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SPECIAL ISSUE

THE FEDERAL RESERVE BANK
OF CHICAGO

MARCH 2001
NUMBER 163a

Chicago Fed Letter
E-money and e-commerce:
Two alternative views of
future innovations
Some in the banking industry have
wrung their hands over the slow adoption of debit cards, e-cash, electronic
bill payment, financial electronic data
interchange (FEDI), and smart cards
in the U.S. Whether or not these innovations grow swiftly, this subject is
important for several reasons. First,
payment services bring in significant
revenues for financial institutions,
and changes in technology could impact future revenues. Second, a cornerstone of policy on issues of safety,
soundness, and consumer protection
is the assumption that a significant
portion of financial services activity
flows through “trusted” financial institutions. As a result, it is important for
policymakers, the industry, and the
public to understand the broad implications of technology for the payments
mechanism and banking.
How will the future path of electronic payment systems be determined?
One school of thought argues that
a number of obstacles and barriers
stand in the way of e-payment innovations and that these will need to be
addressed before e-payment technologies can be successful. Other studies
have suggested an alternative theory—
that the advent of the Internet will
cause revolutionary changes in banking and commerce requiring fundamentally new payment systems to
evolve.1 At the root of this debate are
several questions. Why do some innovations succeed and others fail? How
do these changes occur? Are e-money
innovations and the supporting law
and technology infrastructure driven
by planning for future needs or by
focusing more narrowly on past problems? Will the innovations be spurred

by current institutions or by nontraditional providers?
In this Chicago Fed Letter, I provide an
overview of developments in e-money
systems and commerce. I then explore research on the economics of
innovation to put these changes in a
broader context. Lastly, I analyze the
potential implications of changes in
banking and commerce for the evolution of e-money. In the process, I
build on a theory advanced by Clayton
Christianson that aims to explain and
predict how different product innovations do or do not occur.2
The changing nature of commerce
The nature of commerce will continue to change with the growing familiarity of the Internet and the World
Wide Web. Use of the World Wide
Web is on track to reach a critical mass
of U.S. households many times more
quickly than the telephone did when
it was introduced into American households. The Gartner Group predicts
that over $7 trillion worth of businessto-business (B2B) commerce will be
conducted electronically in 2004 and
over $380 billion of business-to-consumer (B2C) commerce will be conducted electronically in 2003.3 While
the last five years have seen firms experiment with the Internet to advertise the availability of products and
to offer services for sale in a transaction capacity, more fundamental
changes in commerce have begun to
emerge. Consider Ebay, which allows
consumers to trade with consumers
without a direct intermediary, creating
a fundamentally new market of buyers and sellers who would otherwise
have been unlikely to find one another. Yet, while providing important
benefits, this new commercial environment also exposes consumers to risks
that they may not be accustomed to

managing, such as finality of payments
and recourse in case of untimely
delivery or poor quality. Similarly,
emerging Internet-based B2B portals
may offer significant improvements
to market participants, but again may
potentially expose them to important
risks, relating to seller performance,
buyer financial stability, and dispute
resolution.
Changing nature of payment systems
As one would expect, payment systems
have been evolving to meet the changing needs of buyers and sellers. New
payment instruments are being created
to expand the reach of the payments
infrastructure that has been in place
for decades; current systems are being
reengineered at the fringe; and fundamentally new payment systems are
being developed as well. For instance, while the development of new
e-cash technologies continues to be
explored, PayPal, an Internet payment
mechanism, puts a “new front end”
on existing credit card and ACH (automated clearing house) networks to
make them more convenient for consumers and to allow consumers to send
money to each other. Paper checks
are being converted to electronic
transactions and cleared via the ACH
and ATM (automated teller machine)
networks by some retailers as a device
to reduce check-clearing costs and to
begin to wean some consumers from
checks. Some organizations are also
exploring the use of ATM networks
and the ACH for Internet transactions
in order to offer a lower cost alternative to credit cards. Some retailers
have also implemented store-based
debit cards that are cleared and settled over the ACH rather than ATM
networks, again to reduce costs while
broadening the store’s relationship
with its customers.

Payment innovations
How does the process of innovation
occur? There are two general, complementary theories of how new products are adopted. The first theory, the
new product diffusion model, assumes
that the primary determinant of new
product adoption is the time it takes
customers to learn about a product,
to experiment with it, and then ultimately to use it. This theory assumes
that customers view a new product or
service as a clear substitute for past
products. These types of innovations
essentially “sustain” or “extend”
the current product (see figure 1).
Christianson notes that new entrants
in this market will tend to find it
harder to enter successfully against
incumbent competitors, who can roll
out innovations profitably to their
existing customer bases.

Theory 2: New market
development
The second theory
suggests that broader
Disruptive technology
(new market)
structural changes are
underway, driven by
Sustaining technology
technology, and these
(diffusion)
changes are blurring
Evolution without
the lines between bankinnovation
ing and commerce.
While it is both natural
and critical for incumbent firms to experiment, this theory
time
suggests that these innovations tend to unleash improvements
The second theory, the new market
that incumbents may not find valuable
development model, suggests that some
in the short- or mid-term. Some obinnovations—disruptive technoloservers may suggest that incumbent
gies—lead to new products or services
firms in these industries “do not unthat by themselves have a limited marderstand their markets” or “are not
ket potential (see figure 1). This theadequately investing in the future.”
ory suggests that, in order to reach
However, Christianson finds that inmass markets, firms need to offer adcumbent firms, for purely profit maxiditional product features and/or inmizing reasons, may not want to choose
frastructure, tailoring the product
to pioneer some of these innovations
to new uses and to nontraditional
themselves, leaving other firms with
customers. In many of these cases,
different specialties to do so.
Christianson suggests that “new” or
“nontraditional” providers tend to
Blurring lines of banking
have an advantage over incumbent
and commerce
firms since they have the freedom to
Figure 2 provides an overview of the
focus on fringe benefits rather than
historical changes underway in the
focusing on mass market needs.4
financial services industry. Looking
back 20 years, banks competed primaWhy haven’t e-payments succeeded?
rily on the basis of geography. With
Theory 1: Product diffusion
the advent of deregulation and techBuilding on new product diffusion
nology, significant changes occurred
theory, some studies cite a laundry
in the 1980s and 1990s with the emerlist of barriers standing in the way of
gence of more product-based institue-payment innovations. On the detions. It is not clear how the industry
mand side, studies have cited customer structure will progress in the 21st
resistance or inertia, lack of incentives,
century, but future models of financial
and lack of customer awareness of the
services might include: 1) a universal
innovation as obstacles to change. On
bank that bundles a broad range of
the supply side, studies have pointed
financial products and services under
to the lack of clear standards, the need
one roof for a broad range of customto overcome industry fragmentation,
ers,5 2) an institution that focuses on
inadequate incentives among incumthe broad financial and nonfinancial
bents, and the presence of network
needs of a narrow segment of the
externalities. This theory assumes
market,6 3) a “virtual portal’ or “aggreimplicitly that a significant portion of gator” that uses technology to intee-payment innovations are clear subgrate financial services from a variety
stitutes for existing services and that
of specialized providers,7 or 4) a traadditional work by incumbent firms
ditional, financial institution, which
alone or in collaboration will lead to
focuses on a limited number of finanbroad acceptance.
cial products.
1. New product innovation models

value to customer

That organizations are using “different payment networks” for “similar”
commercial purposes and the “same
payment networks” for “very different”
commercial reasons is not a new phenomenon. For instance, for decades
some organizations have used checks
for payments of hundreds of thousands of dollars rather than using
large-dollar, real-time funds transfer
systems. Other organizations have
traditionally used large-dollar, realtime funds transfer systems to make
fairly modest-sized payments. Some
of these events are motivated by the
fact that it is easier to pay using “preset mechanisms” than to change to a
new system for infrequent transactions. At other times, decisions are
driven by a payment instrument’s
“special features.” For example, a
firm might use checks for large-dollar
payments to slow down the process
for exchanging funds or to improve its
negotiating leverage with a supplier.
On other occasions, a firm might use
large-dollar payments mechanisms to
guarantee timely payment. Thus, a
significant amount of pressure is exerted on payment systems as various
parties attempt to push innovations
with certain characteristics or to leverage other instruments for their relative strengths.

a larger fraction of
customers may need
to become more willBrokerages
ing to accept fee-based
services rather than
Universal bank?
Banks
bundled services.9 In
Customer-based bank?
this case, rising conInsurers
Banks
sumer receptivity to
Virtual portal?
fees could spur potenMutual funds
tial innovations. In a
Product-based bank?
third example, some
Mortgage
e-money innovations
originators
may not be commer1980–1990s
2000 and beyond
pre-1980s
cially feasible until
other banking and
nonbanking functions
According to the new market develare more closely integrated (i.e., a
opment theory, many of the so-called
move towards the second model).10
obstacles and barriers to innovation
may be better viewed as symptoms
A payment systems framework
of the broader changes underway,
The above discussion makes it clear
rather than as problems per se. For
that payment systems questions are
example, a larger number of financomplex, involve a significant numcial institutions may need to have a
ber of interrelated issues associated
broader relationship with customers
with commercial relationships, tech(i.e., a move towards universal banknology, the law, and business practicing). In these cases, institutions may
es, and involve coordination among
be able to invest in e-payment innoa variety of parties with different
vations as a cost of doing business
and sometimes competing interests.
for obtaining the customer’s broader
Adding to the complexity of these
business, rather than purely as a reverelationships, payment systems
nue generator.8 As a second example,
2. Financial services industry structure

3. Payments framework

involve long-term infrastructure investments, which evolve slowly over time.
As a result, it is critical to evaluate payment systems changes in a broader
context, which recognizes the various
component factors, including the nature of the commercial relationship
as well as the nature of the payment
systems used. See figure 3 for a graphical schematic of the simplified payments relationship. Frameworks like
this one allow for more careful analysis
of which innovations are clear substitutes for one another and the potential implications for different parties.
Conclusion
This article provides an alternative
theory to the traditional “obstacles
and barriers” theory for explaining
why some e-money innovations have
not succeeded more quickly. In the
process, it provides a framework for
characterizing new innovations as well
as better understanding where, when,
how, and by whom these new innovations will occur.
This theory has potentially important
implications for public policy. In terms
of safety and soundness policy, some
would argue that the growing role of
nonbanks will pose significant questions to safety and soundness. Yet, the
“new market development” theory

Ordered and fulfilled electronically
Ordered online, fulfilled manually
Traditional commerce
Consumer to
consumer

Consumer to
business

Consumer to
government

Business to
consumer

Business to
business

Business to
government

Government to
consumer

Government to
business

Government to
government

Customer/
Issuing
bank

Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors’ and are not necessarily those of the
Federal Reserve Bank of Chicago or the Federal
Reserve System. Articles may be reprinted if the
source is credited and the Research Department
is provided with copies of the reprints.

Payment instruments:
Checks, cash, money orders,
credit cards, debit cards, smart
cards, ACH, PC banking,
wire transfers, et cetera

Merchant/
Acquiring
bank

Michael H. Moskow, President; William C. Hunter,
Senior Vice President and Director of Research; Douglas
Evanoff, Vice President, financial studies; Charles
Evans, Vice President, macroeconomic policy research;
Daniel Sullivan, Vice President, microeconomic policy
research; William Testa, Vice President, regional
programs and Economics Editor; Helen O’D. Koshy,
Editor; Kathryn Moran, Associate Editor.

Clearing houses and networks:
Fedwire, CHIPS, book entry,
net settlement, ACH, credit card
networks, ATM networks, check
and cash couriers, et cetera

Chicago Fed Letter is available without charge from
the Public Information Center, Federal Reserve
Bank of Chicago, P.O. Box 834, Chicago, Illinois
60690-0834, tel. 312-322-5111 or fax 312-322-5515.
Chicago Fed Letter and other Bank publications are
available on the World Wide Web at http://
www.frbchi.org.
ISSN 0895-0164

suggests that nonbanks will not necessarily replace the functions of banks
but rather provide parts of services
that financial institutions do not have
a comparative advantage in providing.11 Second, much of consumer
protection policy is based around
bundling protections around a few
fairly common banking products. To
the degree that commerce and banking continue to mingle, public authorities may need to be particularly careful
about attempting to regulate the relative rights, warranties, and incentives
associated with alternative e-money
implementations, leaving markets to
influence the outcomes.12

1

A critical issue running through both of these
theories relates to the problems associated with
implementing products with network externalities. For instance, see G. Gowrisankaran and J.
Stavins, 1999, “Are there network externalities in
electronic payments?,” Global Financial Crises: Implications for Banking and Regulation, proceedings
from the 35th Conference on Bank Structure and
Competition, Chicago: Federal Reserve Bank of
Chicago, pp. 302–312.

2

Clayton Christianson, 1997, The Innovator’s
Dilemma: When New Technologies Cause Great Firms to
Fail, Boston, MA: Harvard Business School Press.

3

Leah Knight, 2000, “Triggering the B2B electronic
commerce explosion,” Trends and Directions
Note, Stamford, CT: Gartner Group; and Blaine
Mathieu, 1999, “Global consumer e-commerce
forecast update,” Trends and Directions Note,
Stamford, CT: Gartner Group.

—Brian Mantel
Program Manager
Emerging Payments Studies
Department

7
For instance, see Ross Snel, 1999, “Intuit offers
view of accounts with more than one provider,”
American Banker, Vol. 164, No. 220, November 1.
8

For instance, see Steve Ollenberg, 1999, proceedings from the Federal Reserve Bank of Chicago
and Illinois Institute of Technology’s Electronic
Payments Workshop, Chicago, IL, September.

9
For instance, see “Impose those fees—And stick
to your guns,” American Banker, Vol. 165, No. 65,
April 4, 2000.
10

4

It should be noted that the above types
of questions are not new. Indeed,
banking and commercial markets have
been facing these types of issues for
years. The above points are observations advanced as a theory for how
e-money systems may evolve. Clearly,
these are not resolved questions; rather they are questions warranting careful monitoring. More importantly, the
policy implications for private sector
and public sector leaders may be
quite different depending on one’s
view of how the market is evolving. 13

6
For a broader discussion, see Peter Wallison,
2000, “The Gramm-Leach-Bliley Act eliminated
the separation of banking and commerce,” The
Changing Financial Industry Structure and Regulation: Bridging States, Countries, and Industries, proceedings from Conference on Bank Structure
and Competition, Chicago: Federal Reserve Bank
of Chicago, pp. 34–41.

An important segment of the “new market development” theory, as I define it, is for those
innovations 1) with positive network externalities
and 2) with users who make significant and irreversible investments leading to an installed base.
This installed base, coupled with the presence of
switching costs, leads to significant challenges
for new innovations to prosper. As a result, I argue
that some innovations, which might appear to be
natural extensions of current products (such as
smart cards for credit cards), actually fall into
the “new market development” category. For
more on this subject, see Michael L. Katz and
Carl Shapiro, 1993, “Network externalities, competition, and compatibility,” Princeton University,
Woodrow Wilson School, discussion paper in
economics, No. 54, September.

5

For instance, see Liz Moyer, 1999, “Citigroup’s
strategy: Multiple products, multiple channels,”
American Banker, Vol. 164, No. 191, October 5.

For instance, see Catherine Allen, 1999, “Remarks,” proceedings from the Federal Reserve
Bank of Chicago and Illinois Institute of Technology’s Electronic Payments Workshop, Chicago,
IL, September.

11
For instance, see “Banks giving aggregators
respect, biz,” American Banker, Vol. 165, No. 157,
August 16, 2000.
12

For instance, see Henry H., Perritt Jr., 1999,
“Remarks” in proceedings from the Workshop
on Promoting the Use of Electronic Payments:
Assessing the Business, Legal, and Technological
Infrastructures, Chicago, IL, September.

13

The author would like to recognize the participants at Electronic Commerce Canada’s Conference “The E-Business Transformation: Where to
Go?” for their helpful comments on an early version of this article.

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