Barter & Cash to Cashless & Blockchain: A Brief Journey through Payments & Ledgers

The English word cash is rooted from the Tamil / Malayalam (Two South Indian Dravidian Languages) word 'kasu' meaning money. It is interesting that India is also pioneering the leap to an open cashless economy via UPI. Starting in late August 2016, 19 banks in India are rolling out mobile apps for UPI, or Universal Payments Interface, which will usher in an era of growing cashless payments and finance. This is a remarkable leapfrog opportunity in a part of the world (South Asia) where less than 20% of the small B2B transactions are cashless. Compare this to High-income OECD where 71% of small B2B transactions are electronic.

Ever since the age of agricultural productivity in ancient times, when people have had excess production beyond self-consumption, we have had the need to give this produce to someone and get something we seek in return.

Barter was the first system where Good A is given an exchange for Good B, and the value parameters are negotiated. If a person do not want Good B, it is a problem, and the transaction does not happen. Also if the commodities being exchanged are not of the same value it becomes difficult (Would you barter a kg of rice for a goat?) It is better to share a store of value or medium of exchange, a.ka. money, so that one can go and purchase Good C that I want from someone else in the market. Easily traded goods like animal skins, salt and weapons served as the medium of exchange over the centuries even though the unit values were still negotiable. Soon the need arose to minimize negotiation of value, and standardize the value of money units.

Coins, Banks and Credit:

Coins issued by kings and rulers subsequently became medium of value exchange and storage, aka money, used in trade and transactions. A coin is a small, flat, round piece of metal or plastic used primarily as a medium of exchange or legal tender. {Note cheques, credit cards are not legal tender.} Coins are standardized in weight, and produced in large quantities at a mint in order to facilitate trade. In 600 B.C., Lydia's (in western Turkey) King Alyattes minted the first official currency. The coins were made from a mix of silver and gold and stamped with pictures that acted as denominations. The Chinese moved from coins to paper money in 7th century AD (to minimize hassle of carrying heavy strings of coins around) and this was widely available by the time Marco Polo visited in 1200 AD. Avoiding forging was now a new headache.

Once coins or paper money were available, loans and credit became easier to help finance the inputs of production. Banks evolved in the 14th century Renaissance Italy to store coins safely, and aggregate / channel the flow of credit (primarily to support agriculture and trade flows). Excess money was parked in banks, but coins were still used for payments. "Interest" or a "price" of money was developed to encourage the parking of excess money in banks, and to lend money to those who needed it.

Bank Notes & Accounting Ledgers

Venetian merchants realized that the money sitting in banks could also be tapped for payments, and introduced paper bills essentially asking their banker to make payments. A banknote (often known as a bill, paper money, or simply a note) is a type of negotiable instrument known as a promissory note made by a bank payable to the bearer on demand. In this sense, bank notes were essentially contracts, i.e. promise to pay a specific amount of money, either on demand, or at a set time, with the payee named on the contract document. When no payee was mentioned, the bearer of the note was the payee. This allowed such bank notes to be exchanged quickly, and anonymized and viewed as cash. But now they also had to be protected since once stolen, the bearer could use them.

Banknotes were originally issued by commercial banks, who were legally required to redeem the notes for legal tender (usually gold or silver coin) when presented to the chief cashier of the originating bank. These commercial banknotes only traded at face value in the market served by the issuing bank. Commercial banknotes have primarily been replaced by national banknotes issued by central banks. This is the "cash" and "currency" we use today, also called "fiat" currency. The value of the currency was determined by the policies of the central bank, who could print more notes, anchor the value of the currency to a metallic standard (eg: gold standard), or target the price of money, i.e. interest rates as a function of macroeconomic conditions.

In parallel to the developments above, it became important to account for the growing set of financial transactions to manage the trading business. With the availability of paper, printing and easier writing, a double-entry accounting system was developed with two accounting entries are required to record each financial transaction. These ledger entries may occur in asset, liability, equity, expense, or revenue accounts. Today we manipulate these in excel spreadsheets.

Inter-Bank Automated Clearing & Settlement Networks

With the advent of bank accounts, and practice of payments against those accounts, and the growth of computers and networks (including telephonic / fax networks), new networks started emerging for inter-bank automated clearing and settlements. The Automated Clearing House (ACH in USA), Clearing House Interbank Payments System (CHIPS), Society for WW Interbank Financial Telecommunication (SWIFT), National Electronic Fund Transfer (NEFT in India), RTGS (Real-time Gross Settlement), IMPS (Immediate Payment System), and credit card networks (Visa, Mastercard) are examples of such networks for different purposes. Some are for large payments (eg: FedWire, RTGS), some are settled in batches (eg: ACH, NEFT, etc), some immediately (IMPS, RTGS etc), some owned by banks (CHIPS, SWIFT).

Due to jurisdictional issues, many of these are national networks (except SWIFT and credit card networks). The transaction costs of different networks differ, but are coming down due to competition. In India, IMPS charges are Rs. 2.50 + svc tax for amounts of Rs. 10,000 (0.1% for a Rs. 2500 transaction and 1% for a Rs. 250 transaction). This drops further to Rs. 15 for Rs. 1-2 lakh transaction (0.01% transaction cost). Compare this to 2%+ costs for some of the other networks. UPI + IMPS in India for mobile therefore also promises to drive up micro-payment transactions.

Credit Card Networks

VISA and Mastercard are two inter-bank networks established 1958 and 1966 respectively. Credit cards are payment cards issued to users (cardholders). The issuing bank creates a revolving account and a line of credit to the cardholder from which cardholder can borrow money for payments or cash advances. A charge card is similar, but requires the balance to be repaid in full each month. A debit card charges the transactions to bank accounts. Since merchants are charged for each transaction, payments now became a revenue generating operation for banks (from a costed service that they needed to support to ensure they keep customers happy), and a way to drive personal loans (via revolving credit). Seeing the success of such cards, airlines, retailers, casinos and hotels started issuing loyalty cards and new forms of "currency" such as Airline miles, hotel stay points etc emerged as a form of customer engagement and innovative discounting. Co-branding of airlines and cards also emerged (eg: JAL and Visa below).

From a technological perspective, managing security of payments, real time electronic verification, fraud detection, and credit scoring of cardholders became important functions. A point of sale (POS) terminal with communications to the merchant's acquiring bank. Data from the card is obtained from a magnetic stripe or chip on the card with the EMV - Europay, Mastercard, Visa standard. EMV cards are either physically inserted (or "dipped") into a reader and contactless (near field communications - NFC) that can be read over a short distance using radio-frequency ID (RFID) technology. Visa and MasterCard have also developed standards for using EMV cards in devices to support card not present transactions over the telephone and Internet. MasterCard has the Chip Authentication Program (CAP) for secure e-commerce.

Mobile Payments & Remittances

Apple Pay is a digital wallet and mobile payment service that lets mobile devices make payments at contactless PoS and in iOS apps. The service lets Apple devices wirelessly communicate with point of sale systems using a NFC antenna, a chip storing encrypted payment info (Secure Element), Apple's Touch ID and Wallet. All of these methods are "cashless" since they promote money to remain in the bank, reduce ATM withdrawals of cash.

While these developments happened in major markets, emerging markets like India and Africa were struggling with broadening financial access to their citizenry. Financial inclusion via basic bank accounts was slow. When these markets discovered that there were more mobiles in the hands of people than bank accounts, and users were "topping up" their mobile phones via retail stores, using mobile phones and mobile credit on them as money or stores of value became attractive. M-PESA was the pioneering service in Kenya from SAFARICOM (Vodafone) that built this service on top of 2G phones at low transaction costs (1%) and it became an instant hit.

Telecom-led initiatives have been challenging on other parts of the world, but the banking regulators in places like India have allowed the proliferation of mobile wallets, payment banks (that telcos have applied for), and universal payment interface (UPI) to inter-bank instant payments (IMPS). In parallel, the adoption of Aadhar (universal ID, 1 billion+ issued) and Jan Dhan financial accounts on a war footing (241 million+ accounts opened), with over 200M smart phones in India has opened the door for aggressive cashless payments via UPI / IMPS.

These developments have dramatically lowered the cost and increased convenience of remittances within the country. International remittances have to still cross a number of interbank networks. But services like Xoom (a service of online payment giant Paypal), TransferWise (a peer-to-peer money transfer service) have lowered the costs of such international remittances, the time taken for transfers to complete, and give clarity on the exchange rates incurred. Whether it is UPI + IMPS, or M-PESA or Xoom / TransferWise, the inexorable trend of lower transaction costs by the use of mobile based payments will drive up adoption and potential for cashless micropayments and embedding in cashless finance modes.

BitCoin and BlockChain: Transforming the Accounting Ledger & InterBank Networks

We have seen the role of trusted networks (typically across banks) and coordination by a central national authority (eg: a central bank that mints currency and manages its value) in the background of the money economy. BitCoin was an amazing strike at creating a fully decentralized, all-digital peer-to-peer value transfer mechanism. Rather than give a simplified summary, I'll point to one of the best technical explanations of BitCoin protocol by Michael Nielson here.

A sketchy overview: when A(nanya) sends value to B(adri) 0.03 bitcoin, she sends a message that reads something like: "I, A(nanya), am giving B(adri) 0.03 bitcoins with serial number 1234567", digitally signed with her private key. Everyone w/ A's public key can decrypt this message; and it is not repudiable by A. This message itself is the currency transfer (once accepted/validated), and all entities are collectively the "bank", i.e. a trusted source from where the serial numbers are obtained. The way this is done is for everyone to maintain a "shared ledger" (called the blockchain)which have a complete record of who has how many bitcoins and all transactions so far. The proposed transaction is checked by a consensus of a set of bit coin miners who solve a hard computational puzzle, called "proof of work" (for an incentive) before everyone updates their blockchain.

It takes nifty technology to ensure that double spending of digital money is avoided, incentive compatibility, resistance to fraud, and achieving consensus across the fully peer-to-peer network with no central root of trust. The blockchain is an artifact used to sequence the bitcoin transactions and achieve consensus. If some of the bitcoin artifacts are removed (miners, proof of work), the underlying blockchain technology can be used to create a distributed ledger. Multiple parties can choose to put irrevocable, provenance guaranteed information on the blockchain, and this can in turn be used as a foundation for multi-party networks and lowering transaction costs even further. We'll explore blockchain applications / use cases in emerging markets like India in a future article.

Summary:

The journey from barter to cashless transactions is still underway and in early stages. The end point costs (eg: cards, POS machines) and overall transaction costs are being relentlessly lowered with the advent of mobile / wearable and blockchain technologies. UPI in India is an example of an ultra-low-transaction cost inter-bank platform that is fully open and not controlled by banks themselves. Blockchain, and mobile allows disruptors to build new networks, and incumbent networks to lower transaction costs further. As transaction costs drop, smaller and smaller transaction sizes will come on board. Further, payments will get embedded into more complex cashless financial products as explored in a companion article on UPI.

Twitter: @shivkuma_k

ps: Material in part from several open sources, including WikiPedia.

ps: Part of a set posts: "Payment Banks: Reliance Jio vs Airtel & More" , "Financial Inclusion post demonetisation", "Cashless Finance & Universal Payment Interface (UPI)" , "Cashless boosted by demonetisation ...", "Barter & Cash to Cashless & Blockchain... " , "Service vs As-a-Service ... "

pps: List of all my LinkedIn Articles