(FORTUNE Magazine) – "The new thing at Koster and Bial's last night was Edison's vitascope, exhibited for the first time.... When the hall was darkened last night a buzzing and roaring were heard in the turret, and an unusually bright light fell upon the screen. Then came into view two precious blonde young persons of the variety stage, in pink and blue dresses, doing the umbrella dance with commendable celerity." --New York Times, April 24, 1896

Plenty has changed about movies since that early exhibition. For one thing, the plots aren't as clever. For another, a raft of innovations has made film seem more lifelike--Technicolor and sound and 3-D and (briefly) Odorama. But one thing hasn't changed: the film itself. Today, as in 1896, film is a long, thin strip of celluloid pulled in front of a lamp by the means of holes punched along its sides.

But all that began to change on June 18. That's when George Lucas' Star Wars, Episode 1: The Phantom Menace and Miramax's An Ideal Husband premiered on a handful of screens with nary a scrap of celluloid in sight. Instead the movies were compressed into zeros and ones and beamed onto screens via exceptionally complex digital projectors. To listen to digital cinema's boosters, those initial screenings were the first emissaries of a brave new multiplex, one in which films will always look pristine; sold-out shows will be less commonplace; and live concerts, plays, and sporting events will be a regular part of the theater's viewing options. It sounds pretty good. And all that has to happen for this to take place is that someone devise a security system that can't ever be cracked by hackers. Oh, yes, and that movie studios and theaters figure out which one of them is going to spend $1.6 billion or so on new technology.

Given those obstacles, what's most striking about the discussion of digital cinema is its air of inevitability: It was only in March, at the theater owners' annual trade show in Las Vegas, that Texas Instruments and Hughes-JVC gave the first public side-by-side comparison of their digital projectors. Later that day Lucas announced his plans to test out the digital projectors with The Phantom Menace; now, five months later, studio executives talk about digital cinema in the future, not the conditional, tense. "Failure is inconceivable," declares Phil Barlow, Disney's longtime head of domestic theatrical distribution, who switched jobs in April to head that studio's inquiry into digital film distribution. Barlow's adamance is easy to understand, once you've heard the claims of digital cinema's boosters.

The pitch goes like this: Instead of celluloid, digital projectors rely on streams of data, which they cleverly convert into moving images using black magic and voodoo (see diagram). Why bother, you say, if what you end up with is a movie on a screen? Well, there are implications. Under the most common proposals, your local multiplex will be able to receive digital movies via satellite or dedicated land lines. This, the argument goes, will benefit everybody: The studios currently spend around $2,000 on each celluloid copy of a movie, which means a cost of $5 million or more every time they have a wide release; this adds up to $600 million or so in domestic distribution costs per year. Digital distribution will enable them to put a movie on thousands of screens at a tiny fraction of that cost. Theater owners, meanwhile, will be able to shift a sleeper hit from a small auditorium to a large one with the flick of a switch, or alternate Spanish-dubbed showings of a movie with English-language ones in multilingual neighborhoods--tasks that are far more difficult with big, bulky reels of film. What's more, that satellite dish or land line will enable theaters to show live events--concerts or Broadway shows or sport- ing events--in their auditoriums and even rent out space for teleconferencing on weekday mornings and afternoons, when theaters lie mostly vacant. Moviemakers will benefit because their works of art (or Big Daddy, as the case may be) will be unblemished by the natural enemies of film: scratches, dirt, smudges, and fading. And moviegoers? Well, we'll get to see pristine versions of current releases, plus big-screen Wrestlemania!

That's the idea, anyway. But there are those two pesky problems--three, really. There's the security issue and the matter of who will finance these marvelous projectors. And then, hovering above those two problems--indeed, casting a shadow over the whole discussion of digitization--are the internal politics and catfights that are integral to the movie business.

Take, for instance, the security question. Certainly, it's a big one: Estimates of how much video piracy costs the studios are hard to pin down ("Excuse me, sir? Just how many of those bootlegged videos have you sold this month?"), but the lost revenue to the studios is assumed to be at least $1 billion per year, and estimates range as high as $4 billion. That figure could grow substantially if video pirates were to devise a way of stealing exhibition-quality prints off satellites or land lines.

Now let's listen in on a bit of the discussion: The biggest naysayer on the security issue is Al Shapiro, president of domestic theatrical distribution for New Line Cinema (which, like FORTUNE, is owned by Time Warner). "Security is absolutely, 1,000%, the most important thing," Shapiro says. "If it involved bouncing the movie off a satellite, I would be about 95% against it." To which Barlow--who has had public fights with Shapiro in which he's alleged that Shapiro inflates his box-office grosses (Shapiro has denied it)--retorts, "I think Al will probably change his mind as he becomes better informed." Now, it's not that the two don't have a legitimate disagreement. It's that the image of them discussing it quietly at a table doesn't readily leap to mind.

The problem of developing a security standard, however, pales next to the money issue--the question of who's going to pay for all the equipment that digital cinema will require. The current cost of a digital projector is between $100,000 and $200,000, although the price, in the way of all new technology, should drop fairly quickly--perhaps to as little as $50,000 within a few years. There are around 33,000 movie screens in the U.S. alone. Multiply that out, tot up the zeros, and...if every screen in the country were to convert at that price, it would cost over $1.6 billion. That's just in America; for true network efficiencies to kick in--for the studios to do business entirely digitally--the whole world would have to convert, which would mean 100,000-some screens.

Under the model by which the movie industry has operated for the past century or so, the theaters would be the ones to foot the bill for the new projectors. But in this case, most of the benefits of having the new projectors will accrue to the studios, since they're the ones who'll save millions in distribution costs. The costs, in short, are incurred by those who don't reap the benefits. That is a problem.

There is one solution already out there: A company called Cinecomm, an alliance between Qualcomm and Hughes-JVC, has put forward a proposal whereby it would pay for the projectors and devise a delivery system; the studios would then pay Cinecomm to deliver their movies to theaters. To which the studios have, in essence, replied, "Go to hell." Or as Barlow told a recent conference of motion-picture engineers, "We at Disney oppose a system in which a single, outside, parasitic entity serves as a gatekeeper, with its foot on the throat of both studios and exhibition." Cinecomm's CEO, Michael Targoff, maintains that he would be just another vendor, not unlike the FedEx shippers the studios use to deliver prints to theaters. Replies Barlow: "If I remember the story of Little Red Riding Hood, the wolf didn't announce itself as a wolf."

The approach that both the studios and the exhibitors seem to favor is one in which the studios would share some of the burden of buying the new projectors. But that comes with its own set of problems: For starters, how much of the cost would the studios have to pay? At the moment, the two sides are playing poker. Says Barlow: "If I knew the answer, I'd float a trial balloon with you right now and see if it was going to work." On the exhibitors' side, Bill Kartozian, president of the National Association of Theatre Owners, says, "[Barlow] probably has a percentage in his mind, and I have one in mine."

If the studios are going to pay for some of the costs, however, that could raise all sorts of other issues--having a supplier own a delivery system could raise some eyebrows at the Justice Department. It was the threat of antitrust lawsuits, after all, that prompted the studios to sell off their theaters in 1948; although the studios have since been allowed to own theaters again, a proprietary distribution system could renew concerns of collusion. "If the studios go to school on what antitrust enforcers have been interested in in the last seven or eight years, they will realize that they have some antitrust-sensitive decisions that they have to make," says William Kovacic, professor of antitrust law at George Washington University. The studios are all too aware of this: As Jim Tharp, president of theatrical distribution at DreamWorks, puts it, "It could end up being an issue that might be illegal for us to even discuss."

So what then? Are the studios simply to spend hundreds of millions on projectors, then hand them over to the theaters, no strings attached? And what if one studio doesn't feel like paying? Will it still get to use the equipment?

All these questions will have to be hashed out, and probably in fairly short order: Both studios and exhibitors say they expect that digital distribution should begin in three to five years and that it will be widespread by next decade's end. Which means that the next few years should be interesting. For digital cinema to happen, the major studios, the theaters, and the technology vendors will all have to work closely, reaching accords on standards, on security, on payment issues, and so forth. This in a business where studios would rather race to make two lousy volcano movies than team up to make one good one; where it took two years for studios to agree on the DVD standard; and where Loews Cineplex didn't show The Phantom Menace in its Manhattan theaters because it couldn't agree with Fox on terms. The last time all these parties tried to reach agreement was when digital sound was being introduced to theaters in the early 1990s. Ever wonder why there are three different digital sound systems in movie theaters?

If nothing else, then, the attempt to reach agreement on digital standards should be intriguing to watch--perhaps almost as entertaining as two precious blonde young persons of the variety stage, doing the umbrella dance with commendable celerity.