ESSAY
Exploring the Role of Digital Currency in the Retail Payments System
Julia Alpert Gladstone *
I. Introduction
Advanced telecommunications and computer technology have been moving trillions of dollars around the world each day for many years. The technology for electronic retail payments is here and society's demand for it is burgeoning. These payment transactions must be as transparent, convenient and secure for customers and merchants as cash, checks and credit cards. Our current legal and regulatory payments infrastructure is based upon principles of paper negotiability, which is not suited to deal with the commercial electronic future. While private contracts and procedures will be established there is a need for clear and uniform rules which address the risk and liability in a digital currency transaction.
The electronic payments marketplace is a new and exciting frontier. However, not only are the stakes high, but the players and the rules are undefined. In considering the various policy decisions that will bring about a uniform legal construct for the electronic payments marketplace, this Essay describes the retail electronic payments systems and examines the key issues raised in creating payments efficiency. Part II defines digital currency, one of the newest forms of electronic payments, and clarifies its relationship to other payment forms. Part III describes the creation of a digital currency payment obligation, and in doing so, discusses the problems of characterizing the underlying funds and the difficulty in ascertaining the obligor. Part IV analyzes two main problems that arise during the transfer process of a digital currency transaction: spawning, or double payment, and risk apportionment. Finally, Part V describes in more detail the problems of spawning, which occurs in the final stage of a digital currency transaction. Successful integration of electronic payments into our current payments system is dependant upon a functional uniform legal framework that can regulate transactions, such as the digital currency transactions described in this Essay.
A thorough discussion of the new electronic payment systems encompasses diverse disciplines some of which will only briefly be touched upon in this Essay. Initially one must distinguish between the various types and examples of electronic payment systems. This Essay will consider open system stored value products, in which a payment obligation is given by an issuer in exchange for money.(1) This payment obligation may be placed on a plastic card or on a computer device and is hereinafter referred to as "digital currency."(2)
There are several organizations conducting pilot programs of different digital currencies none of which have garnered a significant user mass.(3) Cryptographic protocols, which require trusted third parties, will be implemented in these new products to create secure systems to facilitate consumer confidence and acceptance of digital currency. A technical explanation of cryptography including digital signatures which are an integral part of these product profiles is beyond the scope of this Essay, as well as the related legal issues of anonymity and privacy.(4) The impact of digital currency on the global economy, particularly central banks and their monetary systems, is also not addressed in the following exploration.(5)
II. Credit, Money and Cash: What's the Difference?
Money is well defined in the Uniform Commercial Code (UCC), as "a medium of exchange authorized or adopted by a domestic or foreign government."(6) Legal tender is a concept without a concrete meaning, and therefore, it is critical to explain the complex relationship of legal tender, money and digital currency.
Prior to the Civil War the United States government had a very limited role in the issuance of money. Banks issued private notes, or IOUs, that were backed by collateral, principally gold. These notes were most often sold at a discount that was determined by the financial market's perception of the creditworthiness of the issuing institution. This system of private money created an unstable financial environment in which banks failed and note holders consequently suffered great losses. This atmosphere of financial insecurity resulted in a general reluctance by the public to take the paper/notes of issuing institutions.(7)
In response to this financial crisis and to finance the Civil War, the Federal government began to issue to the public its own notes or "greenbacks" which were redeemable upon demand by the government in gold coin. From approximately 1861 to 1932 private bank notes, "temporary currency" issued under the Aldrich-Vreeland Act, and Federal Reserve Notes circulated along side of each other as a means to discharge debt. By 1933 the Federal Reserve Note was the only direct obligation of the United States government.(8) The Federal Reserve Note, that green 6 ¼" x 2" piece of paper, remains the only form of circulating legal tender today.
In its simplest form legal tender is the particular medium of exchange that the government determines shall be accepted in satisfaction of taxes. In the Legal Tender Cases, a series of United States Supreme Court cases decided between 1870 and 1884, the Court held that Congress had the power to establish paper as the national currency.(9) Furthermore, the United States Supreme Court defined "legal tender" as currency that is lawfully used to pay all debts, public charges and taxes.(10)
Based upon the Court's clear articulation of legal tender, no rational person would discharge a payment obligation with anything other than a Federal Reserve Note or dollar bill. Pursuant to the Banking Act of 1933, however, the Federal Deposit Insurance Corporation (FDIC) was established, whereby the Federal government began to guarantee preset amounts and types of bank credit. This deposit insurance has functionally eliminated any practical difference between a U.S. dollar, a direct claim on the government, and a deposit held in an insured bank. Money, as it is represented in one's bank account, is an insured bank credit obligation up to a certain limit. But this money will always remain legally distinct from the dollar bill, which is legal tender. The special status that FDIC insurance bestows upon bank credit has caused the transfer of bank credit, or "money," to displace legal tender as the preferred method of payment for the vast majority of financial transactions.
Society's ready substitution of legal tender for the payment obligation of another, otherwise know as bank credit versus the dollar, is a vital development, or precursor, to understanding the role and function of new payment methods.(11) Digital currency is the representation in binary code of an other's promise to pay. It is not considered legal tender and will not have that status absent an act of Congress. It is very likely, however, that digital currency like money and other payment obligations, such as cashier's and traveler's checks, will become readily acceptable to discharge debt.
The suitability and success of digital currency in our retail payments system will depend upon the development of an effective framework that defines the process of payment discharge and delineates the method of recourse when payment and discharge are disrupted (such as a stop payment or returned check). The commercial practices that evolve to facilitate the integration of digital currency into our payments system may ultimately develop through self regulation as efficiently as by legislation. The key will be for digital cash transactions to be as transparent and as convenient as all other alternatives to legal tender.
A digital currency transaction that does not execute successfully presents key risk assessment and risk allocation issues. The existing commercial or banking regulations provide very little guidance in addressing the parties' rights and liabilities in a digital currency transaction? The American Bar Association's Task Force on Stored Value Cards prepared a report, which presents a "life cycle" of a stored value payment obligation. The Task Force examined the legal issues that arise when "digital currency" is created, transferred and redeemed. This life-cycle paradigm is instructive because it focuses on the creditworthiness of the digital currency issuer as well as on the legal responsibilities of the participants in a digital currency transaction.
III. The Creation Process of Digital Currency
Digital currency is a representation of an issuer's obligation to repay the user, and therefore, a digital currency payment obligation is created when the "user" or "holder" delivers money to the issuer. This may happen when a Federal Reserve Note is tendered to the issuer or, if the issuer is a bank, when the user's account is debited by the amount transferred into digital electronic form. The issuer incurs a liability or "due to" account while adding value to its asset or cash account. In practical terms the user has extended credit to the issuer; there is a lapse of time between the digital currency purchase or creation, and its use by the holder to purchase information or products.(12)
Several issues arise in determining the legal characterization of the funds that are held by the issuer to redeem the digital currency payment obligation. One such issue is whether these funds constitute a "deposit." Under the Federal Deposit Insurance Act a deposit is defined as "the unpaid balance of money or its equivalent received or held by a bank or savings association in the usual course of business and for which it has given or is obligated to give credit."(13) If these funds are determined to be deposits it is likely that the FDIC will take regulatory action to provide insurance coverage.(14)
At first blush FDIC regulatory insurance coverage would appear to foster consumer confidence and a smooth implementation of digital currency into our retail payments system. There are several well developed explanations that contradict such a finding, primarily, the fact that digital currency deposits are not liabilities of the issuing institution. Such rationales will result in a quicker and more stable commercial success. Those institutions that hold FDIC insured deposits are subject to numerous regulations and supervision. In an attempt to manage the risks of these institutions the FDIC imposes, among other restrictions, costly capital and reserve requirements. Digital currency does not involve any physically tangible representation and is so different from its existing counterparts (such as cash, checks, and credit cards) that consumer expectations regarding electronic money should be allowed to develop free from old formats. Therefore, offering private insurance for these products might strike the right balance between the confidence premium and the compliance burden which accompanies government insurance.(15)
The Glass-Steagall Act of the Banking Act of 1933(16) and its successor statutes, namely The Bank Holding Company Act of 1956,(17) as amended, and the Competitive Equality Banking Act of 1987(18) provide alternative considerations in the attempt to characterize finds underlying digital currency. In essence, these laws require that an institution which accepts demand deposits or deposits that a depositor "has a legal right to withdraw on demand" by check or similar means for payment to a third party, must be chartered as a bank.(19) According to these laws, if the funds underlying digital currency are defined as deposits, will only banks be able to issue digital currency? Currently, digital cash issuance is not generally deemed to constitute banking. This position is supported by the variety of existing currency equivalents, such as money orders and traveler's checks that are not exclusively within the domain of banks.(20)
Not only is it difficult to characterize the funds underlying digital currency, but the issuance of digital currency implicates numerous parties. The problem of identifying the obligor of the digital currency becomes apparent early in the "life cycle." The previous discussion of the bank as the "issuer" of digital currency implicitly assumes that the bank is the obligor. However, the practice of "cobranding" complicates labeling the bank as the obligor.(21) In the Mondex system, for example, the obligation will be issued by the originator and sold to members, who in turn sell the obligation to the user. While the credit risk ultimately lies with the originator this fact may be unclear from the information readily available to the user who may believe that the obligation is backed by someone who is not the obligor. As with traditional credit or charge cards, the obligor on a stored-value product may be only one of several disclosed names.
The ambiguity in identifying the obligor in the issuance of digital currency has led courts to hold all entities whose name appears on the card or computer device liable to the user. In apportioning this liability courts will likely look to any agreements between the various parties, contract common law, and agency principles. Analogies to negotiable instruments law, specifically accommodation and endorsement principles, are useful in determining responsible parties.(22) While there are currently no regulations surrounding obligor liability in digital currency issuances, Regulation E of the Electronic Funds Transfer Act(23) provides rules governing disclosure of the terms and conditions of an electronic funds transfer, as well as limiting consumer liability for unauthorized transfers. These disclosure requirements for electronic funds transfers would likely address the obligor identity problem in digital currency issuance, but the application of Regulation E to digital currency transactions is uncertain.(24) The electronic funds regulation, as it currently reads, would require the delivery of a physical receipt in a digital currency issuance, which seems to be unworkable for digital currency payment products. Debate on Regulation E's relevance to digital currency is ongoing. The most significant issue to the enhancement of consumer confidence, which is critical to the deployment of digital currency is the provision that limits the holder's liability and loss in various situations. Currently, digital cash accounts are for small amounts of money. The regulatory trend appears to exempt digital currency from the transactional notice requirements of Regulation E.
IV. The Transfer Process
Two key issues or characteristics of digital currency arise at the time of transfer of the digital currency payment obligation. First, the original digital denomination can and is intended to be broken into smaller amounts. This divisibility feature sets digital currency apart from similar traditional payment instruments. Although a dollar bill or a traveler's check may be counterfeited, thus producing multiple directions to pay, only the stored payment obligation is legally capable of being divided into smaller constituent parts. This risk in growth, which is recognized as a significant potential problem, is referred to as "spawning" and is discussed more fully in the discussion of the final, or settlement stage, of digital currency.(25)
The second pertinent issue that arises during the transfer process of digital currency concerns the apportionment of risk. This issue requires determining when the underlying obligation of the user or "payor" is discharged. In other words, when is the payment transfer completed? The threshold consideration in determining "completion" is whether the action taken by the payor in placing the digital currency into the system, or the receipt of the transfer by the payee, is required to execute a transfer. The advanced technology that effects these transfers is within the control of the payor, and therefore, a court would likely conclude that payment must be received for the obligation to be discharged.(26) As with most components of the digital currency transaction this issue will likely be addressed by agreement between the parties.
The complex questions concerning the allocation of risk and the legal consequences that arise when the original issuer fails to complete final payment are illustrated by the following hypothetical. A, the "user" or "buyer," buys a book from C, the "payee" or "seller," and pays for the book with digital currency. C redeems the currency from an intermediary, such as a bank, which in turn seeks payment from the original issuer, BBank. If BBank does not pay the claim or redeem the digital currency, can C seek repayment from A? This question may be answered by several different resolutions, depending upon the existing retail payment model which is followed.(27) There are various legal consequences to the various parties, which range from positive to negative, if you impose a cash, check, or banker's note/cashier's check analogy. The discrepancies between existing retail payment models and digital currency payment models are significant, and not surprisingly, the sponsors of current digital currency products are contracting away the uncertainties.
Here again one is are presented with fashioning a legal and policy decision that will facilitate acceptance of digital currency in the world of money. If we address the risk of loss issues in this hypothetical as though it were a cash transaction and the issuer/BBank refuses to pay C, then C will bear the risk of loss. A's obligation is discharged when the cash is handed over to C. Because there is virtually no credit risk when dealing with the United States government as an issuer which is the case with cash and legal tender, this analogy is not helpful in formulating digital currency regulations.
A personal check analogy also does not assist in allocations of risk in digital currency transactions. In a check transaction, a dishonored check that is returned by the intermediary bank by the midnight deadline limits C's recourse.(28) C may only go after the drawer A or the drawer bank BBank. If BBank has failed before A's debt is discharged then A would be required to repay C. In the digital currency scenario, however, C does not actually regard A as her debtor. Once the stored value is received, C does not expect to deal with A again. Thus, the personal check analogy falls short when allocating the risk in digital currency transactions.
The most appropriate allocation of loss and legal consequences is presented by the risk allocation model of the cashier's check. Here, as with the personal check scenario, we look to the rules and practices set out in Articles 3 and 4 of the Uniform Commercial Code. Upon the dishonor of a cashier's check C will look either to the issuer (BBank), or an endorser, (A). Absent A's endorsement, C will look to BBank, and if BBank has failed, then C must bear the risk of loss. Digital currency functions like a promise of the issuer to pay a note upon demand. C may have recourse against an insurer of the issuer, if applicable. While the cashier's check analogy seems most applicable to the digital currency risk allocation, it is not conclusive. The hypotheticals involving A, BBank, and C, merely highlight the potential areas of concern in the transfer of digital currency.
V. The Settlement Process
In the final stage of the digital currency's life cycle we face the almost certain possibility that our original stored payment obligation has been divided into smaller denominations and is being redeemed for money or legal tender. While it is not science fiction to envision a time when digital currency stays on line and gets "moved around," thus creating a full-blown internet currency,(29) such a vision does not further the current discussion of the role and regulation of digital currency today or in the foreseeable future.
"Spawning," the process whereby multiple claims for payment are created by a single authentic claim, may result from an innocent technical error or as the result of fraud. The particular nature of digital currency that allows divisibility from the initial denomination creates this unique problem of spawning. Double payment results because the issuer is unable to distinguish an authenticate claim from a counterfeit one. All holders' claims must therefore be paid as legitimate, and the assets to back up these payments are derived only from the authenticate issuance of digital currency. Consequently, the issuer will face illiquidity problems and potential insolvency.
Spawning is problematic because it increases the risk to the user. In essence, the user is extending credit or making a loan to the issuer. The destabilizing consequences of spawning certainly increase the credit risk to the user, consumer confidence, which is a prerequisite to the success of digital currency is threatened. It is therefore incumbent upon the developers of digital currency to address both the operational risks and the fraudulent activities that lead to spawning.
VI. Conclusion
In the context of searching for a functional uniform legal framework this Essay has outlined the historical and fundamental transactional principles that underlie digital currency's operation. The major areas where rights and liabilities of the participants will be implicated are in characterizing the underlying payments and defining the obligor. The legal mechanisms of the existing retail payments system, such as cash, personal checks, and cashiers checks, are of little help in constructing the avenues for an efficient allocation of risks in digital currency transactions. Digital currency is in its infancy, and more legal and policy discussion is needed to arrive at a flexible, yet strong, legal construct that can be applied to the digital currency payment scheme.
* J.D., LL.M. in Banking; adjunct professor at New England School of Law; special lecturer at Providence College. She serves as vice-chair of the Information Infrastructure Committee of the American Bar Association Committee on The Law of Commerce and Cyberspace. Her previous publications in this discipline have appeared in regional bar journals.
1. "Open system" value products are distinguishable from the widely available "closed system" value products where the value placed on the card or other storage device is to be used only for a single purpose such as prepaid transit authority cards or prepaid telephone cards.
2. These new payment products or mechanisms are alternately described as the catchy electronic or "ecash," the propriety Digicash or Cybercash, or the now popular term, "stored value products." Each of these terms has its own particular characteristics. "Digital currency" is the designation used in this Essay to describe a generic payment obligation of an issuer, not necessarily an insured depository institution, which maintains its value as a medium of exchange and which has no tangible form. The currency is represented by a binary code of digits that is transmitted by electronic impulse. This code is maintained on a tiny piece of silicon or "chip" and may be stored as easily on a computer device or network as on a plastic card.
3. There are several electronic stored payment products in various stages of development. These entities include Mondex, which is conducting a trial of its Smart Card for cash transactions over the Internet in Swindon, England. See (visited May 2, 1997) <http://www.mondex.com/mondex/home.htm>. Cybercash of Reston, Virginia is a maker of software that uses encryption to provide on line payment services using cash; they are working with several financial institutions. See (visited May 2, 1997) <http://www.cybercash.com>. Digicash has developed a software system that allows users to download cash from banks and use it to buy information and products on the Internet. Mark Twain Bank of St. Louis, Missouri is the principal partner of Digicash. See (visited May 2, 1997) <http:/www.digicash.com>.
4. See generally A. Michael Froomkin's writings at <http:/www.law.miami.edu/~froomkin/articles>; see also A. Michael Froomkin, The Essential Role of Trusted Third Parties in Electronic Commerce, 75 Or. L. Rev. 49 (1996) (providing a thorough discussion of cryptographic protocols); A. Michael Froomkin, Flood Control on the Information Ocean: Living with Anonymity, Digital Cash and Distributed Databases, 15 U. PITT. J.L. & Com. 395 (1996) (providing a complete discussion of the relevant security and privacy issues).
5. See Sean Craig et al., Bank for International Settlements of the Monetary and Economic Dept., Implications for Central Banks of the Development of Electronic Money (visited May 31, 1997) <http://www.bis.org/publ/>.
7. See generally Task Force on Stored-Value Cards, A Commercial Lawyer's Take on the Electronic Purse: An Analysis of Commercial Law Issues Associated with Stored-Value Cards and Electronic Money, 52 BUS. LAW. 653 (1997) [hereinafter ABA Report].
8. See Thomas P. Vartanian et al., Echoes of the Past With Implications for the Future: The Stamp Payments Act of 1862 and Electronic Commerce, 67 Banking L. Rep. (BNA) 465-70 (Sept. 23, 1996) (thoroughly discussing past, present, and future multi-currency monetary structures).
9. See Henry H. Perritt, Jr., Legal and Technological Infrastructures for Electronic Payment Systems, 22 RUTGERS COMPUTER & TECH. L.J. 1, 8-10 (1996).
10. See The Legal Tender Cases, 79 U.S. (12 Wall.) 457 (1870).
11. See Hearings Before the House Subcomm. on Domestic and International Monetary Policy: "The Future of Money" (visited May 31, 1997) <http://eclipse.osc.edu/eclipse/dri.testimony.htm> (statement of Jeffrey B. Ritter).
12. See ABA Report, supra note 7; see also Thomas P. Vartanian, Key Question for Emerging Systems: Where is the Money?, AM. BANKER, June 17, 1996, at 6A.
13. 12 U.S.C. § 1813(1)(1) (1994).
14. See Stored Value Cards and Other Electronic Payment Systems, 61 Fed. Reg. 40,494, 40,494-97 (1996).
15. See Thomas P. Vartanian, Statement Before the Federal Deposit Insurance Corporation Concerning Stored Value Cards and Electronic Payment Systems (visited May 31, 1997) <http://www.ffhsj.com/bancmail/bancpage.htm>.
19. Board of Governors of Fed. Reserve Sys. v. Dimension Fin. Corp., 474 U.S. 361, 363 (1986). Interestingly, the Comptroller of the Currency's recently authorized four national banks to establish operating subsidiaries that will operate Mondex.
20. See generally Julia Alpert Gladstone, Esq., Designing Legislation to Facilitate Electronic Commerce on the Internet, XLV R.I. Bar J. 13 (1997).
21. ABA Report, supra note 7, at 681.
22. See generally U.C.C. § 3-300-400 (1994).
23. See 12 C.F.R. §§ 205.1-205.15 (1996).
24. See Electronic Funds Transfer Act, 61 Fed. Reg. 19,696, 19,696-705 (1996).
26. See generally ABA Report, supra note 7, at 695-700.
28. See U.C.C. § 4-301 (1994).
29. Tatsuo Tanaka, Possible Economic Consequences of Digital Cash, visited May 31, 1997) <http://www.FirstMonday.dk/issues/issue2/digital_cash/index.html>.