What's the use of adding a challenge to a one time password algorithm?

Question

In these YouTube videos Challenge-Respond Mode and Sign Mode the customer enters a challenge into the CAP device before generating a one time password. Why not just generate the one time password directly?

Answer 1

I think this is to ensure that the response entered into the website is a fresh(ish) one. If the one time password was generated directly then it could be used at any point in the future, the server has no way of checking when it was generated. By providing the challenge to the card it means that the response generated can only be used for the transaction with the matching challenge.

Here's an example of an attack that takes advantage of the fact that a challenge isn't used for all online transaction or logging into your bank account:

A similar attack could be performed with CAP. The customer, using a tam- pered Chip & PIN terminal, would insert their card and enter their PIN as usual. The terminal would then generate the necessary CAP responses, and optionally also carry out the legitimate transaction. Shortly after, the customer would re- ceive a personalised phone call or email, stating that a suspicious transaction had been noticed (stating the shop name they just used), asking for their online banking credentials. Since Barclays only uses identify and sign mode, there is no server-provided freshness or a timestamp, so the previously collected responses can be used, provided the customer had not logged into online banking in the meantime. With NatWest, which uses respond, there is a server-provided nonce, so the fraudulent transaction has to be in near real-time, and account credentials would need to be collected before the CAP responses were generated. The banks could resist this problem by offering separate CAP-only cards, but NatWest refused to do so for one of us.

It's taken from Optimised to Fail: Card Readers for Online Banking by Ross Anderson, a paper that talks about the CAP protocol and its various vulnerabilities. A link to it for you if you want to read more on the topic: http://www.cl.cam.ac.uk/~sjm217/papers/fc09optimised.pdf