A Brief History of Digital Currencies

The birth of the Internet led many, including economist Milton Friedman, to assume that the invention of some sort of digital money would soon follow. Arguments in favor of digital money were numerous. One obvious benefit realized early on was that it might help prevent counterfeiting:

The advent of high-quality color copiers threatens the security of paper money. The demands of guarding it make paper money expensive. The hassles of handling it (such as vending machines) make paper money undesirable. The use of credit cards and ATM cards is becoming increasingly popular, but those systems lack adequate privacy or security against fraud, resulting in a demand for efficient electronic-money systems to prevent fraud and also to protect user privacy.

—Jorg Kienzle and Adrian Perrig in "Digital Money: A divine gift or Satan's malicious tool?" (1996)^[1]

However, the creation of a secure digital money system must overcome many obstacles that might not be readily apparent. For example, anything stored in digital form can be copied and duplicated infinitely—so how can you prevent users from duplicating their money? Also, the money must be stored in a secure form that can't be easily stolen or tampered with but can be backed up in the event of hardware failure.

Initially, these and other obstacles were tackled by people like David Chaum, one of the early pioneers of digital money. Chaum studied problems in cryptography while completing his PhD at the University of California, Berkeley, and was particularly interested in ways people could transfer money digitally and anonymously. He went on to create DigiCash in 1992, a company whose mission was to establish a digital, anonymous cash system (called e-cash). The system used a concept called blind signatures to guarantee the anonymity of its users, but a central company or bank was needed to ensure that each unit of ecash wasn't spent twice. Chaum's was not the only digital money company. By the mid-1990s, several private companies were developing electronic cash systems, mainly hoping to facilitate online purchases in the then nascent Internet. In addition to DigiCash, others—including First Virtual Holdings, Cybercash, and even a division of Microsoft—were significantly invested in developing digital money solutions. At the time, the use of credit cards to make payments via the Internet was rare, and these efforts were seen as critical to enabling e-commerce.

But almost all attempts to create digital money had the same Achilles' heel: A trusted middleman was needed to keep track of everyone's transactions. Unfortunately, many companies like DigiCash had much difficulty garnering that kind of trust from consumers and banks (whose cooperation they also needed). The reluctance was understandable: If a company operating a digital money system collapsed due to a catastrophic event, the value of the currency units could vanish overnight.

Obviously, it's precarious for an entire currency to have a fragile single point of failure. Even the perception of such a point of failure can ruin its prospects as a meaningful currency. In the 1990s, the existential threat to digital currency companies was that a government agency might force them to close. Digital currencies were such recent inventions that the regulations to manage them were absent or ambiguous. Consequently, digital currency companies did not have a good idea of what the government would or would not consider acceptable.

DigiCash was challenged by many obstacles when it tried to meet various national regulatory requirements. In particular, regulators would not allow the e-cash anonymity feature to remain; mechanisms needed to be built in to allow law enforcement to trace the movement of money to prevent money laundering, which undermined one of the primary advantages of e-cash. These impediments, combined with slow adoption, forced DigiCash to declare bankruptcy in 1998. Other companies faced even worse fates. Gold & Silver Reserve Inc., which maintained a gold-backed digital currency called e-gold, was shut down. Its proprietors were indicted by the US Department of Justice for violating money-laundering regulations.

Ultimately, the regulatory burdens and lack of consumer demand for digital money led companies to abandon the concept. By the late 1990s, Visa and MasterCard had worked out the technical details of secure online credit card payments. With their already large market share, credit cards became the preferred method for consumers to make online purchases. Hence, many of the posited benefits of a stand-alone digital currency were never realized.

For a decade after the fall of DigiCash, it seemed clear that the idea of a purely digital currency was untenable due to the need for a trusted central party, which in turn was prone to failure (whether due to financial or legal problems).

• [1] This work is available at users.ece.cmu.edu/~adrian/projects/memoire1/memoire1.html.