January 14, 2004

The Web's New Currency


A new generation of e-payment companies makes it easy to "pay as you go" for inexpensive Web content, portending big profits for online businesses.

By Gregory T. Huang
December 2003/January 2004

Ask Ron Rivest if he's ever been whisked away by the CIA in the middle of the night, and he laughs-but he doesn't say no. At Peppercoin, a two-year-old MIT spinoff in Waltham, MA, the renowned cryptographer oversees an operation far less secretive than an intelligence agency but almost as intense: a clearinghouse for electronic "micropayments," pocket-change transactions that may finally allow magazines, musicians, and a multitude of others to profit from selling their wares online. It's September, and with only weeks to go until commercial launch, Peppercoin's software engineers troubleshoot at all hours. Marketing executives shout across the room and over the phone, making deals.

But in the eye of the storm, Rivest is calm and collected. Eyes sparkling, real change jingling in his pocket, he even wears sandals with authority. What Peppercoin is trying to do, he says, is make it easy to "pay as you go" for inexpensive Web content-so you won't need to pay subscription fees, limit yourself to free content, or share files illegally. With a click of the mouse-and Peppercoin's software churning away behind the scenes-you can now download a single MP3 from an independent-music site, watch a news video clip, or buy the latest installment of a Web comic from your favorite artist. All for just pennies.

It sounds simple, but it wasn't possible a few months ago. Most Web merchants still can't support micropayments-transactions of about a dollar or less-because the processing fees from banks and credit card companies erase any profit. But Peppercoin, the brainchild of Rivest and fellow MIT computer scientist Silvio Micali, is in the vanguard of a new crop of companies-including BitPass of Palo Alto, CA, and Paystone Technologies of Vancouver, British Columbia-that make cash-for-bits transactions superefficient. These companies' founders are well aware of the string of defunct e-payment companies whose virtual currencies have gone the way of the Confederate dollar. But they've got something new up their sleeves: easier-to-use technology that allows Web sites to accept tiny payments by effectively processing them in batches, thereby cutting down on bank fees.

So throw out your current conceptions of Web surfing. Rather than sifting through pop-up ads and subscription offers, imagine dropping a quarter on an independent film, video game, specialized database, or more powerful search engine. If programmers and Web artists could profitably charge a few cents at a time, their businesses could flourish. And with an easy way for users to buy a richer variety of content, experts say, the current deadlock over digital piracy could effectively dissolve, giving way to a multibillion-dollar business stream that rejuvenates the wider entertainment industry the same way video rentals did Hollywood in the 1980s. Down the road, cell phones, personal digital assistants, and smart cards equipped with micropayment technology could even supplement cash in the real world.

"The key is timing and technology," says Rivest, who thinks Peppercoin has both right. The company's technical credibility, at least, is not an issue. Rivest coinvented the RSA public-key encryption system, used by Web browsers to make credit card purchases secure. Micali holds more than 20 patents on data security technologies and won the 1993 Gödel Prize, the highest award in theoretical computer science. Their system uses statistics and encryption to overcome profit-erasing transaction fees; the approach is unique and more efficient than its predecessors.

The timing looks good, too-not just for Peppercoin, but for other micropayment companies as well. "One year ago, it was, 'Will people pay?' Now it's, 'How will they pay?'" says Ian Price, CEO of British Telecommunications' Click and Buy division, which uses micropayments to sell articles, games, and other Web content to customers in more than 100 countries. And in September, Apple Computer announced that its online music store sold more than 10 million 99-cent songs in its first four months. Apple's success was the "starting gun for a track meet of companies" planning to roll out pay-per-download services by 2004, says Rob Carney, Peppercoin's founding vice president of sales and marketing.

Indeed, 40 percent of today's online companies would sell content they're currently giving away if they had a viable micropayment system, says Avivah Litan, an analyst at Gartner Research who specializes in Internet commerce. According to Forrester Research, the market for music downloads is expected to grow from $16 million in 2003 to $3 billion in 2008. And a Strategy Analytics report states that mobile-gaming revenues could top $7 billion by 2008. "The market is ready" for micropayments, says Rivest.

Even so, getting the technology to take off won't be easy. Micropayment companies need to make their systems fully reliable, secure, and easy to use. Just as important, they need to increase demand by working with Web businesses to deliver a broader range of digital products. So on the eve of Peppercoin's commercial launch, the question is not whether the timing and technology are good. It's whether they're good enough.

In Statistics We Trust

Understanding Peppercoin requires a little history. According to old English common law, the smallest unit of payment that could appear in a contract was a peppercorn. Silvio Micali's wife, a professor of law, suggested that as the name for his startup back in 2001, and it stuck (becoming "Peppercoin" for the sake of clarity). Now, in his office at MIT's Computer Science and Artificial Intelligence Laboratory, Micali is explaining what makes Peppercoin tick. On hand are technical books and papers in neat piles, should we need them. It's simple mathematics, says Micali-but don't believe him.

Micali knows two things: cryptography and coffee. His micropayment analogies involve cappuccinos. There are two standard ways of buying digital content, he says. One is like prepaying for a certain number of cappuccinos, the other like getting a bill at the end of the month for all the cappuccinos you've had. That is, the customer either pays up front for a bundle of content-say, 10 archived New York Times articles-or runs a tab that's settled every so often. The problem with both models is that the seller has to keep track of each customer's tab, and the buyer is locked into a particular store or site. But in the spring of 2001 came a "very lucky coffee break" when Micali and Rivest, whose office is just down the hall, put their heads together. "We started discussing this problem, and within minutes we had the basic solution," says Micali. "And we got very excited! First, from the discovery. Second, from the coffee."

What they discovered was a way to cut the overhead cost of electronic payments by processing only a statistical sample of transactions, like taking a poll. On average, Peppercoin might settle, say, one out of every 100 transactions-but it pays the seller 100 times the amount of that transaction. Given enough transactions, it all evens out, says Micali

It looks simple to the buyer, who only has to click on an icon to charge an item to her Peppercoin account, but the action behind the scenes is pretty complicated. In beta tests, special encryption software runs on both the buyer's and seller's computers, protecting their interactions from hackers and eavesdroppers. And encrypted in each transaction is a serial number that says how many purchases the customer has made over time, for how much, and from whom.

Ninety-nine transactions out of a hundred are not fully processed-but they're still logged by the seller's computer. One transaction out of a hundred, selected at random, is sent to Peppercoin. After Peppercoin pays the seller 100 times the value of that transaction, it bills the customer for all of her outstanding purchases from all sites that use Peppercoin. Since about one out of a hundred purchases is processed, her last bill will have come, on average, a hundred purchases ago. That's the trick: by paying the seller and charging the customer in lump sums every 100 purchases or so, Peppercoin avoids paying the fees charged by credit cards-roughly 25 cents per transaction-on the other 99 purchases. "This is fantastic," says Greg Papadopoulos, chief technology officer at Sun Microsystems and a member of Peppercoin's technical advisory board. "Ron and Silvio have done what needed to be done-get the cost of transactions down without ripping up the existing infrastructure of credit cards and banks."

But what's to keep all this fancy statistical footwork from cheating sellers out of their due? And what's to keep buyers and sellers both from cheating the system? "That's the secret sauce," says Micali.

He's talking about cryptography, the sweet science of codes and ciphers. Its inner workings are, well, cryptic-paper titles at conferences include things like unimodular matrix groups and polynomial-time algorithms-but it's used every day to keep communications, documents, and payments secure. Roughly speaking, says Rivest, statistical sampling of transactions makes the system efficient, while cryptography keeps the random selection process fair and secure. So Peppercoin charges users exactly what they owe, and if Peppercoin's payment to the seller happens to be more or less than the value of the purchases customers actually made, the discrepancy is absorbed by the seller. Over time, this jiggle will become negligible, especially compared to the amount of money Web sites will make that they couldn't make before.

Think about it for too long, and most people get a headache. But Micali and Rivest have been thinking about this sort of thing for 20 years, so they make a formidable and complementary team: Micali is as animated as Rivest is understated, like fire and ice. "They've done brilliant work over the years," says Martin Hellman, a professor emeritus of electrical engineering at Stanford University and a pioneer in cryptography going back to the 1970s. "Peppercoin has a clever approach."

But clever mathematics aside, the proof is in the pudding. In the end, Peppercoin's executives say, their system must be as easy to use as cash. Perry Solomon, Peppercoin's founding CEO, explains it this way, pulling some change out of his pocket. "I can give you this quarter, and you can look at it quickly and say, 'Okay, that's a quarter.' You don't need to call the bank to verify it." Online merchants, however, must check a credit card holder's identity and available credit before approving a purchase. Going to that trouble makes sense for a $50 sweater or a $4,495 Segway transporter, but not for a 50-cent song. So Peppercoin's software stamps each transaction with the digital equivalent of e pluribus unum-a guarantee to the seller that it's Peppercoin handling the transaction, and that payment is forthcoming. The seller can quickly verify this stamp and deliver the goods.

Bootstrapping with Bits

The theory may be impeccable, and the founders' credentials outstanding, but how does a startup transform a micropayment system into a practical, sellable product? That's the stuff of late-night whiteboard discussions enhanced by takeout Chinese food and bad TV movies, says Joe Bergeron, Peppercoin's vice president of technology. Bergeron, a baby-faced programming whiz, has the task of translating Rivest and Micali's algorithms into software. Like any good engineer at a startup, he has spent many a night under his desk trying to squeeze in a few hours of sleep. "I'm dreaming in Peppercoins now," he says.

Minting micropayments starts with hardware. A secure data center a few kilometers from company headquarters houses hundreds of thousands of dollars' worth of computing horsepower and memory. All of Peppercoin's money transfers flow electronically through these machines. A rack of 20 processors and backups and four levels of hardware security are set up in a special cage walled off by Plexiglas guaranteed to withstand a 90-minute riot; the rental contract even specifies that the cage will repel "small-arms fire and manual tools."

First Out of the Gate
Andreas Gebauer remembers the pesky young guy well. Five times in 2000, Firstgate Internet founder Norbert Stangl showed up at the Berlin offices of Stiftung Warentest (Product Testing Foundation), Germany's leading consumer reports magazine, to peddle his e-payment technology. Five times Gebauer, the magazine's online editor, said he wasn't interested. Finally, on the sixth trip, Gebauer agreed to give it a try if Stangl would just leave him alone.

Persistence pays off. "We've been very successful," says a converted Gebauer. In the three years since Stiftung Warentest adopted Firstgate's system, its monthly online revenues have skyrocketed from $5,000 to more than $100,000. And today, while the U.S. micropayment market is still in its early stages, Firstgate has some 2,500 merchant users and almost two million paying customers in Europe-and pulls in more than $1 million a month in revenues, making it one of the world's leading e-payment and distribution companies. Its users in media and publishing, the fastest-growing market segment, include the Independent, Der Spiegel, Reader's Digest, Encyclopedia Britannica, and Gruner and Jahr.

Firstgate's software, unlike Peppercoin's, must keep track of every transaction, and most are dollars rather than cents. But it works. Web customers can go to any Firstgate-enabled site, click on an article, and read it. They are billed via their credit card, debit card, or phone bill once they accrue a few dollars in charges. The system works by fetching digital content from Web merchants and delivering it only to paying customers. Firstgate charges a setup fee for merchants and pockets 10 to 30 percent of each transaction. (That may sound steep, but for micropayments, Firstgate can be cheaper than a credit card company.) Meticulously hand-tailored, the system has won a slew of European industry and consumer awards. "It's finely tuned, like a BMW," says Ian Price, CEO of British Telecommunications' Click and Buy division, which has partnered with Firstgate to sell online games, articles, and even a voting mechanism for interactive TV shows.

Most important, Firstgate has proven that a global market exists for Internet content priced in the $1 to $10 range, says Stangl, who is now the company's chairman. In late 2002, the company set up offices in New York. How will its success in signing up newspapers, magazines, and other media groups translate to the U.S. market? "We have experience working with so many online companies," says George Cain, Firstgate's CEO in North America. "What people are thinking about here, we've already got built into our system."

But Peppercoin's system must also be bulletproof to electronic problems. Take transaction speed, for instance. Peppercoin is working with one Web site that delivers 1,000 digital maps per second. For Peppercoin to handle that many purchases, and for buyers to get their content without waiting, the behind-the-scenes computations must happen in milliseconds. As Bergeron explains, sketching a flow chart on a whiteboard, the software module that identifies what the buyer is paying for, verifies that the payment is good, and sends the digital content to the buyer has been taking a few milliseconds too long in beta tests. The solution: do these steps in parallel, and manage customer queries in a flexible way by devoting more computing resources to the steps that take longer. Trimming bits of fat like this saves precious processing time per click-and ultimately keeps the system running efficiently.

Perhaps even more crucial to Peppercoin's success, though, is its sales strategy. "The challenge isn't getting people to buy the math. It's enabling a new business model for the Web," says Rob Carney. In two respects, micropayment startups are fundamentally different from online person-to-person payment companies like Mountain View, CA-based PayPal, one of the most successful of e-payment companies. First, they are enabling Web merchants to sell low-priced digital content, not physical items. Second, they don't have anything approaching the captive market that PayPal has in the customers who use eBay, the San Jose, CA, online auction house that purchased PayPal in 2002.

So Peppercoin's plan-similar to those of other micropayment startups (see table "The Micropayment Movement,")-is to go after Web merchants, work with them to decide what kinds of content to sell, and build up a brand name with which to approach larger distributors. It's a painstaking process; Solomon and Carney have attended more than 400 sales meetings in two years, trying to persuade merchants that Peppercoin's own fees-which work out to be much lower than the flat transaction fees charged by credit cards-are a small price to pay for the extra business micropayments will generate.

But all this work is starting to pay off. "Peppercoin has been a huge benefit for us," says Rex Fisher, chief operations officer at Music Rebellion, a Terre Haute, IN, company that last June started selling 99-cent MP3s by the download, using a beta version of Peppercoin's system. The bottom line: micropayments allow the music site to triple its profit margin, as compared with traditional payment methods. As for the user interface-buyers sign up for a Peppercoin account and then click on music icons to charge songs-Fisher says he's working with Peppercoin to make it "easy and hassle free." He acknowledges that it's still early, however, and that results in the next year will say more about the overall success of micropayments.

Other users go further in their praise for e-payments as enablers of new kinds of Web content. "The promised land is filled with micropayments," gushes David Vogler, a digital-entertainment executive formerly in charge of online content at Disney and Nickelodeon. One of Vogler's current ventures is a humor site called CelebrityRants.com. There, using Peppercoin's software, you can buy animated recordings of embarrassing diatribes or confessions from celebrities caught on tape-everyone from Britney Spears to new California governor Arnold Schwarzenegger. "We explored many solutions, but Peppercoin seemed like the right horse to bet on," says Vogler. Moreover, he adds, it was "insanely easy" to get the system up and running. That and a painless consumer experience seem to be the keys to early adoption.

So this is how it starts: not with a conglomerate of media giants adopting micropayments, but with pockets of small entertainment and Web-services sites. Plenty of sites will still be free, supported by advertising, says Carney. But micropayments, alongside ad sales and subscriptions, will become another leg of the stool that supports Web businesses. And micropayment companies are hoping that their systems will give entrepreneurs and consumers the freedom to try out new kinds of commerce on the Web, and to buy and sell an ever wider variety of digital goods. "The Web was dying," says Kurt Huang, CEO of BitPass, a micropayment startup he cofounded while he was a graduate student at Stanford University. "We needed to do something to change its economics."

Take Web comics. Today there are more than 3,000 online cartoonists worldwide, and that number is growing fast, says Scott McCloud, an author and Web comic artist based in Newbury Park, CA. "Micropayments are the missing piece of the puzzle," he says. Using a beta version of BitPass's technology-users prepay a few dollars into an account-McCloud sold 1,500 copies of his comics for 25 cents each in eight weeks. Not huge numbers, to be sure, but the potential for steady growth is there. And it's not supplementary income-this is how Web artists will make their money. "We're not just slapping a price tag on what could be free," says McCloud. "This is allowing us to do work that we couldn't do before."

The Micropayment Movement
Company Technology Market/Status
BitPass (Palo Alto, CA) Costs of Web content and services are deducted from an account
prepaid via credit card or PayPal Independent artists, publishers, musicians; beta trials under way; commercial release in late 2003
Firstgate Internet (Cologne, Germany) Servers fetch Web content and deliver it to customers; charges
appear on credit card or phone bill News and analyst reports; in operation since 2000; nearly two million customers in Europe
(New York, NY) Delivers digital items via e-mail after users have paid using PayPal Electronic books, music, software; commercial release in May 2002;
9,600 sellers signed up
Paystone Technologies
(Vancouver, British Columbia) Customer accesses Web content after paying via bank account Music, publishing; commercial release in May 2003; 700 sellers signed up
(Waltham, MA) Uses statistics and encryption to process a sample of transactions; users pay via credit card once per 100 or so transactions Music, games, publishing; commercial release in late 2003

The Coin-Op Web?

In the 1990s, e-payment startups like DigiCash, Flooz, and Beenz crashed because dot-com companies didn't think they needed the technology to make money, and because consumers expected Web content to be free. Times have changed, but there are still plenty of skeptics who doubt micropayments will catch on broadly, considering that MP3 listeners and Web-comics fans are the technology's main U.S. consumers so far. Even those who have made their fortunes in the online-payments world acknowledge that it's an uphill battle. "It's quite possible they could fail miserably in this economic climate," says Max Levchin, cofounder and former chief technology officer of PayPal (see sidebar "The PayPal Precedent").

But both the supply of digital content and consumers' willingness to pay for it are increasing, and the micropayment companies' strategy of signing up Web merchants, one at a time, has promise. "There will be small companies who figure out how to play this chicken-and-egg game," says Andrew Whinston, director of the Center for Research in Electronic Commerce at the University of Texas at Austin. "The key is to become successful before big companies like Microsoft get into it."

The PayPal Precedent

Max Levchin believes that micropayment companies' two keys to success are a simple user interface and an aggressive distribution strategy. TR's 2002 Innovator of the Year, Levchin is the cofounder and former chief technology officer of PayPal, the online-payments pioneer that was sold to eBay for $1.5 billion in October 2002.

Technology Review: Are micropayments ready to take off?
Max Levchin: The Apple music store is a good example that 99-cent payments are a reality. What is uniquely different about the market now is that personal publishing has become a lot more pervasive than it was three to five years ago. There are literally thousands of Web sites that specialize in comics, music, and art that's only available on the Internet. [Artists] look to the Internet to actually make money. So demand is definitely increasing. The question is, are these solutions actually what the market needs?

TR: What do Peppercoin and other micropayment startups need to do to become successful?
Levchin: Most of the technical challenge is about the user interface, not the billing process. Overall, Peppercoin's [beta version] user interface is very raw. I have to download software. I have to wait for a confirmation e-mail. What if my computer crashes? You should never force people to download software. The security is a good thing, but it adds complexity.

TR: What's the greatest challenge, going forward?
Levchin: The biggest difficulty, by far, is distribution. How do you get all these people to start using the system? At PayPal, as soon as we "infected" a couple popular eBay merchants, very quickly we saw this massive growth, where buyers started pushing other merchants to sign up. But there isn't a giant market online right now where you can go to look at all digital content available. Digital merchants are very disparate. And consumers aren't going to sign up, download software, or prepay for a card, because there are not that many places to spend it yet. So marketing to digital merchants directly is one way to go. But it will take an incredible amount of human effort to get enough people to sign up.

For a glimpse into the future of micropayments, look overseas. In Japan, most mobile content and services, such as cell-phone users downloading games and ring tones, are paid. And micropayments are becoming prevalent in Europe's publishing and news-media markets. Firstgate Internet, a digital content distributor in Cologne, Germany, has nearly two million customers and 2,500 clients, including British Telecommunications' Click and Buy, and it is bringing in more than $1 million a month in revenues, says founder and chairman Norbert Stangl (see sidebar "First Out of the Gate"). Its most successful kinds of low-price content: news, research articles, and financial reports.

But Firstgate tallies each purchase separately and pays credit card fees, so its own fees are higher for merchants than most micropayment startups'. Peppercoin and BitPass hope to succeed in the U.S. market by being more efficient for small payments. So will micropayments take off here? "The truth is, nobody knows," says Guy Kawasaki, CEO of Garage Technology Ventures, a venture capital firm that is funding BitPass. "But I look around and I see 50,000 unsigned bands in the world. I see thousands of bloggers, analysts, and artists who want to publish their stuff. And how many databases would you want to search for 50 cents?" Asked when he expects to see a return on his investment, the former Apple guru laughs and says, "Before I die!"

Other observers see a clear path to adoption. "The future of micropayments is very simple," says Sun's Papadopoulos. "You'll get to a critical mass on the network. It will become the equivalent of pocket change, and you'll see fierce price competition on digital content." Falling prices, companies hope, will only increase demand. And as digital content gets cheaper, the temptation to pirate should diminish.

We're already seeing competition: last summer, the music-download store BuyMusic.com put up billboards parodying Apple's music ads and undercutting Apple's 99-cent pricing by selling songs for as little as 79 cents. With America Online, MusicMatch, and Roxio (Napster 2.0) launching stores as well, the music industry will be a proving ground-or perhaps a killing field-for e-payment technologies.

As the contest begins, most micropayment startups have enough capital to see them through the rollout phase. In September, Peppercoin announced that it had raised $4.25 million in its second round of venture funding. But in the long run, how will micropayment companies stay in business? Signing up Web merchants is fine now-deals are quick and the need is there-but an eventual goal is to hook up with a distributor that will become the eBay of bits.

So as Peppercoin makes final preparations for its commercial launch, Carney and Solomon make sales calls. Engineers sit on the edges of their seats, watching the ebb and flow of processing loads and user levels on their monitors. Rivest and Micali, ever patient, stay out of the limelight. If victory arrives, it won't come thundering out of the sky. For companies like Peppercoin, success will build up gradually, like coins clinking into a piggy bank, one by one.

Posted by graeme at January 14, 2004 05:16 PM | TrackBack

Read Michael Levchin's comments for the verdict.

Posted by: Ian Grigg at January 14, 2004 08:06 PM