Electronic Payment Systems
20-763
Michael I. Shamos, Ph.D., J.D.
Co-Director, Institute for eCommerce
Carnegie Mellon University
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Course Objectives
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Understand money and its movement
Understand foreign exchange
Learn how money is made electronic
Learn the role of banks in electronic payments
Understand the cryptographic basis of electronic
payment systems
• Understand how all major types of payment systems
work; appreciate their risks and advantages
• Choose the right payment system for a given
business model
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Course Outline
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Introduction to Money and Banks
Automated Clearing and Settlement systems
ePayment Security (cryptography, digital certificates)
Credit Card Protocols: SSL/TLS and SET
Stored-value Cards
Micropayments
Electronic Cash
Electronic Banking
Electronic Invoice Presentment and Payment (EIPP)
Future of epayments
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
How Much Payment Is There?
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World securities: $100 billion USD per day
U.S. interbank payments: $1 trillion USD per day
World foreign exchange: $2 trillion USD per day
World interbank payments: $6 trillion USD per day
$2 quadrillion ($2 x 1015) per year
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Electronic Payment Systems
20-763
Lecture 1
Introduction to Money
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Lecture Outline
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Nature of money
What is a payment?
What is a payment system?
Desirable properties of money
Payment system requirements
Payment risks
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
The Payment Process
NATIONAL ECONOMY / FINANCIAL MARKETS
CUSTOMER PAYMENT SERVICE SYSTEM
BANKING SYSTEM
INTERBANK SYSTEM
Buyer
Buyer
Payment
Access
Point
Bank
Clearing House
Central Bank
Agree on
Trade
Instruct
Payment
Initiate
Payment
Clear/
Switch
Settle
Bank
Seller
Payment
Access
Point
Seller
Complete
Payment
Notify of
Payment
Complete
Trade
SOURCE: PHILIP TROMP, PERAGO.COM
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Development of Money
• Definition: “something generally accepted as a medium of
exchange, a measure of value, or a means of payment.”
Monetary History:
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ABSTRACTION
Barter (direct exchange of goods)
Medium of exchange (arrowheads, salt)
Coins (gold, silver)
NEED
Tokens (paper)
BANKS
Notational money (bank accounts)
Dematerialized schemes (pure information)
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Barter
• Direct exchange of goods and services -- possible
when production exceeds individual needs
• Problem: “double coincidence of wants”
– Trade a bicycle for a cow
– Alice must have a bicycle and want a cow
– Bob must have a cow and want a bicycle
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UNLIKELY
But: Internet allows rapid discovery of wants
Problem: remote barter requires an escrow (or risk)
Problem: outside the monetary and tax systems
When money is not trusted, barter returns
Electronic barter systems exist, e.g. LETS
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Types of Money:
Fiduciary vs. Scriptural
• Fiduciary money (fiat money, legal tender)
– Issued by a central (government) bank
– Has real “discharging power” (to discharge debts)
– Cannot be refused
• Scriptural money (not legal tender)
– Money not issued by a central bank
– Examples: bank accounts, travelers checks, gift certificates,
scrips
– Discharging power based on trust in issuer
– Can be refused
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Types of Money:
Token vs. Notational
• Token money
– Represented by a physical article (e.g. cash)
– Can be lost
• Notational money
– Examples: bank accounts, frequent flyer miles
– Electronic (scriptural) money: wide recognition
– Jeton = electronic token with limited recognition
• Hybrid money
– Check
– Telephone card (carries jetons for future service)
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
The Money Matrix
TOKEN
NOTATIONAL
HYBRID
FIDUCIARY
• CASH
• GOVERNMENT
BEARER BOND
• ACCOUNT WITH
CENTRAL BANK
• GOVERNMENT
CHECK
SCRIPTURAL
• CERTIFIED
CHECK
• TRAVELER’S
CHECK
• BANK ACCOUNT
• FREQUENT
FLYER MILES
• PERSONAL
CHECK
• GIFT
CERTIFICATE
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Specialized Payment Instruments
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Money order (allows named person to claim money)
Traveler’s check (limited to one spender)
Gift certificate (limited to one merchant)
Coupons, food stamps (limited to certain goods)
Bill of lading (sight draft), letter of credit
– Purpose: atomicity (connect goods and payment)
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Bill of Lading (B/L) Transaction
1. BUYER SENDS SIGHT DRAFT TO SELLER
BUYER
SELLER
8. BUYER PRESENTS
B/L, CLAIMS GOODS
7. BUYER’S BANK
DEBITS BUYER’S
ACCOUNT, GIVES
B/L TO BUYER
SHIPPER’S
DOCK
BUYER’S
BANK
2. SELLER DELIVERS
GOODS AND SIGHT
DRAFT TO SHIPPER
4. SHIPPER SHIPS
SHIPPER
3. SHIPPER CREATES
B/L, SENDS IT WITH
DRAFT TO BUYER’S
BANK
5. BUYER’S BANK PAYS
DRAFT TO SELLER’S BANK
6. SELLER’S BANK
CREDITS SELLER’S
ACCOUNT, NOTIFIES
SELLER
SELLER’S
BANK
SHIPPER IS AN ESCROW AGENT. IF B/L IS NOT PRESENTED, GOODS WILL NOT BE DELIVERED
IF SELLER NEVER SHIPS GOODS, SHIPPER WILL NOT GENERATE B/L AND BUYER’S BANK WILL NOT PAY
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Ecommerce Payment Ranges
Minimum
Transaction
Value
Typical
Transaction
Value
Maximum
Transaction
Value
Macro
$5.00
$50.00

Mini
$0.10
$1.00
$10.00
Micro
$0.001
$0.01
$1.00
SOURCE: COMPAQ CORP.
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Objective of Payment Systems
• To allow the payee to obtain real (fiduciary) money
– Usually in his bank account (convertible to fiduciary)
– Cash is rare except for low-value face-to-face payments
– Consider a credit card. Who pays the merchant real money?
• Payment in real money is called settlement
• Most payments are not settled individually
– Example: bank checks – too small to justify separate
transfers of funds; they are batched for efficiency
• Batching to determine how much real money must be
paid is called clearance or clearing
• Payment systems must provide for both clearance
and settlement
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Credit Card Transaction
1. BUYER TENDERS CREDIT CARD INFO TO SELLER
BUYER
SELLER
6. SELLER SHIPS GOODS TO BUYER
9. BUYER PAYS
BUYER’S BANK
USING SOME
OTHER METHOD
OF PAYMENT
8. BUYER’S BANK
SENDS BILL TO
BUYER
BUYER’S
BANK
5. SELLER’S BANK
CREDITS
SELLER’S ACCOUNT,
NOTIFIES SELLER
3. SELLER’S BANK
ASKS BUYER’S BANK
FOR AUTHORIZATION
4. BUYER’S BANK
AUTHORIZES/REJECTS
2. SELLER TRANSMITS
PAYMENT DATA TO
SELLER’S BANK
SELLER’S
BANK
7. BUYER’S BANK PAYS
SELLER’S BANK
CLEARANCES:
2. HOW MUCH SHOULD SELLER GET?
-- HOW MUCH SHOULD EACH BANK GET/PAY?
8. HOW MUCH SHOULD BUYER’S BILL BE?
20-763 ELECTRONIC PAYMENT SYSTEMS
HOW?
FALL 2002
SETTLEMENTS:
5. SELLER GETS REAL MONEY
7. SELLER’S BANK GETS REAL MONEY
9. BUYER’S BANK GETS REAL MONEY
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Payment Issues
• How does the payor know how much to pay?
(bill presentment, invoicing)
• What mechanism will be used to “pay” (payment)?
• When will payment be made (before, during, after)
• How will the payments be added up? (clearance)?
• How will the payee receive real money (settlement)?
• How will the payee credit the payor (reconciliation)?
• What records are available to the parties (audit)?
• Security for all the above
– authentication of parties
– prevention of forgery
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Payment Systems by Timing
• Prepaid Systems (Bank access before transaction)
– Cash
– Octopus, phone card
– Bank stored-value cards (GeldKarte)
• Instant-Paid Systems (Access during transaction)
– Debit card
• Post-Paid Systems (Access after transaction = credit)
– Credit card
– Cheques & electronic forms: Wirecard, eCheck
– Commercial invoice
• Huge differences in risk, authentication, cost
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Some “Payment” Methods
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Cash
Check
Credit transfer (giro), automated clearinghouse (ACH)
Interbank transfer (EFT)
Credit cards
Payment cards, smart cards (Mondex, phone cards)
Aggregation (accumulation, e.g. Qpass)
Intermediaries (PayPal)
Scrip systems (micropayments, e.g. Millicent)
Loyalty systems (Flooze, Beenz -- now bankrupt)
Electronic cash
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
System Issues
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Physical support (smart card, files, encrypted strings)
Value representation (denominations, numbers)
Location of value store (bank, electronic wallet)
Discharging power (who accepts it?)
Mode of use (remote, face-to-face)
Methods of payment (credit transfer, jeton exchange)
Genuineness (is it valid? stolen? double-spent?)
Authentication (of user)
Traceability (anonymity, privacy)
Scalability, cost
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Desired Properties of Money
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Universal acceptance
Transferability, portability
Safety (unforgeable, unstealable)
Privacy (no one except parties know the amount)
Anonymity (no one can identify the payor)
Work off-line (no need for on-line verification)
Divisible into change (pay for $10 item with $100 bill)
Arbitrary denominations (e.g. $325.14)
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Costs of Money
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Time
Risk
Physical cost (print currency, mint coins)
System infrastructure
Processing cost (transactions)
Security
Human time
Law enforcement
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Payment Risks
• ALL RISK HAS COST
– Suffering loss has cost
– Protecting against loss has cost
• System design must respond to risk posture
(willingness to accept various kinds of risk)
• Transferable v. non-transferable risk
– Insurance
– Hedging
• Example tradeoff: open v. closed payment networks
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Payment Risks
System design must respond to risk posture
• Operational (reliability and integrity)
– Security (unauthorized access)
– Employee fraud
– Counterfeiting (ecash)
– System design, implementation, maintenance
– Customer misuse
– Service provider risk
– System obsolescence
– Transaction repudiation by customer
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Payment Risks
• Reputational
– Negative public opinion  loss of business
• Bank of New York Russian money laundering
• Lose both legitimate customers AND launderers
– System deficiencies
– Security breach
– Failure of similar systems
• Systemic
– Risk that failure to meet an obligation spreads
through the system, causing others to fail to meet
obligations
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Payment Risks
• Legal
– Violation of law, ambiguity, legal sanctions
– Money laundering
– Inadequate disclosure
– Violation of privacy
– Violation by linked site
– Certificate authority risk
– Foreign law
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Payment Risks
• Banking
– Credit (non-payment, insolvency)
– Liquidity (demand for redemption of ecash)
– Interest rate (spread)
– Market (inflation, foreign exchange)
– Cross-border (social, political, economic)
• Crime
– Fraud, forgery
– Theft
– Kiting (illegal use of float)
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
B2B Payments
• High dollar value
• Tied to paperwork
– Requisitions, authorization, purchase order, shipping
documents
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Financial controls, auditing
Connection with legacy ERP and accounting systems
Cash management
International issues
– Customs documents, foreign currency
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
B2B Payments
Buyer
Supplier
Order
• Procurement
• Receipt Status
• Reconciliation
and Payment
• Financing/
Cash Mgmt
Cash
Payment
Details
• Order Mgmt
• Fulfillment
• Credit and
Collections
• Financing/
Cash Mgmt
Order Confirmation
Advance Shipping Notice
Invoice
Letter of Credit/
Escrow/
Line of Credit/
Risk Management
Financial
Institution
Payment Guarantee/
Insurance/
Trade Finance/
Risk Management
Cash
Receipt
Details
Logistics Providers
Proof of Delivery
Shipping Invoice
Payment
Authorization
Buyer
Bank
Account
Packing List
• Order Mgmt
• Credit/ Collections
• Financing/ Cash Mgmt
Proof of Delivery
Shipping Invoice
Payment
Authorization
(Shipping
Charges)
Cash Receipt Details
Cash
Logistics
Provider
Bank
Account
Cash
Cash
Supplier
Bank
Account
Goods Move Faster Than Money
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
Cash
Payment
Details
(Shipping
Charges)
SOURCE: TRADECARD
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Major Ideas
• Money classifications
– Token v. notational (what form does it take?)
– Fiduciary v. scriptural (“real” (government) or issuer-based)
– Prepay, instant-pay, post-pay
• Risk is a factor in all payment processes
• Cash is very expensive to use
• B2B payments are complex
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Q&A
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS