E-MONEY AND PAYMENT SYSTEM RISKS

I. INTRODUCTION Today we observe the rapid development of information-processing systems that may displace, over time, many of the systems by which payment-related information is communicated. Indeed, stored-value systems, as well as credit-based and deposit account-based systems that communicate instructions or transfer value over open communication and computer networks, represent new techniques (based on encryption schemes) to initiate payments. These new techniques hold a great deal of promise in that they potentially offer added convenience to the consumer. This promise is qualified by the question of whether these new means of payment might add to risk in the payment system. The new forms of payment being developed can be broadly grouped into three categories: those that allow payments to be made using credit cards over communications systems such as the Internet; those, such as the electronic check, that involve transmitting instructions to banks to transfer funds from one deposit account to another; and those, such as some forms of stored-value cards and digital cash, that represent the electronic equivalent of bank notes. For the time being all these systems that transmit payment or payment instructions over open networks will be dubbed "e-money." Many of these new systems will clear and settle the system's payments in a special-purpose private bank - a clearinghouse. Issues of settlement risk in clearinghouses are reasonably well understood as a practical matter. Several precepts, including "know your counterparty," "manage counterparty risk through bilateral net debit limitations," "manage system risk with limits on total, multilateral net debit limits," and others, including collateral requirements, are practically implemented in the operating rules of many clearinghouses. These rules are attempts to ensure adequate liquidity of the settlement facility, especially in times when members of the system experience financial distress. It is not, however, conventional credit, liquidity, and settlement risks that pose novel threats to the smooth operation of the payment and banking systems from the introduction and widespread acceptance of e-money. Rather, the threat arises principally from the uncertainty regarding fraud, legal, and operational risks to the systems. These risks may be exacerbated by the type of industrial organization emerging in the e-money industry. The American banking industry is unique for its decentralization. The current trend of consolidation in banking is changing this feature of American banking only slowly. Payments are still cleared and settled through clearinghouses (including the Federal Reserve) and correspondent networks that are, for practical purposes, invisible to the retail customer. The new means of payment, in contrast, are provided to a large extent in "branded networks," in which the clearinghouse and its identity have a strong retail presence and are the foremost link with the product in the consumer's mind. This type of organization in payments is illustrated today by the credit card associations Visa and MasterCard. The nature of competition in which such networks engage, in conjunction with the fraud, legal, and operational risks to which they are subject, can also pose risks to the payment system. The next section briefly reviews some of the likely forms of e-money in more detail. Section III provides a quick review of payment risk issues and then provides examples of their applicability to e-money systems. Section IV considers the effects of e-money branded network competition on the stability of the payment system, and section V discusses forms of risk control. The paper concludes in section VI with a discussion of lessons learned concerning banking and payment system regulation and control. II. FORMS OF E-MONEY AND E-MONEY FIRMS In some ways it can be said that the e-money world is here now. …