Stored value cards have recently generated considerable attention.
On April 10, Citibank, Chase Manhattan, MasterCard, and Visa announced an initiative in which 50,000 reloadable stored value smart cards will be issued for use with 500 retail vendors on the Upper West Side of Manhattan. And Visa has announced plans to promote the use of smart cards at the Olympics this summer in Atlanta.
Although there is a lot of sizzle associated with smart cards, no one really knows how this market will develop.
Currently, we are seeing the growth of "closed" systems for smart cards, such as mass transit systems, phone companies, or universities that accept smart cards on campus. "Open" systems, in which the same card can be used at multiple unrelated locations, may develop over the next decade.
The growing interest in smart cards combined with this uncertainty puts the financial regulators in a bind. On one hand, current law could have the unintended effect of impeding the development of these new technologies and services.
For example, the purchase of a stored value card from a bank may resemble the making of a bank deposit, as that term in defined in federal law. If the purchase is a deposit, is that deposit insured and subject to FDIC premiums? Does the bank have to maintain reserves against the deposit or increase its capital? A determination that the purchase of a smart card is a deposit could impose substantial costs on banks issuing such cards, impeding the development of this product.
On the other hand, changing the law to facilitate the development of smart cards could lead to government favoritism of one product over another. The private sector, not the government, should determine how, and even if, these products become successful. The regulators' role should be to ensure the safety and soundness of the financial system, not to micromanage the design and implementation of new products and services.
As the regulator responsible for enforcement of the Electronic Fund Transfer Act of 1979, the Federal Reserve has directly confronted these dual concerns. Currently, the agency's Regulation E contains provisions that would impose costly and impractical requirements on stored value cards, such as transaction receipts and periodic statements.
After two years of consideration, the Federal Reserve adopted On March 20 a final rule amending Regulation E, but did not deal with the issues raised by stored value cards. At the same time, however, the Federal Reserve released for comment proposed amendments to Regulation E to address stored-value cards specifically. Comments are due by July 10.
The purpose of the proposed amendment is to ensure that inappropriate regulation does not impede the development of stored value cards. In a memo to the board, the staff noted that disparate regulatory treatment of different types of stored value cards could create incentives for issuers to design their systems in particular ways to avoid being covered by Regulation E. Specifically, the staff wrote "(i)t is not desirable to have system design be guided by regulatory rather than economic considerations." However, the proposal advanced by the board is likely to have this very effect.
In its proposed regulation, the Federal Reserve lists three categories of0 system design for stored value cards, each of which would be regulated differently under the board's proposal.
In "off-line unaccountable stored-value systems," the card's value is maintained only on the card itself. Transaction data for debits to the card's "stored-value" are recorded on the card and captured at the merchant terminals. Only the aggregate amount of transactions for a given period is transmitted by the merchant to the financial institution so that the merchant can receive credit.
In "off-line accountable stored-value systems," the balance of funds available is recorded on the card, but is also maintained at a central data facility. There is no on-line authorization of transactions, but transaction data is periodically transmitted to and maintained by a data facility.
In "on-line stored-value systems," there is on-line access to a data base for purposes of transaction authorization and data capture. The card itself is not "smart" - the balance information is maintained only at the financial institution or central data facility. The result is similar to using a debit card to access a traditional deposit account, except that the value associated with a card is limited to the amount that the cardholder has specified.
The staff recommended that off-line unaccountable stored value systems be entirely exempt from Regulation E. Off-line accountable and on-line systems would be exempt if the maximum amount that could be associated with the card at any given time is $100 or less. Off-line accountable stored value systems with cards over $100 would be exempt from all of Regulation E except for requirements related to initial disclosures.
In contrast, on-line systems would be subject to all provisions of Regulation E except:
*The periodic statement requirement, if an account balance and a summary of recent transactions is provided upon request.
*The annual error resolution notice requirement.
*Change-in-terms notices.
The Federal Reserve solicited comments on whether the proposed modifications should be different for on-line stored-value cards that are "reloadable" as opposed to disposable.
By segregating stored value cards into three categories and proposing different regulation for each, the Federal Reserve may be heading down the path it seeks to avoid - having regulatory considerations direct the development of smart cards. Under its proposal, an issuer could be more likely to limit such cards to $100 or less in value to avoid Regulation E. If the issuer seeks to issue cards above $100, there would be a strong incentive to limit such cards to off-line unaccountable stored value systems.
The weakness of this approach is particularly apparent for on-line cards. For instance, if Regulation E imposes one set of rules on disposable cards and a more stringent set of rules on reloadable cards, whether issuers prefer disposable or reloadable cards may well be "guided by regulatory rather than economic considerations," exactly what the staff sought to avoid.
By favoring one stored card system over another, the Federal Reserve might also affect the possible uses for these cards. An off-line unaccountable system may be more likely to be used as a substitute for cash in smaller retail purchases. On-line systems may become more common for larger transactions, such as car purchases. A regulatory structure that encourages the development of one system over another may skew the commercial future of these instruments.
Regulations necessary to ensure safety and soundness can affect the direction of an industry, but the Federal Reserve has not indicated that its proposed differential regulation of smart cards is warranted for safety and soundness reasons. The Federal Reserve may believe that the Electronic Fund Transfer Act requires these distinctions. If so, amendments to this statute may be needed.
The Federal Reserve is aware of these risks in its proposed approach and has explicitly requested comment on whether disparate regulatory treatment would affect system design. It is important that commentators on this proposed regulation share with the Federal Reserve concerns about the possible unintended consequences of this approach.
Ms. Heaton is a counsel in the Washington law firm's finance and real estate department.
