstacle to the realization of the scheme. A bank is integral to the scheme, since it is required to hold collateral and to provide ultimate settlement of e-cash to more directly convertible currencies.
One example is First Virtual Holdings which is a start-up company based in Cheyenne, Wyoming. First Virtual has developed a system for linking credit card, banks and processing agents with the Internet. It has developed a closed loop payment system which involves First Virtual's providing a mailbox from which instructions to make the payment and to credit the seller's account are made. The system depends on the "off-line" network provided by EDS which is used to transfer credit card/bank account information, with First Virtual effectively acting as a message clearing house. In effect the buyer sends a message to First Virtual which passes this on to EDS. EDS in turn acts under instruction from First Virtual to pass on the account details to the seller. When the transaction is confirmed, First Virtual sends a message to the buyer to confirm that the transaction should still go ahead, at which point payment is effected.
The First Virtual system has been in operation since October, 1994, and is seen to have the advantage that it does not require encrypted messages as do other credit card-based systems. First Virtual checks with the buyer that a particular transaction is to go ahead before arranging the appropriate account debit. First USA Merchant Services have been contracted to provide clearing, settlement, and authorization for the credit card transactions. First Virtual is significant in that its payment system was created almost entirely independently of the banking system. The President and Chief Executive of First Virtual is quoted as stating "There was no traditional banking mechanism set up to deal with the Internet". First Virtual's initial aim is to permit businesses to receive income for services (such as publications) over the Internet where traditional payment methods would be uneconomic.
CyberCash Inc. is a small start-up company set up in August, 1994, in Reston, Virginia. Its founder is William Melton, who was responsible for the creation of Verifone Inc., currently the leading supplier in the United States of POS (point of sale) credit card authorization systems. CyberCash is developing an on-line payment service and on December 12, 1994 announced that it had signed an agreement with Wells Fargo to run a pilot service. Initially the system will provide a secure means of providing credit card details and thereby effecting payment electronically. One of the features of the systems being developed by CyberCash is that it will be 'browser independent.' This stems from the breakthrough which Verifone made in supplying authorization terminals which can handle all the principal credit card services. William Melton is quoted as saying "The Internet is going to happen, with or without the bankers. But the bankers, the bright ones, are going to make this an opportunity".
CyberCash provides a useful illustration of how electronic payment clearing systems on the Internet will work. Users of the CyberCash system must first obtain copies of software which can be downloaded from the CyberCash web server. Once a price has been negotiated with the merchant, the customer is sent an on-line invoice detailing the purchase information together with a statement confirming the total charges to which the customer adds credit card number or debit card information, including personal identification number (PIN) where appropriate. This information is then sent to the merchant in encrypted form together with the original invoice. The merchant adds identification information and forwards all the information to the CyberCash server. CyberCash then initiates a standard credit card or debit authorization request to the merchant's bank or designated merchant acquirer (processing center). After the authorization request has been processed, CyberCash forwards a response to the merchant who then completes the transaction. Involvement on the part of CyberCash is completely automated and runs off its Internet file server.
In addition to facilitating debit or credit card payments, CyberCash will also provide independent electronic payment services. Accounts are established directly with CyberCash and maintained on the basis of an account holder's CyberCash key and not on direct user identity. CyberCash accounts are non-interest-bearing holding accounts for cash which the account holder intends to transfer or has received through CyberCash. There are neither float nor checks, only signed receipts that can be sent to receivers to indicate that a transfer has occurred. The only way to place cash into or remove cash from a CyberCash account will be through a demand deposit account in a bank. Consequently, any funds in CyberCash accounts remain within the participating banks. CyberCash accounts are particularly suitable for electronic cash payments that are too small to be processed cost effectively as discrete credit card or debit card payments. This service is expected to permit the processing of the large volume of small payments which are expected to arise from a projected explosion in entrepreneurial electronic information publishing and commerce.
Meanwhile the Information Networking Institute of Carnegie Mellon University is sponsoring 'NetBill,' which is a scheme which would broker transactions through a third-party financial institution, similar to the system of debit cards which is already in existence. The system requires both the customer and merchant to maintain accounts with the third party acting as the broker. When a customer wants to make a purchase of goods or services, a message is sent using the NetBill software to the third party financial institution instructing a transfer of the relevant amounts to the seller's account. Similarly, the Information Sciences Institute at the University of Southern California is developing both a cash/cheque model and a debit card model based on a similar structure. Selection can then be made according to whether the buyer is or is not seeking anonymity. ISI is working with a several banks including Bank of America and Citibank (Economist, 1994d).
On November 9, 1994, Visa and Microsoft announced that they were jointly developing software based on a security architecture which will enable customers to make purchases using coded credit card, debit card and chargecard numbers on-line. The intention is to add future optional upgrades to the PC-based Windows operating system which will permit card details to be encrypted so that payment will be secure. The intention is to make the software available as part of future optional upgrades to the Windows operating system, which will also incorporate a user-friendly interface to the Internet as standard. Visa International is a non-stock, non-profit-making company which is registered in Delaware, US. It is controlled by its members, the banks that issue VISA credit cards. Voting rights are in proportion to the volume of business transacted. In common with other credit card-based systems, Visa's Internet payment system will be limited to merchants who have been approved by the organization to accept their credit cards.
In January, 1995, MasterCard announced that it will start providing banking services on the Internet. MasterCard will base their services on the Netscape computer software, which is designed to encrypt transactions and keep them secure. MasterCard International is also registered in the US and controlled by its bank membership. Netscape is a California based company which is developing secure encryption software for transmitting payments over the Internet. It has already successfully developed a suite of programs for accessing the Internet which are sold commercially. Netscape is also working with Bank of America and with First Data Corp as well as MasterCard International.
National Westminster Bank is one of several organizations developing smart card technology to create what is referred to as an 'electronic purse'. While the magnetic strip on a credit card can only hold one or two lines of information, smart cards can store several pages of text. This permits credit card-sized smart cards to be used to transfer cash amounts which can then be 'spent' using special terminals. The initial applications will involve replacing small cash payments made to retailers (e.g., for newspapers, confectionery) or to pay for services like public telephones or public transport.
NatWest's longer range vision is for Mondex to be used on a more global basis to buy goods from suppliers on the Internet. Payments would involve having a special smart card reading device linked to the PC and software that recognized the card reader. Although this may prove a cumbersome alternative compared with more direct payment methods, NatWest and other smart card developers believe there would be a key benefit from the inherent security which is built into smart cards. Smart cards could also be more readily integrated into the existing networks of ATMs, integrating with what is likely to remain the predominant form of payment transaction, namely cash.
The emergence of an electronic payment system which is easy to use and cheap to process is likely to have a range of only partly anticipated side effects. It could, for example, result in a push for greater convertibility and the creation of truly global currencies. This will in turn have important economic implications, perhaps accelerating the move towards currency union in Europe or reinforcing the dominance of currencies like the Deutschmark and the US Dollar. Overall, such developments will create a more globalized economy which will be less subject to the direct political wills and whims of national governments. Ironically, such developments will undermine existing large value electronic payment systems which function largely in order to service the transaction amounts generated by the international foreign exchange markets.
There are concerns that more widely available systems to make electronic payments could exacerbate the problems currently being created by illegal money flows. According to estimates made by British intelligence, laundered money may amount to some US Dollars 500 billion per annum. Over half the total is estimated to be accounted for by illegal trade in drugs, with the balance from other forms of organized crime and terrorism. However, in many respects a move to electronic payments is likely to permit more rather than less control of payment transfers, since there will be greater information capture. High levels of activity in the 'black economy' are generally associated with cash based payment transfers and generally result in lower use of electronic payment systems like credit and debit cards. The introduction of e-cash and electronic payment methods may therefore permit greater rather than less monitoring of the payments system with correspondingly more control over the money launderer, drug smuggler and tax evader.
Other similar issues concern authentication. Contract law remains ambiguous regarding the use of electronic signatures. In principle, Personal Identification Numbers (PIN) used in conjunction with credit or debit cards should have the same treatment as a signature in law, but the area remains relatively untested.
A protracted legal wrangle is going on between RSA Data and the US government's rival digital signature technology called Clipper. A number of software companies are presently developing encryption software, some of which is based on patented algorithms which have been developed by RSA (Economist, 1994f). Encryption has become a key element in discussions concerning commerce on the Internet. CommerceNet hopes soon to distribute Mosaic in a new, improved form with added 'public-key cryptography'. Public-key cryptography makes it possible to 'sign' a document so that the recipient can be assured that the source of the message is authentic as well as to 'seal' a document, ensuring that no one except for the recipient can open or change it. The encryption technology will be based on algorithms which have been developed by the company, RSA Data Security. Encryption facilitates services that require privacy, such as home-banking and electronic money-transfer between businesses.
There are some historical precedents when considering the radical changes in trading relationships which may shortly be upon us. In Europe, medieval trade fairs grew to prominence as trade across kingdoms and principalities revived in the 11th century. At the time, these fairs represented a radical break with the past and participants had to develop what was virtually a completely new separate political and legal system. Merchants had to negotiate rights of passage and protection from archaic feudal as well as ecclesiastical laws and customs acting as impediments to trade. The period saw the emergence of credit-based banking systems and financial instruments such as bills of exchange, which remain with us in their modified form to this day (Chown, 1994).
New trading opportunities are being established as a result of the growth of the Internet and other on-line networks. At the same time there is increasing pressure to move from existing paper-based payment systems to electronic transfer. Microsoft's chairman, Bill Gates, is not alone in believing that the convergence of money, commerce and personal computers represents one of the great new markets of modern times. New and unforeseen opportunities can be expected to arise once a secure and cost effective 'mass' market electronic system for making low value payments is successfully established. Serious efforts to establish such a system on the Internet are still less than 15 months old. However, the coming 12 months should witness some interesting developments as small entrepreneurs, such as DigiCash and First Virtual, battle it out with the credit card companies and, to a lesser extent, with the commercial banks to establish new standards for electronic payments.
Many bankers remain skeptical that Internet-based payment can and will emerge. They believe that they will prove to be largely peripheral to established unchanged patterns of retailing and commerce along with their associated payment systems. However, the evidence is pointing to an alternative consensus. The result is likely to be the creation of a new global commercial market place which permits goods to be ordered and paid for electronically irrespective of location. This will require new institutional structures to be formed as well as changes to existing outdated legal and commercial systems. The changes brought about by electronic commerce may be similar in scope to those experienced when the medieval trade fairs were established in Europe in the 11th century. The comparison is particularly apt, since that period saw the emergence of many of the banking institutional structures and payment instruments which remain in use today.
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