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orlin grabbe on digital cash
from zolatimes, an interesting online newspaper
also Orlin's site is an eyeful!
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From: Kris Millegan RoadsEnd <[email protected]>
Subject: Digital Cash and the Regulators
To: [email protected]
from:
http://zolatimes.com/
<A HREF="http://zolatimes.com/">Laissez Faire City Times Newspaper</A>
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Another fine issue, As always, . . .
Om
K
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January 29, 1998 - Volume 2, Issue 3
Editor & Chief: Emile Zola
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- - III-By J. Orlin Grabbe
The City Times
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Digital Science Department
Digital Cash and the Regulators
by J. Orlin Grabbe
""" Digital cash, like other forms of money, can be issued in any
political or legal jurisdiction, or in any banking environment: Salt
Lake City, the Cayman Islands, Cyprus, or Sidney. There is a great deal
of flexibility available to the digital cash provider when viewed from a
global perspective.
Nevertheless, digital cash may operate locally under a set of rules and
regulations similar to other forms of computer money such as bank
deposits. ("Locally" can be almost any Internet-accessible country.) The
question of how banking regulators view digital cash is a practical one,
because the answers to the question demonstrate the sort of issues that
arise in any banking context. All the examples here will involve the
U.S., a country with a complex maze of banking regulations.
>From the point of view of central bankers, digital cash generates three
sorts of questions. Who issues it? How is it used as a means of payment?
What impact does it have on the banking system balance sheet or
bottom-line?
Currency Competition and Seigniorage
Digital cash is by design a partial substitute for ordinary cash. Hence
it will be used in much the same fashion as ordinary cash--a context
with which central bankers are familiar. To a certain extent, digital
cash threatens the profitability inherent in central bank note issue.
Consider traveler's checks. Traveler's checks are a form of private bank
currency. They are analogous to the bank notes issued by private
commercial banks in the U.S. prior to the Civil War. As such, they are
very profitable to the banks and companies that issue them, because no
interest is paid out on traveler's checks to the check holders, but the
issuer earns interest on the funds that customers use to purchase them.
When you purchase American Express Traveler's Checks, you are making an
interest-free loan to American Express. That's why AMEX likes to sell
them to you--apart from the fees involved in the transaction.
As with traveler's checks, digital cash products such as electronic
purses (a card with a memory chip on it) represent an attempt by
commercial banks to capture part of the seigniorage earned by the
central bank from issuing notes. Holders of currency (Federal Reserve
notes) are making an interest-free loan to the government. The interest
opportunity cost adds up. The approximate $20 billion that the Federal
Reserve turned over to the U.S. Treasury in 1994, for example,
represented about 5 percent of the $400 billion in Federal Reserve
notes.
The Bank for International Settlements (BIS) estimated that in the
United States seigniorage is .43 percent of gross domestic product
(GDP), while central bank (Federal Reserve) expenses are .03 percent of
GDP, implying a profit of .40 percent of GDP. [1]
These numbers can be used as a reference base to calculate the amount of
seigniorage recapture available to providers of digital cash. Suppose
that that digital cash was so successful for small purchases that it
eliminated the U.S. $1, $5, $10, and $20 dollar bills. In that case, the
BIS estimates the loss in seigniorage at .14 percent of GDP. Now it is
highly unlikely that digital cash would replace all small denomination
bills, as assumed in this calculation. But the calculation shows that up
to one-third of current Federal Reserve seigniorage is potentially
available to digital cash providers. And that's a lot of money.
While some central banks may be concerned that digital cash will
infringe on their monopoly of issuing bank notes (although most do not
appear to be particularly alarmed), such a monopoly can be easily
circumvented without computers and without telecommunications. All that
is required for the success of any privately-issued currency is local
acceptance as a means of payment for goods and labor. Consider, for
example, HOURS, which is a local currency circulating in Ithaca, New
York. Here is a brief (albeit dated) summary of the HOURS system. [2]
HOURS is a local currency created and issued by citizens in Ithaca, New
York. The organizers have issued over $50,000 in local paper money to
over 950 participants since 1991. An estimated $500,000 of in
HOURS-based transactions have taken place.
The idea behind an HOUR is that it is a rough equivalent to a $10.00
bill. The unit was chosen because ten dollars per hour was the average
wage paid in Tompkins County. HOUR notes come in four denominations, and
have been used to buy goods and services like plumbing, carpentry,
electrical work, roofing, nursing, chiropractic care, child care, car
and bike repair, food, eyeglasses, firewood, and gifts. The local credit
union accepts them for mortgage and loan fees. People pay rent with
HOURS. Some of the best restaurants in town take them, as do movie
theaters, bowling alleys, two large locally-owned grocery stores, and
thirty farmer's market vendors.
Everyone who agrees to accept HOURS is paid two HOURS ($20.00) for being
listed in the newsletter Ithaca Money. Every eight months they may apply
to be paid an additional two HOURS, as reward for continuing
participation. This mechanism increases the per capita supply of HOURS.
Ithaca Money contains 1200 member listings. HOUR loans are made without
interest charges.
Multi-colored HOURS bear serial numbers and are printed on
hard-to-counterfeit locally-made watermarked cattail (marsh reed) paper.
Naturally, HOUR payments are taxable income when received for
professional goods or services.
The organizers have created a guide to creating local currency, called a
Hometown Money Starter Kit. The Kit explains the start-up and
maintenance of an HOURS system, and includes forms, laws, articles,
procedures, insights, samples of Ithaca's HOURS, and issues of Ithaca
Money. They've sent the Kit to over 300 communities in 45 states. To get
one, send $25.00 (or 2.5 HOURS) to Ithaca Money, Box 6578, Ithaca, NY.
14851.
HOURS, much like traveler's checks, are an attempt to recapture a part
of the currency seignoriage usually given up to the central bank. Like
HOURS, digital cash does not require the approval of some central
authority to form a viable mechanism. And the presence of seigniorage
means that digital cash products can be highly profitable, for they
simply arbitrage the difference between the cost of producing digital
cash and the return available to the issuers of the medium of exchange.
As we saw previously, the Federal Reserve made $20 billion of this
arbitrage in 1994, after payment of all expenses.
Is Digital Cash (Stored-Value) a Deposit?
U.S. banking regulations distinguish broadly between deposit-issuing
institutions and others. Thus the question whether the digital cash
liability of a private company represents a deposit or not determines
who might attempt to regulate it or whether it is eligible for federal
deposit insurance.
Some of these questions here are more important in a non-anonymous
digital cash system than in an anonymous one. A depositor who is
anonymous, or who wishes his transactions to remain private, is probably
not interested in being identified for insurance purposes, or receiving
regular bank statements detailing his financial activities. But, that
having been said, a look at some representative regulations is important
for the purpose of understanding the political and legal barriers to the
creation of an anonymous digital cash system.
Digital cash is a balance sheet liability of the commercial banks or
companies that issue it. Does it thus fall under the laws governing
ordinary checking accounts? And what about discharge of debt? In the
case of the U.S., federal law does not currently address obligations
discharged by stored value cards--only those settled by cash, check, or
wire transfer.
FDIC deposit insurance, which applies to most bank deposits, can be
easily extended to stored value cards under the guise of a general
liability account. The FDIC General Counsel has issued an opinion [3]
that divides stored-value cards into four categories:
·Bank Primary-Customer Account Systems--where funds stay in the
customer's account until they are transferred to a merchant or other
payee (as with a debit card). These are considered customer "deposits"
and covered by FDIC deposit insurance.
·Bank Primary-Reserve Account Systems--where funds are downloaded
onto a customer's card (or software), and the bank's obligation is
transferred to a reserve or general liability account to pay merchants
and other payees. These are also considered issuer "deposits", and
covered by FDIC insurance.
·Bank Secondary-Advance Systems--where a card issuer is a third
party, the bank makes the cards available to customers, and customers
pay the third party for the stored value using funds from their bank
account. The stored-value funds in this case are not considered
deposits, and are not covered.
·Bank Secondary-Pre-Acquisition Systems--where the card is issued
by a third party, the bank pays the third party for the card value, and
subsequently sells the stored value to customers. Again, the
stored-value funds are not considered deposits, and are not covered.
Non-banks, meanwhile, are not eligible for FDIC deposit insurance. But
the question remains, If non-banks issue stored-value products, are
these stored-value funds "deposits"? For if stored-value is legally a
deposit, then federal and state regulators might attempt to deny a
company or other entity the right to issue the product, using the
Glass-Steagall Act or similar provisions.
If stored value-products are "deposits," then a non-bank might also
become subject to the jurisdiction of the Federal Trade Commission (12
U.S.C.A. 1831 t(e)) or might be treated as a bank for the purposes of
the Bank Holding Company Act (12 U.S.C.A. 1841 (c)(1)). This is
something to keep in mind before selecting Salt Lake City as your
digital cash base.
Nationally chartered banks are under the supervision of the Office of
Comptroller of the Currency (OCC). The OCC has explicitly approved
national bank participation in one digital cash system, Mondex, and in
stored value systems generally, stating "national banks may under 12
U.S.C. 24(Seventh) engage in the business of Mondex USA", and also that
"national banks may under 12 U.S.C. 24(Seventh) engage in the business
of operating a stored value system". [4]
In addition, the Federal Reserve has authorized bank-holding companies
who own ATM networks to provide stored-value card systems through these
networks.
A Closer Look at Mondex
Mondex is known as a stored value card system. "Stored value" simply
means the money is stored on a memory chip on the Mondex card instead
of, say, being stored as pieces of paper in your wallet. This "stored
value" will be used in everyday purchase and sale transactions just like
cash. Hence the chief function of the "stored value" is as a medium of
exchange (and not, as the name might imply, as intertemporal
savings--which is the usual meaning of the phrase "store of value" in
economic discussions of money).
The rights to Mondex are held by Mondex International Ltd., a U.K.
limited liability company. Fifty-one percent of Mondex International is
owned by MasterCard International, while a consortium of global banks
owns the other 49 percent. The U.S. rights to Mondex have been purchased
by a group of nationally-chartered U.S. banks, listed below.
These U.S. banks have in turn formed two Delaware limited liability
companies to operate Mondex. One of these two companies will act as a
bank. It will create, sell, and redeem the "electronically stored value"
(ESV) on Mondex cards. That is, it will trade other forms of U.S.
dollars for value stored on the Mondex card. It will issue (sell) ESV
for dollars, and it will redeem (buy back) ESV in exchange for dollars.
ESV is thus just another form of money: dollars, if denominated in
dollars; pounds, if denominated in pounds, and so on. From now on we
will simply call the Mondex ESV "Mondex Dollars".
The Delaware company acting as the bank is called an OLLC (Originator
Limited Liability Company). Its liabilities will be the Mondex Dollars
it issues against payment. The money the OLLC receives will be invested
in U.S. government securities, and cash and cash-equivalents such as
interbank deposits and overnight repurchase agreements. These are the
OLLC assets. The holdings of cash and cash-equivalents is required in
order to be able redeem Mondex Dollars on demand.
The second Delaware company will act as a licensing and servicing
entity. The equity in the two companies is divided up between Wells
Fargo (30 percent), Texas Commerce Bank (20 percent), First National
Bank of Chicago (10 percent), AT&T (10 percent), NOVUS (10 percent), and
MasterCard (10 percent).
In granting these nationally-chartered banks the right to operate a
subsidiary which carries out digital cash operations, the OCC applied
four criteria: (1) Is the operation related to banking? (2) Do the banks
have sufficient control to disallow non-banking activities? (3) Is the
banks' loss exposure limited? (4) Is the investment related to the
banks' ordinary banking business? Since the OCC determined that the
answers to these four questions were all "yes", it approved the Mondex
proposal.
Regulation E
The Federal Reserve's Regulation E implements the Electronic Fund
Transfer Act (EFTA). Under the guise of consumer protection, Regulation
E requires various disclosures related to electronic funds transfer, as
well as advance notice of changes in terms, transaction receipts,
periodic statements, error resolution procedures, limitations on
consumer liability, and restrictions on unsolicited giving of
funds-transfer access-devices to consumers. On May 2, 1996, the Federal
Reserve proposed to extend Regulation E to stored value cards. It would
classify stored-value systems as "on-line", "off-line accountable", or
"off-line unaccountable".
On-line systems would be simple debit cards where accounts balances are
stored in a central database, not on the card, and communication with
the central facility is required for balance transfers. Off-line
accountable systems are ones in which balances are recorded on the card,
transactions do not have to be transmitted to a central facility to be
pre-authorized, but where each transaction is stored and periodically
transmitted to a central facility. Off-line unaccountable systems are
those in which transactions are not pre-authorized, transactions are not
traceable to a particular card, and the card's value is only recorded on
the card itself.
The Fed proposes to make both on-line and off-line accountable systems
subject to Regulation E requirements on transaction receipts and dispute
resolutions if the maximum value that can be loaded is greater than
$100, but exempt if the maximum value is $100 or less. Off-line
unaccountable systems allowing values greater than $100 would be subject
to the Regulation E requirement on initial disclosure, but would be
totally exempt with respect to payment transactions. On-line systems
allowing values greater than $100 would have to meet all requirements of
Regulation E, except for periodic statements, provided an account
balance and account history is available on request.
The Fed's proposal would thus seem to eliminate on-line anonymous
systems (because of the transaction history requirement), but would
allow for off-line anonymous systems under the "off-line unaccountable"
option--as long as account withdrawals were recorded.
A digital cash system like Mondex, operating out of Delaware, has to
grapple with all these issues. This has the advantage that, having made
the regulators happy, the Mondex owners can then aggressively market
their product through all the usual banking and financial channels.
But those who are looking to create a digital cash product where privacy
and security are paramount will probably want to go off-shore and avoid
the regulators to a great extent. But they will still be left with the
more important, and practical, problem of making their customers happy.
And they will still be looking to recapture some of the central bank
seigniorage.
Click for a Menu of Other Digital Cash Articles by J. Orlin Grabbe
* * *
[1] Bank for International Settlements, Implications for Central Banks
of the Development of Electronic Money, Basle, October 1996.
[2] Glover, Paul, "Creating Ecological Economics with Local Currency",
undated manuscript. Glover's article contains a lot of grass-roots
socialism that I don't agree with. But that is not material to the use
of HOURS as an illustration of an alternative currency.
[3] Federal Deposit Insurance Corporation, "General Counsel's Opinion
No. 8--Stored Value Cards," by William F. Kroener, III, General Counsel,
FDIC, July 16, 1996.
[4] Office of the Comptroller of the Currency,
"Interpretations--Conditional Approval #220," published in
Interpretations and Actions, December 1996.
[30]
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Digital Cash - Regulators
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J. Orlin Grabbe
is one of the leading experts in the expanding area of financial data
encryption systems being developed for the new CyberEconomy.
He is also one of the world's leading experts on international finance.
His textbooks on the subject are ubiquitous in top universities
worldwide. No serious student of international finance is unaware of who
he is and what he has done.
He is a Harvard Ph.D. While a professor at Wharton, he trained many of
the top traders and derivatives experts as well as the "quants" who run
Wall Street's automated computer trading systems.
E-mail
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Aloha, He'Ping,
Om, Shalom, Salaam.
Em Hotep, Peace Be,
All My Relations.
Adieu, Adios, Aloha.
Amen.
Roads End
Kris
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