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The Future of Money in the Information Age

Chapter 3: Electronic Liquidity and Domains of Trust

William Melton

The very term electronic money (e-money) carries with it so much hype, so many misconceptions, so many private agendas, that thoughtful discussion becomes difficult. Therefore, let me avoid that emotion-laden word and instead focus on electronic liquidity. In the consumer world, all that matters is liquidity--namely, whether the receiver will readily accept the marker presented as a valid medium of exchange. The source of that liquidity, whether from a line of credit, a bank deposit, or a gift certificate, is not important. What is important is that liquidity be reliable and convenient. Consumers want to know: Is this transaction going to ``bounce,'' come undone, or unravel? What is the nuisance factor? How many forms do I have to fill out? And how long do I have to wait to complete the transaction?

Liquidity and Trust

Liquidity has a strong psychological variable, indeed its principal element is trust. In the technical world of cryptography, we talk about domains of trust. Let me suggest that liquidity can only be produced from a domain of trust. And those domains can be one of at least two types: a domain of actuarial trust or a domain of guaranteed trust.

A Domain of Actuarial Trust

Life insurance companies can trust they will have a certain investment horizon for your policy, based on actuarial tables. The life insurance company does not get your pastor, your mother, or your banker to guarantee you will live to a certain age. The insurance company, sadly to say, is not even very concerned what age you live to, except as it may affect their actuarial averages.

A major grocery chain is willing to accept checks from strangers because the actuarial experience of grocers has shown that less than one half of 1 percent of those checks will go bad.

Obviously life insurance companies and grocery stores will try to tweak the odds: with life insurance companies accepting only nonsmokers or grocery stores rejecting checks with low check numbers. But fundamentally, the trust comes from actuarial dynamics, not from some external guarantor.

A Domain of Guaranteed Trust

The second type of trust domain is one that we are more familiar with: the domain of guaranteed trust. In this type of domain, the government, the bank, or some other strong guarantor says, ``Trust me, I guarantee it.'' Behind any guarantor there may be another guarantor, such as behind your bank stands the Federal Deposit Insurance Corporation, and behind the FDIC is the perceived strength of the government. Thus, these guaranteed trust domains quickly become very hierarchical.

Frequently, there is a mixing of actuarial and guaranteed trust domains. For example, though you as employer may not personally know all of your 500 employees, you believe you have followed good hiring practices and therefore you can say to your bank: ``Please extend to my employees liquidity for travel expenses, and I will make good if anyone fails to pay.'' You have made the actuarial assessment of trust internally, then converted that into a guaranteed trust in dealing with the bank. The bank does not have a clue about your employees; it is looking to your guarantee for its trust.

The distinction between liquidity based on actuarial analysis and on a guarantor relation, although subtle, has substantial social, political, and economic implications. The actuarial domain of trust is frequently found in a market economy, while the guaranteed domain of trust is more at home in hierarchical environments. Modern financial markets spring from the sharing of risk and are actuarial by nature. Even the largest guarantors (governments) are subject to the statistical evaluations of those markets or actuarial domains. As a national and international economy, the United States is moving, and must move, toward actuarial domains of trust.

Electronic Liquidity

We can now apply the concepts of actuarial and guaranteed trust domains to specifically electronic liquidity. I will suggest that electronic liquidity can be substantially and safely increased without inflationary impact. This increase of electronic liquidity with a corresponding increase in goods and services will happen inevitably by trial and error driven by entrepreneurial effort. But to understand this increase of both electronic liquidity and the corresponding increase in goods and service, it is worthwhile to have a better understanding of both actuarial and guaranteed trust domains, and the evolution of those domains.

The Visa and MasterCard systems can serve as an example. In the early days Visa and MasterCard established a wonderfully creative system of cross guarantees and then enabled that guarantee system with cutting-edge telecom technology. As a consumer your local banker guaranteed liquidity for you. The merchant's banker guaranteed liquidity for him. Each of you stayed inside your own preexisting domain of trust. The cutting edge telecom systems linked these two domains of trust with wires, protocols, and operating procedures.

While each local bank acted as a strong guarantor, total system risks were handled actuarially by assessments to the participating banks. Again, note the novel mixing of guaranteed trust systems (locally) with actuarial trust systems (systemwide), enabled by new telecom technologies.

Obviously no system stands still. It evolves and certainly the Visa and MasterCard systems have evolved. As telecom systems became ever more efficient, the merchant bank's ``value add'' became less (measured as a percentage of the total transaction cost). Thus, the acquirer (or merchant's) bank provided an ever declining relative value. Transaction approval costs (a merchant bank's function) have dropped from perhaps 30 cents in the early 1980s to roughly 3 cents now. The merchants' banks ``value add'' became ever more technical, commoditized, and out-sourced. Thus, there has been huge consolidation on the merchant bank side of the transaction. Trust (i.e., liquidity) on the merchant side of the transaction now comes from technical prowess rather than from maintaining a personal banking relationship with the merchants.

Today a larger share of the revenue and profits goes to the consumers' end of the transaction. This is where the liquidity is extended, or where the liquidity is created. Here the issuing banks continue to shine and continue to make large profits. But even here there has been rapid and dramatic movement toward an actuarial trust domain. Aggressive banks now routinely issue liquidity to customers whom they have never seen, on a nationwide basis. State boundaries are thin veils to be nodded at in passing. With the help of massive data bases, sophisticated scoring techniques, and carefully delineated actuarial domains, banks issue billions of dollars of liquidity based solely on actuarial trust.

But a funny thing has happened on the way to this great outpouring of liquidity. The cost of distribution (that is, the cost of getting the liquidity to the consumer) is more expensive than evaluating and granting the credit or liquidity. By today's economics, it might cost $50 to $70, including advertising and mailings, to acquire a new bank liquidity customer. At the same time, using advanced actuarial techniques it might cost less that $10 to evaluate and complete the granting of the credit or liquidity.

Thus, distribution and marketing costs have become the tall pole in the tent on the road to providing consumer liquidity. Crudely explained, if you were running a mint, and the cost of the precious metals or the cost of printing were no longer significant, but rather the cost of distributing your money was now 90 percent of your budget, you would obviously focus on those costs. Moreover, if a competitive mint had zero costs of distribution, its money may well, in a competitive market, gain market share. To a large extent this is the situation in the consumer liquidity granting environment today.

To solve the problem of high distribution costs, aggressive players have begun to rely on existing natural groupings (e.g., United Airlines' Visa Card). These groupings already support distribution infrastructure and costs for their own pre-existing purposes. In the banking world these are known as ``affinity'' or ``co-branding'' efforts.

As we move to the newer and ever evolving world of the Internet, the relative distribution and mind-share acquisition costs become even more extreme. The need to use affinity groups, subgroups, special interest groups, and specific purpose groups, in an effort to rise above the white noise of nearly infinite information flow, becomes quickly apparent and urgent.

Each subgroup used as a distribution channel will ask for some benefit for their assistance in the distribution of liquidity, the mint product. The market will become ever more differentiated with rewards for specific skills such as ``just distribution,'' or ``distribution and credit guarantee,'' or just ``credit guarantee.''

In a traditional physical world such complexity and convoluted relations would soon become too costly to manage. However with modern computers and telecommunications links, it is now possible to profitably use the Sierra Club as an actuarial grouping and distribution partner. As we move further into the world of the Internet and further down the road of electronic liquidity, we will economically be able to manage ever greater differentiation and even finer granularity.

There will be coupons, interactive game prizes, rewards for the best song or best poem. There will be corporate petty cash boxes, school fund-raising drives, and a myriad of other closed-end or limited-use liquidity systems. These limited-use liquidity systems will meld with and help distribute more traditional liquidity instruments from more traditional players.

In an economic environment so complex, and probably highly leveraged, breakage in any one area, unless contained, could be dangerous for the whole system. Therefore, local reserves managed by the market ``experts,'' whether those be traditional bankers or the stock market, will be used as firewalls to contain ``actuarial mistakes'' within small local pockets.

Actuarial systems work well only when there can be reliable tracking and statistical feedback continually updating the actuarial model. Such tracking raises the specter of personal identity tracking and potential losses of personal privacy. Without going into the details, suffice it to say that maintaining most any degree of privacy is not contradictory to adequate statistical feedback. In any transaction there is the identity of the guarantor, the identity of the asset or account holder, the identity of the liquidity or credit issuer, and the identity of the shopper or conveyer. Any or all of these various identities can be exchanged, blinded, or proxied to provide whatever level of privacy is appropriate for that type of transaction. Yet, because the actuarial system is interested in the epidemiological behavior of the actuarial group as a whole, rather than individual behavior, the benefits of an actuarial domain of trust can be preserved while maintaining full privacy.

As actuarial trust domains become more differentiated, filling many niches that heretofore could not be envisioned, the total system will still be able to manage these interacting complex identity sets in an efficient manner. Digital certificates, digital signatures, private certificate authorities, and increasingly capable actuarial evaluation and scoring systems will easily manage complexity at lower costs than is possible today.

The Challenge of the Marketplace

If chains of trust are the primary ingredient of liquidity, then the technology of digital signatures and digital certificates are the technological breakthroughs that allow maintenance of ever more subtle, more complex, and yet still reliable, chains and domains of trust. The economic impact is to provide greater liquidity. Yet, this additional liquidity is provided under the tight feedback loops of the market and is, on the whole, noninflationary.

The liquidity (in all of its various forms ) provided by these evolving systems will stimulate sales, not only of existing goods and services, but more importantly this more efficient electronic liquidity will stimulate production of new goods and services, services that cannot today be economically provided.

In traditional economics we assumed, for simplicity of discussion, that there was a finite amount of goods and services available in the marketplace. I take issue with this mechanistic assumption of finite market limits. Is there a limit to the number of songs that can be produced or enjoyed? Are the number of ideas that can be thought finite? Are the number of computer programs to be written finite? Are ideas about efficiency itself finite? I would argue, no, there is an infinite progression, and therefore potentially an infinite supply of goods and services.

The challenge of the marketplace and the newer forms of electronic liquidity is to continually lower transactions costs, continually increase convenience, and thereby enable new markets heretofore not possible. With strong actuarial feedback, it is also the job of the market to match the supply of these new forms of liquidity with the equivalent supply of goods and services coming from both old and new markets.

I am extremely optimistic about the enabling power of increasing efficiency and convenience in payment systems and in the granting of liquidity. I am doubly optimistic about the power of the marketplace that is being born on the Internet, a marketplace where geography has largely evaporated and time is measured in baud rates. These combined efficiencies, I believe, can bring society a new age of plenty and opportunity. We live in exciting times.

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