The proliferation of prepaid card programs in Europe has prompted the European Monetary Institute to explore the need for central bank oversight. A report to the institute last year from the Working Group on EU Payment Systems, now making the rounds in U.S. regulatory circles, recommended a central role for banks as issuers of the cards. Following are slightly edited excerpts from the report:
Over the years, payment with cards has become common practice in most European Union countries as a method of gaining access to funds held in a bank account or to an agreed credit line.
For security reasons, on-line systems are now often used for authorization of the transaction, and sometimes, on-line transaction processing also takes place. Usually, the information needed to enable transactions is contained in a magnetic stripe on the back of the card.
Technological developments have enabled further improvements in the use of plastic cards. In this respect the introduction of the chip or smart card was an important development. A chip card contains a microcomputer, consisting of a processor and a memory component, which is embedded in the card, thereby allowing remote verification and, accordingly, purchases at a local level that previously could only be executed after on-line reference to a control computer.
Apart from offering the advantage of independence of on-line data communications, with their attendant costs, this microcomputer also allows for multipurpose applications.
This means the use of such a card need not be restricted to payment transactions but could be extended to, for instance, the registering of retailers' promotional activities or even to totally unrelated functions like the storage of medical information. In such a way, the typically higher cost of the chip card could be shared among several market participants.
Many features of chip cards are optional. In particular, while it is possible to install PIN (personal identification number) authorization for payment transactions, such a facility need not be part of systems developed for off-line, low-value applications.
Protection against counterfeiting will be a very important element on which the future of electronic purses will depend. Forgery will probably be more difficult to detect with this instrument, particularly if the card can be used anonymously and is not personalized in any way.
By virtue of their higher degree of built-in security, chip cards have a far greater potential than traditional cashless payment technologies. And although it is not the only option available, recent experience suggests that the chip card is the most probable choice in this context.
For security reasons, an electronic purse system installed on the basis of cards with magnetic stripes does not seem very realistic. There is no certainty, however, that chip cards will provide an absolute protection against forgeries.
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For electronic purses to succeed, a distinct business case must exist for cardholders, for shopkeepers, and for issuers. Electronic purses can have various advantages for cardholders. The most important aspect relates to convenience, as there would be less need to carry loose change for low- value transactions.
An additional advantage might be that, compared with bank notes and coins, the risk of robbery might diminish if the use of electronic purses included a security feature such as a PIN code.
Furthermore, prepaid cards would have the advantage that noncash payments could be made without necessarily being linked to a bank account.
On the other hand, there are disadvantages as well. Transaction costs may apply, and the electronic purse must be supplied with value in advance, which may transfer float income from consumers to card issuers.
Some, but not all, prepaid card schemes envisage offering cardholders the possibility to transfer purchasing power from one electronic purse to another. Such payment transactions would avert the need for clearing procedures and would further increase the possibility for electronic purse money to substitute for bank notes and coins.
For suppliers of goods and services, the use of electronic purses could offer the advantage of reducing cash-handling costs and, possibly, some financial benefit from the lesser need for till money. Also, an important characteristic by comparison with other face-to-face cashless instruments is that, since the card would be supplied with value in advance, no risk would exist of payment's being refused for insufficient funds.
On the other hand, additional costs might arise if several incompatible electronic purse systems were to evolve and if the terminals for electronic purse systems were not compatible with those in use for other card schemes. In addition, potential financial benefits might be smaller than expected if the card-providing institutions were to impose fees for electronic purse transactions.
Nevertheless, surveys in a number of countries indicate that some categories of shopkeeper favor electronic purses and want to encourage their introduction - not just for their payments functionality but also, and perhaps even more importantly, for the additional opportunities for promotional activities based on the cards' memory capacity.
For issuing institutions, in general, the most important reason to take part in the development of electronic purse schemes is, perhaps, the gain of float income that would otherwise accrue to other parties (individuals, business enterprises, or, in the case of bank notes, central banks). If issuers were forced by competitive pressures to pay market interest rates on electronic purses, the advantages of using electronic purses would of course decline.
For credit and financial institutions, the advantage of issuing or promoting electronic purses would be that they could be designed as a relatively cheap, off-line substitute for other noncash payment instruments with no risk of overdrawing bank accounts.
Furthermore, the substitution of electronic purse payments for bank notes and coins would reduce cash-handling costs and the need to hold noninterest-bearing cash balances.
If the issuing institution is also the account holder, an additional incentive to persuade consumers to use electronic purses instead of notes and coins would be that the issuing institution would only lose reserves when the funds embedded in the card are spent and merchants demand payment. By contrast, when notes and coins are withdrawn by an account holder, the drain on reserves is immediate.
Other companies may also try to introduce such instruments or to upgrade existing forms of prepayment. An example of such upgrading could be the issuance by PTTs (postal-telephone-telegraph agencies) of universally applicable cards based on those which are now solely used to operate public telephones.
To a certain extent, the advantages of electronic purses for some economic agents are disadvantages for others. Therefore, the overall acceptance of this new payment instrument is as yet uncertain.
In any case, a key factor will be its acceptance by consumers, which will depend on many factors such as reliability, user-friendliness, and the financial conditions applied in terms of costs and fees.
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European Union central banks are of the opinion that the market should decide which payment instruments can best serve customer needs. Therefore, they do not wish to interfere unnecessarily in the development of prepaid card schemes. They do not feel that, in general, they need to be heavily involved in retail payment systems.
Nevertheless, the creation of the electronic purse must be evaluated carefully because, if it develops, this payment instrument will affect central banks in the long run: as overseers of their countries' payment systems, as the authorities in charge of monetary policy, and as issuers of bank notes.
All EU central banks are concerned with the integrity, stability, and efficiency of their countries' payment systems. Even if central banks generally concentrate their attention on large-value payment systems because of the systemic risks involved, they cannot neglect the implications that the inappropriate functioning of a payment instrument may have for public confidence in the currency, retail payment systems, and payment media in general.
In this respect, electronic purses raise at least two kinds of problem - one relating to the issuer's soundness, the other to the instrument's soundness.
In the schemes that the Working Group on EU Payment Systems has been able to examine, the issuer of an electronic purse has three functions: It makes the card available to the customer; it is the beneficiary of the payment made by the cardholder to load a card; and it is the institution with the contractual liability to pay merchants for goods or services bought by the cardholder. It may also have to reimburse unused funds to the cardholder.
In economic terms, it is clear that the money received by the issuer of an electronic purse is a bank deposit. It is indeed a claim that the cardholder (or account holder) has on a third party, and it can be used to make cashless payments to a wide range of providers of goods and services.
Such deposits contrast with deposits that are payments in advance for which the range of goods or services to be purchased is well defined and limited in scope. Therefore, in economic terms, the reasons that prompted public authorities to reserve deposit-taking to a specific category of institution should also apply to the issuers of electronic purses.
These reasons relate both to protection of the consumer and to protection of the money transmission system. If corporations other than credit institutions were to issue electronic purses, banking regulations that, in the end, seek to protect customers' deposits would not apply. Deposit guarantee schemes would not apply, either.
As far as the money transmission system is concerned, its stability could be threatened by failure of one or several issuers. Public confidence in other retail payment instruments (debit cards, for example) might also be affected.
Therefore, it is very important that the liquidity regime applied to credit institutions serve to ensure that issuers of prepaid cards are able to meet their liabilities to retailers in the settlement of transactions made with the cards.
Moreover, there would be additional concern for central banks and banking supervisors if banks subject to prudential regulations (and, in some countries, reserve requirements) were unable to compete on equal terms with other issuers of electronic purses.
In some circumstances (for example, in the case of schemes in operation before the policy conclusions of this report were drawn up), the local central bank may agree that electronic purse issuers do not have to be full-fledged credit institutions. This could apply if the issuers provide only domestic payment services; are subject to regulations with respect, in particular, to reserve requirements; and are supervised by the institution that supervises credit institutions.
