Are the card associations preparing a $14 billion-a-year scam?

A 1987 Booz-Allen & Hamilton study conducted for Visa and MasterCard projected that the card associations would lose 86% of their network traffic when they migrated to smart cards. The reason: Smart cards can approve a card transaction without a network authorization.

This projection was confirmed in the first U.S. smart card test, in 1984. The smart cards issued in that test carried three variables: credit available, number of transactions permitted, and a time period — for example, cards allowed a $500 credit limit for 30 days or five transactions. When a card violated these conditions, the smart card did not make a decision — it forced a central online authorization for 10% of the card’s subsequent authorizations. The network could then adjust the in-smart-card controls based on account performance such as timely account payments. Since card association networks are a big investment and the merchant fees are a substantial source of card association revenues, the study became the basis of a long-term effort to avoid the smart card migration.

Smart cards’ effect on network activity has been proven. In France more than 35 million smart cards handle point of sale transactions extremely efficiently. In the decade after the cards’ introduction, French banks reduced their authorization network usage by 90% and losses by an average of 10% a year.

The entry of American Express’ Blue smart card seems to have forced the issue of bank migration to the smart card. This is a repeat of American Express’ catalytic announcement of migration to the magnetic stripe card in the early 1970s, which caught the attention of banks and forced acceptance of the magnetic stripe by the banks and card associations. Affluent cardholders use the Blue card, and if they abandoned Visa and MasterCard cards in favor of the American Express product, it would be a serious blow to the bank card market. Moreover, online use of Blue has the ability to bypass the card associations’ networks through a facility called Virtual Private Network: Authentication, authorization, and billing data capture can be done over the Internet. Hence, the smart card is still a serious threat to card associations revenues.

The delay in adopting smart cards has denied card issuers and users big savings. The Booz-Allen study predicted that using smart card authorization instead of network authorization would cut bad debt by 7%, or $3.8 billion using last year’s data. The study also predicted a 22% reduction in fraud; smart card-based authorization would have prevented $1.3 billion in fraud last year.

The largest savings would have come from reduced network authorizations. There are about $1,000 billion in transactions performed every year, and each one has a 1% transaction fee. If smart cards reduce authorizations by 90%, fees charged by the card associations would fall from $10 billion to roughly $1 billion. In other words, consumers and issuers would save close to $9 billion. Total cost per year: more than $14 billion in issuer and user costs.

Here comes the scam. Several card suppliers have anonymously stated (the developers are under strict nondisclosure agreements and Visa has declined comment) that at least one of the card associations is forcing the smart card application architecture to support and compel network usage rather than authorization through smart cards. It does this by putting the credit card application decisions into a nonupdatable portion of the smart card memory.

Hence, the card must go to the network for information such as available credit, available transactions, and permitted usage period. Actual experience has demonstrated that adequate control data can be maintained on the smart card. This contradicts any industry claims that adequate data can only be found on the network.

How will this issue be resolved? Only one way — in the marketplace. Entrepreneurs will establish smart cards that use alternative networks such as the Internet. However, it is safe to project a continuing stream of association network decisions designed to protect the status quo in fees.

The irony is that the multiple-application smart card will enhance bank card marketing efforts. For example, response to banks’ credit card direct mailing has been diminishing; the multiple-application smart card can be loaded with a variety of applications, and when cardholders respond to marketing campaigns, smart card applications can be activated electronically. Thus a quicker market response is possible, since the time-consuming step of issuing an entirely new card is eliminated. Perhaps the card associations would be better advised to sell the functional attributes of the smart card rather than scheming to preserve the old magnetic-stripe based networks. Mr. Svigals is director of the Smart Card Institute in Redwood City, Calif.

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