Roger W. Ferguson, Jr: E-commerce: lessons learned to date
Remarks by Mr Roger W. Ferguson, Jr., Vice Chairman of the Federal Reserve Board, at the Owen
Graduate School of Management, Vanderbilt University, Nashville, Tennessee, on 14 February 2001
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I am pleased to be here with you today at Vanderbilt University. Your e-Lab and e-commerce
programs make this a particularly appropriate place to talk about the lessons that can be drawn from
developments in electronic commerce over the past several years. Governor Daane, thank you for
inviting me to speak.
The recent past has provided an excellent opportunity to observe how businesses and individuals
respond to significant technological changes. But we should also be mindful that Internet-based
commerce, in particular, is still young and unquestionably evolving. Hence, I must emphasize that
these are only preliminary observations.
Today I will touch on three main topics. First, I will explore a few early observations about the
economics of electronic commerce based on the experiences of the past few years. Second, I will talk
about payments, a key part of the country's economic infrastructure, and whether the current payment
instruments can effectively support future electronic commerce. Finally, I will briefly review some
activities that the Federal Reserve is pursuing to remove barriers to innovations in electronic payments
and commerce.
A few early lessons of e-commerce
The terms "electronic commerce" and "e-commerce" generally refer to commercial activity involving
the Internet, although they can also describe any commerce that relies primarily on electronic
exchange of information. For many entrepreneurs, e--commerce is an entirely new market opportunity,
while others see it as a versatile new channel offering opportunities to enhance existing markets.
Whatever the business case for an application of new technology, generally successful applications
have the potential to improve the lives of ultimate consumers by reducing transaction costs. Reduced
transaction costs, in turn, can broaden the array of choices, expand the size of markets, and
ultimately, through competition, improve the quality of existing goods and services.
An initial observation is that, despite the novelty of the Internet applications we see today, electronics
have been used for commercial purposes for well over a century. In the nineteenth and twentieth
centuries, installation of telegraph wires and then telephone networks created a revolution in business
communications not unlike the current e-commerce revolution, broadening markets by easing
communications between distant trading partners and reducing risks associated with slow physical
communication and transportation. In the extreme, telephone networks enabled two distant parties to
communicate interactively and in real time. Of course, there are limits to the uses of voice
communications. The advent of computers and new communications technology introduced the
opportunity to transmit vast quantities of data, as well as voice, over existing telephone networks.
The commercial prospects of combining new and existing communications technology with new
information management technology, both software and hardware, spawned the investment boom that
underpins, in part, the most recent revolution in e-commerce. But we must be careful to recognize that
the rapid evolution of modern e-commerce does not repeal the laws of economics. In fact, we see now
that economies with significant investments in information and communications technology remain
subject to occasional capital goods overhangs, which may influence macroeconomic conditions. Over
the last few months, data on orders and shipments of nondefense capital goods have provided hard
evidence of a slowdown in business spending on high-tech capital goods. Our economy is clearly
undergoing a stock adjustment to bring the supply of and demand for capital goods in some sectors
into better alignment. Importantly, measures of growth of output per hour in the second half of 2000
were sufficiently strong to suggest that the growth rate of structural productivity remains robust. This in
turn suggests that the rate of return on capital should be sufficiently attractive to foster new investment
once this stock adjustment is complete.
There are two key questions. First, when will the stock adjustment in high tech capital run its course,
and the supply and demand for capital goods return to balance? Second, when balance is restored,
what pace of investment in high tech capital goods will ensue? Unfortunately, neither question is
answerable with certainty at this stage. With respect to the duration of the stock adjustment, those who
think that the process will be protracted point to both the length of the current investment boom and
the historical experience with lengthy stock adjustments in capital goods to suggest that the period of
retrenchment will be a long one. Those who are optimistic that this phase of rebalancing will be
relatively short highlight two facts. The adjustment in capital goods ordering and production has been
relatively rapid in this cycle and modern high tech capital goods are relatively short-lived--being
depreciated in many cases in three years or less as opposed to the seven years or more that
characterizes many types of traditional capital equipment. Which of these sets of factors predominates
will determine, in part, the shape of the recovery from this period of slowing.
Similarly, we cannot know with certainty the pace of investment in capital goods going forward. As I
will discuss below, it is certain that the pace of future demand for capital goods will depend in part on
the ability of providers of capital--banks, creditors in fixed income markets, and purchasers of
equity-to recognize the risks inherent in high tech capital investment plans and to price the risk appropriately.
Let me now offer a few observations on cost, demand, and the microeconomics of e-commerce. The
cost structure of electronic networks tends to be characterized by high fixed costs and very low
marginal operating costs. This also appears to be true of the cost structure of a number of firms
engaged in e-commerce. Initially, purchasing or developing software to support a competitive
commercial enterprise on the Internet can be costly. But once software that meets a market demand is
built, it can be paired with scalable hardware to handle significant additional volume for very little extra
cost.
It appears, however, that the basic cost structure of e-commerce has different applicability for different
types of businesses in this sector. For example, the high fixed cost, low marginal cost model may fairly
accurately characterize the cost structure of companies that provide on-line information services, such
as information vendors, search engines, and electronic communications networks. Those that produce
their own information content clearly pay some production costs, but those costs appear to be small
compared with the cost of building and operating a network. Interestingly, many information providers
do not originate any content at all and rely instead on markets, commercial partners, or even
subscribers to provide the content. For different reasons, information-based e-commerce companies
seek high sales volumes. They all wish to take advantage of the economies of scale that are inherent
in their cost structure, seeking large scale to reduce their average production costs as volumes grow.
As with other businesses that have this cost profile, e-commerce businesses in this category often
respond to their cost structure by charging a flat fee per user, such as a subscription fee, with the price
structure often transitioning to some form of discounted fee for heavy volume accounts. Obviously for
those information-based e-commerce businesses for which advertising is the major source of revenue,
scale is important to keep advertisers happy. Overall, even with rapidly declining marginal costs, if
pricing does not cover the marginal costs and revenues in the long run do not recoup fixed costs, this
model of e-commerce can prove financially disappointing.
On the other hand, the cost structure for those e-commerce firms that use electronic means to
distribute tangible goods, such as books, apparel, and toys, appears to mirror more conventional
business models. The network costs for these firms reflect the well-understood high fixed cost and low
marginal cost model of the electronic world. However, the economics of fulfillment--that is, providing
and servicing the goods--still depend on these businesses' ability to achieve efficiencies and low unit
costs for materials, storage, distribution, and after-sales service.
The story of the demise of one prominent Internet-only retailer may be instructive in this regard. News
reports indicate that the company had to build and maintain a web site costing about $40 million
annually, the high fixed cost element of e-commerce, which it thought was required to achieve the
desired revenue in the national market it hoped to serve. Besides this new economy cost, this retailer
decided to build a proprietary distribution network, an old economy cost that, according to public
sources, raised its investment in property and equipment to more than $100 million, a fourfold increase
in one year. Analysts indicate that this equaled around 100 percent of the firm's 1999 revenues. As a
benchmark, for land-based retailers a comparable number would be 20 percent of annual revenue and
for catalogue retailers, who often subcontract distribution, the comparable number would be
12 percent to 13 percent.
Finally, because of low barriers to entry to the Internet market and the low cost to customers of
switching from one seller to another, Internet-only firms appear to face high costs to obtain and retain
customers. Again, published reports indicate that the retailer increased its budget by 30 percent in one
year as new competitors moved into its market.
Clearly, appropriately scaling the cost model to the market potential is another key lesson in the world
of e-commerce.
On the demand side, the so-called network effect is extremely important for some e-commerce
businesses because the value of some services increases as the number of customers using them
increases. The most obvious example is an on-line auction site, in which the more buyers and sellers
using an auction site, the deeper the liquidity--that is, the greater the number of opportunities to trade
and the greater the likelihood that trades will occur. For these firms, which include those that support
the "auction" of equities as well as collectibles, high volume is critical to their success, and volume
expectations appear to influence investments in these firms. I have already referred to economies of
scale. Auctions and chat rooms provide an example of how network effects and scale economies can
be mutually reinforcing, making high transaction volumes critical to both the supply and the demand
sides of the market. Here let me also note that, for those for whom advertising is a key source of
revenue, there is a virtuous cycle as a large customer base attracts more advertisers, which in turn
finances more and better content and attracts even more users. The need for scale or volume appears
to create an advantage for the first business to achieve critical mass in any market in which there are
strong network effects. Understanding this dynamic and taking advantage of it appears to be another
lesson from the early experience with e-commerce.
The evolution of investment in e-commerce firms, particularly web-only firms, continues to receive
attention in the press. Needless to say, rational economic behavior suggests that investors would
require a high return to invest in unproven but potentially profitable endeavors. After all, some
innovations struggle but succeed, while others arrive too soon for the technology, arrive too soon for
the market, or are not commercially successful for a wide variety of other reasons. The rapid
reassessment of the business prospects of some e-commerce firms during the course of last year is a
reflection of this reality.
Of course, the equity securities of these firms were revalued to reflect these changing assessments.
Are stocks today overvalued, correctly valued, or undervalued? I certainly do not know, and I am not
aware of anyone who does. As a result, I believe that it would be unwise--and indeed impossible--for
the Federal Reserve to target specific levels of valuations in equity markets. However, valuation
methods that are appropriately sensitive to the obvious business risks of e-commerce, as opposed to
being driven by the assumption of the most optimistic outcomes for every concept, are key. In the long
run such approaches should provide a healthy base for maintaining a reasonable and sustainable
pattern of growth and investment in the e-commerce segment. Costs of capital that reflect risks
accurately are critical to a well-functioning economy.
Therefore, with respect to observations and lessons, it appears that the basic rules of economics,
commerce, and finance continue to apply. Though some macroeconomic conditions have changed
importantly because of the technology investments that underpin e-commerce, the laws of economics
have not been repealed. At the commercial level, any company considering a substantial investment
needs to understand the business case and underlying market cost, competition, and demand
structures. Companies and their investors still need to assess the potential risks and returns based on
that commercial reality.
Payments and e-commerce
Now I would like to turn to the topic of payment systems and discuss whether the existing
arrangements support electronic commerce. In many ways the rapid growth of some elements of
e-commerce is built on the solid base of preexisting payment systems and protocols.
Even with the apparent ups and downs of specific electronic commerce providers, many purchases
are being initiated through the Internet. The Census Bureau estimates that roughly $20 billion worth of
retail transactions flowed over the Internet during the year ending September 2000, excluding
largedollar business-to-business transactions at least partly initiated through the Internet. Some private
calculations reach twice that amount. These purchases are being paid for predominantly with
traditional payment instruments that predate the World Wide Web. Given the growing importance and
apparent potential of e-commerce, it is important that the older protocols of the payment system
evolve to support this new element of our economy.
To explore recent payment developments, it may help to distinguish among the markets for different
types of payment transactions. Although the consumer-to-business (C2B), person-to-person, and
business-to-business (B2B) categories likely break down when pushed too far, they can provide a
convenient organizing framework for identifying payment transactions with some common
characteristics.
For some types of commerce, existing electronic payment instruments were easily adapted to the
Internet. Most notably, small- to medium-sized C2B purchases are frequently made using credit cards.
Because credit cards were already widely used for retail telephone transactions, these
"card-notpresent" transactions were easily accepted as part of commerce on the World Wide Web. Moreover,
unlike many other payment instruments, credit cards could already support low-value international
commerce, one of the historical barriers being challenged by the Internet. One card network estimates
that 95 percent of retail purchases over the Internet in 1999 were made using debit, credit, and other
payment cards.
Some entrepreneurs are adapting other payment instruments for C2B electronic commerce. For
example, debit card networks are exploring ways to enhance security and inter-network arrangements
so that PIN-based debit transactions will be widely accepted as an alternative to credit cards for
Internet-based sales. Similarly, vendors have developed pre-paid cards for which value can be
purchased in advance and used to pay for on-line purchases by individuals who do not have access to
credit cards or who prefer not to use them. In addition, some service providers have begun to offer
"electronic check" or "e-check" products in which customers enter the information shown on the
bottom line of a check and authorize the electronic debit of their checking accounts through a
mechanism called the automated clearinghouse, or ACH.
But existing and evolving payment instruments do not yet satisfy all of the needs of C2B e-commerce
transactions. For instance, many firms provide bill payment services, and many are exploring ways to
present bills electronically as well. Despite the growth of electronic bill payment applications, many of
the bills for which payment instructions are initiated on-line are still paid by check. Similarly, there is
not yet an easy way to pay for transactions such as on-line stock purchases, which have become
popular. Instead, these purchases are generally charged against pre-funded brokerage accounts,
although they could also be paid for by wire transfers through the purchaser's bank or by the prompt
mailing of checks. Devising new ways to pay for securities trades is becoming increasingly important
as the securities industry tries to reduce the time needed to settle trades from trade-date plus-three
days to trade-date plus one day.
For person-to-person commerce over the Internet, typically conducted through auction and similar web
sites, there are very few electronic payment alternatives that can be easily transferred from physical
commerce. Over the past few years, however, several service providers have created Internet-based
person-to-person transfer mechanisms based on the credit card clearing mechanism but requiring
transfer of funds through an intermediary. Other service providers enable individuals to accept credit
card payments, a function previously available only to businesses.
Finally, a number of service providers are also trying to address the market for electronic B2B
transactions. Thus far, some companies have adopted corporate purchasing cards, issued by
traditional card-issuing companies, for their low- and medium-value on-line purchases. The demand
for improved payment instruments for B2B transactions, however, may be even greater than for the
C2B and person-to-person markets. Improving speed, reducing risk, and ensuring appropriate levels
of privacy are important in all three markets. Also, to attract users, B2B payment mechanisms may
need to provide additional features--for example, tools that reduce credit and timing risks in domestic
and international markets. Other desirable features might enable data to flow seamlessly through the
internal systems of the purchaser, the seller, and perhaps intermediaries--all at a low cost, of course.
Because the products or services, scale, and complexity of business-to-business transactions vary
widely, satisfying the needs of this diverse market may be more difficult than satisfying those of the
other markets. I have heard reports, however, that many banks and other organizations are
aggressively seeking ways to provide services for this market.
The Federal Reserve in the payment system
Now, turning to the role of the Federal Reserve, recall that one reason that the Congress established
the Federal Reserve was to improve the nation's payment system; the Federal Reserve Act of 1913
provides the foundation for the Federal Reserve to establish a national check-clearing system. Today,
the Reserve Banks distribute cash, clear checks, and provide electronic payment services to banks. In
addition, the Federal Reserve System has had a long-standing role in helping to formulate public
policies that improve the overall efficiency of the nation's payment system and reduce risks.
Recently, evolving technology and growth in alternatives to cash and check payments have raised
questions about the Federal Reserve's role in the payment system. In 1996 and 1997, a committee
headed by Alice Rivlin, then the Federal Reserve Vice Chair, studied the Federal Reserve's
operational role in the payment system. Ultimately, the study concluded that the Federal Reserve
should continue to provide all its existing payment services with the explicit goal of enhancing
efficiency, effectiveness, and convenience, while ensuring access for all banks. The study also
recommended that the Federal Reserve work actively, closely, and collaboratively with providers and
users of the payment system, both to enhance the efficiency of check and ACH services and to help
develop strategies for moving to the next generation of payment instruments.
To follow up on the recommendations of that study, the Federal Reserve created the Payments
System Development Committee, which I co-chair with Cathy Minehan, President of the Federal
Reserve Bank of Boston. The Payments System Development Committee has an explicit mission. In
addition to identifying strategies for enhancing the long-term efficiency of the retail payment systems, it
also identifies barriers to innovation and works to address those barriers where possible. The
committee is active in monitoring developments in payment markets and has sponsored workshops
and forums that encourage focused discussions with the private sector. Our current activities include
efforts to reduce legal and regulatory barriers to payment innovation, examine future clearing and
settlement systems to support electronic commerce, assess our role in helping to set standards, and
find ways to use new technologies to collect checks more efficiently.
Conclusion
The technological developments that enable us to engage in electronic commerce today have created
tremendous opportunities to improve the ways in which we do business. Even as some businesses
fail, they are contributing to our store of knowledge about what will and will not work in e-commerce.
But beyond just the success or failure of specific businesses, electronic commerce has challenged the
thinking of entrepreneurs and of those who lead traditional businesses. The developments in
ecommerce have reminded us that change, even rapid change, is part of the normal evolution that we
expect from market economies. They have also shown, however, that no matter what delivery
mechanism is used, successful businesses must still follow good business practices, pay attention to
basic economic principles, and sell products and services that buyers want.
I believe this to be true for business generally and certainly for payments. A market-oriented approach
to payment system innovation promises to provide long-lasting benefits to the consumers and
businesses that use the U.S. payment system. We need to approach payment system innovations with
an open mind and a willingness to learn. This is particularly true in the world of electronic commerce,
where payments are being adapted to new technologies, products, and methods of doing business.
These innovations are important in themselves. But they are also important because successful
innovations to support electronic commerce may, over the long term, have a broad influence on the
payment systems we use throughout our economy.
I commend Vanderbilt University and its Owen Graduate School of Management for moving so
forcefully to train the next generation of leaders in the e-commerce world. Not only are you serving
your students; you are serving the global economy.
Thank you for your attention.