Second of Two Parts

To evaluate the opportunities and challenges of smart cards, it is important to understand a few key components of smart card mechanics.

Like a PC chip, the embedded smart card chip enables card-based processing and information storage. To share information and initiate processing, the chip communicates with a client-server through a smart card reader. The reader enables processing functions, such as payment decisioning, authentication, data encryption, and uploading and downloading information to and from other computers.

The first chip-embedded card patent was filed in Germany in 1968, but smart cards remained relatively undeveloped in the U.S. market until recently. Unlike Europe, where smart payment cards facilitate offline transaction approval, the U.S. telecommunications infrastructure provided an efficient method of authorizing transactions online, limiting initial smart card investments. U.S. government agencies and universities began using smart cards for security, identification, and stored value, but mass-market use of smart cards has, until this past year, remained cost-prohibitive.

Just over a year ago, the race to issue smart cards in the United States began. In August 1999 American Express launched its Blue card, propelling smart cards to the forefront of financial services buzz. Though limited in chip-driven functionality, Blue created enough marketing hype to encourage a few Visa and MasterCard issuers to introduce smart cards.

Though their capabilities and opportunities are considerable, smart cards must overcome big obstacles, the biggest being that few consumers have smart card readers and few merchants have point of sale terminals that can handle chip card transactions.

At the moment, fewer than 3% of people with smart cards have received and installed readers, which most card issuers are giving away free. Even among people who request the reader, installing the software and hardware is often plagued with difficulties, causing operating errors and system crashes.

Since there are so few smart cards out there, merchants have little incentive to replace their terminals. Most likely, the new terminals will be phased in over time as merchants replace older or damaged ones.

As more and more smart cards are issued and the number of cardholders increases, a significant and potentially attractive market will be created, and physical as well as virtual merchants will see the appeal of preparing for chip. Merchants will see the value of using smart cards to conduct marketing programs, such as loyalty and discounting.

As the cost of issuing smart payment cards declined, card issuers developed new strategies. At less than $20 for both the card and reader, the smart card has become a branding and imaging tactic rather than an enhanced functionality proposition.

Card functionality requires merchant participation, which will not occur without a large card-carrying population. By issuing more cards to more people, issuers can begin attracting the capital required to create value-added features that will extend beyond standard payment capabilities.

The race is on. Over the next two years, if expected volume increases meet projections, leaders and laggards in this segment will be determined. Increased volume will lead to new software application testing, the formation of crucial business alliances, and issuers' positioning to gain market share.

Could smart cards be the next major consumer portal, battling the likes of America Online or wireless communication providers? Will AOL decide to issue a smart card to its subscribers?

In the near term, smart cards will likely remain tied to the Internet. Over the longer term, as brick-and-mortar merchants become chip-enabled, smart cards will move beyond the Internet and could become a unique delivery channel.

Mr. Wendel is president and Mr. Chinn senior engagement manager at Financial Institutions Consulting in New York. The first part of this essay appeared March 1.

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