The Regional Economist April 1996

“We’re about to see another revolution similar to the Industrial Revolution.” James G. Cosgrove, vice president, AT&T “Do not get caught up in the PR hype in the press.” Scott Cook, chairman, Intuit Inc.

by Adam M. Zaretsky

he quotes above represent A New Wrinkle on in-house merchants to settle just two of the many diver- an Old Idea transactions. Although these Tgent views about electronic prepaid cards can usually be currency. Using “money” stored Transit systems and universities reloaded with additional value, electronically on a microchip have used prepaid cards for years. their use is limited to specific embedded in an ATM-like card is More recently, telephone and regions or merchants. supposed to change the way con- telecommunication companies The emerging smart cards with sumers and merchants carry out have been selling them, too. stored value (hereafter, stored- transactions. No longer will a per- Single-purpose prepaid cards, like value cards) will act like multi- son have to fumble for change at those used for telephone calls and purpose prepaid cards, but be the bottom of a purse or find that mass transit fares, can be used even broader in scope because a dollar bill is too ratty for a vend- only at specific locations for cer- they will not be limited to specific ing machine to accept it. The new tain products. The consumer regions or merchants. This antici- “smart cards,” as they are known, exchanges cash for a card that has pated widespread acceptance by will purportedly replace cash and an equivalent value stored on a merchants and consumers is why coins for small transactions, while magnetic stripe. This value can pundits place these cards on par offering more security than cash.1 then be used to purchase the ser- with cash. One card can act as a , vices for which the card is , ATM card and “cash.” designed. When the value has The multi-function convenience is been depleted, the card is usually A Cash Equivalent? the advantage of this technology, discarded. In some instances, Are stored-value cards really a smart card proponents report. though, the value on the card can form of cash? No, they are not, There are many questions, be replenished. and this is a fundamental differ- however, that these proponents Multi-purpose prepaid cards are ence between the two. Yet, poten- do not address. What happens if more commonly found at univer- tial issuers of these cards argue the card is lost? How and when sities and corporate offices. In that they are.2 does settlement of the transaction these cases, the university or The confusion centers on the occur? Is the transaction anony- employer collects cash from stu- perceived similarities in the way mous like using cash? Who will dents or employees and issues ATM and stored-value cards work. issue the cards? Are the cards real- them cards with stored value. The Today, a consumer inserts an auto- ly different from the forms of cards can then be used to make mated teller card into an ATM and used today? These are purchases at a variety of sites on can withdraw cash, which the questions most potential card campus—for example, the book- machine dispenses, from his users are likely to want answered store, cafeteria or other food out- account. The withdrawal either is before deciding whether this tech- let. University or corporate immediately posted to the account nology is really a useful innova- merchants accept the value from if the ATM belongs to the bank tion or just a marketing gimmick. the card as payment, knowing with the account, or is posted a day that the university or corporation or two later if the ATM belongs to a will convert these balances back different bank. Cash has moved into cash. Thus, the university or from the bank to the consumer. corporation acts like a bank With a stored-value card, a sim- because it collects funds and then ilar transaction occurs. The con- disburses them to the various sumer inserts the stored-value card

5

into an ATM-like machine and makes microchip does not actually transfer a withdrawal from his bank account. “funds” from the card to the mer- “It really is no different than if [the chant, but only gives the merchant ATM] had dispensed cash,” said David the right to claim these funds from Van Lear, president of Electronic the bank. In other words, the stored- Payment Services Inc., to Congress.3 value card verifies that the funds to But there is a difference. The con- honor the liability are available from sumer might believe he has received the card-issuing institution. Settle- “cash,” but he has instead received ment takes place afterward, when the only a balance of monetary value customer’s bank transfers the funds to from the bank. This monetary value the merchant’s bank. is in the form of a promise the bank makes to pay the debts the consumer incurs by using the stored-value card Uh-oh, the Card’s Gone! up to its available balance. Thus, the customer has “funds” on the card Like cash, the risks from loss, dam- with which to conduct transactions, age or theft also exist with stored- re but, in fact, no cash has left the bank. value cards. But unlike cash, the AAre “funds” on a stored-value card cannot The bank actually moves the with- drawn funds from the customer’s actually be “lost” because they are still account into its own account, from at the card-issuing institution in its sstororeed-d- which it will settle transactions its account. Thus, whether a lost, dam- t customers make with stored-value aged or stolen card will mean the cards. These funds, which could have stored balances are gone for good— been earning interest for the cus- like losing a $20 bill—is still unclear. valuvaluee tomer, can now earn interest for the Even the use of personal identification bank while awaiting a payment order.4 numbers (PINs), like those used with In addition, float—the balance that ATM cards, will not guarantee the remains in an account while a check consumer reimbursement. They can, cardscards aa or other debit instrument is in process however, prevent others from - of collection—has been transferred ing the value stored on the card. from the consumer to the bank. That individuals would be reim- bursed for losses seems unlikely, formform ofof though, because—like trying to pay Settling a Transaction interest—determining the exact bal- ance on any card at any given time When a purchase is made using would be costly and impractical. cashcash?? currency, final settlement occurs on Moreover, if the issuer wants to make the spot because currency is legal ten- this determination, it would also need der. No third-party involvement is to match individuals to particular No, they necessary. If the purchase is made cards, which would require tracking No, they using a stored-value card, however, consumers’ purchases through mer- final settlement does not occur at the chants, thus destroying anonymity. because payment Merchants, on the other are not. has not been made in legal hand, might benefit because are not. tender. In fact, all the accepting stored-value stored-value card does is card balances could pre- inform the merchant sumably reduce the that the bank that security costs associated issued the card has the with safeguarding cash funds to pay the mer- in the store until it is chant upon presenta- deposited. The risk of tion of the liability. employee embezzle- Thus, a third party, like a ment and the costs of bank, must be involved in secured storage and trans- discharging the debt. A similar portation could be reduced or process—a wire transfer—illustrates eliminated if the volume of cash at the point. an establishment were to drop drama- For years, Western Union has been tically. The additional costs incurred wiring money around the country to install and operate the technology and world. Western Union, of course, necessary to accept stored-value cards, does not actually send money to the however, will probably offset many of designated destinations. Instead, the these potential savings, at least in the company sends only an short run. to the office at the receiving end to issue funds to a particular party. Final settlement of the debt occurs a day or Off-Line Convenience two later, when the issuing office’s bank transfers the funds into the One major convenience of stored- receiving office’s bank account. value cards is that their transactions The same is true for the stored- occur off-line. This means that no value card transaction. The card’s real-time contact with a central com-

6 Regional Economist April 1996 puter for verification of identity or A potential problem, however, is that funds is necessary. The off-line capa- these firms might then begin acting bility is a fundamental difference like , while not being subject to between stored-value card banking regulations. Former Federal and credit, debit or ATM card pay- Reserve Board Vice Chairman Alan ments. Essentially, the “computer” Blinder and others have expressed on the stored-value card serves as its the concern that in this situation own balance verification mechanism. banks and nonbanks would be trea t e d Rather than the merchant confirming differently.5 According to Blinder, identity and availability of funds under current regulations, “Stored- through a central computer, the chip value balances issued by depository on the stored-value card verifies this institutions would be treated as trans- information instead. action accounts and hence subjected With credit cards, each time one is to reserve requirements.” The Federal used, the cashier swipes it through the Reserve, however, does not have the reg i s t e r , which then calls the cred i t authority to impose reserve require- ca r d company’s central computer, ments on nondepository institutions. Reprinted with transfers the account number and pur- Other disparities can occur permission from chase amount to it and awaits autho- because banks are subjected to strict The New York Times rization. Authorization means there is enough available credit in the iden- tified account for the trans- action to occur. When a pu r chase is made with an ATM or debit card, the fi rm ’ s register or terminal is connected with the issuer’s computer network, which verifies the funds in the cus- BANK issues electronic CONSUMER MERCHANT to m e r ’ s account. The PIN card to consumer loads card uses terminal that se r ves as an electronic signa- with “money” deducts “money” from tu r e that authorizes the using an ATM or a telephone the card at the time of bank to transfer funds from equipped to read the cards purchase. Merchant the customer’s account to the merch a n t ’ s account. uses card-reading A stored-value card telephone to make req u i r es no connection to a BANK collects usage fee bank deposits central or authorizing com- puter because the availabil- ity of funds is encoded on it. Th e r e is no need to identify or verify a particular account because capital and portfolio restrictions, Consumers transfer th e r e is no account to verify; the while nondepository institutions are “money”from their funds are in the bank’s general pool, not.6 Conceivably, nondepository rather than an individual’s account. institutions could invest the funds bank accounts on to These features make a stored - v a l u e collected for stored-value cards in cards embedded ca r d more like a check than a debit risky assets to increase their earnings. with computer chips ca r d. A check is nothing more than a This could impair their ability to cu s t o m e r ’ s written authorization to redeem stored-value balances at par and then use them to the bank to pay the specified bearer a (face value). Also, what happens if make purchases. pa r ticular dollar amount. It is essen- the firm issuing the stored-value bal- tially an off-line debit instrum e n t ances becomes illiquid or insolvent Using these cards is because there is usually no verification or declares bankruptcy? Who, if any- faster than using of availability of funds at the point of one, would be liable for these funds, credit or debit cards, sale. Likewise, a stored-value card acts and what claim could holders of the as an off-line, electronic authorization card balances have on the assets of but there are risks. for the bank to pay the bearer . In this the issuer? case, the bank need not even know Some might believe that deposit who paid the merchant because it insurance could solve these potential do e s n ’ t have to identify an individual’s problems. The Federal to debit. Insurance Corporation (FDIC), how- ever, has not yet determined whether stored-value card balances held The Issuing Issue through banks would be insured, not to mention those held through non- So far, this analysis has assumed banks. Besides, the FDIC and other that only banks will be issuing bank regulators, like the Federal stored-value cards. This assumption Reserve, do not have the authority to need not be true; nondepository permit or require insurance on bal- institutions may also get involved. ances at nondepository institutions

7

fter the par and can be exchanged demise for coin. These features of the make them, like bank notes Second Bank of the , during the Free Banking Era, an acceptable medi- Awhich President Andrew Jackson refused to um of exchange. However, two big differences recharter in 1832, the country entered a period between the two currencies exist: Bank notes cir- known as the “Free Banking Era.” From 1837 culated without a central bank during the Free to 1863, states that enacted free banking laws Banking Era—the Federal Reserve had not yet allowed free entry in the banking industry. This been created—and there was no deposit insurance meant that banks could issue notes on the condi- on them. Nevertheless, bank notes functioned as tion that designated securities, placed on deposit “cash” and were used for transactions even though with state regulatory authorities, backed them. they had no intrinsic value like specie. In general, state authorities directed the printing The analogy to bank notes can also be applied and registering of bank notes and issued them to to stored-value card balances. U.S. dollars (or some banks in amounts equal to the securities depos- foreign legal tender) are on deposit at the issuing ited. Free banks had to redeem their notes at par institution to “back” the stored-value card balances, (face value) for specie (coins minted by the U.S. which presumably will be accepted for transactions Treasury) on demand, otherwise the state would because consumers and merchants believe they can close the bank. be exchanged on demand for legal tender.1 If During this era, many different bank notes consumers and merchants do not have faith that were circulating, making the ability to determine these liabilities will be honored by the issuing which notes were valid and sound, and which institution, then stored-valued balances might not were risky,necessary for transactions to occur. circulate as a medium of exchange. In particular, As a result, bank note reporters—newspapers if a lesser-known firm were to issue the liability, that, like today’s financial pages, listed which merchants might be skeptical about accepting bank notes were valid and what their market val- this “currency” at par as payment for a transaction ues were—were published and used as guides for because of the risk of redemption. Skepticism bank note acceptance. about the issuer could lead to publications (or Once a note was determined to be valid, mer- online data bases) similar to the old bank note chants had to know at what price it was trading: reporters to help identify and verify liabilities Was the note trading at par or at some other issued by lesser-known firms. value? Evidence suggests that bank notes backed Thus, there is a lesson we can draw from the by creditworthy securities circulated at or near Free Banking Era: Privately issued bank notes (or par. Those notes backed by risky securities, how- stored-value card balances) can circulate at par as ever, were accepted only at a discount, which an accepted medium of exchange if a certain compensated for the additional risk. amount of regulation assures the public that the These bank notes were not unlike today’s cur- currency is backed sufficiently,or, at least, that it is rency. Federal Reserve notes (dollar bills) are issued through institutions the public feels secure printed, registered—each has a unique serial dealing with. If the public does not have this con- number—and backed by the full faith and credit fidence, the balances either will not circulate or of the U.S. government. They are redeemed at will not do so at par. 8 ENDNOTES REFERENCES 1 The discussion of U.S. dollars or other foreign legal tender a aGorton, Gary. The Enforceability of Private Money Contracts, Market “backing”stored-value card balances is symbolic because the Efficiency,and Technological Change, National Bureau of funds are not actually deposited with any state or federal Economic Research,Working Paper No. 3645 (March 1991). authority like bonds were during the Free Banking Era. The Rockoff, Hugh. “The Free Banking Era:A Reexamination,” analogy is made, however, to help the reader understand that, Journal of Money,Credit, and Banking (May 1974), pp. 141-67. like checks,funds are being held at the bank as collateral for Rolnick,Arthur J. and Warren E.Weber. “Explaining the the liability it is issuing in the form of stored-value balances. Demand for Free Bank Notes,” Journal of Monetary Economics (January 1988), pp. 47-71. Regional Economist April 1996 or even at all depository institutions.7 gence of stored-value cards does not If it is determined that stored-value cr eate money but only substitutes for card balances will not be insured, cu r rent forms of money, the biggest issuing institutions could disclose change would be in the measurem e n t ENDNOTES this information up-front, along with of money. Electronic currency may, 1 The term “smart card” refers to a card with a microchip on it. It the customer’s rights and responsibil- ho w e v e r , change the details of how need not have “money” stored on ities, as banks are now required to do mo n e t a r y policy is implemented, as it, though; personal identification for other nondeposit products like pr evious financial innovations, like or medical information, for exam- ple, can also be stored on the card. mutual funds. money market mutual funds, have. However, this article will focus on To handle these potential dispari- the stored “money” capability of ties, some analysts have rec o m m e n d - the card. ed that depository institutions alone Is There a Future for 2 See U.S. Congress, p. 23. 3 be allowed to issue stored-value bal- These Cards ? See U.S. Congress, p. 30. ances. This action would ensure 4 While, theoretically, it might be possible to pay interest on stored- un i f o r mity of regulation and res p o n s i - Whether stored-value cards take value card balances, it is unlikely bi l i t y . Others agree. In a May 1994 off depends on their acceptability. to happen because of the cost rep o r t to the Council of the Europ e a n Merchants must be willing to accept involved in determining the bal- ance on a stored-value card at any Mo n e t a r y Institute, the Wor k i n g them as a form of payment, and con- given time. Gr oup on European Union Payment sumers must have the assurances 5 See Blinder (1995). Systems recommended that only they now have with other types of 6 The Securities and Exchange de p o s i t o r y institutions be allowed to payment instruments. Clearly, there Commission (SEC), however, issue stored-value cards. A reg u l a t o r y is some regulatory role for the gov- imposes certain portfolio restric- tions on some nonbanking institu- en v i r onment that creates confidence ernment, but what that role is has tions with transaction-like in the product or the firm issuing the not yet been determined. Most regu- accounts—money-market mutual pr oduct might also allay the public’s lators and industry proponents agree, funds, for example. co n c e r n, as the example in the sidebar though, that Congress should wait 7 Federal Reserve member banks are required to have deposit insur- demonstrates. Even with the rec o m - and allow the market to develop ance; nonmember banks usually mendation, however, recent stored - before attempting to regulate it. petition the FDIC for it. value card pilot programs overseas At recent hearings on the matter, 8 See Block (1996). have generally not met early expecta- members of Congress have acknowl- 9 See U.S. Congress, p. 18. tions because usage is below antici- edged that payment instru m e n t s pated levels and enrolling merch a n t s must be widely accepted, conve- REFERENCES has been diffi c u l t . 8 nient, cost effective, safe and confi- Blinder, Alan S. Statement before the dential to ensure wide usage. Any Subcommittee on Domestic and International Monetary Policy of the regulation should strive to attain Committee on Banking and Financial The Effect on these goals. Industry re c o g n i z e s Services, U.S. House of Represen- Mo n e t a r y Policy this too, as made clear by one of tatives (October 11, 1995). M a s t e r C a rd Intern a t i o n a l ’s senior Block, Valerie. “Smart Cards Off to a Bumpy Start, Critics Say,” American In all likelihood, it would not be vice presidents, Heidi Goff: “The Banker (January 17, 1996). too difficult to take stored-value card bottom line is, consumer trust is U.S. Congress, House of Represen- balances to the next step: person-to- key to our continued success.”9 tatives, Committee on Banking person exchange of balances without Stored-value card balances will and Financial Services, Subcom- mittee on Domestic and Interna- first ret u r ning them to the issuer for also not likely replace cash as a tional Monetary Policy. The Future cr edit. This action would make the means of payment. Although there of Money—Part I, Serial No. 104-27, balances function much more like may be some who see cash becoming 104 Cong. 1 Sess., (July 25, 1995). cu r ren c y , although at some point a useless relic, others understand that Wenninger, John and David Laster. “The Electronic Purse,” Current final settlement would be req u i re d it will continue to serve an impor- Issues in Economics and Finance, th r ough the banking system. How- tant role. Electronic mail is a good Federal Reserve Bank of New York ev e r , once it reaches a point at which analogy. Although e-mail has (April 1995). these balances do trade among con- become a popular communications Working Group on EU Payment Systems. Report to the Council of sumers and firms without immedi- tool, the U.S. Postal Service is still the European Monetary Institute on ately passing through banks, a system operating and widely used. Prepaid Cards (May 1994). of private currency that could poten- Finally, it behooves potential pur- tially compete with cash will have veyors of electronic currency to lay been established. out all the issues regarding its usage This emergence of private currency up-front because only informed con- in the United States would not be sumers and merchants will venture new, however; traveler’s checks are a into this territory. The early interna- form of private currency that is famil- tional evidence shows that the iar to everyone. Historically, private stored-value card pilots have not currency has existed in the economy been as successful as anticipated. at various times, which begs the This suggests there is a slow learning question, how might it affect mone- that all involved must go tary policy? through for the cards to be success- Bl i n d e r , in his testimony before ful. It also says, perhaps, that people Co n g r ess, stated that it is most un- aren’t ready to part with their hard likely that, “What amounts to a form currency just yet. of private currency might damage the Federal Reserve ’ s control of the Adam M. Zaretsky is an economist at the money supply and lead to inflation- Federal Reserve Bank of St. Louis. Thomas A. ar y pres s u r es.” Assuming the emer- Pollmann provided research assistance.

9