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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. Return service requested Public Information Center P.O. Box 834 Chicago, Illinois 60690-0834 (312) 322-5111 FEDERAL RESERVE BANK OF CHICAGO Chicago Fed Letter PRESORTED FIRST CLASS MAIL US POSTAGE PAID CHICAGO, IL PERMIT 1942