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?

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.

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.

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.

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.

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.

[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.