ELECTRONIC PAYMENT SYSTEM
Electronic Payment Systems
Electronic payment is an integral part of electronic commerce.
Broadly de-fined, electronic payment is a financial exchange that takes place online be-tween buyers and sellers. The content of this exchange is usually some form of digital financial instrument (such as encrypted credit card numbers, elec-tronic checks, or digital cash) that is backed by a bank or an intermediary, or by legal tender. Three factors are stimulating interest among financial in-stitutions in electronic payments: decreasing technology costs, reduced op-erational and processing costs, and increasing online commerce.
The desire to reduce costs is one major reason for the increase in elec-tronic payments. Cash and checks are very expensive to process, and banks are seeking less costly alternatives. It is estimated that approximately 56 percent of consumer transactions
in the United States are cash and 29 per-cent are check. Credits, debits, and other electronic transactions account for about 15 percent of all consumer transactions, and are expected to increase rapidly. Electronic transactions numbered 33 billion in 1993 and are ex-pected to climb to 118 billion by the year 2000. For the same period, paper transactions are forecast to show very modest growth, from 117 billion in 1993 to 135
billion in the year 2000. Banks and retailers want to wean customers away from paper transactions because the processing overhead is both labor intensive and costly.
The crucial issue in electronic commerce revolves around how con-sumers will pay businesses online for various products and services. Currently, consumers can view an endless variety of products and services offered by vendors on the Internet, but a consistent and secure payment ca-pability does not exist. The solutions proposed to the online payment prob-lem have been ad hoc at best. For instance, in one method marketed by CyberCash, users install client software packages, sometimes known as “electronic wallets,” on their browsers. This software then communicates with “electronic cash registers” that run on merchants’ Web servers. Each vendor’s client works with only
that vendor’s own server software, a rather restrictive scenario.
Currently, merchants face the unappealing option of ei-ther picking one standard and alienating consumers not subscribing to a standard or needing to support multiple standards, which entails extra time, effort, and money.
Today, the proliferation of incompatible electronic payment schemes has stifled electronic commerce in much the same way the split between Beta and VHS standards stifled the video industry’s growth in the 1970s. Banks faced similar problems in off-line commerce in the early nineteenth century. Many banks issued their own notes, and a recurrent problem was the tendency of some institutions to issue more notes than they had gold as back-ing. Further, getting one bank to honor another’s notes was a major problem. Innovations in payment methods involved the creation of new fi-nancial instruments that relied on backing from governments or central banks, and gradually
came to be used as money. Banks are solving these problems all over again in an online environment.
The goal of online commerce is to develop a small set of payment meth-ods that are widely used by consumers and widely accepted by merchants and banks. This chapter offers a brief examination of the various types of electronic payment systems. It then provides an overview of the business, consumer, and legal implications of electronic payment systems.
Overview of the Electronic Payment Technology
Electronic payments first emerged with the development of wire transfers. Early wire transfer services such as Western Union enabled an individual to deliver currency to a clerk at one location, who then instructed a clerk at an-other location to disburse funds to a party at that second location who was able to identify himself as the intended recipient. Cash was delivered to the customer only after identity was established. In this scenario, there was no banking environment; Western Union was a telegraph company. Assurance of payment relied on the financial stability of the firm. Security was pro-vided to the
extent that Western Union was a privately controlled transmission facility used to send messages about funds transfer; its lines were not shared with the public, and transactions were private. Authentication was provided only by a signature at the other end of the transmission that veri-fied that the intended party had indeed received the funds.
During the 1960s and early 1970s, private networking technology has enabled the development of alternative electronic funds transfer (EFT) sys-tems. Electronic funds transfer systems have shortened the time of payment instruction transfer between
banks, and in the process have reduced float. However, EFT systems have not changed the fundamental structure of the payment system. Many of the so-called payment innovations over the past two decades have been aimed at minimizing
banking costs such as reserve requirements, speeding up check clearing, and minimizing fraud. However, the consumer rarely interacted with the early EFT systems. Recent innova-tions in electronic commerce aim to affect the way consumers deal with
payments and appear to be in the direction of a real-time electronic trans-mission, clearing, and settlement system.
Consumer electronic payment systems are growing rapidly, but the op-portunities are scarcely tapped. In the United States, it is estimated that only 3 percent of the $460 billion supermarket industry is transacted on credit or debit cards. Only 1 percent of
the $300 billion professional services area is transacted electronically. Less than 12 percent of business at gasoline service stations is electronic and less than 1 percent of fast food restaurants have magstripe readers. The educational market alone is more than $100 billion today, only 6 percent of which is transacted electronically. Even more important is the predicted growth ahead. Consumer payments at the point of sale were $3.6 trillion in 1994, 19 percent of which was on credit and debit cards [F09S].
Recently, several innovations helped to simplify consumer payments. These include:
• Innovations Affecting Consumers: Credit and debit cards, automated teller machines (ATMs), stored-value cards, and electronic banking.
• Innovations Enabling Online Commerce: Digital cash, electronic checks, smart cards (also called electronic purses), and encrypted credit cards.
• Innovations Affecting Companies: The payment mechanisms that banks provide to corporate customers, such as interbank transfers through au-tomated clearing houses (ACHs) that allow companies to pay workers by direct deposits.
Types of Electronic Tokens
An electronic token is a digital analog of var-ious forms of payment backed by a bank or financial institution. The two basic types of tokens are real-time (or pre-paid) tokens and postpaid tokens.
Real-time tokens are exchanged between buyer and seller. Here, users prepay for tokens that serve as currency. Transactions are settled with the exchange of electronic currency. Examples of prepaid payment mechanisms are digital cash, debit cards, and electronic purses that store electronic money (such as Mondex Electronic Money Card).
Settlement or postpaid tokens are used with funds transfer instructions being exchanged between buyer and seller. Examples of postpaid mecha-nisms are electronic checks (such as NetCheck and NetBill), encrypted credit cards (Web form-based encryption), and third-party authorization mechanisms (such as First Virtual, which is an online intermediary).
Evaluating Various Electronic Token-based Methods
Before examining the specifics of each type of payment instrument, we will discuss the fol-lowing questions to help us to evaluate the various methods.
What is the nature of the transaction for which the instrument is designed?
Some tokens are specifically designed to handle micro payments, or pay-ments for small snippets of information (such as five cents for a file). Some systems target specific niche transactions;
others seek more general transac-tions. The key is to identify the parties involved, the average amounts, and the purchase interaction.
What is the means of settlement used?
Tokens must be backed by cash, credit, electronic bill payments (prearranged and spontaneous), cashier’s checks, letters of credit, or wire transfers. Each option incurs trade-offs among transaction speed, risk, and cost. Most transaction settlement meth-ods use credit cards, while others use other tokens for value, effectively cre-ating currencies of dubious liquidity and with interesting tax, risk, and float implications.
What is the payment system’s approach to security, anonymity, and authen-tication?
Electronic tokens vary in the protection of transaction privacy and confidentiality. Encryption can help with authentication, non reputability, and confidentiality of information.
Who assumes what kind of risk at what time?
Tokens might suddenly be-come worthless because of bank failure leaving customers with currency that nobody will accept. If the system stores value in a smart card, consumers may be exposed to risk as they hold static assets. Further, electronic tokens might be subject to discounting or arbitrage. If the transaction has a long lag time between product delivery and payment to merchants, there is a risk to mer-chants that buyers will not pay, or to buyers that the vendor will not deliver.
Electronic or Digital Cash
Electronic or digital cash combines computerized convenience with security and privacy that improve on paper cash. The versatility of digital cash opens up a host of new markets and applications. Digital cash attempts to replace paper cash as the principal payment vehicle in online payments. Although it may be surprising to some, even after thirty years of develop-ments in electronic payment systems, cash is still the most prevalent con-sumer payment instrument. Cash remains the dominant form of payment for three reasons: lack of consumer trust in the banking system; inefficient clearing and settlement of noncash transactions; and negative real interest rates on bank deposits.
These reasons behind the prevalent use of cash in business transactions indicate the need to re-engineer purchasing processes. In order to displace cash, electronic payment systems need to have some cash-like qualities that current credit and debit cards lack. For example, cash is negotiable, mean-ing that it can be given or traded to someone else. Cash is legal tender, meaning that the payee is obligated to take it. Cash is a bearer
instrument, meaning that possession is proof of ownership. Cash can be held and used by anyone, even those without a bank account. Finally, cash places no risk on the part of the
acceptor; the medium is always good.
In comparison to cash, debit and credit cards have a number of limita-tions. First, credit and debit cards cannot be given away because, techni-cally, they are identification cards owned by the issuer and restricted to one user. Credit and debit cards are not legal tender, given that merchants ‘have the right to refuse to accept them. Nor are credit and debit cards bearer in-struments; their usage requires an account relationship and authorization
system. Similarly, checks require either personal knowledge of the payer, or a check guarantee system. A really novel electronic payment method needs to do more than recreate the convenience that is offered by credit and debit cards; it needs to create
a form of digital cash that has some of the proper-ties of cash.
Properties of Electronic Cash
Any digital cash system must incorporate a few common features. Specifically, digital cash must have the following four properties: monetary value, interop-erability, retrievability, and security (KALA96].
Digital cash must have a monetary value; it must be backed by cash (currency), bank-authorized credit, or a bank-certified cashier’s check. When digital cash created by one bank is accepted by others, reconciliation must occur without any problems.
Without proper bank certification, digi-tal cash carries the risk that when deposited, it might be returned for insuf-ficient funds.
Digital cash must be interoperable, or exchangeable as payment for other digital cash, paper cash, goods or services, lines of credit, deposits in banking accounts, bank notes or obligations, electronic benefits transfers, and the like. Most digital cash proposals use a single bank [MN93]. In prac-tice, not all customers are going to be using the same bank or even be in the same country, and thus multiple banks are necessary for the widespread use of digital cash.
Digital cash must be storable and retrievable. Remote storage and re-trieval (such as via a telephone or personal communications device) would allow users to exchange digital cash (withdraw from and deposit into bank-ing accounts) from home or office or while traveling. The cash could be stored on a remote computer’s memory, in smart cards, or on other easily transported standard or special-purpose devices. As it might be easy to cre-ate and store counterfeit cash in a computer, it is preferable to store cash on an unalterable dedicated device. This device should have a suitable inter-face to facilitate personal authentication using passwords or other means, and a display for viewing the card’s contents.
Digital cash should not be easy to copy or tamper with while it is be-ing exchanged. It should be possible to prevent or detect duplication and double-spending of digital cash. Double spending, the electronic equiva-lent of bouncing a check, is a particularly tricky issue [DFN88]. For in-stance, a consumer could use the same digital cash simultaneously to buy items in Japan, India, and England. It is particularly difficult to prevent double-spending if multiple banks are involved in the transactions. For this reason, most systems rely on post-fact detection and punishment.
Electronic Payment Systems
Electronic payment is an integral part of electronic commerce.
Broadly de-fined, electronic payment is a financial exchange that takes place online be-tween buyers and sellers. The content of this exchange is usually some form of digital financial instrument (such as encrypted credit card numbers, elec-tronic checks, or digital cash) that is backed by a bank or an intermediary, or by legal tender. Three factors are stimulating interest among financial in-stitutions in electronic payments: decreasing technology costs, reduced op-erational and processing costs, and increasing online commerce.
The desire to reduce costs is one major reason for the increase in elec-tronic payments. Cash and checks are very expensive to process, and banks are seeking less costly alternatives. It is estimated that approximately 56 percent of consumer transactions
in the United States are cash and 29 per-cent are check. Credits, debits, and other electronic transactions account for about 15 percent of all consumer transactions, and are expected to increase rapidly. Electronic transactions numbered 33 billion in 1993 and are ex-pected to climb to 118 billion by the year 2000. For the same period, paper transactions are forecast to show very modest growth, from 117 billion in 1993 to 135
billion in the year 2000. Banks and retailers want to wean customers away from paper transactions because the processing overhead is both labor intensive and costly.
The crucial issue in electronic commerce revolves around how con-sumers will pay businesses online for various products and services. Currently, consumers can view an endless variety of products and services offered by vendors on the Internet, but a consistent and secure payment ca-pability does not exist. The solutions proposed to the online payment prob-lem have been ad hoc at best. For instance, in one method marketed by CyberCash, users install client software packages, sometimes known as “electronic wallets,” on their browsers. This software then communicates with “electronic cash registers” that run on merchants’ Web servers. Each vendor’s client works with only
that vendor’s own server software, a rather restrictive scenario.
Currently, merchants face the unappealing option of ei-ther picking one standard and alienating consumers not subscribing to a standard or needing to support multiple standards, which entails extra time, effort, and money.
Today, the proliferation of incompatible electronic payment schemes has stifled electronic commerce in much the same way the split between Beta and VHS standards stifled the video industry’s growth in the 1970s. Banks faced similar problems in off-line commerce in the early nineteenth century. Many banks issued their own notes, and a recurrent problem was the tendency of some institutions to issue more notes than they had gold as back-ing. Further, getting one bank to honor another’s notes was a major problem. Innovations in payment methods involved the creation of new fi-nancial instruments that relied on backing from governments or central banks, and gradually
came to be used as money. Banks are solving these problems all over again in an online environment.
The goal of online commerce is to develop a small set of payment meth-ods that are widely used by consumers and widely accepted by merchants and banks. This chapter offers a brief examination of the various types of electronic payment systems. It then provides an overview of the business, consumer, and legal implications of electronic payment systems.
Overview of the Electronic Payment Technology
Electronic payments first emerged with the development of wire transfers. Early wire transfer services such as Western Union enabled an individual to deliver currency to a clerk at one location, who then instructed a clerk at an-other location to disburse funds to a party at that second location who was able to identify himself as the intended recipient. Cash was delivered to the customer only after identity was established. In this scenario, there was no banking environment; Western Union was a telegraph company. Assurance of payment relied on the financial stability of the firm. Security was pro-vided to the
extent that Western Union was a privately controlled transmission facility used to send messages about funds transfer; its lines were not shared with the public, and transactions were private. Authentication was provided only by a signature at the other end of the transmission that veri-fied that the intended party had indeed received the funds.
During the 1960s and early 1970s, private networking technology has enabled the development of alternative electronic funds transfer (EFT) sys-tems. Electronic funds transfer systems have shortened the time of payment instruction transfer between
banks, and in the process have reduced float. However, EFT systems have not changed the fundamental structure of the payment system. Many of the so-called payment innovations over the past two decades have been aimed at minimizing
banking costs such as reserve requirements, speeding up check clearing, and minimizing fraud. However, the consumer rarely interacted with the early EFT systems. Recent innova-tions in electronic commerce aim to affect the way consumers deal with
payments and appear to be in the direction of a real-time electronic trans-mission, clearing, and settlement system.
Consumer electronic payment systems are growing rapidly, but the op-portunities are scarcely tapped. In the United States, it is estimated that only 3 percent of the $460 billion supermarket industry is transacted on credit or debit cards. Only 1 percent of
the $300 billion professional services area is transacted electronically. Less than 12 percent of business at gasoline service stations is electronic and less than 1 percent of fast food restaurants have magstripe readers. The educational market alone is more than $100 billion today, only 6 percent of which is transacted electronically. Even more important is the predicted growth ahead. Consumer payments at the point of sale were $3.6 trillion in 1994, 19 percent of which was on credit and debit cards [F09S].
Recently, several innovations helped to simplify consumer payments. These include:
• Innovations Affecting Consumers: Credit and debit cards, automated teller machines (ATMs), stored-value cards, and electronic banking.
• Innovations Enabling Online Commerce: Digital cash, electronic checks, smart cards (also called electronic purses), and encrypted credit cards.
• Innovations Affecting Companies: The payment mechanisms that banks provide to corporate customers, such as interbank transfers through au-tomated clearing houses (ACHs) that allow companies to pay workers by direct deposits.
Types of Electronic Tokens
An electronic token is a digital analog of var-ious forms of payment backed by a bank or financial institution. The two basic types of tokens are real-time (or pre-paid) tokens and postpaid tokens.
Real-time tokens are exchanged between buyer and seller. Here, users prepay for tokens that serve as currency. Transactions are settled with the exchange of electronic currency. Examples of prepaid payment mechanisms are digital cash, debit cards, and electronic purses that store electronic money (such as Mondex Electronic Money Card).
Settlement or postpaid tokens are used with funds transfer instructions being exchanged between buyer and seller. Examples of postpaid mecha-nisms are electronic checks (such as NetCheck and NetBill), encrypted credit cards (Web form-based encryption), and third-party authorization mechanisms (such as First Virtual, which is an online intermediary).
Evaluating Various Electronic Token-based Methods
Before examining the specifics of each type of payment instrument, we will discuss the fol-lowing questions to help us to evaluate the various methods.
What is the nature of the transaction for which the instrument is designed?
Some tokens are specifically designed to handle micro payments, or pay-ments for small snippets of information (such as five cents for a file). Some systems target specific niche transactions;
others seek more general transac-tions. The key is to identify the parties involved, the average amounts, and the purchase interaction.
What is the means of settlement used?
Tokens must be backed by cash, credit, electronic bill payments (prearranged and spontaneous), cashier’s checks, letters of credit, or wire transfers. Each option incurs trade-offs among transaction speed, risk, and cost. Most transaction settlement meth-ods use credit cards, while others use other tokens for value, effectively cre-ating currencies of dubious liquidity and with interesting tax, risk, and float implications.
What is the payment system’s approach to security, anonymity, and authen-tication?
Electronic tokens vary in the protection of transaction privacy and confidentiality. Encryption can help with authentication, non reputability, and confidentiality of information.
Who assumes what kind of risk at what time?
Tokens might suddenly be-come worthless because of bank failure leaving customers with currency that nobody will accept. If the system stores value in a smart card, consumers may be exposed to risk as they hold static assets. Further, electronic tokens might be subject to discounting or arbitrage. If the transaction has a long lag time between product delivery and payment to merchants, there is a risk to mer-chants that buyers will not pay, or to buyers that the vendor will not deliver.
Electronic or Digital Cash
Electronic or digital cash combines computerized convenience with security and privacy that improve on paper cash. The versatility of digital cash opens up a host of new markets and applications. Digital cash attempts to replace paper cash as the principal payment vehicle in online payments. Although it may be surprising to some, even after thirty years of develop-ments in electronic payment systems, cash is still the most prevalent con-sumer payment instrument. Cash remains the dominant form of payment for three reasons: lack of consumer trust in the banking system; inefficient clearing and settlement of noncash transactions; and negative real interest rates on bank deposits.
These reasons behind the prevalent use of cash in business transactions indicate the need to re-engineer purchasing processes. In order to displace cash, electronic payment systems need to have some cash-like qualities that current credit and debit cards lack. For example, cash is negotiable, mean-ing that it can be given or traded to someone else. Cash is legal tender, meaning that the payee is obligated to take it. Cash is a bearer
instrument, meaning that possession is proof of ownership. Cash can be held and used by anyone, even those without a bank account. Finally, cash places no risk on the part of the
acceptor; the medium is always good.
In comparison to cash, debit and credit cards have a number of limita-tions. First, credit and debit cards cannot be given away because, techni-cally, they are identification cards owned by the issuer and restricted to one user. Credit and debit cards are not legal tender, given that merchants ‘have the right to refuse to accept them. Nor are credit and debit cards bearer in-struments; their usage requires an account relationship and authorization
system. Similarly, checks require either personal knowledge of the payer, or a check guarantee system. A really novel electronic payment method needs to do more than recreate the convenience that is offered by credit and debit cards; it needs to create
a form of digital cash that has some of the proper-ties of cash.
Properties of Electronic Cash
Any digital cash system must incorporate a few common features. Specifically, digital cash must have the following four properties: monetary value, interop-erability, retrievability, and security (KALA96].
Digital cash must have a monetary value; it must be backed by cash (currency), bank-authorized credit, or a bank-certified cashier’s check. When digital cash created by one bank is accepted by others, reconciliation must occur without any problems.
Without proper bank certification, digi-tal cash carries the risk that when deposited, it might be returned for insuf-ficient funds.
Digital cash must be interoperable, or exchangeable as payment for other digital cash, paper cash, goods or services, lines of credit, deposits in banking accounts, bank notes or obligations, electronic benefits transfers, and the like. Most digital cash proposals use a single bank [MN93]. In prac-tice, not all customers are going to be using the same bank or even be in the same country, and thus multiple banks are necessary for the widespread use of digital cash.
Digital cash must be storable and retrievable. Remote storage and re-trieval (such as via a telephone or personal communications device) would allow users to exchange digital cash (withdraw from and deposit into bank-ing accounts) from home or office or while traveling. The cash could be stored on a remote computer’s memory, in smart cards, or on other easily transported standard or special-purpose devices. As it might be easy to cre-ate and store counterfeit cash in a computer, it is preferable to store cash on an unalterable dedicated device. This device should have a suitable inter-face to facilitate personal authentication using passwords or other means, and a display for viewing the card’s contents.
Digital cash should not be easy to copy or tamper with while it is be-ing exchanged. It should be possible to prevent or detect duplication and double-spending of digital cash. Double spending, the electronic equiva-lent of bouncing a check, is a particularly tricky issue [DFN88]. For in-stance, a consumer could use the same digital cash simultaneously to buy items in Japan, India, and England. It is particularly difficult to prevent double-spending if multiple banks are involved in the transactions. For this reason, most systems rely on post-fact detection and punishment.
Electronic tokens vary in the protection of transaction privacy and confidentiality. Encryption can help with authentication, non reputability, and confidentiality of information.
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