Journal of Electronic Commerce Research, VOL. 5, NO.4, 2004
`
`USING E-CASH IN THE NEW ECONOMY:
`AN ECONOMIC ANALYSIS OF MICROPAYMENT SYSTEMS
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`
`Michelle Baddeley
`Gonville & Caius College and Faculty of Economics and Politics, Cambridge, UK
`mb150@cam.ac.uk
`
`ABSTRACT
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`The growth of electronic commerce is dependent upon the emergence of effective electronic payment systems.
`Whilst payments for large purchases can be made relatively easily using credit/debit cards, small-scale electronic
`commerce is constrained by the limited nature of existing e-cash (or ‘micropayments’) systems. This paper outlines
`the evolution of electronic payment systems, leading to an analysis of the essential characteristics of e-cash, and
`microeconomic / macroeconomic implications of the development of e-cash. Finally, the key characteristics of
`successful electronic payment innovations are analysed using binary dependent variable estimation techniques on
`data derived from the Electronic Payments Systems Observatory (ePSO) database.
`
`Keywords: e-cash, micro-payment systems, e-commerce
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`1. Introduction
`Electronic commerce is growing at an increasing pace and financial instruments are adapting to the increased
`volume of spending taking place over the Internet (Economides, 2001). Until now, most buyers have used credit
`arrangements or checking accounts as the principle means of paying for Internet purchases. There is however, a
`'price umbrella' underneath credit-card transactions that makes them an excessively costly financial instrument for
`low-value purchases (Rivest, 1998). Given the transactions costs involved with card transactions, the opportunity
`gap that remains in terms of e-money products lies in developing a popular alternative to conventional cash as a
`convenient way to make small payments (‘micropayments’1). For many Internet transactions, electronic cash (e-
`cash) could provide a potentially superior substitute for conventional monetary instruments.
`Most existing electronic small payments schemes are in essence account-based systems mediated by middle-
`people, in practice in much the same way as a bank or credit institution acts as a financial intermediary. Accounts-
`based payment mechanisms lack some of the key characteristics of conventional cash, e.g. complete anonymity and
`low transactions costs. Financial cryptographers are attempting to harness the lower computational and/or
`administrative transactions costs of electronic payments schemes in order to devise an efficient electronic micro-
`payments scheme whilst retaining in electronic cash the virtues of conventional cash (e.g. in terms of security and
`anonymity) and some of the computational and technical difficulties have been overcome (van Someren, 2001, van
`Someren et al., 2003). But attempts at a practical implementation of e-cash systems have met with limited success
`because logistical problems remain; to some, the widespread adoption of e-cash systems seems to be a distant
`prospect (Odlyzko, 2003).
`This paper begins with an analysis of ideas about the evolution of money, applied to modern forms of electronic
`money systems. Then the characteristics of electronic cash relative to conventional money and other electronic
`payment systems are outlined followed by an examination of the potential microeconomic and macroeconomic
`implications of e-cash systems. The evolution of electronic payment systems within the real world is analysed using
`data derived from the Electronic Payments Systems Observatory (ePSO), which is run by the European Central
`Bank (ECB) as part of its monitoring role. These data are used in a binary dependent variable analysis of the
`characteristics of successful electronic payment services. The paper concludes with the observation that whilst e-
`cash systems have the potential to change monetary systems by directly matching buyers and sellers in exchange,
`there is still a long way to go in developing effective and extensive e-cash systems. And the further evolution of
`widely accepted systems will require the co-operation of governments, central banks and business.
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`1 Micro-payments systems are defined as e-payment solutions that allow for payments up to 5 Euros (Carat, 2002).
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`2. Definitions of electronic money
`In understanding the evolution of electronic money, it is useful first to define electronic money and then to
`examine some of the specific characteristics of e-money in general and e-cash in particular. Fullenkamp and Nsouli
`(2004) argue that one of the ‘puzzles’ surrounding the evolution of electronic money has emerged because of
`confusions over terminology and definitions. This point is recognised by the Basel Committee of the Bank for
`International Settlements (BIS): electronic money is difficult to define because it blends particular technological and
`economic characteristics (Basel Committee, 1998; BIS, 1996). In addition, different e-money schemes will vary
`according to their technical implementation, the institutional arrangements required to support them, the way in
`which value is transferred, the recording of transactions and the currency of denomination (BIS, 1996). This means
`that several definitions of electronic money have evolved over time.
`In broad terms, electronic money can be defined as monetary value stored on an electronic device issued on
`receipt of funds or accepted as a means of payments (Carat, 2002, p. 11). This mirrors the official definitions
`published by ECB and BIS in focussing on the stored value aspect of electronic money (e.g. BIS 1996, Basel
`Committee, 1998). The ECB (1998, 2000), following the first official definition issued by the European Monetary
`Institute (EMI, 1996), define electronic money in the following terms:
`‘Electronic money is broadly defined as an electronic store of monetary value on a technical device
`that may be widely used for making payments to undertakings other than the issuer without
`necessarily involving bank accounts in the transactions, but acting as a prepaid bearer instrument.’
`Again, the focus in this definition is on the pre-paid aspect of electronic money. The Basel Committee (1998)
`further divides types of electronic money into the categories of electronic purses (hardware or card based) and
`digital cash (software, network based). But whether these instruments are ‘balance-based’ (i.e. account based) or
`‘token-based’ (i.e. involving the expenditure of electronic tokens), the essential characteristic is their pre-paid
`nature. For this reason, credit cards and debit cards are regarded as access products or electronic payment systems,
`rather than as electronic money (BIS, 1996; Basel Committee, 1998).
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`3. Characteristics of electronic money
`3.1 The Evolution of Money2
`In analysing whether or not electronic cash can evolve as an efficient and flexible facilitator of exchange in the
`Internet economy, it is useful to revise theories about why and how conventional money has evolved over time.
`Money plays a number of roles in economic activity: it is a unit of account, a means of deferred payment, a store of
`value and a medium of exchange. According to a Mengerian view, the evolution of money has taken place in a
`context of economising on time, effort and scarce resources (Menger, 1892; Alvarez, 2002). All economic
`exchanges, including the exchange of money for goods and services, involve transaction costs and these hinder the
`trading of goods and services. Economists regard transactions costs as a form of economic friction: if economic
`friction is reduced, more productive potential will be released. The Mengerian view asserts that money has evolved
`over the centuries to minimise the friction of transactions costs that are involved in mediating exchange.
`The process can be seen from the development of the very first monetary products. Conducting economic
`transactions in barter economies was uneconomical: a double coincidence of wants between buyers and sellers was
`the necessary pre-condition for exchange. Transactions costs were considerable because a lot of time and effort was
`involved in finding a suitable barter partner. At first glance it may appear that e-cash is the opposite – having the
`potential to lead the monetary system to an even higher evolutionary point. To a non-technician, the transactions
`costs involved in e-cash may seem to be almost zero whilst the benefits are much the same as conventional cash. But
`the picture is in fact more complex.
`Another element in the evolution of money was the need for divisibility and fungibility. Limits on the
`divisibility of goods and services created problems: if a loaf of bread is worth a tenth of a goat, what's the solution?
`The advent of commodity money made the process of transacting more economical by allowing people to specialise
`in production according to their strengths and by enabling monetary authorities to mint coins in convenient
`denominations, creating divisibility and fungibility: when people withdrew coins from a bank they did not have to
`withdraw the same coins that they deposited because all coins of a particular denomination were homogenous and
`standardised. This reduced the complexity of exchange.
`As for the role of government, within a commodity money system a monetary authority is not essential. As
`long as people believe that their commodities or coins represent purchasing power then the commodity is its own
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`2 For analyses of the nature and evolution of money, including electronic money, see Davies, 2002 and Solomon,
`1997; Baddeley and Fontana, 2004.
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`guarantor. But government usually has a key role in legitimising coinage by affixing a stamp to guarantee that a
`coin contained a given amount of precious metal. Nonetheless, risks of counterfeiting and debasement remained.
`Also, using commodity money whether based upon gold, other metals, or cigarettes, meant either that extra
`resources were devoted to producing more of the commodity; or that limitations had to be imposed on the use of the
`commodity for non-monetary purposes. Also, costs were incurred in storing, holding and carrying commodity
`monies. An early solution came via token money: with trusted goldsmiths issuing transferable certificates to register
`gold reserves, commodity money could survive without the need to carry around the commodity itself.
`Gradually, the issuing of notes by private banks was supplanted by central bank control of cash in the economy.
`Initially, central banks issued convertible paper currencies e.g. the gold standard or dollarisation. The development
`of convertible paper currencies allowed a decrease in the costs involved in the production, storage and use of money.
`The average cost of printing and storing a bank note or coin are far less than the value of that note or coin. It is likely
`that electronic money will have the capacity further to reduce these production and holding costs, though the role of
`government is likely to be constrained.
`Another distinctive characteristic of conventional money over electronic money is the importance of fiat money:
`money that is declared by government fiat to be legal tender with people being obliged to accept it as such. It seems
`unlikely that governments will be willing or able to declare similar fiats with respect to electronic money. This is the
`essence of the problem with any form of non-commodity money: why would a person hold something inherently
`worthless as a store of value or medium of exchange? They hold it because they believe in it; using fiat money as a
`medium of exchange is vitally dependent upon a social convention. This is the essence of the Chartalist view,
`popularised by Knapp (1924), of money as a social relation. Whilst there are still risks of forgery and fraud
`associated with fiat money, the most important advantage that fiat monies have is that they are cheap. They are
`cheap because they are based upon a social convention supported by trusted institutions and a legal system.
`Credibility is crux of the system; fiat money cannot work if people are not prepared to use their tokens as a medium
`of exchange. And for people to be prepared to use tokens in exchange, the tokens must be legal tender or at least
`almost universally acceptable. This is one of the key problems for e-cash: encouraging people to adopt the
`convention. For conventional money, reliable monetary institutions support the fiat; modern central bankers focus
`on the interactions between monetary policy, inflation and purchasing power. It follows that the private production
`of money must be illegal: if anyone can produce monetary tokens, central banks would not be prepared to guarantee
`the value of money and the social convention would collapse. But for electronic cash, the private producers are the
`innovators and monetary authorities have had little direct impact on the various e-cash alternatives available.
`So history shows that all money has evolved to meet a set of essential requirements including wide
`acceptability; low production/carrying/storage costs; fungibility, divisibility; and resistance to forgery.3 For future
`developments in electronic money, there is no doubt that technology has evolved to a stage at which e-cash systems
`will be able to supplant conventional cash systems in terms of some of these characteristics. Conventional token or
`fiat monies do incur production, storage, carrying and handling costs which, whilst less substantial than those
`involved in commodity money systems, are still likely to be greater than the costs of effective e-cash systems. In
`addition, if systems can be devised to limit on-line processing costs, e-cash systems have the potential to be more
`secure than conventional cash systems. However, many barriers remain if e-cash systems are to replicate the
`liquidity, ubiquity and anonymity of conventional cash, particularly as ease of access to conventional cash has
`increased with the proliferation of ATMs (The Economist, 2000a, p. 21).
`3.2 Constraints on the evolution of e-cash
`Some of the constraints on the effect evolution of e-cash systems emerge in designing instruments that are able
`easily to mimic some of the essential characteristics of conventional cash, e.g. in terms of efficiency, wide
`acceptability, security, anonymity, easy transferability (including an ability to support multiple payments).
`Efficiency: The costs involved in producing and storing electronic cash are likely to be lower than those
`involved with printing, storing and carrying conventional cash. These cost savings will create some gains in terms of
`economic efficiency if the use of e-cash becomes more widespread. However, the costs involved in exchanging e-
`cash are relatively high in comparison with the costs involved in exchanging conventional cash. The current
`technology used in security protocols involves relatively high transactions costs and is not economical for ‘micro-
`payment’ systems’ (Foo, 1997). Innovations such as NetCard can support micro-payments by incorporating a digital
`signature into a whole stick of coins that can then be spent individually (with a given merchant). This system allows
`a reduction in computational complexity for series of low value payments to given merchants but is not particularly
`helpful for customers who want to spend their coins at a number of different sites (Anderson, 2000).
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`3 For a more exhaustive summary of the desirable properties of e-cash, see Neumann and Medvinsky, 1998; Choi,
`Stahl and Whinston, 1997.
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`Another way of reducing the transactions costs involved in digital payment systems is via de-coupling the
`various tasks that characterise the exchange of goods and money thereby making the system more suitable for low
`value transactions (Kravitz, 1998). Voucher schemes, lottery ticket and coin-flipping protocols all have the potential
`to minimise the number of messages involved in each transaction (Rivest, 1997; Foo, 1997; Lipton and Ostrovsky,
`1998). Foo's method also transfers the processing burden onto banks, which may be appropriate if banks have the
`specialist skills and technology to be able efficiently to mediate financial transactions. In addition, electronic
`vouchers can be transferable but the problem remains that they cannot mimic conventional cash because direct
`exchange between buyers and sellers is not possible - financial intermediaries are still involved and this will increase
`the transactions costs of exchange. In addition, coin-flipping and lottery ticket protocols are based upon the
`assumption that economic agents are risk-neutral and will be satisfied with fair bets. It does not address the issue of
`risk-averse economic agents who prefer guaranteed sums of money to fair bets.
`Acceptability: No existing e-cash is universally acceptable; most are not even widely acceptable. Existing e-
`cash systems are forms of 'inside' money (available to a select group of insiders) and this is particularly true for
`vendor-specific schemes. If an e-cash system is to be successfully adopted, it will have to attract a wide
`constituency, i.e. to become ‘outside’ money. It is because current e-cash schemes are not widely accepted that they
`must piggyback on the non-cash money supply i.e. bank deposits and credit accounts. This implies that e-cash is
`just a means of re-distributing 'IOU money' (i.e. based on deposit and credit accounts) and financial intermediaries
`must necessarily be involved in its exchange. This contributes to the overall transactions costs involved in the
`exchange of deposit-based electronic cash systems.
`In conventional cash systems, there is a simple bilateral interaction between buyers and sellers; the fact that no
`middle-people are involved means that the transactions costs are lower. This bilateral exchange works because it is
`based upon a trusted social convention: cheap bits of paper/metal represent value. The backing of powerful
`institutions is required to support this sort of fragile social convention. What are the implications for effective virtual
`cash systems? Some observers may believe that we will come to live in a world of 'Disney dollars and Virgin
`pounds' (Birch and McEvoy, 1997). However, most people are too risk-averse to trust their fortunes to the fate of a
`single private enterprise; history has shown that even the most successful multi-national companies do not
`necessarily prosper forever. If an e-cash is to survive as a true cash system, then it requires the backing of
`trustworthy, stable institutions such as central banks – these could implement common protocols and act as unifying
`institutions. The development of e-cash as a form of outside money seems unlikely if e-cash systems do not receive
`this sort of government backing.
`Security and Anonymity: Hypothetically, the potential security of virtual money is greater than that of
`conventional money given the sophisticated printing and counterfeiting methods used for conventional cash. For e-
`money however, adoption of widely available technologies that are tamper-resistant is limited by the US
`government's regulation of ‘strong’ cryptography, including export limits on ‘long’ (i.e. complex) keys. It is only in
`practice and because of governmental constraints that the security and privacy of e-cash systems is limited (Swire,
`1997). Many existing e-cash systems, particularly those that can be used with a number of different merchants, are
`not completely anonymous because the monitoring of their use is actually essential to the proper operation of these
`systems in order to prevent the double spending of virtual coins. This monitoring may be very costly requiring
`collusion between institutions. The use of a conventional cash system allows direct interaction between buyer and
`seller and so it is not possible to monitor transactions taking place mediated using conventional cash. Anonymity is
`ensured. Conventional cash will be preferred by those involved with criminal activities as long as criminals and tax
`evaders believe that electronic transactions will always leave some trace (Goodhart, 2000). It can be argued that
`complete anonymity is not desirable from a social welfare point-of-view (de Solages and Traore, 1998). In theory, a
`system of anonymity that is only revoked by some trusted authority when criminal activities take place would mean
`that criminal activity could be more effectively monitored and punished in a world of e-cash. But, in practice, the
`whole point is that criminals would not use a system that they believe allows effective monitoring and punishment.
`Even with such a system, until complete anonymity can be assured electronic cash cannot substitute completely for
`conventional cash for illicit transactions and there will always be a demand for conventional cash, whether or not
`agents admit their real reasons for holding it.
`Partial / complete transferability and multiple payment systems: Within any system of e-cash, there are difficult
`trade-offs to manage between anonymity/privacy and security/reliability. These trade-offs surface in assessing the
`desirability of easy transferability of e-cash. Sander and Ta-Shma argue that non-transferability is an important
`feature for e-cash systems as it imposes limits on criminal abuses (Sander and Ta-Shma, 1997). However, whilst
`limiting transferability will reduce the potential for fraud, non-transferable e-cash systems will be less flexible and
`more costly. Assuming that double spending of electronic cash can be prevented, an e-cash system that allows
`multiple-payments is likely to lower the monetary costs of transactions. However, for many e-cash systems devised
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`so far (e.g. lottery ticket and voucher systems) each unit of e-cash can only be spent once, even if the
`tickets/tokens/vouchers are transferable before use (Rivest, 1997; Foo, 1997). So each unit of currency is only
`partially transferable, i.e. it is transferable only until it is spent. In contrast, conventional cash is spent many times
`by many different people; it is completely transferable. In response to this problem, some multiple-payment schemes
`have been suggested (Pagnia and Jansen, 1997). In multiple payment systems, the costs of issuing electronic cash
`will be greatly reduced as long as there is an effective mechanism to allow a given unit of currency to be transferred
`easily between many buyers and sellers. If this transferability is possible and a token can be spent many times, then
`the average cost per transaction of issuing a given unit of currency will tend towards zero.
`The use of methods such as Chaum's blind signature scheme (BSS) have some potential to promote
`transferability if a central-bank can issue signed coins and release its public signature key to all traders and
`consumers so that they can authenticate e-cash received (Chaum, 1992). Concerns about crime and fraud can also be
`addressed within such schemes, i.e. by using fair BSS in which trusted authorities have the power to monitor suspect
`transactions (de Solages and Traore, 1998). However, the problem remains that large databases of past transactions
`must be maintained in BSSs in order to prevent double spending. This requirement adds to the costs and limits the
`scalability of such systems. Transactions costs are reduced in systems such as NetCash because only outstanding
`tokens are monitored (Neumann and Medvinsky, 1998). However, these tokens are still not perfectly transferable
`because the holders of digital tokens/coins do not have to relinquish ownership of the digital coin when they spend it
`and the prevention of double-spending requires processing time even if this is reduced in comparison with other
`BSSs. In contrast, for conventional notes and coins, holders relinquish ownership of a physical entity when they
`spend a conventional note or coin and so the monitoring of double spending is not necessary.
`3.3 Constraints on e-cash: some real world examples
`Whilst e-cash systems may in theory have the potential to provide advantages not provided by conventional
`cash systems, as outlined above, designers of effective e-cash systems have the task of exploiting the efficiency
`gains of electronic transfer whilst mimicking desirable characteristics of conventional cash in terms of widespread
`acceptability, security, anonymity and easy transferability. But many early electronic cash innovative e-cash
`products have not stood the test of time, for example schemes such as DigiCash and CyberCash (The Economist,
`2000b, p.77-9). Can this failure to develop e-cash systems in the real world be explained in terms of the
`characteristics outlined above? What underlies the success (or lack of success) of real-world e-cash systems?
`Paypal is generally held to be the most successful example of an electronic cash system. The essence of its
`success lies in the fact that it is relatively widely accepted, being the preferred payment system for the widely
`popular e-Bay auction site (and it was bought-up by e-Bay in 2003). In addition, the verification systems and buyer
`insurance instruments used by PayPal reassure customers about the relative security of the system. Anonymity is not
`a characteristic of PayPal, however, and easy transferability only applies to people who want to re-spend their
`money within the system; it is more difficult to extract money out of the system than to set up an account in the first
`place. Nonetheless, PayPal does seem to have captured some first-mover advantages in the implementation of an
`effective micropayments system and its customer base has grown rapidly from about 185,000 in 2000 to over 45
`million by 2004 (Sources: The Economist 2000b, http://www.paypal.com/). It also has relatively low transactions
`costs (http://www.wired.com/news/ebiz). The links between PayPal and e-bay has been an ingredient for success as
`it has helped to ensure relatively wide acceptability. And it is generally true that barter exchange payment systems
`designed complement some sort of virtual marketplace (e.g. Barter Trust, BigVine, LassoBucks) have been
`relatively successful (Economist 2000b, p. 78).
`Other real-world micropayment systems have been less successful. DigiCash was designed to mimic the
`anonymity of conventional cash but ran into problems of limited acceptability, a problem that was exacerbated not
`only by the multiplicity of alternative, incompatible systems but also by the limited capital financing available for
`the project. In addition, the process of transferring money into an electronic ‘mint’ then to be spent in purchasing
`digital coins was relatively complicated (http://news.com.com/). CyberCash’s CyberCoins system ran into similar
`problems.
`PayDirect offers systems with low costs of entry, which are secure from a merchant’s point of view but do not
`address the problem of merchant fraud. The initial accounts based system is relatively widely accepted but its
`interface with user accounts means that, in principle, spending is not anonymous and can be monitored. In 2003
`PayDirect introduced its World Card – a stored value card that can be used to access local currency via ATMs. To
`an extent this may promote easy transferability but users of the World Card have to be identified when the cards are
`purchased.
`Ultimately the real constraint is an economic or institutional constraint rather than a technological constraint
`and lies in generating widespread acceptability and this is the problem that has been overcome most effectively by
`PayPal. Given the increasing dominance of PayPal within the electronic marketplace, its first-mover advantage will
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`be difficult to reverse even if efficient technological solutions were designed to mimic all the other conventional
`cash characteristics outlined above.
`3.4 The advantages of e-cash over other forms of electronic payment
`Evidence suggests that on-line consumers are dissatisfied with the way they spend money on-line and analysts
`predict that the use of credit cards to fund on-line transactions will decline significantly in the near future
`(Economist, 2000b). Quite apart from the constraints outlined above, does e-cash bestow any advantages relative to
`other forms of electronic payment? Electronic payments via credit card still dominate the market and, as explained
`above, many e-cash systems have not stood the test of time. Do we need a system of electronic cash when most
`people currently purchase goods and services over the Internet using credit cards? One of the main challenges
`confronting e-cash suppliers is providing effective micro-payments systems, whereby small amounts of money can
`be used electronically. Checks and credit/debit cards do not suit small purchases; the key problem for checks and
`credit-card systems is that they are not necessarily effective for micro-payments because of the costs involved in
`interactions between financial institutions (Neumann and Medvinsky, 1998). Using credit cards and checks involves
`financial intermediaries thus adding to the transactions costs involved in on-line purchases. If credit-card payments
`incur additional interest costs and other charges upon buyers this will also add to the costs involved with using credit
`cards.
`Another shortcoming emerges because credit-card purchases on the Internet are not anonymous and a person's
`spending patterns can be tracked using credit-card records. The same is true for mechanisms using electronic
`checks. There is also an increased danger of fraudulent use of credit-card numbers by third parties. Using ATM
`cards/machines to access conventional cash is not susceptible to the same level of fraud because dedicated physical
`devices and anonymous PINs are essential to such transactions. It is costly to tap into telephone networks but it is
`relatively easy to collect databases of credit card numbers over the Internet because it is easy to intercept
`information (MacKie-Mason and Varian, 1998). So the use of credit cards to buy goods and services over the phone
`is not as susceptible to fraud as the use of credit-cards numbers over the Internet. Whilst e-cash may well suffer from
`the same shortcomings as other forms of electronic payment, the financial risks for individual consumers are
`reduced. If a consumer is only risking the loss of a not-particularly-valuable electronic coin, he/she is far more
`likely to conduct transactions over the Internet than if he/she risks an enormous credit-card bill emerging because
`someone has illicitly intercepted his/her credit-card number. Electronic cash therefore has financial potential that is
`not matched by alternative electronic financial instruments.
`
`4. Some macroeconomic implications
`4.1 Macroeconomic policy: the control of risk
`Birch and McEvoy (1997) argue that devolving responsibilities for issuing of money away from governments
`and central banks will remove a ‘single point of failure’ in the economic nexus between government, financial
`institutions, business and consumers.4 This is not an unusual view and many conservative commentators would
`herald a privately-based e-cash system as a potential triumph for laissez-faire capitalism, for example the Cato
`Institute (Dorn, 1997). However this view is an over-simplification because, as outlined above, cash works as a
`social convention and people will only use e-cash if they believe that trustworthy, long-lasting and powerful
`institutions are supporting it. Goodhart (2000) argues that the impacts of electronic money for government policy
`control will be limited. The government will still have control of interest rates and it will still play a key role as the
`government’s bank. But central banks’ supervisory roles will be important whether money is physic