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The Evolution of Digital Currency - MintChip

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At the Digital Money Forum London in May Marc Brule the CFO of the Royal Canadian Mint outlined the research they have been doing on the evolution of currency. He explained the need to be able to handle cash like transactions on the internet and how it might be achieved by an asset transfer model.

Electronic cash has long been the holy grail of payment systems - largely because it's the one area into which the current payment system players - PayPal, Visa, MasterCard - can expand. The properties of cash such as anonymity and immediacy without transaction fees are of course diametrically opposed to the classic credit and debit card systems for which companies have to validate the authenticity of each transaction, and because they are involved in the transactions they also have to manage disputes and chargebacks. This obviously incurs fees.

There are three ways to address a cash like electronic alternative:

Minimise the costs associated with the classical 4-Party model
Aggregate small value transactions for example in a subscription model
Remove the need for intermediaries in the individual transactions
The Royal Canadian Mint has gone for the third approach by adopting a direct asset transfer model. There are advantages and disadvantages of each approach:

The 4-Party model is commonly seen today when paying with a credit or debit card. The bank holds the consumer's account for which funds can be either pre-paid or post-paid. The bank that holds the account is called the issuer because it traditionally issues a card which allows the consumer to access their account. The consumer is called the card holder because they traditionally hold the card that gives access to the account. The merchant is the provider of goods or services to the cardholder in exchange for payment. The fourth member of the set is the merchant acquirer which is the bank or service provider that acquires the transactions for clearing and settlement within the networks of the financial institutions. In other words the acquirer has to get the funds from the issuer on behalf of the merchant.

All these various parties have costs and therefore want to charge fees for their payment services. The issuer charges an interchange fee for the costs of managing the cardholder relationship, the acquirer charges for the costs of managing the transaction (which will include an authentication and authorisation process) and the network processing costs applied by the payment operators such as Visa and Mastercard. All these fees are accumulated and get applied to the merchant, sometimes called the merchant discount fee. These fees are applied per transaction and for a small merchant may be 3% or more for a credit card transaction. Debit card transactions are usually a fixed fee per transaction.

It is obvious that this 4-P model is unlikely to be economically feasible for very low value transactions of a few dollars or less. In the real world cash dominates small value payments.

So how to reduce the cost of these 4-P model transactions? the approach adopted by the payment operators to date has been to remove the on-line authentication/authorisation step.

Effectively what the issuers are doing is taking the risk on an off-line transaction if the value is low enough (e.g $20 or less). However it is clear that there is an increased risk and only a part of the costs have been reduced. In addition you would want to minimise the risk of card fraud and at the least would want the consumer to be using a secure smart card. This is really not a place for a magnetic stripe card. From the consumers point of view there is an advantage because the issuer often has to bear part of the transaction risk under the various consumer protection laws and of course if you lose your card you don't lose your money (assuming you report it to the bank).

This still isn't going to work for transactions with a value of say less than $5 and in the virtual world of the internet there is a need to handle transactions perhaps less than $1. The ultimate test is whether you can handle a transaction of 1 cent? Not by the 4-P model.

The second approach to handling low value payments is to have some form of aggregation. What you want to do is to avoid the 4-P overheads of handling individually small value transactions. Cardis is a company that has been working on this for some time with a scheme that does effectively aggregate small transactions leading to reduced costs. They have recently announced that Austria's Raiffeisen Bank International is to use a Cardis software plug-in for low value payments in Q2 this year.

The other approach to aggregation is effectively a subscription model where you lodge funds with a service provider on a pre or post-paid relationship. What is clear is that you are effectively setting up an account with the service provider and although it is a closed system (only you and the service provider) there are still the overheads of the service provider having to authenticate the consumer requests. This part of the transaction is no different to the 4-P model and if the scheme is post-paid then there is also the risk overhead of the service provider not being paid. Apple's iTunes is effectively a subscription model. From a consumer's point of view this works with any intermediary you regularly use such as Amazon or iTunes. Can you do a 1 cent transaction? It seems unlikely because you still need to cover the overheads.

The third model where the transaction does not require intermediaries is the approach being adopted by the Royal Canadian Mint in their current R&D project. This is of course exactly analogous to the use of cash. I can make a payment to you (in the physical space) where no third party is involved in the transaction. In this case the asset is being handed from person to person. What the Mint has been working on is the ability to do this electronically in the internet world so again you can pass 1 cent from person to person.

Now of course nothing really comes for free, in the UK it has been estimated that it costs £4 Bn per year to manage cash. It is the cost of collecting it, counting it and securely distributing it between merchants, banks and consumers.

Now this is the $64K dollar question, can you electronically manage electronic cash without hidden overheads? - Let's see what happens to a 21st century approach to electronic cash.


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