Smart Cards

Smart cards, also called stored value cards, use magnetic stripe technology or integrated circuit chips to store customer-specific information, including electronic money.The cards can be used to purchase goods or services, store information, control access to accounts, and perform many other functions. Smart cards offer clear benefits to both merchants and consumers. They reduce cash-handling expenses and losses caused by fraud, expedite customer transactions at the checkout counter, and enhance consumer convenience and safety. In addition, many state and federal governments are considering stored value cards as an efficient option for dispersing government entitlements. Other private sector institutions market stored value products to transit riders, university students, telephone customers, vending customers, and retail customers.

One successful use of stored value cards is by New York’s Metropolitan Transportation Authority (MTA). The MTA is the largest transportation agency in the United States and, through its subsidiaries and affiliates, operates the New York City subway and public bus system, the Long Island Railroad and Metro-North commuter rail systems, and nine tolled intrastate bridges and tunnels.These facilities serve four million customers each workday. In 1994, the MTA began the operation of an automated fare-collection system based on a plastic card with a magnetic stripe. The MetroCard is either swiped through a card reader at subway stations or dipped into a fare box on buses where the fare is decremented. All 3,600 MTA buses became operational in 1996. The full complement of 467 subway stations is expected to be operational by mid-1997. By 1999, the MTA anticipates more than 1.2 billion electronic fare collection transactions a year on subway and bus lines.

The management challenges created by smart card payment systems are formidable. Institutions such as the MTA have made a considerable investment in the stored value card processing network, and to get a good return on investment must identify new and innovative ways to achieve additional operating efficiencies and value.

Smart Cards and Electronic Payment Systems

The enormous potential of electronic tokens is currently stunted by the lack of a widely accepted and secure means of transferring money on-line. In spite of the many prototypes developed, we are a long way from a universal payment system because merchants and banks have to be signed up and a means has to be developed to transfer money. Such a system moreover must be robust and capable of handling a large number of transactions and will require extensive testing and usage to iron out all the bugs. In the meantime, thousands of would-be sellers of electronic commerce services have to pay one another and are actively looking for payment substitutes. One such substitute is the smart card. Smart cards have been in existence since the early 1980s and hold promise for secure transactions using existing infrastructure.

Smart cards are credit and debit cards and other card products enhanced with microprocessors capable of holding more information than the traditional magnetic stripe. The chip, at its current state of development, can store significantly greater amounts of data, estimated to be 80 times more than a magnetic stripe. Industry observers have predicted that, by the year 2000,one-half of all payment cards issued in the world will have embedded microprocessors rather than the simple magnetic stripe.

The smart card technology is widely used in countries such as France, Germany, Japan, and Singapore to pay for public phone calls, transportation/ and shopper loyalty programs. The idea has taken longer to catch on in the United States, since a highly reliable and fairly inexpensive telecommunications system has favored the use of credit and debit cards. Smart cards are basically of two types:

  • Relationship-based smart credit cards
  • Electronic purses. Electronic purses, which replace money, are also known as debit cards and electronic money.

Relationship-Based Smart Cards

Financial institutions worldwide are developing new methods to maintain and expand their services to meet the needs of increasingly sophisticated and technically smart customers, as well as to meet the emerging payment needs of electronic commerce. Traditional credit cards are fast evolving into smart cards as consumers demand payment and financial services products that are user-friendly, convenient, and reliable. A relationship based smart card is an enhancement of existing card ser-vices and/or the addition of new services that a financial institution delivers to its customers via a chip-based card or other device. These new services may include access to multiple financial accounts, value-added marketing programs, or other information cardholders may want to store on their card.

The chip-based card is but one tool that will help alter mass marketing techniques to address each individual’s specific financial and personal requirements. Enhanced credit cards store cardholder information including name, birth date, personal shopping preferences, and actual purchase records. This information will enable merchants to accurately track consumer behavior and develop promotional programs designed to increase shopper loyalty. Relationship-based products are expected to offer consumers far greater options, including the following:

  • Access to multiple accounts, such as debit, credit, investments or stored value for e-cash, on one card or an electronic device
  • A variety of functions, such as cash access, bill payment, balance inquiry, or funds transfer for selected accounts
  • Multiple access options at multiple locations using multiple device types, such as an automated teller machine, a screen phone, a personal computer, a personal digital assistant (PDA), or interactive TVs Companies are trying to incorporate these services into a personalized banking relationship for each customer. They can package financial and non financial services with valueadded programs to enhance convenience, build loyalty and retention, and attract new customers. Banks are also attempting to customize services on smart cards, offering a menu of services similar to those that come up on ATM screens. As with credit cards/banks may link up with health care providers, telephone companies, retailers, and airlines to offer frequent shopping and flyer programs and other services.

Electronic Purses and Debit Cards

Despite their increasing flexibility, relationship-based cards are credit based and settlement occurs at the end of the billing cycle. There remains a need for a financial instrument to replace cash. To meet this need, banks, credit card companies, and even government institutions are racing to introduce “electronic purses,” wallet-sized smart cards embedded with programmable microchips that store sums of money for people to use instead of cash for everything from buying food, to making photocopies, to paying subway fares.

The electronic purse works in the following manner.

After the purse is loaded with money, at an ATM or through the use of an inexpensive special telephone, it can be used to pay for, say, candy in a vending machine equipped with a card reader. The vending machine need only verify that a card is authentic and there is enough money available for a chocolate bar. In one second, the value of the purchase is deducted from the balance on the card and added to an e-cash box in the vending machine. The remaining balance on the card is displayed by the vending machine or can be checked at an ATM or with a balance-reading device. Electronic purses would virtually eliminate fumbling for change or small bills in a busy store or rush-hour toll booth, and waiting for a credit card purchase to be approved. This allows customers to pay for rides and calls with a prepaid card that “remembers” each transaction. And when the balance on an electronic purse is depleted, the purse can be recharged with more money.

As for the vendor, the receipts can be collected periodically in person—or, more likely, by telephone and transferred to a bank account. While the technology has been available for a decade, the cards have been relatively expensive, from $5 to $10. Today the cards cost $1, and special telephones that consumers could install at home to recharge the cards are projected to cost as little as $50. A simple card reader would cost a merchant less than $200.

Electronic or Digital Cash

Electronic or digital cash combines computerized convenience with security and privacy that improve on paper cash. The versatility of digital cash opens up a host of new markets and applications. Digital cash attempts to replace paper cash as the principal payment vehicle in online payments. Although it may be surprising to some, even after thirty years of developments in electronic payment systems, cash is still the most prevalent consumer payment instrument.

Cash remains the dominant form of payment for three reasons:

  • lack of consumer trust in the banking system;
  • inefficient clearing and settlement of non-cash transactions; and
  • negative real interest rates on bank deposits.

These reasons behind the prevalent use of cash in business transactions indicate the need to re-engineer purchasing processes. In order to displace cash, electronic payment systems need to have some cash-like qualities that current credit and debit cards lack. For example, cash is negotiable, meaning that it can be given or traded to someone else. Cash is legal tender, meaning that the payee is obligated to take it. Cash is a bearer instrument, meaning that possession is proof of ownership. Cash can be held and used by anyone, even those without a bank account. Finally, cash places no risk on the part of the acceptor; the medium is always good.

In comparison to cash, debit and credit cards have a number of limitations. First, credit and debit cards cannot be given away because, technically, they are identification cards owned by the issuer and restricted to one user. Credit and debit cards are not legal tender, given that merchants ‘have the right to refuse to accept them. Nor are credit and debit cards bearer instruments; their usage requires an account relationship and authorization system. Similarly, checks require either personal knowledge of the payer, or a check guarantee system. A really novel electronic payment method needs to do more than recreate the convenience that is offered by credit and debit cards; it needs to create a form of digital cash that has some of the proper-ties of cash.

Properties of Electronic Cash

  • Digital cash must have a monetary value; it must be backed by cash (currency), bank-authorized credit, or a bank-certified cashier’s check. When digital cash created by one bank is accepted by others, reconciliation must occur without any problems. Without proper bank certification, digital cash carries the risk that when deposited, it might be returned for insufficient funds.
  • Digital cash must be interoperable or exchangeable as payment for other digital cash, paper cash, goods or services, lines of credit, deposits in banking accounts, bank notes or obligations, electronic benefits transfers, and the like.
  • Digital cash must be storable and retrievable. Remote storage and retrieval (such as via a telephone or personal communications device) would allow users to exchange digital cash (withdraw from and deposit into banking accounts) from home or office or while travelling.
  • Digital cash should not be easy to copy or tamper with while it is being exchanged. It should be possible to prevent or detect duplication and doublespending of digital cash.

Using the Digital Currency

Once the tokens are purchased, the e-cash software on the customer’s PC stores digital money undersigned by a bank. The user tan spend the digital-money of any shop accepting e-cash, without having to open an account there first or-having to transmit credit card numbers. As soon as the customer wants to make a payment, the software collects the necessary amount from the stored tokens.

Two types of transactions are possible: bilateral and trilateral.

Typically, transactions involving cash are bilateral or two-party (buyer and seller) transactions, whereby the merchant checks the veracity of the note’s digital signature by using the bank’s public key. If satisfied with the payment, the merchant stores the digital currency on his machine and deposits it later in the bank to redeem the face value of the note. Transactions involving financial instruments other than cash are usually trilateral or three-party (buyer, seller, and bank) transactions, whereby the “notes” are sent to the merchant, who immediately sends them directly to the digital bank. The bank verifies the validity of these “notes” and that they have not been spent before. The account of the merchant is credited.

In this case, every “note” can be used only once. In many business situations, the bilateral transaction is not feasible because of the potential for double spending, which is equivalent to bouncing a check. Double spending becomes possible because it is very easy to make copies of the e-cash, forcing banks and merchants to take extra precautions. To uncover double spending, banks must compare the note passed to it by the merchant against a database of spent notes .Just as paper currency is identified with a unique serial number, digital cash can also be protected. The ability to detect double spending has to involve some form of registration so that all “notes” issued globally can be uniquely identified. However, this method of matching notes with a central registry has problems in the on-line world. For most systems, which handle high volumes of micro payments, this method would simply be too expensive. In addition, the problem of double spending means that banks have to carry added overhead because of the constant checking and auditing logs. Double spending would not be a major problem if the need for anonymity were relaxed. In such situations, when the consumer is issued a bank note, it is issued to that person’s unique license. When he or she gives it to some-body else, it is transferred specifically to that other person’s license.

Each time the money changes hands, the old owner adds a tiny bit of information to the bank note based on the bank note’s serial number and his or her license. If somebody attempts to spend money twice, the bank will now be able to use the two bank notes to determine who the cheater is. Even if the bank notes pass through many different people’s hands, whoever cheated will get caught, and none of the other people will ever have to know. The downside is that the bank can tell precisely what your buying habits are since it can check the numbers on the e-cash and the various merchant accounts that are being credited. Many people would feel uncomfortable letting others know this personal information.

Bank digital currency server

Drawback of E-cash

One drawback of e-cash is its inability to be easily divided into smaller amounts. It is often necessary to get small denomination change in business transactions. A number of variations have been developed for dealing with the “change” problem. For the bank to issue users with enough separate electronic “coins” of various denominations would be cumbersome in communication and storage. So would a method that required payees to return extra change. To sidestep such costs, customers are issued a single number called an “open check” that contains multiple denomination values sufficient for transactions up to a prescribed limit. At payment time, the e-cash software on the client’s computer would create a note of the transaction value from the “open check.”

Business Issues and Electronic Cash

Electronic cash fulfils two main functions: as a medium of exchange and as a store of value. Digital money is a perfect medium of exchange. By moving monetary claims quickly and by effecting instant settlement of transactions, e-cash may help simplify the complex interlocking credit and liabilities that characterize today’s commerce. For instance, small businesses that spend months waiting for big customers to pay their bills would benefit hugely from a digital system in which instant settlement is the norm. Instant settlement of micro payments is also a tantalizing proposition.

The controversial aspects of e-cash are those that relate to the other role, as a store of value. Human needs tend to require that money take a tangible form and be widely accepted, or “legal tender”. In most countries, a creditor by law cannot refuse cash as settlement for a debt. With the acceptability of cash guaranteed by law, most people are willing to bank their money and settle many of their bills by checks and debits, confident that, barring a catastrophe, they can obtain legal tender (cash) on demand. If e-cash had to be convertible into legal tender on demand, then for every unit there would have to be a unit of cash reserved in the real economy: or, to look at it the other way round, there would be cash in the real world for which digital proxies were created and made available.

This creates problems, because in an efficient system, if each e-cash unit represents a unit of real cash, then positive balances of e-cash will earn no interest; for the interest they might earn would be offset by the interest foregone on the real cash that is backing them. The enormous currency fluctuations in international finance pose another problem. On the Internet, the buyer could be in Mexico and the seller in the United States. How do you check-that the party in Mexico is giving a valid electronic currency that has suitable backing? Even if it were valid today, what would happen if a sudden devaluation occurs such as the one in December 1994 where the peso was devalued 30 percent overnight. Who holds the liability, the buyer or the seller? These are not technological issues but business issues that must be addressed for large-scale bilateral transactions to occur. Unless, we have one central bank offering one type of electronic currency, it is very difficult to see e-cash being very prominent except in narrow application domains.

From a banker’s point of view, e-cash would be a mixed blessing. Because they could not create new money via lending in the digital world, banks would see electronic money as unproductive. They might charge for converting it, or take a transaction fee for issuing it, but on-line competition would surely make this a low-profit affair. In the short term, banks would probably make less from this new business than they would lose from the drift of customers away from traditional services. It seems unlikely that e-cash would be allowed to realize its potential for bypassing the transaction costs of the foreign exchange market. If you pay yen for e-cash in Osaka and buy something from a merchant based in New York who cashes them for francs, a currency conversion has taken place. That, however, is an activity toward which most governments feel highly defensive; and if e-cash started to bypass regulated foreign exchange markets by developing its own gray market for settlement, then governments might be provoked into trying to clamp down on it. Because of these obstacles, e-cash in its early forms may be denominated in single currencies and exchanged at conventional market rates.

Next we will see the risks involved while doing the transactions involving the use of e-cash.

Operational Risk and Electronic Cash

Operational risk associated with e-cash can be mitigated by imposing constraints, such as limits on

  1. the time over which a given electronic money is valid,
  2. how much can be stored on and transferred by electronic money
  3. the number of exchanges that can take place before a money needs to be redeposit with a bank or financial institution, and
  4. the number of such transactions that can be made during a given period of time.

These constraints introduce a whole new set of implementation issues For example, time limits could be set beyond which the electronic money, would expire and become worthless. The customer would have to redeem or exchange the money prior to the expiration deadline. For this feature to work; electronic money would have to be timestamped, and time would have to be synchronized across the network to some degree of precision. The objective of imposing constraints is to limit the issuer’s liability. A maximum upper limit could be imposed on the value that could be assigned to any single transaction or that could be transferred to the same vendor within a given period of time. Since the user’s computer could be programmed to execute small transactions continuously at a high rate over the network, a strategy of reporting transactions over a certain amount would be ineffective for law enforcement.

However, a well-designed system could enforce a policy involving both transaction size and value with time. For example, an “anonymous coinpurse” feature might be capable of receiving or spending no more than $500 in any twentyfour hour period. Alternatively, the “rate ceiling” for the next twenty-four hours could be made dependent on the rate of use or on the number of exchanges that could be permitted before any electronic money would have to be redeposit in a bank or financial institution and reissued. Finally, exchanges could also be restricted to a class of services or goods (e.g., electronic benefits could be used only for food, clothing, shelter, or educational purposes). The exchange process should allow payment to be withheld from the seller upon the buyer’s instructions until the goods, or services are delivered within a specified time in the future.

Legal Issues and Electronic Cash

Electronic cash will force bankers and regulators to make tough choices that will shape the form of lawful commercial activity related to electronic commerce. As a result of the very features that make it so attractive to many, cash occupied an unstable and uncomfortable place within the existing taxation and law enforcement systems. Anonymous and virtually untraceable, cash transactions today occupy a place in a kind of underground economy. This underground economy is generally confined to relatively small scale transactions because paper money in large quantities is cumbersome to use and manipulate organized crime being the obvious exception. As long as the transactions fare small in monetary value, they are tolerated by the government as an unfortunate but largely insignificant by product of the modern commercial .state. As transactions get larger the government becomes more suspicious and enlists the aid of the banks, through the various currency reporting laws, in reporting large disbursements of cash so that additional oversight can be ordered.

E-cash on taxation

Transaction based taxes (e.g., sales taxes) account for a significant portion of state and local government revenue. But if e-cash really is made to function the way that paper money does, payments we would never think of making in cash-to buy a new car, say, or as the down payment on a house-could be made in this new form of currency because there would be no problem of bulk and no risk of robbery. The threat to the government’s revenue flow is a very real one, and officials in government are starting to take cognizance of this development and to prepare their responses. To prevent an underground economy, the government through law may prevent a truly anonymous and untraceable e-cash system from developing. Just as powerful encryption schemes permit the design of untraceable e-cash systems, so, too, do powerful electronic record-keeping tools permit the design of traceable systems-systems in which all financial transactions are duly recorded in some database, allowing those with access to know more about an individual than anyone could know today. Anything that makes cash substantially easier to use in a broader range of transactions holds the potential to expand this underground economy to pro-portions posing ever more serious threats to the existing legal order.

Under the most ambitious visions of e-cash, we would see a new form of currency that could be freely passed off from one computer to another with no record, yet incapable of being forged. A consumer could draw such e-cash electronically from his or her bank. The bank would have a record of that transaction, just as a withdrawal or check is recorded now. But after that, the encrypted e-cash file could be handed off without the knowledge of anyone but the par-ties to the transaction. However, as the politics and business play out, the technology is forcing legal, as issues to be reconsidered. The question e-cash poses is not, “Should the law take notice of this development?” but rather, “How can it not?” By impacting revenue-raising capabilities, e-cash cannot escape government scrutiny and regulation; but it is going to take some serious thinking to design a regulatory scheme that balances personal privacy, speed of execution, and ease of use. Without a functioning system, what the government will do remains a mystery. Moreover, it is not even clear yet that the market as a whole will adopt an anonymous e-cash standard. For now, we are mainly watching and trying to educate ourselves about the likely path of the transition to electronic cash.

Electronic Tokens

An electronic token is a digital analogue of various forms of payment backed by a bank or financial institution.

Electronic tokens are of three types:

  1. Cash or real-time. Transactions are settled with the exchange of electronic currency. An example of on-line currency exchange is electronic cash (e-cash).
  2. Debit or prepaid. Users pay in advance for the privilege of getting information.Examples of prepaid payment mechanisms are stored in smart cards and electronic purses that store electronic money.
  3. Credit or post-paid. The server authenticates the customers and verifies with the bank that funds are adequate before purchase. Examples of post-paid mechanisms are credit/ debit cards and electronic checks.

The following sections examine these methods of on-line payment. But we must first understand the different viewpoints that these payment instruments bring to electronic commerce.

Here are four dimensions that are useful for analyzing the different initiatives.

  1. The nature of the transaction for which the instrument is designed, Sometokens are-specifically designed to handle micro payments, that is, payments for small snippets of information. Others are designed for more traditional products. Some systems target specific niche transactions; others seek more general transactions. The key is-to identify the parties involved, the average amounts, and the purchase interaction.
  2. The means of settlement used. Tokens must be backed by cash, credit, electronic bill payments (prearranged and spontaneous), cashier’s checks, letters and lines of credit, and wire transfers, to name a few. Each option incurs trade-offs among transaction speed, risk, and cost. Most transaction settlement methods use Credit cards, while others use other proxies for value, effectively creating currencies of dubious liquidity and with interesting tax, risk, and float implications.
  3. Approach to security, anonymity, and authentication. Electronic tokens vary in the protection of privacy and confidentiality of the transactions. Some may be more open to potentially prying eyes-or even to the participants themselves. Encryption can help with authentication, non reputability, and asset management.
  4. The question of risk. Who assumes what kind of risk at what time? The tokens might suddenly become worthless and the customers might have the currency that nobody will accept. If the system stores value in a smart card, consumers may be exposed to risk as they hold static assets. Also electronic tokens might be subject to discounting or arbitrage. Risk also arises if the transaction has long lag times between product delivery and payments to merchants. This exposes merchants to the risk that buyers don’t pay-or vice versa that the vendor doesn’t deliver.

Other Emerging Financial Instruments

Several other electronic payment systems are currently being prototyped and tested. These include debit cards, electronic benefit transfer cards, and smart cards.

Debit Cards at the Point of Sale (POS)

The fastest growing number of electronic transactions today is debit card pointof- sale transactions. Such a transaction occurs when a customer uses a debit card to make a purchase from a merchant (supermarket, gas station, convenience store, or some other store that accepts such cards instead of using cash, check, or credit card). The transaction works much like a credit card transaction. For example, a customer gives an ATM card to the merchant for the purchase. The merchant swipes the card through a transaction terminal, which reads the information; the customer enters his personal identification number (PIN); and the terminal routes the transaction through the ATM network back to the customer’s bank for authorization against the customer’s demand deposit account. The funds, once approved, are transferred from the customer’s bank to the merchant’s bank. These transactions occur within the banking system, and safety of payment is assured.

The third-party processors who provide services for merchants are also examined by the federal regulators for system integrity. Both the consumer and the merchant maintain bank accounts, and the funds are transmitted inter-bank within the payment system. Authentication is provided by the use of the digital signature or PIN numbers, just as it is at ATMs. Further, PINs are sent through the system in an encrypted form, and the PIN pads and terminals are tamper-proof. Dedicated lines are also often used for transmission, particularly by larger merchants.

Debit Cards and Electronic Benefits Transfer

Debit cards are being used extensively for electronic benefits transfer (EBT). Electronic benefits transfer uses debit cards for the electronic delivery of benefits to individuals who otherwise may not have bank accounts. In an EBT system, recipients access their benefits in the same way that consumers use debit cards to access their bank accounts electronically: the card is inserted into or swiped through a card reader and the cardholder must enter a PIN associated with that card. The benefit recipient can then access his or her benefits to make a purchase or obtain cash. For example, food stamp purchases are charged against the participant’s allotment, and other purchases or cash distributions are charged against the participant’s cash assistance program allotment.

Benefits that can be delivered via EBT generally fall into three cate-gories: federally funded, but state administered benefits (such as food stamps, Aid to Families with Dependent Children programs); state-funded and state-administered benefits (such as general assistance, heating assistance, refugee assistance, and supplemental or emergency payments); and benefits that are both federally funded and federally administered (such as Social Security and Veterans benefits). Through EBT, existing networks and technologies can provide benefit recipients with online access to their funds at pas devices and ATMs. In an EBT process, no paper changes hands, except for the receipt printed for the purchaser by the pas device or the ATM. Recipients can access cash through any number of establishments, including grocers, drugstores, and financial institutions, as well as ATMs. Certain cash payments can also be facilitated by installing pas devices in housing authority and utility company offices to accept rent and bill payments. Electronic benefits transfer has several advantages over paper based, benefit distribution systems.

First, EBT is less costly. Currently, many recipients of federal and state benefits must pay significant fees (three or more dollars) to cash their checks. EBT systems are designed to provide nocost or low-cost access methods. - Second, EBT is more convenient than paper methods. EBT eliminates the need to carry food stamp coupons, stand in long lines to cash checks, or accept the entire benefit amount at one time. EBT programs also provide recipients with toll-free customer service lines and multilingual support to handle questions or problems. EBT is safer than cash or coupons, which can be lost or stolen. In EBT, benefits are stored electronically, and can be used only when needed and in the amounts required. Recipients control all ac-cess to their benefits through their cards and PINs. They can also deactivate lost or stolen cards immediately and request a replacement card by a toll free phone call. Third, EBT is convenient for retailers. It eliminates the time-consuming task of handling food stamp coupons, making grocery checkout procedures faster and easier. By eliminating checks and coupons, EBT reduces losses associated with theft, forgery, and fraud.

Finally, EBT is convenient for the government. Its inherent audit and tracking advantages enhance investigations into suspicious conduct by retailers. EBT improves benefit program management by creating an audit trail and record of benefit usage, ensuring that programs are working properly and effectively.

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