Digital cash, like other forms of money, can be issuedin any political or legal jurisdiction, or in any bankingenvironment: Salt Lake City, the Cayman Islands, Cyprus,or Sidney. There is a great deal of flexibility availableto the digital cash provider when viewed from a globalperspective.

Nevertheless, digital cash may operate locally undera set of rules and regulations similar to other formsof computer money such as bank deposits. (“Locally”can be almost any Internet-accessible country.) Thequestion of how banking regulators view digital cashis a practical one, because the answers to the questiondemonstrate the sort of issues that arise in any bankingcontext. All the examples here will involve the U.S.,a country with a complex maze of banking regulations.

From the point of view of central bankers, digital cashgenerates three sorts of questions. Who issues it? How is it used as a means of payment? What impactdoes it have on the banking system balance sheet orbottom-line?

Digital cash is by design a partial substitute for ordinarycash. Hence it will be used in much the same fashionas ordinary cash--a context with which central bankersare familiar. To a certain extent, digital cash threatensthe profitability inherent in central bank note issue.

Consider traveler’s checks. Traveler’s checks are aform of private bank currency. They are analogousto the bank notes issued by private commercial banksin the U.S. prior to the Civil War. As such, theyare very profitable to the banks and companies thatissue them, because no interest is paid out on traveler’schecks to the check holders, but the issuer earns intereston the funds that customers use to purchase them. When you purchase American Express Traveler’s Checks,you are making an interest-free loan to American Express. That’s why AMEX likes to sell them to you--apart fromthe fees involved in the transaction.

As with traveler’s checks, digital cash products suchas electronic purses (a card with a memory chip onit) represent an attempt by commercial banks to capturepart of the seigniorage earned by thecentral bank from issuing notes. Holders of currency(Federal Reserve notes) are making an interest-freeloan to the government. The interest opportunity costadds up. The approximate $20 billion that the FederalReserve turned over to the U.S. Treasury in 1994, forexample, represented about 5 percent of the $400 billionin Federal Reserve notes.

The Bank for International Settlements (BIS) estimatedthat in the United States seigniorage is .43 percentof gross domestic product (GDP), while central bank(Federal Reserve) expenses are .03 percent of GDP,implying a profit of .40 percent of GDP. [1]

These numbers can be used as a reference base to calculatethe amount of seigniorage recapture available to providersof digital cash. Suppose that that digital cash wasso successful for small purchases that it eliminatedthe U.S. $1, $5, $10, and $20 dollar bills. In thatcase, the BIS estimates the loss in seigniorage at.14 percent of GDP. Now it is highly unlikely thatdigital cash would replace all small denomination bills,as assumed in this calculation. But the calculationshows that up to one-third of current Federal Reserveseigniorage is potentially available to digital cashproviders. And that’s a lot of money.

While some central banks may be concerned that digitalcash will infringe on their monopoly of issuing banknotes (although most do not appear to be particularlyalarmed), such a monopoly can be easily circumventedwithout computers and without telecommunications. Allthat is required for the success of any privately-issuedcurrency is local acceptance as a means of paymentfor goods and labor. Consider, for example, HOURS,which is a local currency circulating in Ithaca, NewYork. Here is a brief (albeit dated) summary of theHOURS system. [2]

HOURS is a local currency created and issued by citizensin Ithaca, New York. The organizers have issued over$50,000 in local paper money to over 950 participantssince 1991. An estimated $500,000 of in HOURS-basedtransactions have taken place.

The idea behind an HOUR is that it is a rough equivalentto a $10.00 bill. The unit was chosen because tendollars per hour was the average wage paid in TompkinsCounty. HOUR notes come in four denominations, andhave been used to buy goods and services like plumbing,carpentry, electrical work, roofing, nursing, chiropracticcare, child care, car and bike repair, food, eyeglasses,firewood, and gifts. The local credit union acceptsthem for mortgage and loan fees. People pay rentwith HOURS. Some of the best restaurants in town takethem, as do movie theaters, bowling alleys, two largelocally-owned grocery stores, and thirty farmer's marketvendors.

Everyone who agrees to accept HOURS is paid two HOURS($20.00) for being listed in the newsletter IthacaMoney. Every eight months they may apply to bepaid an additional two HOURS, as reward for continuingparticipation. This mechanism increases the per capitasupply of HOURS. Ithaca Money contains 1200member listings. HOUR loans are made without interestcharges.

Multi-colored HOURS bear serial numbers and are printedon hard-to-counterfeit locally-made watermarked cattail(marsh reed) paper. Naturally, HOUR payments are taxableincome when received for professional goods or services.

The organizers have created a guide to creating localcurrency, called a Hometown Money Starter Kit. TheKit explains the start-up and maintenance of an HOURSsystem, and includes forms, laws, articles, procedures,insights, samples of Ithaca's HOURS, and issues ofIthaca Money. They’ve sent the Kit to over 300 communitiesin 45 states. To get one, send $25.00 (or 2.5 HOURS)to Ithaca Money, Box 6578, Ithaca, NY. 14851.

HOURS, much like traveler’s checks, are an attempt torecapture a part of the currency seignoriage usuallygiven up to the central bank. Like HOURS, digital cashdoes not require the approval of some central authorityto form a viable mechanism. And the presence of seignioragemeans that digital cash products can be highly profitable,for they simply arbitrage the difference between thecost of producing digital cash and the return availableto the issuers of the medium of exchange. As we sawpreviously, the Federal Reserve made $20 billion ofthis arbitrage in 1994, after payment of all expenses.

U.S. banking regulations distinguish broadly betweendeposit-issuing institutions and others. Thus the questionwhether the digital cash liability of a private companyrepresents a deposit or not determines who might attemptto regulate it or whether it is eligible for federaldeposit insurance.

Some of these questions here are more important in anon-anonymous digital cash system than in an anonymousone. A depositor who is anonymous, or who wishes histransactions to remain private, is probably not interestedin being identified for insurance purposes, or receivingregular bank statements detailing his financial activities. But, that having been said, a look at some representativeregulations is important for the purpose of understandingthe political and legal barriers to the creation ofan anonymous digital cash system.

Digital cash is a balance sheet liability of the commercialbanks or companies that issue it. Does it thus fallunder the laws governing ordinary checking accounts?And what about discharge of debt? In the case of theU.S., federal law does not currently address obligationsdischarged by stored value cards--only those settledby cash, check, or wire transfer.

FDIC deposit insurance, which applies to most bank deposits,can be easily extended to stored value cards underthe guise of a general liability account. The FDICGeneral Counsel has issued an opinion [3] that dividesstored-value cards into four categories:

· Bank Primary-CustomerAccount Systems--where funds stay in the customer’saccount until they are transferred to a merchant orother payee (as with a debit card). These are consideredcustomer “deposits” and covered by FDIC deposit insurance.

· Bank Primary-Reserve AccountSystems--where funds are downloaded onto a customer’scard (or software), and the bank’s obligation is transferredto a reserve or general liability account to pay merchantsand other payees. These are also considered issuer“deposits”, and covered by FDIC insurance.

· Bank Secondary-AdvanceSystems--where a card issuer is a third party, thebank makes the cards available to customers, and customerspay the third party for the stored value using fundsfrom their bank account. The stored-value funds inthis case are not considered deposits, and are notcovered.

· Bank Secondary-Pre-AcquisitionSystems--where the card is issued by a third party,the bank pays the third party for the card value, andsubsequently sells the stored value to customers. Again, the stored-value funds are not considered deposits,and are not covered.

Non-banks, meanwhile, are not eligible for FDICdeposit insurance. But the question remains, If non-banksissue stored-value products, are these stored-valuefunds “deposits”? For if stored-value is legally adeposit, then federal and state regulators might attemptto deny a company or other entity the right to issuethe product, using the Glass-Steagall Act or similarprovisions.

If stored value-products are “deposits,” thena non-bank might also become subject to the jurisdictionof the Federal Trade Commission (12 U.S.C.A. 1831 t(e))or might be treated as a bank for the purposes of theBank Holding Company Act (12 U.S.C.A. 1841 (c)(1)). This is something to keep in mind before selectingSalt Lake City as your digital cash base.

Nationally chartered banks are under the supervisionof the Office of Comptroller of the Currency (OCC). The OCC has explicitly approved national bank participationin one digital cash system, Mondex, and in stored valuesystems generally, stating “national banks may under12 U.S.C. 24(Seventh) engage in the business of MondexUSA”, and also that “national banks may under 12 U.S.C.24(Seventh) engage in the business of operating a storedvalue system”. [4]

In addition, the Federal Reserve has authorized bank-holdingcompanies who own ATM networks to provide stored-valuecard systems through these networks.

Mondex is known as a stored value card system. “Storedvalue” simply means the money is stored on a memorychip on the Mondex card instead of, say, being storedas pieces of paper in your wallet. This “stored value”will be used in everyday purchase and sale transactionsjust like cash. Hence the chief function of the “storedvalue” is as a medium of exchange (and not, as thename might imply, as intertemporal savings--which isthe usual meaning of the phrase “store of value” ineconomic discussions of money).

The rights to Mondex are held by Mondex InternationalLtd., a U.K. limited liability company. Fifty-one percentof Mondex International is owned by MasterCard International,while a consortium of global banks owns the other 49percent. The U.S. rights to Mondex have been purchasedby a group of nationally-chartered U.S. banks, listedbelow.

These U.S. banks have in turn formed two Delaware limitedliability companies to operate Mondex. One of thesetwo companies will act as a bank. It will create,sell, and redeem the “electronically stored value”(ESV) on Mondex cards. That is, it will trade otherforms of U.S. dollars for value stored on the Mondexcard. It will issue (sell) ESV for dollars,and it will redeem (buy back) ESV in exchangefor dollars. ESV is thus just another form of money: dollars, if denominated in dollars; pounds, if denominatedin pounds, and so on. From now on we will simply callthe Mondex ESV “Mondex Dollars”.

The Delaware company acting as the bank is called anOLLC (Originator Limited Liability Company). Its liabilitieswill be the Mondex Dollars it issues against payment. The money the OLLC receives will be invested in U.S.government securities, and cash and cash-equivalentssuch as interbank deposits and overnight repurchaseagreements. These are the OLLC assets. The holdingsof cash and cash-equivalents is required in order tobe able redeem Mondex Dollars on demand.

The second Delaware company will act as a licensingand servicing entity. The equity in the two companiesis divided up between Wells Fargo (30 percent), TexasCommerce Bank (20 percent), First National Bank ofChicago (10 percent), AT&T (10 percent), NOVUS (10percent), and MasterCard (10 percent).

In granting these nationally-chartered banks the rightto operate a subsidiary which carries out digital cashoperations, the OCC applied four criteria: (1) Isthe operation related to banking? (2) Do the bankshave sufficient control to disallow non-banking activities? (3) Is the banks’ loss exposure limited? (4) Is theinvestment related to the banks’ ordinary banking business? Since the OCC determined that the answers to thesefour questions were all “yes”, it approved the Mondexproposal.

The Federal Reserve’s Regulation E implements the ElectronicFund Transfer Act (EFTA). Under the guise of consumerprotection, Regulation E requires various disclosuresrelated to electronic funds transfer, as well as advancenotice of changes in terms, transaction receipts, periodicstatements, error resolution procedures, limitationson consumer liability, and restrictions on unsolicitedgiving of funds-transfer access-devices to consumers. On May 2, 1996, the Federal Reserve proposed to extendRegulation E to stored value cards. It would classifystored-value systems as “on-line”, “off-line accountable”,or “off-line unaccountable”.

On-linevoyage Glasgow systems would be simple debit cards whereaccounts balances are stored in a central database,not on the card, and communication with the centralfacility is required for balance transfers. Off-lineaccountable systems are ones in which balancesare recorded on the card, transactions do not haveto be transmitted to a central facility to be pre-authorized,but where each transaction is stored and periodicallytransmitted to a central facility. Off-line unaccountablesystems are those in which transactions are notpre-authorized, transactions are not traceable to aparticular card, and the card’s value is only recordedon the card itself.

The Fed proposes to make both on-line and off-lineaccountable systems subject to Regulation E requirementson transaction receipts and dispute resolutions ifthe maximum value that can be loaded is greater than$100, but exempt if the maximum value is $100 or less. Off-line unaccountable systems allowing valuesgreater than $100 would be subject to the RegulationE requirement on initial disclosure, but would be totallyexempt with respect to payment transactions. On-linesystems allowing values greater than $100 would haveto meet all requirements of Regulation E, except forperiodic statements, provided an account balance andaccount history is available on request.

The Fed’s proposal would thus seem to eliminate on-lineanonymous systems (because of the transaction historyrequirement), but would allow for off-line anonymoussystems under the “off-line unaccountable” option--aslong as account withdrawals were recorded.

A digital cash system like Mondex, operating out ofDelaware, has to grapple with all these issues. Thishas the advantage that, having made the regulatorshappy, the Mondex owners can then aggressively markettheir product through all the usual banking and financialchannels.

Those who are looking to create a digital cash productwhere privacy and security are paramount will probablywant to go off-shore and avoid the regulators to agreat extent. But they will still be left with themore important, and practical, problem of making theircustomers happy. And they will still be looking torecapture some of the central bank seigniorage.

[2] Glover, Paul, “Creating Ecological Economics withLocal Currency”, undated manuscript. Glover’s articlecontains a lot of grass-roots socialism that I don’tagree with. But that is not material to the use ofHOURS as an illustration of an alternative currency.

[3] Federal Deposit Insurance Corporation, “GeneralCounsel’s Opinion No. 8--Stored Value Cards,” by WilliamF. Kroener, III, General Counsel, FDIC, July 16, 1996.

[4] Office of the Comptroller of the Currency, “Interpretations--ConditionalApproval #220,” published in Interpretations andActions, December 1996.