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

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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 PA and PB for Alice and Bob respectively, and a secret key, denoted SA and SB 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=PB(M). Note that C is thus a permutation of the set D.

The public and secret keys are inverses of each other

M=SB(PB(M)) M=SA(PA(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
Z2 (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

1 x mod 12

2 x mod 12

Encryption

3 x mod 12

4 x mod 12

Encryption

5 x mod 12

6 x mod 12

Encryption

7 x mod 12

8 x mod 12

Encryption

9 x mod 12

10 x mod 12

Encryption

11 x mod 12

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:

Z 2 Z12 , Z 2 = 6 Z12 = 12 Z 3 Z12 , Z 3 = 4 Z12 = 12 Z 4 Z12 , Z 4 = 3 Z12 = 12 Z 5 Z12 , Z 5 = 12 Z12 = 12

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:

Fermats Little Theorem If p is prime, then for any a Z p a 0, a p 1 mod p = 1

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

de = 1 mod ( p 1)( q 1)
Publish the pair P=(e,n) as the public key Keep secret the pair S=(d,n) as the secret key

Encryption
For this specification of the RSA system, the message domain is Zn Encryption of a message M in Zn is done by defining

C = P ( M ) = M e mod n
Decrypting the message is done by computing

S ( C ) = C d mod n

Encryption
Let us verify that the RSA scheme does in fact define an invertible mapping of the message.

For any M Z n

P ( S ( M ) ) = S ( P ( M ) ) = M ed mod n. Since d and e are modular inverses of each other ed = 1 + k ( p 1)( q 1) for some integer k . Hence, M ed mod n = MM k ( p 1)( q1) mod n = MM ( p 1) M k ( q 1) mod n
( q 1) k

) mod n = M = M (M (the last steps follow by applying Fermat' s theorem.)

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