Types of Electronic Payment Systems

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Module 2

Electronic Payment systems

 Electronic payment systems are becoming central to on-line business process


innovation as companies look for ways to serve customers faster and at a lower cost.
 Emerging innovations in the payment for goods and services in electronic commerce
promise to offer a wide range of new business opportunities.

Types of Electronic Payment Systems

 Electronic payment systems are proliferating in banking, retail, health care, on-line
markets, and even government—in fact, anywhere money needs to change hands.
 Organizations are motivated by the need to deliver products and services more cost
effectively and to provide a higher quality of service to customers.
 The emerging electronic payment technology was labeled electronic funds transfer
(EFT).
 EFT is defined as “any transfer of funds initiated through an electronic terminal,
telephonic instrument, or computer or magnetic tape so as to order, instruct, or authorize
a financial institution.
 Work on EFT can be segmented into three broad categories:
1. Banking and financial payments
 Large-scale or wholesale payments (e.g., bank-to-bank transfer)
 Small-scale or retail payments (e.g., automated teller machines)
 Home banking (e.g., bill payment)
2. Retailing payments
 Credit Cards (e.g., VISA or MasterCard)
 Private label credit/debit cards (e.g., J.C. Penney Card)
 Charge Cards (e.g., American Express)
3. On-line electronic commerce payments
a) Token-based payment systems
 Electronic cash (e.g., DigiCash)
 Electronic checks (e.g., NetCheque)
 Smart cards or debit cards (e.g., Mondex Electronic Currency Card))

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b) Credit card-based payments systems


 Encrypted Credit Cards (e.g., World Wide Web form-based
encryption)
 Third-party authorization numbers (e.g., First Virtual)

Digital Token-Based Electronic Payment Systems

New forms of financial instruments are developed. One such new financial instrument is
“electronic tokens” in the form of electronic cash/money or checks.

Electronic tokens are three types:

1. Cash or Real-time
 Transactions are settled with exchange of electronic currency.
 Ex: on-line currency exchange is electronic cash (e-cash).
2. Debit or Prepaid
 Users pay in advance for the privilege of getting information.
 Ex: prepaid payment mechanisms are stored in smart cards and electronic purses
that store electronic money.
3. Credit or postpaid
 The server authenticates the customers and verifies with the bank that funds are
adequate before purchase.
 Ex: postpaid mechanisms are credit/debit cards and electronic checks.

Electronic cash (e-cash)

 Electronic cash is a new concept in on-line payment systems because it combines


computerized convenience with security and privacy that improve on paper cash.
 E-cash presents some interesting characteristics that make it an attractive alternative for
payment over the internet.

Properties of Electronic Cash


E-cash must have the following four properties:

1. Monetary value
2. Interoperability

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3. Retrievability
4. Security

1. E-cash must have a monetary value; it must be backed by either cash, bank authorized credit
or a bank-certified cashier’s check. When e-cash created by one bank is accepted by others,
reconciliation must occur without any problems.

2. E-cash must be interoperable- that is, exchangeable as payment for other e-cash, paper cash,
goods or services, lines of credit, deposits in banking accounts, bank notes or obligations,
electronic benefits transfers.

3. E-cash must be storable and retrievable. Remote storage and retrieval (eg, from a telephone
or personal communications device) would allow users to exchange e-cash from home or office
or while travelling. The cash could be stored on a remote computer’s memory, in smart cards,
or in other easily transported standard or special-purpose devices. One example of a device that
can store e-cash is the Mondex card- a pocket-sized electronic wallet.

Electronic Cash in Action

 Electronic Cash is based on cryptographic systems called “digital signatures”.


 This method involves a pair of numeric keys: one for locking (encoding) and the other
for unlocking (decoding).
 Messages encoded with one numeric key can only be decoded with the other numeric
key and none other.
 The encoding key is kept private and the decoding key is made public.

Purchasing E-cash from Currency Servers

The purchase of e-cash from an on-line currency server (or bank) involves two steps:

 Establishment of an account and


 Maintaining enough money in the account to bank the purchase.

Some customers might prefer to purchase e-cash with paper currency, either to maintain
anonymity or because they don’t have a bank account.

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Using the Digital Currency

 Once the tokens are purchased, the e-cash software on the customer’s PC stores digital
money undersigned by a bank.
 The users can spend the digital money at any shop accepting e-cash, without having to
open an account there or having to transmit credit card numbers.
 As soon as the customer wants to make a payment, the software collects the necessary
amount from the stored tokens.
 Two types of transactions are possible: bilateral and trilateral.
 Transactions involving cash are bilateral or two-party transactions, whereby the
merchant checks the veracity of the note’s digital signature by using the bank’s public
key.
 Transactions involving financial instruments other than cash are usually trilateral or
three-party (buyer, seller and bank) transactions, whereby the “notes” are sent to the
merchant, who immediately sends them directly to the digital bank. The bank verifies
the validity of notes and that they have not been spent before. The account of the
merchant is credited.
 In many business situations, the bilateral transaction is not feasible because of the
potential for double spending, which is equivalent to bouncing a check.
 Double spending becomes possible because it is very easy to make copies of the e-cash,
forcing banks and merchants to take extra precautions.
 To uncover double spending, banks must compare the note passed to it by the merchant
against a database of spent notes.

Fig: Detection of double spending

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Electronic Checks

 It is another form of electronic token.


 They are designed to accommodate many individuals and entities that might prefer to
pay on credit or through some mechanism other than cash.

Fig: Payment transaction sequence in an electronic check system


 In the given model shown in fig, buyers must register with third-party account server
before they are able to write electronic checks.
 The account server acts as a billing service.
 The registration procedure can vary depending on the particular account server and may
require a credit card or a bank account to back the checks.
 Once registered, a buyer can then contact sellers of goods and services.
 To complete a transaction, the buyer sends a check to the seller for a certain amount of
money.
 These checks may be sent using e-mail or other transport methods.
 When deposited, the check authorizes the transfer of account balances from the account
against which the check was drawn to the account to which the check was deposited.
 Electronic checks have the following advantages:
1. They work in the same way as traditional checks.
2. These are suited for clearing micropayments.
3. They create float & availability of float is an important for commerce.
4. Financial risk is assumed by the accounting server & may result in easier
acceptance.

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Smart Cards & Electronic Payment Systems

 Smart cards have been in existence since the early 1980s and hold promise for secure
transactions using existing infrastructure.
 Smart cards are credit and debit cards and other card products enhanced with
microprocessors capable of holding more information than the traditional magnetic
stripe.
 The smart card technology is widely used in countries such as France, Germany, Japan,
and Singapore to pay for public phone calls, transportation, and shopper loyalty
programs.
 Smart cards are basically two types:
 Relationship-Based Smart Credit Cards
 Electronic Purses, which replace money, are also known as debit cards and
electronic money.

Relationship-Based Smart Cards

 It is an enhancement of existing cards services &/ or the addition of new services that
a financial institution delivers to its customers via a chip-based card or other device.
 These services include access to multiple financial accounts, value-added marketing
programs, or other information card holders may want to store on their card.
 It includes access to multiple accounts, such as debit, credit, cash access, bill payment
& multiple access options at multiple locations.

Electronic Purses

 To replace cash and place a financial instrument are racing to introduce “electronic
purses”, wallet-sized smart cards embedded with programmable microchips that store
sums of money for people to use instead of cash for everything
 The electronic purse works in the following manner:
1. After purse is loaded with money at an ATM, it can be used to pay for candy in
a vending machine with a card reader.

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2. It verifies card is authentic & it has enough money, the value is deducted from
balance on the card & added to an e-cash & remaining balance is displayed by
the vending machine.

Credit Card-Based Electronic Payment Systems

 If consumers want to purchase a product or service, they send their credit card details
to the service provider involved and the credit card organization will handle this
payment.
 Credit card payment on on-line networks can be divided into 3 categories:
1. Payments using plain credit card details: The easiest method of payment is the
exchange of unencrypted credit cards over a public network such as telephone lines
or the internet. But this is problematic as there is no security.
2. Payments using encrypted credit card details: in this method, encrypted credit card
details are sent on the network.
3. Payments using third-party verification: one solution to security and verification
problems is the introduction of a third party: a company that collects and approves
payments from one client to another.

Encryption and credit cards

 Encryption is instantiated when credit card information is entered into a browser or


other electronic commerce device and sent securely over the network from buyer to
seller as an encrypted message.
 To make a credit card transaction truly secure, the following sequence of steps must
occur before actual goods, services or funds flow:
1. A customer presents his or her credit card information securely to the merchant.
2. The merchant validates the customer’s identity as the owner of the credit card
account.
3. The merchant relays the credit card charge information and signature to its bank or
on-line credit card processors.
4. The bank or processing party relays the information to the customer’s bank for
authorization approval.

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5. The customer’s bank returns the credit card data, charge authentication, and
authorization to the merchant.

Fig: Processing payments using encrypted credit cards

 In this scheme, each consumer and each vendor generates a public key and a secret key.
 The public key is sent to the credit card company and put on its public key server.
 The secret key is re-encrypted with a password, and the unencrypted version is erased.
 To steal a credit card, a thief would have to get access to both a consumer’s encrypted
secret key and password.
 Nobody can cheat this system. The consumer can’t claim that he didn’t agree to the
transaction, because he signed it.
 The vendor can’t invent fake charges, because he doesn’t have access to the consumer’s
key.

Third-party processors and credit cards

 In third party processing, consumers register with a third party on the Internet to verify
electronic microtransactions.
 Verification mechanisms can be designed with many of the attributes of electronic
tokens.
 They differ from electronic token systems in that
1. They depend on existing financial instruments

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2. They require the on-line involvement of at least one additional party, and in some
cases multiple parties to ensure extra security.
 Payments can be made by credit card or by debiting a demand deposit account via the
automated clearinghouse, this is referred as on-line third-party processors (OTPPs).

Fig: On-line payment process using a third-party processor


 OTPPs have created a process that they believe will be a fast and efficient way to buy
information on-line:
1. The consumer acquires an OTPP account number by filling out a registration form.
This will give the OTPP a customer information profile that is backed by a
traditional financial instrument such as a credit card.
2. To purchase an article, software or other information on-line, the consumer requests
the item form the merchant by quoting her OTPP account number. The purchase
can take place in one of two ways: the consumer can automatically authorize the
“merchant” via browser settings to access her OTPP account and bill her, or she can
type in the account information.
3. The merchant contacts the OTPP payment server with the customer’s account
number.

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4. The OTPP payment server verifies the customer’s account number for the vendor
and checks for sufficient funds.
5. The OTPP payment server sends an electronic message to the buyer. This message
could be an automatic WWW form that is sent by the OTPP server or could be a
simple e-mail. The buyer responds to the form or e-mail in one of three ways: Yes,
I agree to pay; No, I will not pay; or Fraud, I never asked for this.
6. If the OTPP payment server gets a Yes from the customer, the merchant is informed
and the customer is allowed to download the material immediately.
7. The OTPP will not debit the buyer’s account until it receives confirmation of
purchase completion. Abuse by byers who receive information or a product and
decline to pay can result in account suspension.

Risks in Electronic Payment systems

 Customer's risks
1. Stolen credentials or password
2. Dishonest merchant
3. Disputes over transaction
4. Inappropriate use of transaction details
 Merchant’s risk
1. Forged or copied instruments
2. Disputed charges
3. Insufficient funds in customer’s account
4. Unauthorized redistribution of purchased items
 Main issue: Secure payment scheme

Electronic payments Issues

 Secure transfer across internet


 High reliability: no single failure point
 Atomic transactions
 Anonymity of buyer
 Economic and computational efficiency: allow micropayments
 Flexibility: across different methods

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Designing Electronic Payment systems

It includes several factors:

 Privacy. A user expects to trust in a secure system; just as a telephone is a safe.


 Security. A secure system verifies the identity of two-party transactions through “user
authentication” & reserves flexibility to restrict information/services through access
control.
 Intuitive interfaces. The payment interface must be as easy to use as a telephone.
 Database integration. With home banking, for ex, a customer wants to play with all his
accounts.
 Brokers. A “network banker”-someone to broker goods & services, settle conflicts, &
financial transactions electronically-must be in place.
 Pricing. One fundamental issue is how to price payment system services. For e.g., from
cash to bank payments, from paper-based to e-cash. The problem is potential waste of
resources.
 Standards. Without standards, the welding of different payment users into different
networks & different systems is impossible.

Interorganizational Commerce and EDI


Electronic Data Interchange

 Electronic Data Interchange (EDI) is defined as inter-process communication of


business information in standardized electronic form.
 Prior to EDI, business depended on postal and phone systems that restricted
communication to those few hours of the workday that overlap between time zones.
 EDI is required to reduce transaction costs and foster closer relationships between
trading partners.
 EDI is one well-known example of structured document interchange which enables data
in the form of document content to be exchanged between software applications that
are working together to process a business transaction.

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Benefits of EDI

• Cost & time savings, Speed, Accuracy, Security, System Integration, Just-In-Time
Support.
• Reduced paper-based systems, i.e. record maintenance, space, paper, postage costs.
• Improved problem resolution & customer service.
• Expanded customer/supplier base or suppliers with no EDI program lose business.

EDI layered architecture

EDI architecture specifies four layers:

1. Semantic or application layer.


2. Standards translation layer.
3. Packing or transport layer.
4. Physical network infrastructure layer.

Fig: Layered architecture of EDI

• The EDI sematic layer describes the business application. For a procurement
application, this translates into requests for quotes, price quotes, purchase orders,
acknowledgements, and invoices. This layer is specific to a company and the software
it uses.
• The information seen at the EDI semantic layer must be translated from a company
specific form to a more generic or universal form so that it can be send to various trading
partners, who could be using a variety of software applications at their end.

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• EDI standards specify business form structure so that information can be exchanged.
• Two competing standards
 American National Standards Institute(ANSI)X12
 EDIFACT developed by UN/ECE, Working Party for the Facilitation of
International Trade Procedures.
• The EDI transport layer corresponds closely in sending a business form from one
company to another. The business form could be sent via regular postal service,
registered mail, certified mail or private carrier such as UPS (United Parcel Service).
• EDI document transport is far more complex than simply sending e-mail messages or
sharing files through a network, a modem, or a bulletin board.
• The relationship between EDI and e-mail can be ambiguous as e-mail systems become
very sophisticated and incorporate more and more form-based features.

EDI in Action:

• The idea behind EDI is very simple. EDI takes manually prepared form or a form from
a business application, translates that data into a standard electronic format and
translates it.
• The fig shows the information flow when paper documents are shuffled between
organizations via the mailroom.

Fig: Information flow without EDI

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• When the buyer sends a purchase order, then relevant data extracted & recorded on a
hard copy.
• This hard copy is then forwarded to the seller after passing through several steps and at
last manually entered into system by the data entry operators.
• This process is somewhat overhead in labor costs & time delays.

EDI can substantially automate the information flow and facilitate management of the business
process as shown in below figure.

Fig: Information flow with EDI

The EDI transactions for a purchase, shipment and corresponding payment are as follows:

1. Buyer sends purchase order to seller computer.


2. Seller sends purchase order confirmation to buyer.
3. Seller sends booking request to transport company.
4. Transport company sends booking confirmation to seller.
5. Seller sends advance ship notice to buyer.
6. Transport company sends status to seller.
7. Buyer sends Receipt advice to seller.
8. Seller sends invoice to buyer.
9. Buyer sends payment to seller.

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EDI Applications in Business

Four different scenarios in industries that use EDI extensively:

1. International or cross-border trade


2. Electronic funds transfer
3. Health care EDI for insurance claims processing
4. Manufacturing & retail procurement

1.International or cross-border trade

• EDI has always been very closely linked with international trade.
• Trade efficiency, which allows faster, simpler, broader & less costly transactions is a
necessity thing.

Role of EDI in International trade

• EDI facilitates the smooth flow of information.


• It reduces paper work.
• EDI benefits for international trade are
1. Reduced transaction expenditures.
2. Quicker movement of imported & exported goods.
3. Improved customer service through “track & trace” programs.
4. Faster customs clearance & reduced opportunities for corruption.

2. Interbank Electronic Funds Transfer (EFT)

• EFTS is credit transfers between banks where funds flow directly from the payer’s bank
to the payee’s bank.
• The two biggest funds transfer services in the United States are the Federal Reserve’s
system, Fed wire, & the Clearing House Interbank Payments System (CHIPS) of the
New York clearing house

Automated Clearinghouse (ACH) Transfers

• ACH transfers are used to process high volumes of relatively small-dollar payments for
settlement in one or two business days.

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• It provides services: preauthorized debits, such as repetitive bill payments; & consumer
initiated payments.

3. Health care EDI for insurance EDI

• Providing good & affordable health care is a universal problem.


• EDI is becoming a permanent fixture in both insurance & health care industries as
medical provider, patients, & payers.
• Electronic claim processing is quick & reduces the administrative costs of health care.
• Using EDI software, service providers prepare the forms & submit claims via
communication lines to the value-added network service provider
• The company then edits sorts & distributes forms to the payer. If necessary, the
insurance company can electronically route transactions to a third-party for price
evaluation.
• Claims submission also receives reports regarding claim status & request for additional
information.

4. Manufacturing & retail procurement using EDI

• These are heavy users of EDI.


• In manufacturing, EDI is used to support just-in-time.
• In retailing, EDI is used to support quick response

Just-In-Time & EDI

 Companies using JIT & EDI calculates how many parts are needed each day based on
the production schedule & electronically transmit orders.
 Delivery has to be responsive, or it will cost too much in money & time.
 A major benefit of JIT & EDI is a streamlined cash flow.

Quick Response & EDI

 For the customer, QR means better service & availability of a wider range of products.
 For the retailer & supplier, QR may mean survival in a competitive marketplace.
 Much focus of QR is in reduction of lead times using event-driven EDI.
 In QR, EDI documents include purchase orders, shipping notices, invoices, inventory
position, catalogs, & order status.

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EDI Software Implementation

 EDI software has four layers, business application, internal format conversion, EDI
translator, and EDI envelope for document messaging.
 These 4 layers package the information & send it over the value-added network to the
target business, which then reverses the process to obtain the original information.

Fig: How EDI works

EDI Business Application Layer

 It creates a document - an invoice, in a software application.


 This software application then sends the document to an EDI translator, which
automatically reformats the invoice into the agreed- on EDI standard.
 If both the EDI translator and business application are on the same type of computer,
the data will move faster and more easily from one to another.
 The translator creates and wraps the document in an electronic envelope “EDI package”
that has a mailbox ID for the company’s trading partner.
 The EDI wrapper software can be a module to the translator, a programming tool to
write different communication protocols, or a separate application.

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Fig: The preparation process followed by the application software

EDI translator layer

 Translation is an integral part of the overall EDI solution.


 Translators describe the relationship between the data elements in the business
application and the EDI standards.
 The translator ensures that the data are converted into a format that the trading partner
can use.
 If EDI is done without translation, companies run a great risk of transmitting data that
trading partners may not be able to read.
 For example, if a word processing file is uploaded and the recipient tries to open it in a
database program, the result is a mess of characters instead of the expected information.
 Custom translators have several disadvantages,
 A custom translator is very restrictive. It is often designed for one trading
partner and limited transaction sets.
 A custom translator is difficult to update. If the trading partner changes
standards or wants additional transaction sets, precious weeks or even months
can be wasted making the changes to the EDI translator and making sure that
everything works correctly.
 A custom translator is unsupported. There is no one to turn to when help is
needed.

EDI communications layer

 The communications portion – could be a part of the translation software or a separate


application, which dials the phone number for the value added network service provider
or other type of access method being used.
 Three main types of EDI access methods are available
1. Direct dial or modem to modem connection

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2. Limited third-party value-added network services


3. Full service third-party VAN’s.
 Direct dial systems are the simplest and most common. The user has direct access to
the partner’s modem and communicates by using the modem to dial the modem of the
other party.
 Full third-party services provide more than just communication between two or more
parties. Electronic mailboxes and extra features are the heart of these services. Extra
features include access control for security and document tracking, which allows users
to track their own documents as they pass through the system.
 A third-party network can also provide a “gateway” to interconnect with other third-
party networks. This facilitates communication between businesses having accounts
with different third-party networks running a variety of protocols and systems.

How much will an EDI implementation cost?

 Prices for EDI products vary form no cost to several thousands of dollars for full-
function applications.
 The final cost depends on several factors:
1. The expected volume of electronic documents.
2. Economics of the EDI translation software.
3. Implementation time.
 Maintenance fees and VAN charges can vary and affect the cost of EDI systems.

Value added networks (VANs)

 A VAN is a communications network that exchanges EDI messages among trading


partners.
 It provides other services also, including holding messages in “electronic mailboxes”,
interfacing with other VANs and supporting many telecommunications modes and
transfer protocols.
 A VAN’s “electronic mailbox” is a software feature into which a user deposits EDI
transactions and then retrieves those messages when convenient.
 Businesses can exchange data either by connecting to each other directly or by hooking
into a VAN.

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 VANs have allowed companies to automatically and securely exchange purchase


orders, invoices, and payments.
 When a company sends an EDI transaction, it arrives at a message storehouse on the
VAN to await pickup by the destination company.
 In this way VANs can safeguard the transaction networks.
 Below figure illustrates the EDI process.
 Company A puts an EDI message for trading partner manufacturing company B in the
VAN mailbox at a date and time of its choosing.
 The VAN picks up the message from the mailbox and delivers it to trading partner B’s
mailbox, where it will remain until trading partner B logs on and picks it up.
 Trading partner B responds to trading partner A in the same fashion.
 The cycle repeats itself on a weekly, daily or even hourly basis as needed.
 This service is generally referred to as mail-enabled EDI,
 The disadvantage of EDI-enabling VANs is that they are slow and high-priced,
charging by the number of characters transmitted.

Fig: Functions of a third-party VAN

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