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Making Payments on the Internet

James J. McAndrews

Making Payments on the Internet
James J. McAndrews*

T

he Internet has begun to make the idealized marketplace discussed in economic textbooks seem more plausible. It allows low-cost,
speedy, convenient, and informative communication across the world. However, to become
an active market in goods and services the
Internet must overcome a fundamental hurdle:
a way must be devised for buyers and sellers
to securely and conveniently exchange payment
over the Internet. Software companies and financial institutions are now developing methods that will allow people to pay on the Internet.
*James McAndrews is a senior economist and research
advisor in the Banking and Financial Markets section of
the Philadelphia Fed’s Research Department.

A review of these efforts reveals the importance
of security, authenticity, and privacy, which are
often overlooked or taken for granted in other
instances of making a payment.
Money is an ancient human artifice. For
approximately 3000 years coins have been
minted in India and Greece. Minting coins for
use as media of exchange was a significant improvement over the alternative: exchange of
metals by weight for purchases. Coins made a
particular amount and quality of metal easily
recognizable and hard to counterfeit. Milling
the edges of coins made the practice of removing small amounts of metal from the coins very
easy to detect. The creation of banks of deposit
and their vaults made safeguarding coins easier.
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BUSINESS REVIEW

Hence, coins became readily identifiable and
transferable, attributes that raw metals did not
possess. These attributes made trade easier.
Our society is grappling with ways to create, once again, a way to make payments in a
new medium: the Internet. The designers of
Internet means of payment have the same concerns that occupied mints centuries ago: how
to make the proposed means of exchange easy
to recognize and authenticate, but hard to counterfeit and steal. Today’s designers work with
powerful mathematical means of encryption,
which can serve the same roles for Internet payments that minting coins served for earlier payment systems.
Several attributes of a successful medium of
exchange—one of money’s primary roles—
have emerged over the centuries. Money
should be identifiable, divisible, easy to transfer (both technologically and in the sense of
there being widespread acceptance), and easy
to protect against theft. The attempts to create
successful media of exchange over the Internet
reveal the importance of these attributes as well
as the difficulties of successfully designing a
system with those attributes.
THE INTERNET
The Internet, a network of computers that
use a common method of communication, has
experienced rapid growth in recent years. While
estimates of Internet size and usage are imprecise, one estimate shows that the number of
computers linked to the Internet increased from
213 in August 1981 to 3,864,000 in October 1994
and to 9,472,000 in January 1996. The amount
of message traffic across one part of the Internet
is estimated to have grown from 85 million
packets in January 1988 (a packet is approximately 200 bytes; a byte holds one alphabetic
character) to more than 60 billion packets in
January 1995.1 The Internet is used to send mail,
to transfer files, and—using the World Wide
Web—to transmit graphics and sound.2
The impressive growth of the Internet has
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JANUARY/FEBRUARY 1997

been facilitated to some extent by the steadily
declining cost of computers. Furthermore, in
many cases, individual users of the Internet (or
their employers or sponsoring organizations)
pay a fixed fee, or a fee that does not vary with
the number of sites from which they gather information, and there is no marginal fee for the
use of the network facilities in sending or receiving information. This zero marginal cost of
usage makes sending a message across the
country essentially free for many users.
The Internet differs from telephone networks
in that each message does not have a circuit
dedicated to it. Instead, a message on the
Internet is divided into packets, each with the
address of the message attached to it, and the
individual packets are sent through computers
(known as routers) to their destinations. This
packet switching method allows many packets
to simultaneously share the physical telecommunication lines across which the packets
travel. This greatly economizes on the use, and
therefore the costs, of telephone lines, relative
to telephone calls, which use a circuit switching
method that dedicates a circuit to a particular
call.3
This inexpensive and increasingly ubiquitous form of communication and information
transmission has made it possible to imagine
continuous, worldwide electronic commerce.
On the Internet, one can comparison-shop, read
1
The first of the two estimates was made by network
analyst Mark Lottor, and the second refers to message traffic across the NSFNET backbone—that part of the transmission lines funded by the National Science Foundation.
These estimates are reported by the Merit Network, Inc., a
nonprofit corporation providing a number of Internet services.
2
The World Wide Web is a communications protocol
developed for graphical content and sound.
3
A good discussion of the Internet is given by Jeffrey K.
MacKie-Mason and Hal Varian in “Economic FAQs About
the Internet,” Journal of Economic Perspectives, Volume 8,
Number 3, Summer 1994, pp. 75-96.

FEDERAL RESERVE BANK OF PHILADELPHIA

Making Payments on the Internet

warranties, establish accounts, view images of
products, and order goods and services from
companies located anywhere in the world.
Home shopping on the Internet could reduce
the transaction costs of shopping significantly;
many believe that it is the “killer app” of the
Internet.4 To flourish as a marketplace, however,
the Internet needs a means of payment, but
payment over the Internet faces some unique
barriers. In particular, the challenge is to devise
ways to protect against theft while conveying
payment information that is recognized as authentic.
CAN I PAY WITH A CREDIT CARD
OVER THE INTERNET?
When I make a phone call to my favorite
mail-order catalog to order a pair of shoes, the
only parties to the call are the order taker and
me. If I were to send an e-mail over the Internet
to the catalog company instead, the information may be routed through many computers
not party to the transaction before it reaches the
merchant, allowing others to intercept my message. If my credit card number is included, others can steal it. Furthermore, if a hacker has infiltrated either the merchant’s computer network or the one of my Internet access provider,
the hacker could intercept, read, and alter messages. Because of that, I can’t be sure that my
messages haven’t been read or altered after I’ve
sent them. The activity of intercepting and reading others’ messages is known as snooping.
While telephone fraud is a big problem, the
ease with which criminals can fake e-mail messages of others—someone with sufficient
knowledge of computer systems can connect
to the victim’s mailserver on the Internet and
send the fake message from it (an activity
known as spoofing)—makes enhanced security
a necessity. It is also much easier for criminals

4

A killer app is an application of a particular technology that many potential users find irresistible.

James J. McAndrews

to establish untraceable computer accounts to
fraudulently collect credit card numbers (if they
were unencrypted). It is much more difficult
to do so with telephone mail-order operations.
The real possibility of theft of the information has precluded the widespread use of
unencrypted credit card numbers over the
Internet. Furthermore, the ease with which
criminals can adopt fraudulent identities and
untraceable addresses on the Internet deters
people from attempting to purchase items over
the Internet. Therefore, new means of making
payment must be devised.
Designing a method of Internet payments,
therefore, requires attention to two features of
money that are necessary to securely convey
payment information. Authentication of messages is important for both parties to a transaction. Finding a means to prevent eavesdropping is important, so that criminals cannot steal
payment-related information, such as credit
card numbers, as they are transmitted over the
Internet. It may be that secret coding of information can solve both of these problems.
ENCRYPTION
As with all types of money, identification and
recognition are necessary before a seller will
accept a payment. Payment systems today use
various means to identify a payer. In credit card
transactions conducted in person, possession
of the card and a signature matching the one
on its back suffice. For point-of-sale transactions with a debit card, possession of the card
and a password identify the account holder.
When paying by check, a signature (and often
a photo identification card) is necessary. For
cash transactions, the currency is examined to
authenticate it.
On the Internet this means that correctly
identifying the customer and maintaining the
integrity of the information are vital. A password—even one that has been encoded by some
encryption device—is not enough to identify a
person if it is used more than once (because of
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the possibility of theft of the password). If an
encoded message is used more than once, it
could be duplicated and sent by some other
person posing as the original sender.
None of the measures used to authenticate
the means of payment today are foolproof.
Counterfeit currency and check and credit card
fraud are significant problems. But the ease with
which snoopers can intercept unencrypted
messages has led security experts to believe that
encryption of financial information is necessary
to approach the levels of security that people
now enjoy with cash, checks, and routine credit
card payments.
Privacy. Securing the integrity of a message
sent on the Internet poses a difficult problem.
Even when a message is encoded, if criminals
were to decode the message, or steal the “key”
by which the original message was encoded,
the integrity of the message would be lost. With
traditional encryption methods the sender and
receiver have to share the key to successfully
encrypt and decrypt a message. Therefore, the
sender has to give the key to the receiver in
some way. This makes the management of the
secret key extremely difficult because it is much
more likely to be stolen as it is shared with many
parties (for example, all the merchants that accept a type of credit card) and as it is being communicated to all the parties to a message. Furthermore, with traditional methods of encryption, once someone has stolen the key, messages
can be both decoded and encoded. Hence, a
criminal, armed with the key, can pose as a legitimate party to the encryption system, and
no one could detect the deception.
A new type of encryption was discovered in
the 1970s by Whitfield Diffie and Martin
Hellman, two American mathematicians. Their
contribution to encryption theory was to recognize that systems of encryption can be created that use a pair of keys, one to encrypt the
message and another to decrypt it. One type of
these “asymmetric” cipher systems is a “public
key/private key”cipher (commonly referred to
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JANUARY/FEBRUARY 1997

simply as a public key cipher) in which the encrypting key need not be kept secret to ensure
a private message.5 The decrypting key (the
“private key”) need never be shared with anyone else and, therefore, is much less susceptible
to theft. (See Keys to Establishing Trust in
Cyberspace.)
Under public key cryptography, if two
people wish to exchange private messages, they
each create a pair of public and private keys.
Alice obtains Bob’s public encryption key, uses
it to encrypt a message to Bob, and sends it to
him. Bob can then decrypt it using his private
key. Only someone who has Bob’s private key
can decrypt messages encoded with his public
key. To reply, Bob obtains Alice’s public key,
encrypts a message, and sends it to Alice. She
deciphers the message using her private key.
This system of encryption offers a great deal of
security in managing the private keys because
they never have to be shared with anyone.
Clever applications of this type of cryptography can be used to verify identity (using a “digital signature”), authenticate messages, and provide a record of when a transaction occurred—
all vital aspects of a trustworthy means of payment on the Internet.
Encryption of electronic financial information traveling across the Internet offers a safeguard against theft of information, and the digital signature offers a way to authenticate the
message. Hence, these sophisticated mathematical devices play the roles that other devices that prevent the theft of money—such as
vaults, wallets, and commonsense security precautions—and devices that authenticate
money—such as watermarks, specially printed
paper, passwords, telephone authorization, and
signatures—play in other forms of money.

5
A good discussion of public key cryptography is contained in Bruce Schneier ’s book Applied Cryptography, John
Wiley and Sons, Inc., second edition, 1996.

FEDERAL RESERVE BANK OF PHILADELPHIA

Making Payments on the Internet

APPROACHES TO INTERNET PAYMENTS
There are currently several approaches to
offering payment services on the Internet:
credit-card-based systems (which represent an
extension of credit by the issuer of the credit
card to the holder); payment orders (much like
a check is an order to one’s bank to make payment); or a new form of payment, digital cash.6
Most use some form of the public key/private
key encryption system, but others safeguard
financial information in other ways.
Trusted Third Party. At least one firm offers
a trusted-third-party method of payment: a
customer authorizes the trusted third party to
make payments on her behalf. In such a system the customer supplies (over the phone or
through the mail) the trusted third party with
her credit card number or a voided check and
written authorization to effect payment on her
behalf. The customer is supplied with a password. As the customer orders a product over
the Internet, she supplies the seller with her
password; the seller reports this to the trusted
third party; and it, in turn, sends to the customer
a report of the transaction and asks the customer
to confirm it. Once confirmed, the trusted third
party conveys the payment information
through the automated clearing house system
(the electronic interbank system that banks use
to exchange small-value payments). This system avoids the problem of eavesdropping,
which is a concern in transmitting payment information across the Internet.
The trusted-third-party method offers the
benefit of securing credit card or checking account information against theft. It requires,
however, sellers as well as buyers to accept pay-

6

An extensive list of such approaches is maintained by
Michael Pierce on the Internet; the address is http://
ganges.cs.tcd.ie/mepierce/Project/oninterest.html. There
are links at this site to many firms offering some of the
services described in this article; those sites typically provide descriptions of the services and plans of the firms.

James J. McAndrews

ment by the trusted third party; therefore, widespread acceptability is a potentially difficult
hurdle for the system. As in all the systems we
discuss, the security of the system itself is vital.
Such security requires electronic firewalls that
cannot be breached by a hacker.
Digital Cash. At least one firm is offering
customers the ability to make payments in
“electronic,” or digital, cash, and others plan to
do so.7 Digital cash consists of messages that
use a sophisticated set of variants on the public
key/private key encryption system. It is stored
on a computer’s hard disk and is electronically
transferred to a payee. It may also be electronically replenished by transfer from one’s account
at a participating bank. A digital cash system
employs software held by the participating financial institutions, their customers, and merchants. Using that software, the customer creates digital messages that are authenticated by
the issuing institution in a way that third parties can recognize. The issuer’s authenticated
message is returned to the customer and acts
as a substitute for cash. A merchant that receives
the digital cash can send it on to its bank and
have its account credited or it can spend the
digital cash.
Digital cash systems typically propose to
prevent counterfeiting by virtue of the issuer’s
digital signature on the digital cash, which verifies its authenticity. Issuers intend to prevent
double spending of the cash by “reissuing” or
replacing digital cash each time it is spent; participating financial institutions will not accept
cash with serial numbers that indicate it has
already been spent.
Digital cash has the potential for a feature
many believe is increasingly important in an
electronic information age: anonymity. In principle, the merchant need not know who is
spending the digital cash it receives: the cash is

7

See “Banks Get the Green Light to Hit the Internet,”
Bank Network News, July 12, 1995.
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JANUARY/FEBRUARY 1997

Keys
Keys to
to
Establishing
Establishing
Trust
Trust in
in
Cyberspace
Cyberspace

Cryptography is the science of hiding
the contents of messages from eavesdroppers by means of “secret writing.”
It has been explored and developed
spectacularly in the last quarter of a century—a happy coincidence given the security needs of the world’s ever-expanding communication networks.
Cryptography can assist in providing the necessary identifiability and protection against theft that a digital or electronic means of exchange requires.
But, first, some definitions are needed.
Cipher. A cipher is a mathematical function used for encrypting (or coding) and decrypting (or decoding) a message. One example is the Caesar
cipher, in which each letter in a message is replaced by the third letter following it in the alphabet: a is replaced by d, b by e, and so on, with x replaced by a, y by b, and z by c. Modern ciphers use a key, which can take on
many values (and are usually very large numbers). The value of the key
affects the cipher; for example, the Caesar cipher is a simple substitution of
one letter of the alphabet for another, with a key value of 3. If we change
the key value to 5, then a is replaced by f, b by g, and so on.
Key. There are two types of key-based ciphers: secret key ciphers, in
which the same key is used for encryption and decryption, and public key
ciphers, in which a pair of keys is created, one for encryption and one for
decryption. In a secret key system, a group that wishes to exchange messages must share the key to communicate but keep it secret from third parties. Secret key, or symmetric, cryptography is most useful for long messages. In a public key system, one of the keys (typically the one used for
encryption) can be made public, but the private key (typically the one used
for decryption) need not be shared with anyone else. Furthermore, if the
keys are chosen well, it is practically impossible to determine the private
key even with knowledge of the public key.* Public key systems make key
management, which refers to the way keys are created, stored, and maintained, much simpler and less susceptible to attack.
Public key systems have many useful features that can aid in authenticating a message, uniquely identifying a person, confirming receipt of a
message, and enhancing the privacy of the message. They have the drawback of being costly in terms of computing time and effort, relative to secret
key systems, for encrypting and decrypting large amounts of text.
Authenticating a Message. A public key system can assist in authenticating a message by incorporating a “digital signature” in the message. A
digital signature is a clever double use of a pair of public key ciphers. Alice,
in sending a message to Bob, appends her signature to the message, and
she encrypts her signature by means of her private key (usually used for
decrypting a message). She then uses Bob’s public key to encrypt this “signature” and sends it on to Bob. Bob uses his private key to decrypt the

8

FEDERAL RESERVE BANK OF PHILADELPHIA

Making Payments on the Internet

James J. McAndrews

message and, seeing a potential signature of Alice, uses her public key to decrypt it. Upon successful
decryption, Bob realizes that only Alice could have sent the message because only she has the private key
counterpart to her public key. Hence, the digital signature has authenticated the message Alice sent to Bob.
Identifying a Person. But how does Bob know thatAlice is in possession of her private key? It’s possible
that an impostor, claiming to be Alice, sent out the public key in Alice’s name simply to intercept messages
intended for Alice. How then to verify that the person who claims a public key in Alice’s name is Alice? A
“digital certificate” can serve to verify the identity of the person holding a particular key because it contains
that person’s name and public key, a digital signature, the name of a trusted certificate authority, a serial
number, and a set of dates for which the certificate is valid. The certifiDIAGRAM 1
cate authority thereby verifies that the public key in the certificate
Alice’s Digital Certificate
belongs to the person whose name is attached to it. The process of
obtaining a certificate for one’s public key requires a high degree of
Alice’s Identifying Information:
trust and may involve visiting the authority in person and showing
Name, Organization, Address
proof of identity.
Confirming a Message. Alice can cheat in this system. First, she
Alice’s Public Key
purchases an item using her credit card and a digital signature and
Certificate Serial Number
certificate. After she receives the item, she publishes her private key.
She then reports that her private key has been compromised, and she
Certificate Validity Dates
did not authorize the purchase. One way to lessen the possibility of
this type of cheating is for the receiver, Bob, to have the message timestamped by an authority upon receipt. The time-stamp would be similar to the digital signature of the time-stamping authority and cannot
be altered. Alice would have had to declare her private key compromised before the purchase, making it possible for the certificate authority to repudiate its certificate for Alice before Bob receives the
message. Diagram 1 shows a digital certificate with a time-stamped
message.
Enhancing Privacy. Using public key cryptography for sending a
long message would be costly in terms of computing time; therefore,
secret key, or symmetric, cipher is preferred. The difficulty lies in how
to communicate the secret key, which cannot be revealed publicly without compromising the encryption. Public key cryptography can solve
the problem by encrypting the secret key using the public key. Then
the secret key would be hidden from everyone except the holder of
the associated private key. This encryption of the secret key is called a
digital envelope (Diagram 2). Digital envelopes are useful when sending a long message. Most payment messages would not be long enough
to require the use of secret key cryptography. The public key cipher
could be used directly to encrypt the message.

Issuing Authority’s Digital
Signature and I.D. Information
Message with Time-Stamp

DIAGRAM 2
A Digital Envelope
Created by Alice
Secret Key Used for
Encrypting and Decrypting
a Message, Encrypted
with Alice’s Public Key
Message Encrypted
with Secret Key

* Decrypting a message in a secret key system requires finding the inverse of the key; for example, in the Caesar cipher
one substitutes a letter three places to the left of the encrypted letter to decrypt a message. Finding the inverse of a public
key is practically impossible for large keys because it would require extraordinarily large amounts of computing.
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authenticated by the bank, not the customer.
The merchant might sell an item and be directed
to send it to a computer account (if it is a piece
of information that can be sent over computer
networks) or to a post office box, not knowing
who requested it. If the merchant is paid in digital cash and does not know the identity of the
holder of the computer account, there is no way
the merchant can find out the identity of the
buyer.8
The concern for privacy is increased today
because of the greater ease of compiling information electronically. Many firms sell information on their customers to other organizations
for marketing purposes. The enhanced privacy
that is possible in a digital cash system comes
at a cost of more complex software to run the
system.
Credit Card Methods. Visa International and
MasterCard announced on February 1, 1996,
that they have agreed to jointly develop a standard to solve the problems of snooping and
spoofing. American Express later joined the
effort as well. The standard is called secure electronic transactions (SET), and it is based on
public key cryptography. The developers of the
standard will attempt to ensure the integrity of
credit card numbers that a cardholder sends to
a merchant by encrypting the numbers. Prior
to any transaction, however, the developers of
SET propose to verify the identity of both merchant and cardholder by having either the bank
that issues the card (in the case of the
cardholder) or the merchant’s bank that processes the transaction (in the case of the merchant) provide both parties with “digital certificates.” These certificates may bear the digi-

8

If the merchant were to find that the cash had previously been spent, it would seem to have no recourse, given
the cloak of buyer anonymity. However, David Chaum,
an expert in cryptography, ingeniously devised a system
in which the buyer’s identity is revealed only if the buyer
attempts to spend the cash twice.
10

JANUARY/FEBRUARY 1997

tal signature of Visa or MasterCard or some
certifying authority (see Keys to Establishing
Trust in Cyberspace). Verifying that the digital
certificate does indeed bear the digital signature of the expected certifying authority should
help to assure the cardholder that the merchant
has a legitimate relationship with a bank and is
therefore not attempting to fraudulently collect
credit card information for later criminal use.
Furthermore, the proposed design for SET seeks
to ensure that the merchant will not be able to
decrypt the holder’s card number; rather authorization from the merchant’s bank will ensure payment, and the consumer’s number will
remain unreadable to the merchant.
Prior to their February announcement, Visa
and MasterCard had embarked on creating
separate standards for securing credit card
transactions on the Internet. The subsequent
decision to join forces to create and adopt a
single standard will simplify the process of using the software that will operate the standard.
With a single standard a merchant will be able
to identify itself and secure its payment information using only one system. The decision to
jointly develop the system avoided a potentially
costly duplication of effort on the part of the
card associations, banks, and merchants.
Internet Banking. At least one bank exists
primarily for banking on the Internet: it has only
a small physical office, but a “virtual branch”
on the Internet. While this bank does not offer
a direct method of payment on the Internet, it
allows its customers to pay bills by writing
checks or making an electronic payment
through the automated clearing house. This
method is a variant of trusted-third-party payments because information flows through private interbank networks.
Other banks and technology companies have
created the Financial Services Technology Consortium. This group is sponsoring research into
electronic commerce over open networks, such
as the Internet. One of their ventures is the electronic check project, an attempt to create a payFEDERAL RESERVE BANK OF PHILADELPHIA

Making Payments on the Internet

ment method that will be accepted much as a
paper check is today. It, too, proposes to rely
on encryption to secure account numbers and
digital signatures to verify identities, but it will
provide access to one’s bank account, rather
than create digital cash.
ACCEPTANCE OF THE NEW MEANS
OF PAYMENT
There are many approaches to payment over
the Internet. Will they all survive? It is too early
to determine whether the different means of
payment are useful and cost-effective, but as in
non-Internet-based payments, it may be that
different forms of payment may survive for different uses and for different users.
Many competing and complementary means
of payment exist today. For example, while
credit cards are useful for international and
many retail and mail-order transactions, only
some merchants are able to accept credit cards
(that is, they are “signed-up” customers of
banks’ credit card services). Nor do all consumers have sufficiently high credit ratings to obtain a credit card. Credit card payments are relatively costly to make because they involve an
extension of credit by the issuing bank. Furthermore, credit cards typically are not useful for
paying a friend. Checks, while convenient for
payments to individuals, are not as useful for
international transactions. Checks are also fairly
costly because of the care that must be taken in
routing the paper check through the banking
system and back to the one who wrote the
check. Cash is convenient for low-value purchases and can be used anonymously in some
circumstances, but it is costly to hold in inventory.
Many foresee demand for a way to make
very low-value payments over the Internet. For
example, a person may wish to purchase a photograph of a movie star for $0.50. For such small
payments it is costly to write a check or to use a
credit card (which usually requires a minimum
payment of about $20 because of relatively high

James J. McAndrews

cost per use). Typically, one uses cash for such
a small payment. Hence, digital cash, if it
proves sufficiently convenient and low cost,
would be much in demand for low-value payments. The cost of a digital cash system is not
yet known. Until such a system is operating on
a fairly large scale, it is not certain that it can be
operated at a sufficiently low cost to make payments for, say, less than a dollar economical.
Credit card methods may prove useful for
larger dollar amounts on the Internet. People
may be discouraged from using digital cash for
large-value payments because they enjoy less
float when using digital cash—a debit method
of payment—than when using a credit card.
Furthermore, many credit-card holders already
use their cards to make payments by phone and
may therefore be more willing to make the leap
to using them over the Internet.
Privacy and security concerns may induce
some people to use the trusted-third-party
method of payment as well as digital cash. Both
of these methods avoid sending credit card information over the Internet, even in a highly
secure encryption scheme. In addition, a consumer may wish to withhold his identity from
a merchant to avoid having the information
used either for marketing purposes or by law
enforcement agencies if he is engaging in illegal activities.
PUBLIC POLICY CONSIDERATIONS
The ways that payments are made in the
United States today are governed and supported by law and public policy. For example,
the laws, policies, and contracts that govern the
rights of the various parties involved in a check
transaction are well established. These policies
help to make checks a reliable and predictable
method for making a payment for all the parties involved in the checking system.
For the proposed Internet payment systems,
issues such as consumer protection, disclosure
and assignment of participant liability, and privacy are being addressed by regulators and law11

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makers. The resolution of these policy issues
will affect the development and acceptance of
the proposed systems.
In particular, questions about the degree to
which disclosure requirements, account statements, and some form of electronic receipt
would be useful and appropriate for Internet
payment systems remain largely unanswered.
Required disclosure of liability can help inform
parties to a system about their responsibilities
and thereby improve decision-making, although such disclosures impose an administrative cost on the system’s operator, which, if the
system is to succeed, will be collected in some
way from the consumers of the service. Account
statements and electronic receipts would assist
users of payment systems in reconstructing
their activities in case there were questions
about unauthorized use of their accounts or
unauthorized payments—again, at a cost of
record-keeping for the system and its users.
Resolution of these issues will clarify the obligations of the parties and, with a careful balancing of the costs and benefits involved, will
advance the development of acceptable forms
of payment systems on the Internet.
Recently, for example, the Federal Reserve
suggested modifying some provisions of its
Regulation E, which governs many (conventional) electronic methods of payment, as it
applies to stored-value cards.9 The Board’s proposal suggested that cards that can store no
more than $100 be exempted from the provisions of the regulation, and it makes further
exceptions for various specific types of cards.
For example, under the proposal, a merchant
would not be required to issue paper receipts
when certain types of stored-value cards are
used for payment. Furthermore, in the proposal
the Board also recognized that stored-value

9
See the proposed rule of the Federal Reserve System,
12 CFR Part 205, Regulation E; Docket No. R-0919, April 3,
1996.

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JANUARY/FEBRUARY 1997

systems (such as various digital cash systems)
are being developed for the Internet: “Systems
are being proposed, for example, for making
payments over computer networks, such as the
Internet”; it also requested comments on the
extent to which the Board should consider applying Regulation E to “various types of network payment products.”
Another legal and contract issue is that, on
the Internet today, the merchant (and the system operator and the consumer, for that matter) has no standardized or generally accepted
and enforceable way to verify the signature or
password of the other party to the transaction.
As a result, the liabilities of the parties are unclear in the event of a repudiation of a transaction by a customer when the transaction was
authorized using the customer’s digital signature. In contrast, the assignment of liability in
a credit card or (off-line) debit-card transaction
is well established. The credit card associations
were instrumental in standardizing the form of
the contracts used today in the credit card industry. If Internet payment systems not based
on credit cards are to succeed, such an association may be helpful in organizing contracts and
standards that would form the basis for widespread merchant and bank acceptance of the
systems.
A widespread acceptance of contractual
standards that make the digital signature of the
customer binding may be desirable to address
the issue of how liability is to be assigned in
the case of a repudiated payment.10 This issue
is complicated by the fact that the federal gov-

10
Such a repudiation may be done fraudulently; that is,
a consumer may make a purchase using a payment system
based on digital signatures and then later fraudulently
claim not to have made the purchase. Hence, the effort to
make it difficult to repudiate one’s digital signature will
reduce fraud of this sort. (Alternatively, the consumer may
have mismanaged his or her private key, thereby allowing
someone else to make a purchase using his or her digital
signature, and repudiated the transaction for that reason.)

FEDERAL RESERVE BANK OF PHILADELPHIA

Making Payments on the Internet

ernment has chosen a standard for digital signatures that is different from the standard that
has emerged in private industry. Neither has
the force of law behind it. Recently, two states,
Utah and California, have passed laws giving
digital signatures the same validity as handwritten signatures. Similar legislation is pending in other states. These laws should reduce
the possibility for repudiation and thereby advance the development of systems using digital signatures.
A second issue regarding digital signatures
is who should be allowed to be a certifying authority for the public key used to create such
signatures (see Keys to Establishing Trust in
Cyberspace for a description of the role of a certifying authority for public keys). The certifying authority, in granting a certificate to a party,
puts its stamp of approval on the certificate
holder’s management of the private key and
provides the certificate holder a proof of identity. Such certification may carry an implicit
guarantee of performance and hence may require the certifying authority to bear a considerable amount of risk. The authority may therefore require considerable oversight power for
those to whom it grants a certificate.
Digital cash also entails policy considerations. The creators of digital cash envision individuals transferring it among themselves
with no intermediary, which raises the issue of
what kind of backing digital cash must have.
For instance, must digital cash be backed by
currency 100 percent? This would involve an
issuer’s holding $1 in currency in its vaults for
every $1 of digital cash created. Alternatively,
should the issuer buy short-term securities,
such as U.S. Treasury bills, as backing for the
digital cash? Under this system, the creation of
digital cash could represent an increase in the
money supply. Beyond this issue lies the possibility for “designer digital cash,” which could
be backed by gold or issued in foreign currencies or which could earn interest. There are few
technological limitations on the backing and

James J. McAndrews

characteristics of digital cash.
Should digital cash be covered by deposit
insurance? This question needs to be settled in
part to determine who is liable in the event of
the failure of an issuer of digital cash. The Federal Deposit Insurance Corporation (FDIC) recently issued a notice and request for public
comment addressing stored-value cards and
other electronic payment systems and their eligibility for deposit insurance.11
The proposed Internet payment systems require areas of expertise new to most banks.
Such expertise is typically found in software
companies. Banks and bank holding companies
are allowed to engage only in activities that are
“closely related” to banking. It is clear from our
discussion that encryption systems, among
other things, are vital to the success of Internet
payment systems. But is developing an encryption system an activity “closely related” to
banking? By approving the acquisition of a
home-banking software company by a group
of U.S. and Canadian banks, and by approving
the acquisition of an Internet banking software
company by a subsidiary of a bank holding
company, the Federal Reserve System and the
Office of the Comptroller of the Currency have
shown a willingness to allow banks to provide
services in this area.12
Encryption systems raise issues that go beyond banking. There is a tension between the
security of financial messages traveling the
Internet (by means of strong encryption systems) and the security of the nation and the
ability of its law enforcement authorities to prevent illegal financial transactions. The United
States closely regulates the use of strong levels

11

See the notice of the FDIC in the Federal Register, August 2, 1996, pp. 40494-97.
12
See the orders of the Board of Governors of the Federal Reserve System in the Federal Reserve Bulletin, April
1996, pp. 363-65, and in the issue of July 1996, pp. 674-76.

13

BUSINESS REVIEW

of encryption because of its important role in
national security. Some commentators fear that
denial of licenses to export software that includes strong levels of encryption may put U.S.
firms at a competitive disadvantage. At least
one firm, though, has won approval to export
software based on strong levels of encryption;
its software was for financial use only, and it
was felt that the encryption system could not
be removed from the software.13
The need for confidentiality of payment information on the Internet is great because of the
greater ease of compiling histories of consumers’ purchases. Enhancements to consumer privacy laws may be needed to preclude the misuse of consumer information by nonfinancial
firms that may offer payment services or affiliated software. The question of how much confidentiality is needed in Internet commerce has
13

“Cybercash Gets Clearance to Sell Product Abroad,”
Wall Street Journal, May 8, 1995.

14

JANUARY/FEBRUARY 1997

spawned a debate about the merits of a completely anonymous payment system versus the
merits of lower cost, more conventional systems
of credit card and electronic checks that allow
merchants, banks, and system operators to
maintain data bases of user information.
CONCLUSION
Efforts to create a form of Internet money are
attempts to put old wine in new bottles. Money
must be easily identifiable, easy to protect from
theft, widely acceptable, and easy to transfer.
Providers of Internet payment systems are attempting to meet these requirements in various ways. Sophisticated methods of encrypting the financial information used in payments
may prove to be the modern equivalent of
vaults, signatures, and watermarks. Public
policy will play a role in securing the legal foundations that can help pave the way to widely
acceptable and secure ways to pay on the
Internet.

FEDERAL RESERVE BANK OF PHILADELPHIA

Making Payments on the Internet

James J. McAndrews

The Economic Benefits and Risks
Of Derivative Securities

D

erivative security markets have shown
extraordinary growth over the past 10 years.
But certain events have raised concern about
the risks associated with derivatives trading.
The stock market crash of October 1987 has, in
part, been blamed on portfolio insurance strategies that used futures markets. Large losses
associated with the use of derivatives by firms
such as Procter & Gamble ($137 million),
Metallgesellschaft ($1 billion), and Barings PLC
($1.3 billion), and by Orange County, California ($1.7 billion) have led to fear among some
market participants that derivatives trading is

*Keith Sill is a senior economist in the Research Department of the Philadelphia Fed.

Keith Sill*
a very risky activity that could lead to a widespread disruption of the financial system.
What sometimes gets lost in the popular discussion about derivative-related losses are the
benefits that derivative securities provide to
firms, investors, and the economy as a whole.
Derivative securities such as options, forwards
and futures, and swaps can provide firms and
investors with opportunities that might not otherwise be available. Derivatives aid in the allocation of risk across investors and firms, and
they can lower the costs of diversifying portfolios. Derivative prices reveal information to
investors that can make financial markets more
stable.
But do derivative securities add significant
risk to financial markets over and above the
15

BUSINESS REVIEW

risks already present? The risks associated with
derivatives are related to how these securities
are used in a specific market setting and economic environment. Since derivatives are contracts, their use can entail legal risks. Derivatives may carry credit risks in that one party to
the contract may default. Problems may also
arise concerning the liquidity of derivative securities or the ease with which they can be
traded. These same risks are, to one degree or
another, associated with almost all financial
assets.
THE DEVELOPMENT
OF DERIVATIVES MARKETS
Derivatives markets are successful institutions because they make financial markets more
efficient. This generally means that borrowing
and lending can occur at lower cost than would
otherwise be the case because derivatives reduce transaction costs. For example, more efficient mortgage markets mean that homeowners
can borrow at lower cost. Similarly, firms can
raise funds for investment at a lower cost when
financial markets are efficient. This in turn can
lead to faster economic growth.
The most common types of derivative securities are equity and interest rate options, currency derivatives, futures and forward contracts, and swaps.1 In each case the derivative
security is a contract between two parties. One
party receives a claim on an underlying asset
or on the cash value of the asset; the other party
has an obligation to meet the corresponding liability (see Derivatives Defined).
Trading in derivative contracts has a long
history. The first recorded accounts of derivative contracts can be traced back to the philosopher Thales of Miletus in ancient Greece, who,
during winter, negotiated what were essentially
call options on oil presses for the spring olive

JANUARY/FEBRUARY 1997

harvest. De la Vega reported in 1688 that options and futures, or “time bargains” as they
were then known, were trading on the
Amsterdam Bourse soon after it was opened.
Evidence also suggests that futures contracts for
rice were traded in Japan in the 17th and 18th
centuries.2
The first formalized futures exchange in the
United States was the Chicago Board of Trade,
which opened in 1848 with 82 members. In
March 1851, the first futures contract was recorded. The contract called for the delivery of
3000 bushels of corn in June at a price of one
cent per bushel below the March price. Listed
stock options began trading in April 1973 on
the Chicago Board Options Exchange (CBOE).
Other exchanges began offering stock call options in 1975 and put options in 1977. Today,
options on more than 1000 stocks trade on five
U.S. exchanges.
In the United States, stock index futures began trading in 1982 and stock index options in
1983. By the end of 1993, stock index futures
markets were established in 14 countries covering 95 percent of world equity market capitalization.3
No one knows how big the derivatives markets really are, in part because trading is global
in scope and regulatory responsibility is fragmented. Data taken from a Congressional Research Service report on derivative financial
markets show that the notional value of derivatives rose from about $1.6 trillion in 1987 to
about $8 trillion in 1991 (Table). Notional value
reflects the sum of the value of all the assets.
However, notional value tends to overstate the
size of the derivatives market, since it does not
take into account offsetting transactions. If a
bank undertakes a $200 million swap of floating assets for fixed-rate ones, then later cancels

2

See page 3 in the book by Darrell Duffie.

3

See the article by Joanne M. Hill.

1

For a discussion of currency derivatives, see the article
by Gregory Hopper.
16

FEDERAL RESERVE BANK OF PHILADELPHIA

The
Economic
Benefits
andInternet
Risks of Derivative Securities
Making
Payments
on the

Keith Sill
James J. McAndrews

Derivatives Defined
Forward Contract: A contract to buy or sell a specified amount of a designated commodity, currency, security, or financial instrument at a known date in the future and at a price set at the time
the contract is made. Forward contracts are negotiated between the contracting parties
and are not traded on organized exchanges.
Futures Contract: A contract to buy or sell a specified amount of a designated commodity, currency, security, or financial instrument at a known date in the future and at a price set at the time
the contract is made. Futures contracts are traded on organized exchanges and are thus
standardized. These contracts are marked to market daily, with profits and losses settled
in cash at the end of the trading day.
Option Contract: A contract that gives its owner the right, but not the obligation, to buy or sell a specified
asset at a stipulated price, called the strike price. Contracts that give owners the right to
buy are referred to as call options and contracts that give the owner the right to sell are
called put options. Options include both standardized products that trade on organized
exchanges and customized contracts between private parties.
Swap Contract:

A private contract between two parties to exchange cash flows in the future according
to some prearranged formula. The most common type of swap is the “plain vanilla”
interest rate swap, in which the first party agrees to pay the second party cash flows
equal to interest at a predetermined fixed rate on a notional principal. The second party
agrees to pay the first party cash flows equal to interest at a floating rate on the same
notional principal. Both payment streams are denominated in the same currency. Another common type of swap is the currency swap. This contract calls for the counterparties
to exchange specific amounts of two different currencies at the outset, which are repaid
over time according to a prearranged formula that reflects amortization and interest
payments.

out its position by entering a $200 million contract of fixed-rate for floating-rate debt with the
same counterparty, notional value is recorded
at $400 million, despite the fact that the two
transactions offset each other.
Growth in the use of derivative contracts has
proceeded at a rapid pace since 1991. The Bank
for International Settlements (BIS) conducted a
survey of foreign exchange and derivative market participants worldwide. The survey found
a notional value of $47 trillion for over-thecounter (OTC) derivative contracts outstanding at the end of March 1995.4 Of that total $17.7
trillion represented foreign exchange derivatives and $28.8 trillion represented interest rate

derivatives. The survey also calculated a notional value for exchange-traded derivative contracts of $8.2 trillion.5 Daily average turnover
in OTC derivative contracts was found to be
$880 billion and that of exchange-traded contracts was $570 billion.
The size of the markets suggests that users
of these contracts derive significant benefits
from including derivatives in their investment
4
OTC derivatives are contracts not traded on organized
exchanges but rather negotiated privately between parties.
5
The figures from the BIS are not directly comparable
to those in the table because the surveys differ.

17

BUSINESS REVIEW

strategies. At the same
time, the size of the derivatives market has led to
fears that a disruption
could have a wide-ranging
impact on financial markets in general. We will
focus first on some of the
economic benefits of derivatives: they reallocate
risk among financial market participants, help to
make financial markets
more complete, and provide valuable information
to investors about economic fundamentals.
Then we will discuss risks
associated with the use of
derivatives.

JANUARY/FEBRUARY 1997

TABLE

Markets for Selected Derivative Instruments,
Notional Principal Values at Year End
in Billions of U.S. Dollar Equivalent
1987

1989

1991

Exchange-Traded Instrumentsa
Interest Rate Futures
Interest Rate Optionsb
Currency Futures
Currency Optionsb
Stock Index Futures
Stock Index Optionsb

725
488
122
14
60
18
23

1762
1201
387
16
50
42
66

3518
2159
1072
18
59
77
132

Over-the-Counter Instruments c
Interest Rate Swapsd
Currency and Cross-Currencyd,e
Interest Rate Swaps
Other Instruments d,f

867
683
184

2402
1503
449

4449
3065
807

---

450

577

TOTALS
1592
4164
7967
SOME ECONOMIC
BENEFITS OF DERIVAa
TIVE SECURITIES
Excludes options on individual shares and derivatives involving commodity
At first glance, the eco- contracts.
nomic benefits of derivab
Calls plus puts.
tives might not be apparc
ent, since derivatives are
Excludes data on forward rate agreements, OTC currency options, forward forzero-sum monetary games: eign exchange positions, equity swaps and warrants on equity. Data collected by
the amount paid by one International Swap Dealers Association (ISDA).
d
side of the contract is the
Contracts between ISDA members reported only once.
amount received by the
e
Adjusted for reporting of both currencies.
other side.6 When the contract expires or is exercised,
f
Caps, collars, floors, and swaptions
the gains and losses completely offset each other. Source: As reported by the Bank for International Settlements: Futures Industry AsBut even though deriva- sociation; ISDA; and various futures and options exchanges worldwide.
tives represent zero-sum
monetary games, they
need not represent zero-sum economic games. to engage in arbitrage. When individuals or
Individuals and firms that use derivative in- firms hedge risks with derivatives, they are atstruments can do so to hedge, to speculate, or tempting to use these contracts as a kind of insurance against a bad future outcome.
Hedging. An example of using derivative
6
instruments to hedge is provided by an adverWe are ignoring transaction costs for now.
18

FEDERAL RESERVE BANK OF PHILADELPHIA

Making
Payments
on the
Internet
The Economic
Benefits
and
Risks of Derivative Securities

tisement by the Student Loan Marketing Association (Sallie Mae) in the Wall Street Journal for
December 31, 1991. Sallie Mae is a publicly held
company that provides private capital funding
for guaranteed student loans. The ad showed
how Sallie Mae used combinations of swap arrangements to hedge the risks of borrowing
money overseas.
Suppose Sallie Mae sells bonds with fixed
interest rates and denominated in pounds sterling in the U.K. financial market. Sallie Mae,
which is a U.S.-based organization, would like
to avoid exchange rate risk between the U.S.
dollar and the pound sterling and so enters into
a currency swap arrangement. Sallie Mae
swaps the principal amount of the bond in
pounds sterling for U.S. dollars at the current
exchange rate. When Sallie Mae has to pay interest to its U.K. bondholders, the parties swap
payments again, with Sallie Mae receiving
pounds sterling to meet interest payments in
exchange for U.S. dollars at the rate fixed in the
swap contract. Finally, when the bonds come
due, the counterparties swap the principal payment. The swap arrangement allows Sallie Mae
to insure itself against exchange rate fluctuations, since the total cost of interest and principal is fixed in U.S. dollar terms.
Derivative contracts are widely used to
hedge a variety of risks. In 1993, the Group of
Thirty published Derivatives: Practices and Principles, which reported on the use of OTC derivatives by various categories of users. Of
the private-sector nonfinancial corporations
responding to the survey, 87 percent used interest rate swaps, 64 percent used currency
swaps, 78 percent used forward foreign exchange contracts, 40 percent used interest rate
options, and 31 percent used currency options.
How do firms use derivative contracts to
hedge the risks they face? Of the respondents,
82 percent indicated they used OTC derivatives
to hedge risks arising from new financing, 33
percent to hedge exposure from foreign currency translation, 69 percent to hedge foreign

James J. McAndrews
Keith Sill

exchange transaction exposures, and 78 percent
to manage or modify the characteristics of their
existing assets and liabilities.
Financial institutions are major players in the
derivatives markets as well. According to the
Group of Thirty report, 92 percent of financial
institution respondents used interest rate
swaps, 69 percent used forward foreign exchange contracts, 69 percent used interest rate
options, 46 percent used currency swaps, and
23 percent used currency options. This group
of respondents uses derivatives to hedge risk
arising from new financing (84 percent), foreign
currency translation exposures (46 percent), and
transaction exposures (39 percent), and to offset option positions embedded in the institutions’ assets and liabilities (39 percent).7
When used to hedge risks, derivative instruments transfer the risks from the hedgers, who
are unwilling to bear the risks, to parties better
able or more willing to bear them. In this regard, derivatives help allocate risks efficiently
between different individuals and groups in the
economy.
Speculating. Investors can also use derivatives to speculate and to engage in arbitrage
activity. Speculators are traders who want to
take a position in the market; they are betting
that the price of the underlying asset or commodity will move in a particular direction over
the life of the contract. For example, an investor who believes that the French franc will rise
in value relative to the U.S. dollar can speculate by taking a long position in a forward contract on the franc. If the value of the franc on
the expiration date is above the delivery rate
set when the forward contract was written, the
speculator earns a profit on the contract.
The use of a forward contract for speculation has an advantage over actually buying

7
The option positions embedded in institutional assets
and liabilities include such things as call or prepayment
features in loans and bonds.

19

BUSINESS REVIEW

francs and holding them because neither party
puts any money up-front when entering into
the forward contract.8 Thus, the forward contract gives the investor much more leverage
than buying the underlying asset in the cash
market.
While speculation may seem to be no more
than gambling on future price movements,
speculators play an important role in financial
markets because they provide liquidity. This
liquidity enables other investors, who may be
using derivatives to hedge risks, to more easily
buy and sell derivative contracts.
Arbitrage. Arbitrageurs represent another
important group of derivatives users.
Arbitrageurs look for opportunities to earn
riskless profits by simultaneously taking positions in two or more markets. Arbitrage opportunities can occur when prices in financial markets get out of sync. When this happens,
arbitrageurs step in and, by doing so, help to
get market prices back into alignment. This
activity helps to keep prices consistent across
markets. Arbitrage trades can be quite complex, but we will give a simple example to show
how such trades can work.9
Suppose that the interest rate on 13-week
Treasury bills is 10 percent and the rate on 26week Treasury bills is 10.5 percent. The rates
on the two Treasury bills imply that the 13-week
Treasury bill rate in three months will be about
11 percent.10 Also, suppose that a T-bill futures
8
Recall that a forward contract is an agreement between
two parties to buy or sell an asset at a specific time in the
future. The price at which the asset is to be delivered on
that future date is called the delivery price. The delivery
price is set in such a way that the price of the forward contract at the time it is made is zero to both parties.
9
For more detail on arbitrage and derivatives, see the
book by John C. Hull.
10
This follows from the fact that the return on the 26week T-bill can be expressed as a geometric average of the
returns on two successive 13-week T-bills:
(1.105)
(1.10)(1.11).

20

JANUARY/FEBRUARY 1997

contract allows one to buy or sell a 13-week Tbill for delivery in three months at a rate of 10.75
percent. Since these two future interest rates
differ, there is an opportunity to earn a risk-free
profit. Arbitrageurs can exploit this mispricing
if, in three months, they can borrow money at
10.75 percent and invest it at 11 percent. They
do so by trading the futures contract and Treasury bills.11
Arbitrage activity also helps to keep asset
markets liquid and thus reduces transaction
costs. Arbitrageurs are taking positions in derivative instruments and in the assets that underlie them. Therefore, arbitrage helps to reduce liquidity premiums, or the difference between the purchase price and the sale price of
the underlying assets.
Leverage. Derivative contracts also aid in
risk allocation because of the cheap leverage
opportunities they provide to the investor.
We’ve already hinted at the leverage obtained
by using forward contracts. In that case, leverage comes about because no cash has to be put
up at the time the parties enter into the contract.
Options are also leveraged investments.
Take the case of a call option on a stock like
AT&T. On March 28, 1996, a July call option on
100 shares of AT&T stock with a strike price of
$60 sold for $400. AT&T shares in March were
selling for a little less than $62. To purchase
100 shares of AT&T would have cost an investor close to $6200. If, in July, AT&T shares sell
for $65 per share, the holder of the option will
exercise it and reap a profit of approximately

11
This requires three steps. First, sell the futures contract short, which means that the arbitrageur will be committed to delivering T-bills with an implied rate of 10.75
percent in 90 days. Second, borrow money at the 10 percent rate for 13-week T-bills. Third, invest the borrowed
money in 26-week T-bills at 10.5 percent. Steps two and
three guarantee that a rate of 11 percent is earned on T-bills
after 90 days, while step one guarantees that a T-bill yielding 10.75 percent can be sold after 13 weeks.

FEDERAL RESERVE BANK OF PHILADELPHIA

Making
The
Economic
Payments
Benefits
on the
andInternet
Risks of Derivative Securities

$100 on his $400 investment in the call option.12
If the shares had been bought outright, the investor would have gained $300 on a $6200 investment.13 Of course, if AT&T shares sell for
$62 in July, the investor loses the $400 investment in the call option. But if he owned the
shares outright, his dollar loss would be negligible.
Is leverage a good thing for financial markets? Generally yes, because leveraged positions give investors access to risk-return
tradeoffs they otherwise would not have.
Broadening the menu of available choices helps
individuals tailor risk to their own investment,
hedging, or arbitraging situation. Derivative
contracts allow investors to leverage relatively
small amounts of funds over a wide class of
assets and thus diversify their portfolios.
However, leverage can work to an investor ’s
disadvantage as well. In the Orange County,
California, bankruptcy episode, the investment
fund took a highly leveraged bet that interest
rates would not rise. When rates did rise, the
fund lost value to a much greater extent than it
would have, had it not been leveraged (see
Orange County and Derivative Securities).
Complete Markets and Derivative Instruments. In addition to efficient allocation of risk,
derivatives offer another important benefit: they
can provide investors with opportunities that
would otherwise be unavailable to them at any
price. That is, derivatives can provide payoffs
that simply cannot be obtained with other, existing assets.
12
If the call is exercised, the profit on the transaction
can be expressed as the difference between the underlying
asset price and the option strike price, less the cost of purchasing the call.
13
Leverage can be gained in stock market transactions
by purchasing stocks on margin. Current regulations allow up to 50 percent of a long position in a stock to be
borrowed. However, the leverage obtained by using derivatives on stocks is substantially higher than the leverage obtained by purchasing stock on margin.

James J. McAndrews
Keith Sill

In theory, derivative contracts can be written to provide any conceivable pattern of payoffs that depend on future conditions. Or, in
economists’ language, derivatives can make
markets complete. Why are complete markets
desirable? Because they provide maximum
flexibility for investors, since any possible pattern of returns can be achieved using a portfolio of existing securities.14 In addition, economic
theory tells us that a complete market is economically efficient, which means that resources
cannot be reallocated in such a way as to make
everyone better off.
In reality, there are obstacles to achieving
complete financial markets. For example, writing and enforcing contracts that cover certain
contingencies present difficulties; costs make
some transactions infeasible; and government
regulations may interfere with the market’s
ability to provide some payouts. Given these
obstacles, we want to create securities that will
help us get closer to complete markets. This is
where derivative instruments come in: derivatives can help move financial markets toward
completeness.15
Furthermore, it may be much less costly to
complete markets by using derivative securities than by creating new basic securities. Thus,
derivative securities can lower transaction costs
for investors.
TRANSACTION COSTS
AND INFORMATION
The standard method for calculating the
prices of options and other derivative securities assumes that securities markets are effec-

14

For a detailed discussion of options and complete markets, see the articles by Stephen Ross and Nils Hakansson.
15
It need not be the case that partially completing an
incomplete market is always best. For example, the article
by Franklin Allen and Douglas Gale shows that, under certain conditions in an incomplete market, financial innovation may not be efficient.

21

BUSINESS REVIEW

JANUARY/FEBRUARY 1997

Orange County and Derivative Securities
Orange County, California, declared bankruptcy in December 1994 after an investment fund run by the
county treasurer reported losses that eventually amounted to $1.7 billion. News reports of the incident
highlighted the fact that the Orange County Investment Pool (OCIP) held derivative securities and often
gave the impression that derivatives were to blame for the county’s losses. The OCIP did hold derivative
securities, which amounted to about 40 percent of invested funds. But OCIP lost about 20 percent of its
investors’ funds because of a risky bet on the direction of interest rates that turned out to be terribly wrong.
The county’s investment strategy was essentially to borrow short and lend long. Usually, long-term
interest rates are higher than short-term interest rates because the short-term return to holding long-term
bonds is risky. A higher interest rate on long-term bonds helps compensate investors for bearing this risk.
When short-term interest rates are lower than long-term rates, it can be profitable to borrow at the shortterm rate and lend the borrowed money at the long-term rate. So funds from the OCIP were invested in
long-term bonds. The OCIP got more bang for its buck by leveraging up its investment: the pool posted the
long-term bonds as collateral and borrowed against them at the short-term interest rate. It then took the
borrowed money and purchased more long-term bonds.
The strategy was profitable as long as interest rates stayed the same or declined. But in February 1994
interest rates began rising. When interest rates rise, the price of bonds falls. As a result, the long-term bonds
in the OCIP declined in value at the same time that the cost of short-term borrowing was rising.
The OCIP also invested in interest rate derivative securities called inverse floaters. These derivatives
gain value when interest rates fall and lose value when they rise. When interest rates rose in 1994, these
securities took a big hit.
The losses in the OCIP can be approximately broken down as follows.* The initial value of the OCIP
portfolio was $7.6 billion. Through leverage, however, the total value of invested funds was on the order of
$20 billion. The OCIP had a $12 billion investment in fixed-rate bonds that had an average maturity of four
years. When interest rates rose in 1994 these bonds lost about $360 million. About $8 billion of OCIP funds
were invested in inverse floaters, which lost about $620 million. Short-term borrowing of about $12.4 billion led to additional losses, through the payment of interest, on the order of $620 million.

*These figures are taken from the book by Philippe Jorion.

tively complete. Nils Hakansson has pointed
out that this is something of a paradox. If markets are complete, options are redundant assets.
So why do they exist?
Transaction Costs. Robert Merton has developed one solution to this paradox. Individual investors may face high transaction costs
for certain types of financial trades, but large
firms will have lower transaction costs in securities markets because of the large volume of
trades they undertake. For these large firms,
markets will be effectively complete, since they
can create different securities by engaging in
carefully constructed trading over time (called
dynamic trading) at low cost. The firms can
22

then sell claims on these dynamic trades as derivative securities to individuals, passing on the
lower transaction costs. The assumption of
market completeness, and thus standard option-pricing theory, would be approximately
correct because of the presence of these large
firms with their low transaction costs.
In reality, derivative securities provide investors with low-cost ways to diversify portfolios.
For example, stock index options allow their
users to trade an entire portfolio of stocks as a
single financial product. It is much more difficult, and expensive, for individual investors to
trade a basket of stocks representing, say, the
S&P500 on the stock exchange, than it is to trade
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an S&P500 stock index futures contract. In addition, it is almost always the case that an option on a portfolio is less expensive than a portfolio of options on the underlying stocks.16
Stock index options and futures allow investors to trade at a fraction of the cost of trading
the underlying basket of stocks on the cash
market or buying portfolios of options.17
Derivatives also provide beneficial opportunities for diversification because they offer easy
and cheap access to classes of assets, such as
commodities, that would otherwise be very
expensive. For example, investors can buy futures contracts on oil, corn, gold, and a host of
other commodities to help diversify their portfolios. In addition, investors can buy futures
on commodity indexes. To purchase these underlying commodities in the cash market would
require a large investment. By purchasing futures, investors can benefit from favorable price
movements in these classes of assets in a relatively inexpensive way. Of course, investors
would also risk large losses from adverse price
movements.18
Derivatives and Market Information. We
saw that, in complete markets, derivatives provide no new investment opportunities beyond
what is available from existing assets. Indeed,
modern finance methods compute the price of
an option by finding a dynamic trading strategy using the underlying asset and T-bills that

16

An option on a portfolio will be cheaper than the portfolio of options provided the underlying assets are not perfectly correlated. When assets are not perfectly correlated,
diversification has benefits, since it lowers the volatility of
the portfolio. Option prices fall as volatility falls.
17

In some cases the investor may be able to purchase
shares in a mutual fund that closely approximate his desired portfolio. This would also be a low-cost way to diversify, but it does not give the leverage opportunities that
come with using derivatives.
18

See the article by Anatoli Kuprianov for case studies
of the Metallgesellschaft and Barings derivatives losses.

Keith Sill
James J. McAndrews

replicates the payout of the option. A dynamic
trading strategy means that the amount of
money invested in the asset and in T-bills is
adjusted over time to ensure that the portfolio
payout is the same as the option payout.
But even if these option-pricing models are
accurate, options are not necessarily redundant
assets. Sanford Grossman contends that the
prices of traded options convey information
about the underlying stock that may serve to
lower its volatility. Grossman argues that many
large investors using dynamic trading strategies instead of traded options to achieve desired
returns can cause an increase in the volatility
of the underlying stock.
Consider the case of portfolio insurance.
Portfolio insurance refers to the desire of portfolio managers to eliminate the risk that their
portfolios’ value will fall below a certain level.
One method of implementing portfolio insurance is by using put options. If an investor buys
a put option on a stock, the risk that the value
of the portfolio composed of the put and the
stock will fall below the strike price of the put
is eliminated.19 However, when investors’ portfolios contain many stocks, it may not be possible to buy puts on all of them. In this case,
the portfolio manager can implement portfolio
insurance by using a dynamic trading strategy
that replicates the payout of a put option on
the portfolio.
Portfolio managers who use dynamic trading strategies are counting on their ability to
sell shares of the stocks in the portfolio before
the market price of the shares falls below their

19
On exercise, the payoff function for a put option can
be expressed as the difference between the strike price and
the underlying stock price. If we denote the strike price by
K and the stock price by S, in the event that S is less than K
at exercise, the put option payoff is K - S. If we hold both
the stock and a put on the stock, when the stock price falls
below K and the option is exercised, the total value of the
portfolio is S + (K - S) = K. K represents a floor below which
the value of the portfolio will not fall.

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floor. But if many portfolio managers are using dynamic trading to implement portfolio
insurance, many traders are attempting to sell
shares once the market begins falling. But as
everyone tries to sell, the market is forced lower
and lower, and thus the dynamic trading strategy may not work since traders find they are
unable to sell stock at a price above the targeted
floor: prices may fall too far, too fast.
Suppose, though, that put options were
available to those portfolio managers who
wanted insurance. If everyone were trying to
buy puts to implement insurance, the price of
puts would go up. In essence, insurance would
become more expensive. As insurance becomes
more expensive, there will be less demand for
it, and so, fewer portfolio managers would use
insurance. Since the demand for insurance is a
driving factor in the determination of stock
volatility, the higher price of the puts is telling
market participants that stock market volatility is expected to be higher in the future and
that the net demand for insurance is high.20 The
price of the put options serves to coordinate the
strategies of the users of portfolio insurance by
revealing expectations about stock price volatility.
If everyone is using a dynamic trading strategy and cannot observe a price for insurance,
there is no way to easily tell how large the net
demand for portfolio insurance is. Stock market volatility could then be higher when dynamic trading strategies are used to implement
insurance compared to the case where put options are used. According to the Brady Commission report, portfolio insurance and index
arbitrage accounted for about 20 percent of to-

20
An investor using an insurance strategy will sell equity after a fall in price and purchase equity after a rise in
price. A net demand for portfolio insurance manifests itself in an increase in equity price volatility regardless of
whether the insurance is implemented by the use of put
options or by dynamic trading strategies. See the articles
by Sanford Grossman for details.

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tal sales on the New York Stock Exchange on
October 19, 1987, the day the stock market
crashed.
When financial markets are complete and
there are no frictions like transaction costs and
imperfect information, derivative instruments
are redundant assets. In such a setting, the presence or absence of derivatives has no implications for the riskiness of financial markets or
the volatility of underlying assets. In reality,
financial markets are not complete and there
are frictions, so the presence or absence of derivatives matters for the economy.
The theoretical and empirical evidence on
how the introduction of derivatives affects the
economy is limited. However, the existing evidence suggests that derivatives do not appear
to add to financial market risk as a whole.21
However, they do involve some risks to individuals and firms.22
RISKS ASSOCIATED WITH THE USE
OF DERIVATIVE INSTRUMENTS
Many firms and individuals use derivative
instruments as part of an overall strategy to
manage the various risks they face. Sophisticated risk-management techniques evaluate the
overall riskiness of investment portfolios that
include options and other derivatives. However, assessing the risks of these portfolios generally requires practitioners to use models of
option pricing that are only approximations.
Sometimes these models do not perform as well
as practitioners would like, and, after the fact,

21

Jerome Detemple and Philippe Jorion review some of
the theoretical and empirical work on the effects of option
introduction on the stock market. The empirical work in
the article suggests that after the introduction of an option,
the price of the underlying stock rises and the volatility of
the underlying stock falls.
22
The paper by Rajna Gibson and Heinz Zimmermann
has a more detailed discussion of the risks associated with
the use of derivatives.

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the firm can find itself exposed to more or less
risk than it desired. In addition, financial innovation has led to new and more exotic securities that are increasingly difficult to price. Thus,
the inaccuracies in various pricing models may lead
investors and traders astray.
Another risk is that one party may default
on the contract, which is called credit risk. Credit
risk is not much of a problem for derivatives
traded on organized exchanges, since these exchanges are designed in such a way that their
contracts are almost always honored.23 Credit
risk is much more of a problem in the OTC
market, where two parties negotiate a derivative contract specific to their needs. For example, a bank may enter into offsetting swap
arrangements with two firms. If neither firm
defaults, the bank is fully hedged. But if one
firm defaults, the bank will still have to honor
its arrangement with the other firm, and so it
faces a credit risk. Banks can try to mitigate
some of this risk by requiring collateral from
the firms participating in the swap arrangement
or by obtaining third-party guarantees.
Another risk in the use of derivative instruments is liquidity risk, which refers to the ease
with which the contract can be traded. Liquidity risk is not specific to derivative contracts; it
can play a significant role in any financial market during periods of high volatility or signifi-

23
Organized exchanges use arrangements such as daily
marking to market and clearinghouses to guarantee performance of the contract.

James J. McAndrews
Keith Sill

cant changes in economic fundamentals. However, even during the market crash of October
1987, both standardized and OTC derivative
markets remained viable, and no market collapse or major liquidity crisis occurred. The
structure of the standardized and OTC markets
appears to have been adequate to manage liquidity risk in the past. Further, there is little
evidence that liquidity risk has increased with
the size of derivatives markets.
When securities become illiquid, however, it
is more difficult to determine their market
value. As a consequence, when firms try to sell
illiquid securities they may find that the market value of their portfolios and securities differs substantially from the values that are “on
the books.” The models that firms use to manage their risks and make financial decisions may
then give incorrect answers because incorrect
values for the securities were used in the analysis.
CONCLUSION
Derivatives markets have shown tremendous growth over the last 10 years. While much
has been made of recent derivatives-related
losses, the economic benefits provided by derivative securities are more important. Derivatives help the economy achieve an efficient allocation of risk. They assist in completing markets, thereby providing firms and individuals
with new investment opportunities. Derivatives provide information to financial market
participants and may help reduce overall market volatility.

REFERENCES
Allen, Franklin, and Douglas Gale. “Arbitrage, Short Sales, and Financial Innovation,” Econometrica, 59
(1991), pp. 1041-68.
Bank for International Settlements. Central Bank Survey of Foreign Exchange and Derivatives Market Activity
1995. Basle: Bank for International Settlements, May 1996.
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REFERENCES (continued)
Cox, John C., and Mark Rubenstein. Options Markets. Englewood Cliffs: Prentice-Hall, 1985.
Detemple, Jerome, and Philippe Jorion. “Option Listing and Stock Returns,” Journal of Banking and Finance,
14 (1990), pp. 781-801.
Duffie, Darrell. Futures Markets. Englewood Cliffs: Prentice-Hall, 1989.
Gibson, Rajna, and Heinz Zimmermann.”The Benefits and Risks of Derivative Instruments: An Economic
Perspective,” Geneva Papers (1994).
Grossman, Sanford. “Insurance Seen and Unseen: The Impact on Markets,” Journal of Portfolio Management,
Summer (1988a), pp. 5-8.
Grossman, Sanford, “An Analysis of the Implications for Stock and Futures Price Volatility of Program
Trading and Dynamic Hedging Strategies,” Journal of Business, 61 (1988b),pp. 275-98.
Group of Thirty. Derivatives: Practices and Principles. Washington, D.C: Group of Thirty, 1993.
Hakansson, Nils. “The Fantastic World of Finance: Progress and the Free Lunch,” Journal of Financial and
Quantitative Analysis, 14 (1978), pp. 717-76.
Hill, Joanne M. “The History of Equity Derivatives,” in Jack C. Francis, William W. Toy, and J. Gregg Whittaker,
eds., The Handbook of Equity Derivatives. Chicago: Irwin, 1995, pp. 33-48.
Hopper, Gregory P. “A Primer on Currency Derivatives,” Federal Reserve Bank of Philadelphia Business
Review (May/June 1995).
Hull, John C. Options, Futures, and Other Derivative Securities. Englewood Cliffs: Prentice-Hall, 1993.
Jorion, Philippe. Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County. San Diego: Academic Press,
1995.
Kuprianov, Anatoli. “Derivatives Debacles: Case Studies of Large Losses in Derivatives Markets,“ Federal
Reserve Bank of Richmond Economic Quarterly (Fall 1995).
Merton, Robert C. Continuous-Time Finance. Oxford: Basil-Blackwell, 1990.
Ross, Stephen A. “Options and Efficiency,” Quarterly Journal of Economics, 90 (1976), pp. 75-89.
U.S. House of Representatives, “Derivative Financial Markets,” Congressional Research Service Report,
Subcommittee on Telecommunications and Finance, 1993.
Vega, J.P. de la. Confusion de Confusiones, translated by H. Kellenbenz, No. 13, The Kress Library Series of
Publications, The Kress Library of Business and Economics, Harvard University, Cambridge, MA.
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