Roadblocks and Emerging Practices


Mr. Chairman and Members of the Committee, thank you for givingme this opportunity to testify today on the monetary impact of theemerging electronic and digital payment systems on monetary policyand financial privacy. I am an Adjunct Scholar at the CatoInstitute, a Senior Fellow at the Discovery Institute, and Chairmanof Novecon Financial Ltd. Also, I am the author of the recent book,The End of Money and the Struggle for FinancialPrivacy.

I will focus my comments today on the emergingdigital money-like products which, I believe, will supplant mostconventional government issued money and existing payments systemsover the next couple of decades.


The age of digital money is upon us. The newtechnologies of the Internet, digital electronics, public keyencryption, and the rapid price declines of computing power andtelecommunications bandwidth are having a dramatic effect on thefinancial world. These new technologies are enabling thedevelopment of financial markets, procedures, and instruments thateconomists in the past could only theorize about. Financialtransactions can be settled in real time even though thecontracting parties may be thousands of miles apart. Money andother assets can be moved at almost the speed of light to any pointon the globe for a minuscule cost. Easy to use encryption programsenable almost anyone to move data or money around the globe withcomplete security.

It is now possible for private digital currencyissuers to compete without the high information and transactioncosts that burdened the multiple-issuer systems in the past.Moreover, new, private monies are emerging, including "digitalgold." The technical barriers have been overcome, as well as manyof the economic challenges.

Digital money is the monetary value of government- orprivately-issued currency units stored in electronic form in anelectronic device. Digital money is one type of a digital financialinstrument that fulfills most or all of the functions of money. Themonetary value stored in the electronic device can be transferredto other such devices, allowing the users to engage in paymenttransactions. This is different from traditional electronic paymentsystems, such as credit and debit cards and wire transfers, whichusually require online authorization and may involve debiting andcrediting bank accounts for each transaction.

A prepaid monetary value may be stored in a computerchip on a card - "smart card" - or stored on a computer chip in awireless device, or on a computer disk drive. Money transfers withcards are most often made through card reader/writers, whiletransfers using computers or wireless devices are made over wiredor wireless communication networks, such as the Internet. Cards,wireless devices, and computers can also be used to merelyauthorize monetary transfers from one account to another. Theseaccounts may be bank accounts or reserve assets held in non-bankinstitutions. Stock, bond, mutual fund, and gold deposit accountsmay allow ownership transfer of assets, even in micro amounts, tobe made by computer or wireless devices. To prevent fraud, all suchtransfers need to be protected by cryptographic codes. Thetechnology now exists to make such transfers anonymous, like papercurrency transactions, if the user so chooses.

Financial cryptographers have developed methodswhereby people will be able to securely hold bearer digital cash,bonds, stock, and even financial derivatives, and make very lowcost and anonymous transactions with them. A US dollar in paperform is a bearer instrument. That is, the person who holds it isnormally considered to be its lawful owner. There is no list ofowners of paper currency (a registration record); ownership isconveyed by physical possession. Gold coins are bearerinstruments.

The advantage of bearer instrument transactions isthat settlement is in real time, and therefore there is no risk ofnon-payment, as there is in book entry transactions such as checksand credit cards. There are no charge backs to the merchant, andthe risk of fraud (in the absence of counterfeiting) is greatlyreduced. Bearer instruments are also anonymous, which can protectthe owner from corrupt governments or criminal types. However,because of this anonymity, many governments do not like or haveprohibited certain types of bearer instruments because they make ithard for tax officials to collect revenue.

Digital monetary and financial products are"disruptive" technologies, in that their creation upsets theexisting legal and public policy order as to how money andfinancial products and institutions are regulated and organized.National borders are ceasing to have the relevancy they once did.Both businesses and governments need to build the appropriate legalorder for the digital age and understand how it should be managed.This will require changes in laws and regulations, leavingbusinesses in a thicket of uncertainty during the transitionperiod. Central bankers, treasury officials, law enforcementauthorities, and intellectual property administrators (patentofficials, etc.) will by necessity have to adjust to a differentworld. Their challenge will be to create a new set of rules andprocedures that bring the necessary order without impinging on therights of privacy of individuals and institutions, or destroyingthe economic efficiencies that the new technology is bringing.

Policy Implications of Digital PaymentsSystems

Many legal issues will arise as digital money becomesmore prevalent. Given that most digital money will be global in thesense that the Internet will facilitate its movement or use outsideits issuing jurisdiction, the lack of legal uniformity betweencountries raises many policy issues. For instance, who has theliability if a failure does occur in a particular digital moneysystem because of fraud or for some other reason? When digitalmoney payments are made across national borders, who hasjurisdiction? Does digital money violate the monopoly rights ofcentral banks to issue money? May a central bank issue digitalmoney? Do non-bank issuers of digital money need to be regulated,and if so, who should the regulator be? Who is going to determineif the clearing organizations have sufficiently robust and fraudproof systems? Given that various digital money systems are nowbeing developed and offered, the answers to the above questionswill probably slowly evolve over the next few years as realproblems emerge. Already, multilateral financial institutions likethe Bank for International Settlements and the InternationalMonetary Fund have established working groups to try to developrecommendations for their members in dealing with theabove-mentioned issues. These BIS and IMF recommendations will beof particular interest to the world's central bankers who arefacing the front line of change.

To the extent people use privately-issued digitalmoney for transactions, the demand for government money is reduced.If people are willing to hold liquid balances in the form ofdigital money, the quantity of demand deposits (checking accounts)that people need or desire is smaller, hence reducing the centralbank's supply of money. The same principle holds true for othermoney substitutes, from very limited money substitutes (i.e.,balances held on telephone cards, or frequent flyer miles) to broadmoney-like products (i.e., digital gold). As these broad andnarrow-use money substitutes grow in popularity because of theirease of use in the digital age, the amount of money supplied bycentral banks will decline. Until some non-government money reachesa critical mass whereby most users and businesses find they can doa substantial portion of their business in the "new money,"virtually all digital money and money substitute products will bereconverted to central-bank-issued money at some point. However,even during this period of partial and temporary substitution ofdigital money for central bank money, the demand for central bankmoney will gradually decline.

Justifiable concerns have been raised about theinnovations in payments technology and the development of digitalmoney and their impact on inflation. For monetary systems with aquantity anchor (such as the US dollar and other fiat currencies),technology changes resulting in an increase in the money multiplieror a decrease in money demand will increase the price level unlessbase money is reduced by an appropriate amount. If digital money isissued by an institution other than a bank, which has no reserverequirement, the growth in digital money will increase the moneysupply unless the central bank takes corrective action. Theincreases in the money supply resulting from the new technologieswill be both gradual and easily recognized, and hence would beneutralized by the central bank by appropriate reductions in themonetary base. As with all innovations with payments technology,the introduction of digital cash has a one-time effect on the pricelevel. The money multiplier would be larger but stable at its newlevel.

If digital money is issued by a bank at the expenseof deposits, and is subject to the same reserve requirements asdeposits, the monetary effect would be approximately neutralized.If digital cash issued by banks is subject to a 100% reserve, or ifdigital cash is issued by a non-bank, with a 100% reserve, no newmoney is created. With any price rule digital money system (i.e.commodity backed systems), inflation by definition is not aproblem.

In general, electronic payments and digital moneysystems increase the efficiency by which the existing money supplycan make payments, thus reducing the demand for money. Theseimprovements tend to take place gradually over time, and areobserved as an increase in the velocity of money, which requires acompensating adjustment in base money by the Federal Reserve. Insum, I see no reason for great concern in terms of monetary policymanagement by central banks as a result of these new technologicalinnovations. The changes will be gradual and obvious, giving plentyof time to make policy adjustments to prevent inflation.

One effect of the decrease in demand for central bankmoney will be the disappearance of central bank seignioragerevenue. At present, the world's central banks make a considerableincome from issuing paper banknotes, which are non-interest bearingcentral bank liabilities. Among the G-10 countries, seigniorage asa percent of GDP ranged from a low of .28% in the UK to a high of.65% in Italy in 1996. This seigniorage not only provides for allof the central bank operations, but also provides their treasurieswith significant revenue. However, it is also apparent that theefficiency gains for the economy from digital money swamp anynegative effect on government revenue of the loss of seignioragerevenue, which has been in effect a tax on the banking system.

It can be expected that the growth of digital moneywill have a direct and significant impact on the common measures ofthe money supply, particularly currency and demand deposits (M1 andM2). Given that many central bankers target these monetaryaggregates in the conduct of their monetary policy, the focus ofmonetary policy may need to change. The growth of digital moneycould ultimately cause a substantial drop in banks' demand forsettlement balances. In the major economies, cash is the largestcomponent of central bank liabilities. Extensive use of digitalmoney is likely to shrink the balance sheets of the central bankssignificantly. At some point the shrinkage might restrict thecentral banks' ability to conduct open market operations or foreignexchange sterilization operations. However, to the extent that thenew digital monies are fully backed by assets such as gold orhigh-quality financial instruments, the need to conduct open marketoperations will diminish, because the supply of money fortransactions should automatically adjust to demand.

As more and more transactions are settled on a realtime basis, the risk of non-payment and fraud declines, and hencethe need for regulation and monitoring also declines. The role ofthe central bank may ultimately shrink to doing little more thandefining the numeraire for the national money. The definition islikely to be a modern version of the gold standard. Specifically, anational currency in the future may well be defined as a monetaryunit that is equal to a basket of specified commodities with a oneworld price, such as gold and crude oil, and even some services.Any good or service having a one world price that is set inorganized auction markets could be a candidate for a currencybasket that would be used to define the value of the monetary unit.Some central banks might also continue to serve as a lender of lastresort to large financial institutions, by using off balance sheettransactions. The need for such a lender of last resort would seemto diminish in a world of instant information on almost allactivities and institutions, and real time settlements. In the newcentury, the kind of financial shocks and surprises experienced inthe past ought to be increasingly rare, unless financial regulatorsinterfere too much with the market adjustments that will naturallyoccur in a world of increasingly perfect information.

The rapidity of adoption of digital money systems byconsumers depends on how their cost, convenience, and anonymity isperceived in relation to paper currency and coin. Eventually,electronic transfer and digital money systems will totally replacepaper and coin, because they can greatly reduce transaction costsand will ultimately become more convenient. At the current level oftechnological advance, it appears that within relatively few years,whether they involve a few cents or millions of dollars, almost allmonetary transactions will move over the Internet, or by wirelessdevice, or by chip card for small transactions. The question ofanonymity will remain an impediment until policy makers understandthat the fundamental desire and right to personal privacy must beaccommodated with the new technologies, to an extent no less thanpeople now have with cash.

The role of central banks will change, and willlikely shrink, as a result of the new technologies. One danger tothe world economy is that central banks will try to hold on totheir traditional roles by restricting the new technologies orregulating them in such a way as to make them non-economic.Regulators should keep a hands-off approach until a problem hasbeen clearly demonstrated and, at that time, devise correctiveactions to do the least damage to innovation and financialfreedom.

Law enforcement officials around the world have beenconcerned about the potential abuse of digital money systems forthe purpose of money laundering, and hence are trying to restrictor ban them. Officials in various government and regulatoryagencies, such as the Financial Crimes Enforcement Network, assertthat they should have more power and ability to monitor alltransactions. It is true that digital money systems, particularlyanonymous ones, may indeed make the job of money laundering easier.On the other hand, many government law enforcement agenciesthroughout the world have abused basic rights to financial privacy.The benefits of digital money greatly outweigh the potentialcriminal abuses, and hence measures to restrict the use of digitalmoney should be resisted. Without the availability of anonymoussystems there will be strong resistance on the part of manyindividuals to fully move to e-payments systems and digitalmoney.

The existing efforts against money laundering,primarily by the US and major European governments, have not provento be the least bit cost effective. For instance, in the US in1998, only 932 people were convicted of money laundering, yet thecost to the private and public sectors of the anti-money launderingefforts exceeded 10 billion dollars, which comes out to more than10 million dollars per conviction. The distinguished British lawprofessor, Barry Rider, has calculated that "the British state hasbeen able to take out 0.004 per cent of the criminal money that hasflowed through London." There is no evidence that authorities inthe US are having much more success. Money launderers do not have astatistically significant chance of being caught and losing theprofits from their misdeeds, and hence the deterrent effect of suchlaws is negligible.

Privacy advocates have also documented that the moneylaundering laws are very arbitrarily enforced in many countries,including the United States. Money laundering is a crime of motive,rather than one of specific activity, hence its enforcement, by thevery nature of the crime, is highly subjective. This subjectivityleads to selective and politically biased enforcement. Because ofthe constant threat of the vagueness of the money laundering lawsand regulations, constructive financial innovation has beenretarded, particularly in the development of digital monies.

The money laundering laws have propelled the US toadopt attitudes insensitive to foreign countries' rights toself-determination, and to violate the sovereignty of foreignstates. The US tries to impose policies on foreign states andbusinesses that the US would never accept if the situation werereversed. The US and the European Union have no business tellingsmaller developing nations that they are involved in "harmful taxcompetition," or that they should abolish bank and corporatesecrecy laws. Small nations have a need and a right to attractforeign capital, and it is perfectly legitimate for them to competeagainst harmful tax, regulatory, and privacy policies that biggernations impose on their own citizens.

Anti-money laundering legislation has not only provento be ineffective and counterproductive, but greatly undermines thefinancial privacy rights of individuals. Such laws requirewidespread reporting on the financial activities of bank customersby bank employees to their governments, thus undermining theseparation of business from law enforcement, and ultimately thefinancial privacy necessary for civil society. The fact is, the newtechnologies of various forms of encrypted e-payments will make thetask of enforcing the money laundering laws even greater, unlessgovernments are permitted a level of financial privacy intrusionthat most civilized people will find unacceptable. However,widespread adoption of digital money will actually reduce thenumber of crimes most people care about, such as murders, thefts,and robberies. In 1998, there were approximately 18,000 murders inthe US, and a substantial number involved people trying to takesomeone else's physical money. A move to digital money would reducethe murder, theft, and robbery rates. Stealing digital money is amuch more complex undertaking than stealing paper currency, andwill be beyond the capabilities of most common criminals. If thereis no physical money to steal, the incentive for criminals to stealand kill people for money will be greatly reduced. Abolishing theanti-money laundering laws is likely to speed up the use of digitalmoney, resulting in less total crime, and less wasted money bygovernments, even though it will make life slightly easier formoney launderers.

Eventually, knowledgeable people are likely toconclude that the "war on money laundering" is going to be no moresuccessful than was liquor prohibition in the United States duringthe 1920s. It will become increasingly obvious that the resourcesutilized in the "war on money laundering" could be better spentattacking the underlying crimes. The knowledge of how to utilizehigh levels of encryption is now widespread. This knowledge,coupled with the Internet, smart cards, and related technology,ultimately means that it is almost futile to try to prohibit thehard-to-define crime of money laundering.

Conclusion and Recommendations

Digital payments and monetary systems are coming ofage, and will replace most existing money and payments systems overthe next couple of decades. These changes will bring enormouseconomic benefits in greatly increasing the efficiency and reducingthe costs of our payments systems. In addition, the absence ofpaper currency and coin, which is readily subject to theft or loss,should greatly reduce crime. The US government has a choice ofeither embracing the new technologies and helping them along(mainly by getting out of the way), or taking a "Luddite" approachand attempting to restrict and deny the inevitable. A civil societydepends on a government that does not unduly restrict liberty andeconomic opportunity.

The following recommendations, I expect, will seemradical and frightening to those who do not understand the newtechnologies and where we are headed. However, I expect that thosewho do understand the new technologies, and desire a civil societythat provides both privacy and economic opportunity, will see theserecommendations as desirable and necessary.


  1. Remove all restrictions on issuing digital bearer financialinstruments, including stocks and bonds. Financialcryptographers have already figured out how to issue suchinstruments in cyberspace, and many feel that they do not needgovernment's permission. Rather than create a new class ofcybercriminals, governments should recognize the reality, and dosomething that is both good for the economy and that supports civilliberties.
  2. Remove the capital gains tax from trading in commodities,in order to allow the full development of commodity backed digitalcurrencies (like gold). The capital gains tax on commoditiesdoes not bring any revenue over the long run to government, giventhat losses and gains offset each other. In the real world it isprobably a net loss for government since people will be more proneto report their losses rather than their gains, and it reduces theefficiency of the commodities markets.
  3. Remove all restrictions on anonymous digital money andpayments systems. Restrictions are almost impossible toenforce, and privacy is a basic human right.
  4. Repeal the Bank Secrecy Act and the subsequent relatedanti-money laundering legislation. The existing legislationand implementation is not cost effective, is subject to abuse,interferes with basic civil liberties to an unacceptable degree,and actually results in higher levels of crime.

Thank you Mr. Chairman. I would be pleased to answerany of your questions.

Richard W. Rahn

Subcommittee on Domestic and International Monetary Policy
Committee on Banking and Financial Services
United States House of Representatives