Electronic Payment Systems

Electronic Payment Systems

Transaction reconciliation
Cash or check
Electronic Payment Systems
Intermediated reconciliation (credit or debit card, 3rd party money
order)
Electronic Payment Systems
Transactions in the U.S. economy
Type of Payment Volume (%) in Millions of Transactions Value (%) in Trillions of Dollars
Checks 59,400.0 (96.3%) 68.3 (12.5%)
Fedwire 69.7 (0.1%) 207.6 (37.9%)
CHIPS 42.4 (0.1%) 262.3 (47.9%)
ACH 2,200.0 (3.5%) 9.3 (1.7%)
Total 61,712.10 547.5
Electronic Payment Systems
Online transaction systems
Lack of physical tokens
Standard clearing methods wont work
Transaction reconciliation must be intermediated
Informational tokens
Ecommerce enablers
First Virtual Holdings, Inc. model
Online payment systems (financial electronic data interchange)
Secure Electronic Transaction (SET) protocol supported by Visa and
MasterCard
Digital currency

Electronic Payment Systems
Digital currency
Non-intermediated transactions
Anonymity
Ecommerce benefits
Privacy preserving
Minimizes transactions costs
Micropayments
Security issues with digital currency
Authenticity (non-counterfeiting)
Double spending
Non-refutability

Electronic Payment Systems
Contemporary forms of digital currency
Ecash
Set up account with ecash issuing bank
Account backed by outside money (credit card or cash)
Move credit from account to ecash mint
Public key encryption used to validate coins: third parties can
bite the coin electronically by asking the issuing bank to verify
its encryption
Spend ecoin at merchant site that accepts ecash
Merchant then deposits ecoin in his account at his participating bank, or
keeps it on hand to make change, or spends the ecash at a supplier
merchants site.
Role of encryption
Encryption
The need for encryption in ecommerce
Degree of risk vs. scope of risk
Institutional versus individual impact
Obvious need for ecurrencies.
Public key cryptography: an overview
One-way functions
How it works
Parties to the transaction will be called Alice and Bob.
Each participant has a public key, denoted P
A
and P
B
for Alice and
Bob respectively, and a secret key, denoted S
A
and S
B
respectively

Encryption
Each person publishes his or her public key, keeping the secret key
secret.
Let D be the set of permissible messages
Example: All finite length bit strings or strings of integers
The public key is required to define a one-to-one mapping from the
set D to itself (without this requirements, decryption of the message is
ambiguous).
Given a message M from Alice to Bob, Alice would encrypt this using
Bobs public key to generate the so-called cyphertext C=P
B
(M). Note
that C is thus a permutation of the set D.
The public and secret keys are inverses of each other
M=S
B
(P
B
(M))
M=S
A
(P
A
(M))
The encryption is secure as long as the functions defined by the public
key are one-way functions
Encryption
The RSA public key cryptosystem
Finite groups
Finite set of elements (integers)
Operation that maps the set to itself (addition, multiplication)
Example: Modular (clock) arithmetic
Subgroups
Any subset of a given group closed under the group operation
Z
2
(i.e. even integers) is a subgroup (under addition) of Z
Subgroups can be generated by applying the operation to elements of
the group
Example with mod 12 arithmetic (operation is addition)
Encryption
12 1 mod x
12 2 mod x
Encryption
12 3 mod x
12 4 mod x
Encryption
12 5 mod x
12 6 mod x
Encryption
12 7 mod x
12 8 mod x
Encryption
12 9 mod x
12 10 mod x
Encryption
12 11 mod x
Encryption
A key result: Lagranges Theorem
If S is a subgroup of S, then the number of elements of S divides
the number of elements of S.
Examples:
12 12 ,
12 3 ,
12 4 ,
12 6 ,
12 5 12 5
12 4 12 4
12 3 12 3
12 2 12 2
= = c -
= = c -
= = c -
= = c -
Z Z Z Z
Z Z Z Z
Z Z Z Z
Z Z Z Z




Encryption
Solving modular equations
RSA uses modular groups to transform messages (or blocks of
numbers representing components of messages) to encrypted form.
Ability to compute the inverse of a modular transformation allows
decryption.
Suppose x is a message, and our cyphertext is y=ax mod n for
some numbers a and n. To recover x from y, then, we need to be
able to find a number b such that x=by mod n.
When such a number exists, it is called the mod n inverse of a.
A key result: For any n>1, if a and n are relatively prime, then the
equation ax=b mod n has a unique solution modulo n.
Encryption
In the RSA system, the actual encryption is done using
exponentiation.
A key result:
1 mod
, 0
1
=
= e

p a
a Z f or any a ime, then If p is pr
rem ittle Theo Fermats L
p
p


Encryption
RSA technicals
Select 2 prime numbers p and q
Let n=pq
Select a small odd integer e relatively prime to (p-1)(q-1)
Compute the modular inverse d of e, i.e. the solution to the
equation



Publish the pair P=(e,n) as the public key
Keep secret the pair S=(d,n) as the secret key
( )( ) 1 1 mod 1 = q p de
Encryption
For this specification of the RSA system, the message domain is Z
n
Encryption of a message M in Z
n
is done by defining



Decrypting the message is done by computing
n M M P C
e
mod ) ( = =
( ) n C C S
d
mod =
Encryption
Let us verify that the RSA scheme does in fact define an invertible
mapping of the message.
( ) ( ) ( ) ( )
( )( )
( )
theorem.) s Fermat' applying by follow steps last (the
mod
mod
mod mod
Hence, . integer some for
1 1 1
other each of inverses modular are and Since
n. mod
any For
) 1 (
) 1 ( ) 1 (
) 1 )( 1 (
M n M M
n M MM
n MM n M
k
q p k ed
e d
M M P S M S P
Z M
k
q
q k p
q p k ed
ed
n
= =
=
=
+ =
-
= =
e -

Encryption
Note that the security of the encryption system rests on the fact that
to compute the modular inverse of e, you need to know the number
(p-1)(q-1), which requires knowledge of the factors p and q.
Getting the factors p and q, in turn, requires being able to factor the
large number n=pq. This is a computationally difficult problem.
Some examples:

http://econ.gsia.cmu.edu/spear/rsa3.asp
Encryption
Applications
Direct message encryption
Digital Signatures
Use secret key to encrypt signature: S(Name)
Appended signature to message and send to recipient
Recipient decrypts signature using public key: P(S(Name)=Name
Encrypted message and signature
Create digital signature as above, appended to message, encrypt
message using recipients public key
Recipient uses own secret key to decrypt message, then uses senders
public key to decrypt signature, thus verifying sender
Policy Issues
Privacy and verification
Transaction costs and micro-payments
Monetary effects
Domestic money supply control and economic policy levers
International currency exchanges and exchange rate stability
Market organization effects
Development of new financial intermediaries
Effects on government
Seniorage
Legal issues