E-money and Prepaid Debit Cards

As was well reported in the press at the time, the US relief effort in the wake of Hurricane Katrina at the end of the summer in 2005 was much criticised.  However, among the few positive stories was the Federal Reserve’s decision to distribute prepaid debit cards to households as an alternative to distributing cash relief to those affected by the disaster.

Following success in the USA, a number of companies have launched prepaid debit cards in the U.K. over the last few years.  In its recent review of the E-money Directive, the European Commission expressed the view that the e-money market, of which the prepaid debit card market forms part, had evolved in ways unforeseen at the time of adoption of the directive.[1]   This article reviews some of the commercial and legal issues concerning the prepaid debit card market.

Prepaid Debit Cards – What Are They?

Prepaid debit cards are normally plastic cards which can be used to make payment for goods or services and/or withdraw money.  Before use, the user needs to load the card with a sum of money which can then be subsequently spent. 

There are inevitably numerous variations on this theme.  From a functional perspective, the industry distinguishes between store-valued cards, where the value of the load is stored on the card itself (eg Oyster card), and or a server-based cards, where the value of the load is stored on a server (eg PrePay Technologies’ 360 money and Post Office ® Travel Money Card).  Server-based cards require technology providers and communication systems which enable real-time determination of unspent balances. 

The industry also distinguishes between open loop cards, which can be used at any merchant acquirer within a payment scheme such as MasterCard or VISA, and closed loop cards, which can be used only at defined outlets, such as the retail outlets of a high-street brand. Semi-closed or semi-open loop cards are somewhere in the middle – examples include shopping centre cards, where the card can be used at outlets within a defined shopping centre.  Cards can also be non re-loadable and re-loadable, personalised and non-personalised.

Markets, Players and Financial Models

As a form of payment, there are various markets for such cards.  For example, they can be used as a replacement for a credit card or debit card to be used at merchants or ATMs where the relevant payment scheme branding is displayed.  They can be used in the travel industry as a replacement for travellers’ cheques and in the corporate incentive market where the incentive company issues e-money to cardholders under a corporate incentive programme.  The electronic gift card market replacing paper vouchers is also seen by many as a huge potential market in the light of its success in the USA, where it is reported the market has grown 20-25% a year over recent years. One of the most successful single uses in the UK is the Oyster card operated by Transport for London, although recent attempts to procure strategy partners for widening its use have run into difficulties.

The industry players can be broken down into a number of categories. First, there are banks and building societies, which have traditionally been active in the debit and credit card market and which are, or are looking to become, issuers of prepaid debit cards.  Second, there are electronic money institutions (or ELMIs), which are authorised to issue e-money (and e-money on prepaid debit cards), but are not banks or building societies.  Currently there are very few ELMIs for the reasons elaborated below.  Third there are other issuers of prepaid debit cards which do not involve the issue of e-money for the purposes of the regulatory regime, such as retail outlets issuing closed loop gift cards. Fourth are the processors, the technology providers.  The final category includes the co-branders or affinity partners.  These are companies under whose brand the cards are marketed, but which rely on an authorised firm to issue the cards to their customers.

The various industry players earn their money from these products in a number of ways. There can be fees for purchase of a card, loading, re-loading, usage and on-going service fees.  Interest can be made from holding the load prior to usage. Income can also be earned from what is called ‘breakage’, unused amounts loaded on to cards which expire although this is not favoured by the regulators.

Structuring Prepaid Card Programmes

The partners and contractual arrangements for a prepaid debit card programme are dependent on the functionality of the card, regulation and know-how.  Businesses which wish to issue cards for limited use, such as a retail outlet gift card, can issue the cards themselves to their customers.  In addition, they need to enter into contractual arrangements with a processor, which has the technology and expertise to operate the programme. 

Where the issue of the prepaid debit card involves the issue of e-money as defined by the regulatory regime, then a business needs to become authorised to issue the card, or enter into a services contract directly or indirectly with an ELMI or a bank or building society authorised to issue e-money.  The ELMI or bank will issue the e-money and the prepaid debit card. The prepaid debit card will be branded with the logos of the business, just like any other branded financial services products.  If a business wants to operate a card which can be used with payment schemes such as MasterCard or VISA, it will invariably need to enter directly or indirectly into a contract with a member of the relevant payment scheme, normally a bank.

Some banks have teamed up with processors with expertise in the prepaid debit card market. The processor or bank finds and contracts with companies interested in operating a product, with the bank having overall regulatory responsibility for the card programme. 

The issuer of the card will typically have the contractual relationship with the end user.

Regulation and Impact on Business Models

The regulations which have the main effect on business models for prepaid debit cards are the rules set out in the electronic money handbook (ELM Handbook and ELM Rules) implementing the E-Money Directive[2] and money-laundering regulations.

In broad terms ELM Rules apply if a business is issuing electronic money.  Electronic money is monetary value as represented by a claim on the issuer which is (a) stored on an electronic device; (b) issued on receipt of funds; and (c) accepted as a means of payment by persons other than the issuer.

The third limb in the definition is crucial.  For example, a gift card issued by a retail outlet and only for use as a payment at that business is not e-money.   The precise scope of e-money has been in debate over the years, not only for prepaid debit cards but also for other forms of e-money.  Discussion concerning payment services of mobile network operators resulted in guidance from the Commission clarifying that certain network payment services fall outside the regulatory regime. The FSA has issued guidance following this approach, and provided guidance on electronic travellers’ cheques and circumstances where e-money regulations do not apply.[3]   

There are also exemptions for small money issuers where there is a purse limit of £150 and a waiver arrangement, where companies can apply for a waiver.

As is to be expected, the ELM rules cover areas such as authorisation, capital requirements, systems and controls, and restrictions to protect the consumer.  The extent to which the rules apply is also dependent on whether the issuer is an ELMI or a bank or building society.

There are a number of key areas of regulation which affect the structure and operation of prepaid debit card programmes. 

Restrictions on business

If the issuer is an ELMI and not a bank or building society then it cannot undertake business activities other than issuing e-money.[4]  This rule, along with other prudential requirements, has meant that there are very few ELMIs in the UK, and that the most likely issuers of e-money are banks and building societies.  The latter are subject to fewer rules in the ELM handbook because they are already subject to a more stringent regulatory regime applying to deposit takers.

Float Requirement for ELMIs

In general terms, the e-money float requirement means that an ELMI is required to hold qualifying liquid assets of a value no less than the amount of e-monies outstanding.   This rule is in place to ensure that the ELMIs have sufficiently liquid financial assets, such as cash, to meet its financial commitments to its customers.  The rule does not apply to banks and building societies.  Inevitably in any programme there is a time lapse between payment by a customer to load monies on to his or her card, and that money reaching the issuer of the card.  An ELMI may therefore need to ensure it has pre-funding in place and a buffer in place to accommodate potential loads onto cards before they receive this money. 

ELMIs issuing e-money for co-branded schemes may require the co-brander to provide the pre-funding and buffer.  While the rule does not apply to banks and other building societies, such issuers may prefer to have similar arrangements to ensure that, for programmes they operate for third parties, they hold sufficient cash at all times to meet the balances on prepaid debit cards.

Purse limits and risk of loss

A cardholder is at risk if the issuer becomes insolvent.  E-money is not covered by a compensation scheme.  Similarly a cardholder is at risk if he or she loses the card.

ELM rules therefore distinguish between e-money which has a maximum load capacity of £1,000 or more and those under this threshold.[5]  For those which are over the threshold, issuers need to warn customers in writing and obtain an acknowledgement.  The issuing of this notice and the need for an acknowledgement (preferably signing an acknowledgement or by way of a tick box if the application is online) dictates the application process.  The issuer for such cards also needs to have processes and technology in place to ensure that the loss, malfunction, theft or damage will not result in the holder losing any e-money, the issuer can prevent a cardholder from using the money, and the issuer maintains the identity of the cardholder.

Redemption requirements

Customers of e-money have a right not to spend the money on the card, but request a redemption of the outstanding balance.[6]   This means that processes need to be in place to arrange redemption, and redemption in the currency in which the e-money is denominated, and paid in cash or by electronic transfer to an account.  For a travel prepaid debit card denominated in a currency other than sterling, for example euros, then the issuer will need to ensure that the cardholder can redeem the card in euros (for example over a counter).  Redemption rights must also not be unreasonably difficult.  This means that the methods of redemption for cash and/or transfer need to be similar to the methods of purchasing or loading the card.

Money Laundering and Cancellation

Money laundering requirements also have an effect on the setting of card limits.  Issuers do not need to undertake customer checks for cards where the aggregate capacity load currently does not exceed £5,000. 

Cancellation rules also apply for products sold at a distance.  These again influence the technology, processes and models used by issuers of prepaid debit cards.

Other Contractual Issues

Agreements between financial institutions and processors, and co-branders and prepaid card issuers, need to cover typical issues such as allocation of responsibilities, service level agreements, approval processes and change management procedures.

Ownership of the programme, customers and prior authorisation of changes can cause tension in co-branded arrangements, which require an authorised issuer of the card to issue directly to the co-brander’s customers.  The co-brander will view the customers and the data from the programme as its own.  At the same time the issuer of the card will have the contractual relationship with the customer, and responsibility for regulatory compliance.  While this tension is similar to other co-branded financial services products, it can be accentuated in the pre-paid debit card market due to the increased number of uses and new users for the products.  Solutions include customer data sharing and contractual restrictions on use and licensing of customer data, obviously subject to data protection compliance.

The contract also needs clearly to define responsibility for collection, payment and return of funds, and the times and dates by which they need to be achieved. 

The Future

While the European Commission’s independent evaluation reported the sentiment that e-money market had developed more slowly than expected, the industry is optimistic of the benefits of prepaid debit cards over cash, and its increased usage potential.[7]  Indeed a number of financial institutions and processors are investing heavily in this happening. 

In its review of the E-Money Directive, the Commission has proposed changes to clarify when the rules apply and to reduce the barriers to entry and controls on ELMIs. The Commission is proposing to include these new rules in the proposed Payment Services Directive,[8] which is intended to harmonise payment services across the EU  for e-money; the Commission is proposing to change the definition of e-money in areas of uncertainty, and to exclude from the regime certain payment services of mobile network operators and electronic vouchers.  The proposals also include a reduction on restrictions of the float and on other business activities for ELMIs.  

If the usage in the USA is anything to go by, the UK market should see some significant growth in the use of pre-paid debit cards over the next five years, hopefully supported by a balanced regulatory regime.

 

Yuban Moodley is a senior solicitor in the TMT Group at CMS Cameron McKenna LLP.  He has advised on a number of pre-paid debit card programmes.