ROBERTGUTTMANN

CYBERCASHThe coming era of

Electronic Money

© Robert Guttmann 2003

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Cybercash : the coming era of electronic money / by Robert Guttmann.p. cm.

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Electronic Money 5

in 1989 to 235.000 in 1999. These ATMs, which lower the operating costsof banks, allow bank customers to conduct various banking activities withthe help of computers which operate faster, more reliably and morecheaply than human hank tellers. By linking their ATM networks, hankshave found a way to bypass geographic branching restrictions (for instancethe long-standing US prohibition against interstate banking) and operatenationwide, even globally organized banking networks.

The other dominant form of paper money, namely checks backed bydemand deposits at banks, still remains by far the preferred form ofnoncash payment among consumers. Having been around for over acentury, they are familiar, widely accepted and fairly convenient. Anyonewriting a check has the feeling of 'hands-on' control over a givenpayment, a significant psychological advantage compared to less tangiblepayment methods using computers. Like cash, checks enable individualsto make payments to other individuals. Checks, however, are very expen-sive to process. The check-clearing mechanism set up by the FederalReserve, the US central bank, in 1918 is a cumbersome and costly affair.Checks travel from the bank, in which Ihe check was deposited, via theregional Federal Reserve banks to the bank on which the check wasdrawn, and back. Each of these steps demands a good deal of paperworkfrom the parties concerned. Since checks have to be physically movedfrom bank to bank, they also involve considerable transportation costs.including the operation of a large Heel of airplanes and trucks deployedeach day by the regional Federal Reserve banks for the movement ofchecks between slates. The costs of printing, handling and delivering the60 billion checks written each year in the United States by individuals andcorporations exceed US$50 billion, nearly $1 per check. In addition tothese direct costs we have to consider indirect costs which are harder to

measure. For instance, the possibility of processing delays is quite high inan air traffic system which is already stretched to capacity and vulnerableto extreme weather conditions. Any delay in check-processing creates aloss of income which could have been earned from investing cash earlier.This opportunity cost has become more important now that (deregulated)interest rales tend to be fairly high.1

In recent years the banking sector has intensified its efforts to automatethe check-collection process. The most promising step in this direction sofar has been the use o\' electronic check presentment (ECP) technology inwhich the payment information on a paper check is transmitted bycomputers between the banks involved to make Ihe check-collection

process faster, more efficient and less costly. Today already roughly one infive checks is presented electronically. Driving check electronification one

Electronic Money 9

1.2 Defining Cybercash

While electronic money ('e-money') Is a broader concept referring to allcompuler-based fund-transfer mechanisms (for instance credit or debitcards. ACHs) and their access hardware (for example ATMs. POS termi-nals). cybercash is a more narrowly focused term applying to all fund-transfer systems routed through the internet. The delineation betweenthese two overlapping characieri/ations of the new money form is (luid. Itis hiucl to distinguish clearly between 'electronic money' and 'cybercash'.because the former has set the stage for the latter and is now graduallymerging into it. Those omnipresent plastic cards, for instance, will soon beturned into smart cards which can be connected with any access ramp tothe internet, whether personal computers (PCs), cell phones, or personaldigital assistants (PDAs). Paper checks can now be spared their costly andcircuitous route through the Fed

'

s traditional check-clearing process bybeing presented electronically and transferred over the internet. ACH-based transactions too will be conducted increasingly online, especiallyonce electronic billing has taken hold among businesses and households.

Official definitions, provided by the world's leading central banksgrouped together in the Bank for International Settlements (BIS) as theirumbrella organization, ignore the distinction between 'electronic money

'

and 'cybercash'

altogether. They only refer lo the former, never to thelatter. Dating to 1996-97 (Bank for International Settlements, 1996a;Group of Ten, 1997), these BIS definitions capture more than a decade ofefforts by banks to automate their payment services through a variety ofproprietary computer and communication networks. But these definitionscame too early to reflect the emergence of cybercash as the next stage inthe evolution of electronic money. The internet provides a centralized andglobal network which will eventually absorb and/or replace all theautonomous fund-transfer networks set up by banks during the first phaseof money automation. E-money is about to be turned into cybercash.

Any technology-driven and innovation-rich object, such as electronicmoney or for that matter cybercash. is inherently difficult to define. Youare faced with the problem of having to describe a dynamic phenomenonwithin a comparatively static framework. This dilemma is clearly evidentin the official central bank definitions of electronic money supplied by theBIS. Those definitions always refer to three specific e-money variantswhich at the time had already emerged as coexisting alternatives, butwhich also represent different stages in the leap from electronic moneyto cybercash.

Electronic Money 13

interdisciplinary fashion than is customary among my colleagues in theeconomics profession.

Economists offer only limited help in clarifying our understanding ofmoney. Most of them analyze money as just another good, albeit oneendowed with unique demand and supply functions. Alternatively, eversince Keynes (1936). some economists have viewed money as a financialasset which offers its owners liquidity and competes with other, less liquidfinancial assets, notably bonds.8 While diese two standard views of moneycontain some important differences in modeling and policy implications,they are similar in that they both treat money as an exogenous variablewhich exists alongside the rest of the economy. From this perspective, thekey problem is how much money is needed to sustain a given level ofeconomic activity. Neither the modalities of money

'

s integration into theeconomy nor the form of money are considered important issues worthy ofcloser examination. Yet these are precisely the questions which gain acertain relevance with the imminent arrival of cybercash. a new form ofdigital money circulating on the internet which, over the next decade, mayvery well come to rival the coins, paper notes, checks, plastic cards andautomated (wire or electronic) fund transfers we use today when making apayment.

The questions we are interested in. namely how money gets integratedinto our economy and why its form matters in that context, demand adifferent theoretical approach. In that alternative, money is best defined asa man-made social institution at the center of our cash-flow economy.Money occupies this strategic place, because all our principal economicactivities - exchange, production, credit - are nowadays organized asmonetary circuits:

Exchange today is almost exclusively monetary exchange, meaning theswap of a good or service for a certain amount of money fixed by itsprice. In such monetary exchange the seller earns the income which thebuyer spends.

Production involves the buying of inputs, their combining in theproduction process for creation of output, and the selling of that outputat a price exceeding costs. This activity necessitates the spending ofmoney now - for purchases of inputs - in order to make more moneylater - from the sale of output.

Credit also involves cash outlays preceding hopefully larger cashinflows. In this activity, the lender first transfers funds to the borrowerin exchange for an income-earning financial asset. Whether that claim is

Electronic Money 17

bidding procedures, as the phenomenal success of eBay suggests. Objects,which up to now have never been put up for sale, may become marketablein the online world of cybercash. Profitable selling of second-hand goods,liquidation of surplus inventories and leasing of excess productivecapacity may all be possible when you can reach millions of new potentialcustomers thanks to the internet and provide them with immediate accessto online funds. Online markets thus have the potential to widen the scopeand increase the scale of exchange, transforming in the process many hith-erto illiquid objects into Iradeable assets. The use of the internet andcybercash in the automation of the production process will transform theproducers

'

relationships with suppliers as well as customers, greatlyenhance their product development capabilities, make it easier for firms tochange their output mix on short notice, centralize cash management andstreamline the flow of production. As producers integrate the internet ever-more tightly into their operations, they will find it opening up new avenuesof capital accumulation. I am thinking here in particular of various intan-gible forms of capital which in the future may well become decisive forthe competitiveness of firms (see Chapter 7). For instance, in-house use ofthe internet, the so-called fatranet, will allow firms lo tap the knowledgebase of their employees much more effectively than has been the case sofar. Access lo cybercash will facilitate the online-automation efforts ofproducers, especially in their interactions with suppliers, customers,employees and partners. Cybercash will also transform finance by creatingmany more credit channels and spawning a variety of new financialcontracts which fund online activity.

1.4 The Dcmatonalization of Money

The long-term Impact of cybercash promises lo be far-reaching. This istrue for any new money form. To the extent that new forms of money alterthe monetary process of its creation, insertion and circulation, they willtrigger corresponding changes in the organization of exchange, productionand credit. Even a cursory look at the historic evolution of money, whichas a social institution is evidently subject to ongoing change, will confirmthis. In the fifteen millennia of its existence, money has undergone avariety of changes in form, and each change has brought about dramatictransformations in the ways humans organized their economy.

Agrarian money, which dominated the prehistoric period of early settle-menls. centered on a variety of commodities which communities deemeduseful and trusted because of their relatively stable value - barley, wheat,

Electronic Money 21

by exlcmal funding. After all. its growth rests on investments, an activityinvolving cash outlays now in order to earn more money later. Suchinvestment-related cash-flow gaps could henceforth be covered by auto-matic liquidity injections, with banks exiending credil and thereby vali-dating the future income-creating activities of their borrowers.uRoosevelt's monetary reforms thus gave us what Hicks (1974) character-ized as an 'overdraft economy', in effect a debt economy propelledforward by continuous debt-financing of excess spending and its partialmonetizalion through automatic liquidity injections by banks.

The debt economy made possible by the inlroduclion of credit-moneyplayed a crucial role in the postwar boom of the 1950s and 6()s:

For one, it greatly facilitated large-scale investment projects associatedwith mass production technology (that is. assembly-line plants) byfunding them amply at low-interest rates. In that sense the new mone-tary regime provided institutional support for a technological revolutionin production which had begun decades earlier when the spread of elec-tricity transfonned the way we produced manufactured goods.15

Consumers finally gained broad access to bank credit in the form ofmortgages, car loans, student loans, personal loans and credit cards.Such debt-financed consumer spending provided the needed impetus forrapidly growing consumption centered on purchases of homes, cars andother large-ticket consumer goods which provided adequate aggregate-demand support for the much enhanced supply capacity of massproduction technology.

s Being able to spread their considerable fixed costs ('overheads'

) over

large production volumes, industrial enterprises enjoyed unit-costreductions with growing output - a type of productivity gain known aseconomies of scale. But instead of being forced to match the valuereductions from such productivity gains with price reductions enforcedby overproduction conditions as happened recurrently in the era ofcommodity-money, elastic supplies of credit-money put companies in aposition to resist such downward pressure on prices and instead use theproductivity gains for increases in real wages. This change created amore stable balance between aggregate demand and supply in theeconomy which ultimately helped to sustain corporate profits moreeffectively.

Moreover, in the postwar regime of credit-money governments found itmuch easier to finance budget deficits, even chronic ones. Such

Electronic Money 25

1.6 The Emergence of Cybercash

Credit-money in the form of paper tokens, surely one of the great achieve-ments of the New Deal, is now being gradually transformed into electronicmoney. In the 1980s, banks began to experiment with emerging computerand communication technologies to benefit from the technological revolu-tion under way. Computerized payments systems, run by consortia ofcommercial banks, could move money transfers beyond the reach ofcentral banks and so undermine their control over the monetary process.Large-volume transfers between businesses were automated through anetwork of bank-operated automated clearing-houses and electronic fund-transfer technology. The banks also tried to push the electronic revolutioninto retail banking by getting households accustomed to using automatedteller machines, paying with plastic (debit or credit) cards and conductingtheir banking transactions at home on the computer.

The accelerating efforts by banks to develop electronic alternatives topaper money are nol just motivated by the desire to take advantage oflechnological progress. They are also caused by the steady erosion of thepostwar regime of slate-administered credit-money. In the next chapter wewill see how a new type of crisis, the stagflation of the 1970s and early1980s, disintegrated thai regime step by step. This process unleashed newforces - notably the deregulation of money, the securilization of credit andthe computerization of finance - which prompted banks to invest muchmore heavily in electronic money and banking.

Electronic money will soon experience an imporlanl push forwardthrough its applications on the internet. In Chapter 3 we will see how thisnew medium of communication is transforming itself into a locus ofeconomic activity which demands access to online-payment facilities. E-commerce on the internet drives electronic money towards cybercash. Thisimminent development in the history of money will give us an entirelynew type of money, one even more immaterial than paper. Its intangibilityas something existing only virtually, as a flow of data over computernetworks, will shift the emphasis of public trust from confidence in banksas third-party intermediaries making good on the promise to pay to thetechnology of fund transfers and nonbank players getting involved in themonetary process.

The Monetary Regime in Transition 33

aboul a particular currency become sufficiently homogenized, these actorscan easily launch massive attacks against the suspect currency and so turntheir widely shared expectations into a self-fulfilling prophecy. In the late1960s, the euromarket had evolved into a devaslatingly efficient networkfor speculative attacks on the dollar and other overvalued currencies. Itwas ultimately the collection of players operating in the euromarket whoseconcerted and repealed runs oul of the dollar forced Nixon

'

s suspension ofdollar-gold convertibility on 15 August 1971. the beginning of the end forthe postwar monetary regime.

When the system of fixed-exchange rates broke down in the early1970s, most economists and politicians hoped that the advent of flexible-exchange rates would remove external imbalances more rapidly whileallowing central banks to focus their monetary policy on domestic condi-tions rather than defending fixed-exchange rales. But the reality turnedoul to be quite different. While giving the world economy much neededflexibilily to absorb exogenous shocks (as in the case of OPEC's oil-pricehikes), market-determined exchange rates have also turned currenciesinto an irresistible object of speculalion. Widespread currency speculationhas in turn fed trading volumes in the foreign-exchange market, theworld

'

s largest market, where national currencies are nowadays traded in

massive quantities like commodilies for short-term capital gains (oravoidance of capital losses).7 This huge market operates with its ownprivate payments system, known as CHIPS (clearing house interbankpayments system) and based in New York, which is seamlessly connectedto both the euromarket

'

s SWIFT and the Fed'

s domestic paymentssystems (for example Fedwire).

Currency speculation, which has become a major profit center oftransnational banks and multinational corporations, has proven fairlydisruptive/ This activity has contributed to a great deal of currency-pricevolatility which disrupts trade patterns, increases transaction costs(because of the need for hedging) and exacerbates price risk to the detri-ment of long-term investments. Once speculative anticipations concerningan apparently overvalued currency have homogenized sufficiently totrigger a sell-off of that currency, the quantities of funds mobilized in suchan atlack have usually far outweighed the relatively meager foreign-exchange resources of central banks. While speculators do force exchangerales lo realign in ihe desired direction, ihey overdo such readjustments. Acurrency, which may need a devaluation of, say. 20 percent, can easily lose50 percent in the wake of such a concerted attack. The overshootingtendency is unrortunaiely reinforced by the perverse J-curve effect

The Monetary Regime in Transition 37

adjustable-Fate loans upwards whenever deposit rales rise. In addilion.borrowers face much greater price risk from variable-rate loans than theyused lo when most of their loans still earned fixed rates. User cosls associ-

ated with deregulaled paper money have also gone up significantly duringthe last iwo decades. Ceilings on bank deposits had operated like a govern-Dient subsidy lo banks, giving those institutions cheap access lo thenation

'

s savings. Once these ceilings (set by the Fed under Regulation Q)had been phased out and banks had lost this hidden subsidy, they began toprice the use of checks and other fund-lransfer services explicitly.imposing a variety of service charges, user fees and minimum-balancerequirements on the public to the chagrin of many.

It is this increasing social cost of private bank money in paper formwhich has opened the door for cheaper and more efficient money alterna-tives to emerge. Thanks to its progressive deregulation, paper-basedcredit-money has in recent years ended up imposing higher interestburdens, greater credit risk and substantial user fees on its users. In addi-lion to these cosls ihe very reliability of paper money has become ques-tionable in Ihe aftermath of ihe terrorist attacks on the United Slates duringthe fall of 2001. Facing first the shutdown of ihe entire domestic air trafficsystem ordered by the US government on II September 2001 and thenanthrax-laced letters causing havoc with mail delivery, US corporationssuddenly had to face Ihe possibility thai they would not be able lo pay theirbills or gel paid on lime. The traditional payment method of sendingchecks through the mail and using planes for their delivery suddenlylooked vulnerable to massive disruption. The combination of terroristattacks has dramatically accelerated efforts by suddenly security-mindedcorporate managers to develop online paymenl-and-billing facilities as amore reliable alternative lo paper money.11 As paper money becomesincreasingly costly and risky, the search for a better money alternative inthe form of cybercash intensifies.

Any such change in money form comes about only slowly, however,since the public gels very vested in whatever it has been using traditionallyas money. In lighl of their deep roots, existing money forms do nol getreplaced easily. New money forms can only succeed if they manage togain public acceptance because of obvious advantages in terms of conve-nience. safety, speed, anonymity, cost and trustworthiness. Still, thoseadvantages are more readily acknowledged when the existing money form

has begun to exhibit some obvious drawbacks, as has happened in recentyears with paper money.

The Monetary Regime in Transition 41

"real*

interest rates, further deregulation of finance as well as certain keyindustries (as a catalyst for massive merger-driven restructuring in thosesectors to boost stock-market valuations), privatization of public-sectorenterprises (as yet anolher boost for the slock market), and lax benefits forfinancial investment portfolios (including capital-gains lax reduction andexpansion of tax-shellered inveslmcnl vehicles). Those upwardly mobileinvestors are a global phenomenon. Already in the United Stales theycomprise in excess of 50 million households. They are also growingrapidly in other industrial nations and some larger emerging-marketeconomies (for example Brazil, and Mexico).

The proliferation of tinancial investors among the general populationposes a threat to traditional banking, a situation which will make thecoming battle over the control of cybercash that much more significant. Asmore and more of the nation's savings has been routed through mutualfunds and pension funds rather than bank deposits, these so-called institu-tional investors have grown very rapidly and poured huge amounts offunds into the world's slock and bond markets. The securilizalion of credit

has also benefited investment banks which specialize in market-makingactivities such as the brokerage, trading and underwriting of securities.The impressive expansion of these nonbank institutions heavily involvedin the securities markets has come at the expense of banks (see Table 2.1).

In the face of such market-share erosion commercial banks have decided

to join the trend of credit securilizalion. They have begun to repackage loansinto marketable securities (for example mortgage-backed securities).supplied securities markets with credit (for example broker loans), diversi-

fied into investment banking or instiluiional investment activities andexpanded their securilies portfolios. These activities provide banks with feeincome and commissions, more stable sources of income than the often

volatile profits from interest-spreads between bank deposits and loans.Banks have also participated actively in the credit securiti/ation trend as

counterparties lo trades in derivatives which industrial corporations andfinancial institutions use to manage the price risk of their portfolios. Havingbecome exposed to renewed price volatility in the financial marketsfollowing the deregulation of exchange and interest rales, investors havemade increasing use of new hedging instruments shielding them from suchprice risk. These instruments are called derivatives, because their value islinked to some underlying financial instrument such as currencies, bonds,or slocks. They can be traded in special markets, as is the case with futuresand options, or they can be specifically customized for individual portfo-lios. such as swaps or collars. These derivatives have become an essentialingredient for any large investor's risk-management strategy. While used

The Monetary Regime in Transition 45

promise lo be the more attractive market model when compared to tradi-tional slock exchanges, promising faster trades, lower costs, greater trans-parency. fewer means for brokers to exploit customers and more extensiveinnovation.

The Big Board and NASDAQ have already begun to see their brokeragecommissions and dealer profits get squeezed by the new electronic start-ups. When in 1999 the SEC authorized OCNs to turn themselves frommere trading systems into fully fledged exchanges, a step already taken bytwo of the leading networks (Archipelago and Island), both the NYSE andthe NASDAQ decided that the time had come lo respond to this compet-ition. Their response was not least triggered by growing engagement oftheir exchange members in online trading and ECNs. Both marketsdecided to turn themselves from member-controlled, nonprohl institutionsinto shareholder-controlled, for-protit organizations by going public. Thisstep might help to secure the loyalty of their largest members by turningthem into shareholders and facilitate needed organizational reforms whichso far had always fallen victim to arcane membership politics. Sharesissued by the exchanges could also be used as currency with which toacquire software firms that can automate the processing of orders, mergewith other exchanges, set up their own ECNs for after-hours trading, orinvade each other's turf of listed slocks.

But this proliferation of for-profit exchanges also poses a regulatorychallenge to the SEC. Such for-profit exchanges may be less capable ofself-regulation in the light of conflicts of interests and profil pressures,thus requiring greater supervisory capabilities by the SEC. Having lo dealwith regulatory inequality belween the traditional exchanges and the newECNs. the SEC will also have to develop a unified regulatory frameworkfor all exchanges which befits the markets of the future. In this regulatoryoverhaul the SEC will need Co find ways that encourage integration ofdifferent markets in order lo counter liquidity-eroding market fragmenta-tion. Eventually, say by 2015. there may be only three to four distinctstock exchanges left worldwide, each probably specializing in a specificcategory of stocks.13

Such market integration is already being fostered by two significantcomputer-based innovations. Soon the largest online brokers and trailersare all going to use

'

intelligent order routing" software which scans all theexchanges. ECNs and market-makers for the best combination of price,order size, speed and transaction costs. Moreover, some of ihe world

'

s

largest securities-processing firms and IT companies, grouped together inthe Global Straight Through Processing Association, are currently devel-oping a seamless electronic network, called a 'transaction-flow monitor

'

Contents

List of Figures and Tables ix

Preface x

Acknowlec/gments xi

List ofAhhreviatioris xiv

Part I Money and the Internet I

Chapter I Electronic Money 3.1 The Beginnings of Electronic Money 4.2 Defining Cybercash 9.3 Money as Social Institution 12A The Dematerialization of Money 17.5 The Dual Nature of Money 22.6 The Emergence of Cybercash 25

Chapter 2 The Monetary Regime in Transition 262.1 Stagflation Crisis 272.2 The Deregulation of Paper Money 3123 Securitization of Credit 38

2A Computerization of Finance 432

.5 Online Banking 50

Chapter 3 The Internet Revolution 563.1 Birth of the Internet 57

3.2 The Dot-com Crash 65

3.3 Restructuring the Internet 70

3.4 The Internet as Payment Sphere 81

Part II The Complexities of Cybercash 83

Chapter 4 Money as Software 854.1 The Properties of Cybercash 87

4.2 Privacy Concerns 89

4.3 Safety Concerns 94

4.4 The Control of Cybercash 101

4.5 High-tech Money 106

vii

The Monetary Regime in Transition 49

ilive ones among iheiii have thrived on enhanced product development.Successful online intermediaries, such as Schwab or E Trade. have devel-

oped very attractive mulli-producl packages for their subscribers whichcombine securities tradhi'i, information access, mutual funds, credit lines

and traditional banking services (that is, cash management, checkingaccounts) into one integrated account. The era of online linancial super-markets is dawning upon us.16

The movement towards online financial supermarkels is driven by start-ups. like E*Trade, or, as in the case of Schwab, by older nonbank institu-tions remaking themselves online. Thus the trend has the potential ofbypassing traditional 'brick-and-mortar" banks altogether. Indeed, nothinghas been more threatening to traditional commercial banking than theemergence of electronic information technologies. As half of the worldgels hooked up to computer networks, the banks have in one swoop losttheir information monopoly concerning ultimate lenders and borrowers(especially corporations) which for so long had justified their central posi-tion as intermediaries in credit relations. Corporations and other borrowerscan now transmit extensive information about themselves via computers toa global audience ready lo place its daily bets in the world

'

s financial

markets. It is fair to say that this fundamental change in the collection andcontrol of linancial information explains much behind the gradual replace-ment of bank loans by marketable securities. After having lost a lot of theirprimary lending business to (increasingly automated) securities markets.the banks now face a challenge on the retail front from the likes ofE*Trade offering customers the full range of banking services online.

We have seen the banks respond to the threat of credit securitization byjoining the trend themselves, a response made easier now in the UnitedStales with the passage of the Financial Services Modernization (Gramm-Leach-Bliley) Act of 1999. This law removed the regulatory barriersimposed on bank activity by the Glass-Steagall Act of 1933 to allow theintegration of commercial banking, investment banking and insurance. Inthe same vein, we can expect banks lo take on the challenge of computer-ization by integrating the new technology into their own operations. Overthe last fifteen years electronic technology has penetrated and. in theprocess, transformed nearly all banking activities. Witness the prolifer-ation of private automated payments services and electronic fund-transfersystems (for example ihe SWIFT system used by banks in the euromarket)which pose a competitive and regulatory threat to the once-secure govern-ment monopoly in this vital arena of our cash-flow economy, the paymentssystem. Banks have also used electronic lechnology to offer their clientsnew types of services (for instance cash management or investment

The Monetary Regime in Transition

Royal Bank of Canada which has since narrowed its focus io so-called'private-label

'

banking services offering customers access to a widevariety of mutual funds, investment advice and insurance products undercontractual arrangements with the providers of such services. Tieback,America's largest inlernel-only bank, was acquired by E Trade in June1999 which six months later bought the nation's largest independentnetwork of ATMs to move beyond a sole reliance on online banking. AndBank One abandoned its online-banking subsidiary Wingspan.com onlynine months after its launch.

Why did these first forays into online banking prove so short-lived? Ittakes a lot of effort and time for any new bank to build trust and loyalty.and internet banks are no different in that regard. Perhaps those earlyonline banks faced an even more daunting task than your traditionalbrick-and-mortar bank. Their growth potential depends on how manyhouseholds are willing to move their banking activity online, and eventoday in the United States this number is not more than 3 percent of retailhanking customers. Americans by and large still do not trust the privacyand safely protections of online banking sites. And they are often reluctantto change long-standing behavior in record-keeping brought about by thepaper-less environment of electronic banking. Slow membership growthcombined with thin operating margins to make the minimum capital levelrequired by regulators difficult to reach for online banks. The resultingdecline in their stock-market valuation made the capitalization task ofthose banks even more daunting and turned them into cheap takeovertargets for anyone wishing to expand their online banking capabilities.

The failure of early online banking has not kept traditional banks fromaccelerating their efforts in that direction. Take, for example. Citibank. In1998 its e-CITl unit lost $142 million, mostly due to costly advertising,research and development of internet-based financial-services products. InAugust 1999 America's largest bank decided to phase out Cili t/i, a retailbank and brokerage unit reachable only on the internet, which hadattracted scant consumer interest. In the face of these disappointments,Citibank's management decided to reorganize its online efforts. Its come-back plans rest on a new full-service online site offering customers a widearray of investing, banking and insurance services.18 With MyCiti.comoffering already a glimpse into the future of (online) one-stop banking,other banks are not far behind. Early converts to online banking, such asthe Bank of America, Wells Fargo and Chase, each have more than twomillion online customers. Banks in Europe, where the introduction of asingle currency has created an opportunity to establish an integrated andlarge market for universal banking, are also aggressively pursuing online

List of Figures and Tables

Figures

2.1 Income erosion and borrowing binge, 1966-79 28

Z2 Credit crunches of US commercial banking, 1965-81 302

.3 US real (inflation-adjusted) interest rates, 1977-93 36Z4 US corporate funding preferences 38

Tables

I.I Noncash payment types. United States 4

2.1 Total financial assets of US financial institutions (in $bn) 42

5.1 Summary of first-gene ration cybercash experiments, 1994-96 118

5.2 Summary of second-generation cybercash experiments, 1997-2000 132

5.3 Summary of third-generation cybercash experiments, 2000-02 142

ix

Preface

Invitation to a Voyage

Attention readers! This book is importanl!Robert Gutlmann's Cyben ash is important because it deals with an

ensemble of '

major"

innovations capable of triggering a powerful wave ofchange. These innovations concern money - arguably the insiiluiionthrough which our social ties manifest themselves in a most consistent andindispensable fashion. The book thus analyzes innovations which, in alllikelihood, will profoundly affect all aspects of social life.

As the author reminds us. money possesses a 'public' dimension beyondits private usage by all of us. We value it and use it only because collec-tively we know with cerlainly that everyone else will consider it as goodas does each one of us. Thus, changing the form of this link by introducingnew intermediaries in acts of exchange means transforming social lifeitself. With cybercash - the new type of money that circulates on theinlernet in several forms - this is precisely what we get: a revolution in thesupport structure of market exchanges and even in the dynamic of theexchange process itself.

Robert Gutlmann deserves to be thanked for having given us thisdetailed and precise analysis of the birth of a new type of money - its firstforms, its first uses - and for having accomplished this task in such aprofound, yet thoroughly readable fashion. He dissects with care the newbusiness models of online firms such as Yahoo!. eBay. or E Trade, andelaborates on the reasons why these firms fascinate us as harbingers of thefuture. With the same sharp edge he analyzes Ihe failures, the victims of thee-crash. Under the direction of Robert Guttmann this constantly shiftingand sometimes strange world of the inlernet is rendered intelligible andtransparent. He presents a radical innovation, in the Schuinpeterian senseof triggering powerful waves of 'creative destruction

"

, as if it were a riddle

in a detective story whose resolution he guides us to step by step.

Preface xi

A key meril of the book lies precisely here, in the way its authoranalyzes the microeconomics of internet-based actors, in particular thoseengaged in online linancial transactions and services. He examines in greatdetail three generations of cybermoney (Chapter 5), both in their suenglhsand weaknesses. While at the moment blocked, these monetary innov-ations are bound to develop and expand a great deal over the next coupleof decades because they have given birth to new concepts and models.Take, for example. Flooz or Beenz. both truly private monies put intocirculation by e-enlerprises and used by millions, which could not with-stand the storm of the dot-com crash of 2000-01. A second importantdimension of the book is to have pushed this microeconomy. in the contextof the birth of cybercash. all the way to the macroeconomic problemswhich that new money form will undoubtedly bring in its wake. The bookfocuses in particular on problems of monetary policy, mostly related to thesetting of interest rates and control over the money supply, as well as onthe problem of risk managemeni. Both types of problem threaten towrong-foot the central banks themselves by eventually shattering themaladjusted policy instruments currently in use.

Gutlmann's key argument, developed throughout the book, is that on theinternet we find not only linns using stored money and those hooked up tothe banks online, but also we find true issuers of cybercash, creators ofmoney and loans, willing to place their bets on security porllbiios and toprotect their risk exposure across the entire spectrum of derivatives. If theycan manage to overcome the disadvantage of their late entry in tenns ofreverse network externalities, these new financial operators have seriouseconomic arguments as to why they should enter into competition withbanks and the traditional credit card companies. That development isentirely rooted in the monetary history of the last two decades. Financialderegulation, the automation of payments and die securilization of credithave already prepared us at lengdi for the arrival of electronic money. Theirresistible spread of the internet has created the locus where this newmoney will inevitably grow and progress. Both the money creationmonopoly of the banks and the Fed

'

s control over the payments system arethus bypassed, threatened and rendered less efficient, a fact that will pushus towards a reform of the public policy apparatus dealing with themanagement of money.

From the micro-phenomenon of online money used or created betweeninternet-based actors - already appearing in different forms within the P2P.B2C and B2B segments of e-commerce - the author derives a macro-economic dimension. He sees the integration of money and finance on the

xii Preface

intcrnel feeding the formation of ficlilious capital on a very large scale.The lessons of the e-crash. briefly but brillianlly analyzed in Chapter 3. arewell presented. They pervade the entire book ensuring that it never sinksto the level of simplistic, oracle-like announcements.

The final part of the book, comprising Chapters 7 and 8. lakes aforward-looking view that is strongly optimistic about the ability of cybcr-cash to find a large number of socially useful applications in the world ofexchange and production. Thai projection closes, however, with ananalysis of the collapse of Enron, presented here not as 'the imperfectchild of an otherwise healthy sysiem

'

. but more likely as 'the perfect childof an unhealthy system

"

. All this makes the point lhal the potentialembodied in cybercash does not develop spontaneously or automatically.Whether it concerns security and privacy (two issues crucial lo its devel-opmenl, as argued forcefully in Chapter 4). risk management or controlover money creation, cybercash gives rise to difficult and generic prob-lems in the form of qualitatively new market failures that only the visiblehand of the government as regulator can confront effectively. Policymakers will gradually develop responses to these challenges. The last partof the book lhal is dedicated to the 'internet-based economy* will captivatethe reader. Describing a combination of opportunities and major risks -qualilied here as systemic - which arise oul of the fusion between moneyand the internet, it gives us a sense of tomorrow

'

s economy.Therein lies one of the mosi fascinating aspects of this book. Through

the analysis of cybercash the author introduces the reader to a veritablesocial history of capitalism. A voyage not only through those nanosecondsin which cybercash moves through huge electronic networks connectingfinancial operators across the world, but also through those long periodsduring which the complex social forms and institutions underlying mone-tary exchange evolve.

In short, a captivating book on a topic of major importance, written witha level of care and knowledge that is a credit to the author. A book whosequality, density and novelty of information presented provokes reflection.

Benjamin Cokiat

(Professor of Economics. University Paris-Nord)Sarlene, Corsica

Acknowledgments

While this book is very much the product of my own thinking, il wouldhave never been written without the input of many friends and colleagues.I would like to thank in particular Francois Chcsnais. Suzanne De Brun-hoff. Martin Kenner. Pascal Petit. Dominique Plihon. Dominique Perrut.Slcphan Schulmeistcr and Claude Serfaty For their valuable help andpatient advice. My thanks extend also to the organizers of the ColumbiaUniversity Seminar. Hofstra University's Economics Club, the ARC2Seminar at CEPREMAP (Paris), and the Faculty Seminar at UniversityParis-Nord for giving me the opportunity of presenting various aspects ofthis book. Finally, I wish to express my gratitude to Stephen Rutt, myeditor at Palgrave Macmillan. for his support and insights.

The author and publishers wish to thank the Federal Reserve Bank ofKansas City for permission to use Table 1.1.

Every effort has been made to trace all the copyright holders but if anyhave been inadvertently overlooked the publishers will be pleased to makethe necessary arrangements at the lirsl opportunity.

xiii

Chapter I

Electronic Money

Ever since its inception about 15.000 years ago. money has been subject toongoing change - both in its form and modus operandi. Such changes havein turn typically brought about major transformalions in the functioning ofour economy. Given money

'

s strategic position in the organization ofeconomic activities, it Is not surprising to see changes in the monetaryprocess having major repercussions for exchange, production and credil.This is especially true when new money forms rise to the fore.

Today we face precisely such a siluation wilh (he shift from papermoney to electronic money. Having gradually replaced central bank notesand bank checks with plastic cards, electronic fund transfers and auto-mated clearing-houses, the world is now readying itself for the next step inthe automation of money. Electronic commerce conducted on the internetis bound to spur a variety of online-payment mechanisms, and such cyber-cash may very well multiply the uses of the internet as marketplace, inproduction, and for financial transactions. We are at the threshold of a newindustrial revolution, fuelled by (he proliferation of digital-money forms.That revolution and the role of cybercash in it are the subject of this book.

We begin our exploration in this opening chapter with a closer look atthe phenomenon of electronic money. First we examine how the penetra-tion of computer and communication technologies in banking has alreadytransformed the way we handle money and make payments {section i.l).Having thus set the stage for further automation of the monetary process,banks are now using the emergence of the internet as a launching pad forcybercash as the ultimate form of electronic money. Given its hetero-geneity. high-lech features and immaterial nature, cybercash promises tobe radically different from any other form of money we have knownheretofore. As such it deserves being defined as a qualitatively new moneyform (section 1.2). The far-reaching implications of a change in money

4 Cybercash

form can only be fully appreciated if we conceptualize money as a socialinslitulion central to the organization of economic activities (section 1.3).Such a theoretical grounding enables us to identify the historic evolutionof money as one of its progressive demateriali/ation (section 1.4) and totake a closer look at money

'

s contradictory nature as a key factor behindchanges in its form (section 1.5). The chapter ends with a brief look at theemergence of cybercash and the driving forces underlying its proliferation(section 1.6).

1.1 The Beginnings of Electronic Money

Today about half of all the transactions in the US economy are still paidfor in cash (currency bills and coins). The other half involves noncashtransactions of which about 70 percent involve payment by check. Whileaccounting for only 30 percent of noncash transactions, electronic-payment methods involving credit cards, debit cards, wire transfers andautomated clearing-houses (ACHs) have been growing much more rapidlythan the number of transactions conducted by cash or check (seeTable LI).

Traditional forms of paper money still offer users certain unique advan-tages. For instance, cash ensures anonymity which makes it the moneyform of choice for lax evasion and illegal activities, such as drug traf-ficking. Cash denominated in 'hard' currencies is also popular in placeswhere the local currency is not trusted (for example dollars in LatinAmerica or euros in Russia). Access to cash has been bolstered greatly hythe dramatic increase in automated teller machines (ATMs) whose number

has tripled in the United States over the last decade from 75.000 terminals

Table LI Noncash payment types. United States

Type Number of Average annual Share of Share of

transactions growth (1993-97) total (1993) total (1997)(billion, 1997) % % %

Checks 66.09 2.3 79.1 111

Credit cards 16.88 7.8 16.4 18.4

Debit cards 3.91 53.3 0.9 4.

3

ACH 4.55 15.5 3

.4 5

.0

Wire transfer 0.15 7.3 0

.1 0

.2

Scarce. Weiner 1999. p. 55). By permission