Emerging models Why has stored - value not caught on ?

Why have general-purpose stored-value cards been unsuccessful in penetrating the U.S. market? Three necessary conditions for a payment instrument to be successful are discussed: consumers and merchants need to be convinced of its advantages over existing payment alternatives for at least some types of transactions; payment providers must convince consumers and merchants simultaneously of its benefits to achieve critical mass; and assure them that adequate safety and security measures have been implemented. This article discusses the credit card industry’s success in meeting these necessary conditions and general-purpose stored-value issuers’ failure to meet them to date. 39 1 I thank Victor Lubasi and Leonardo Mayer for their excellent research assistance. The views expressed are the author’s and should not be attributed to the Federal Reserve Bank of Chicago or the Federal Reserve System. Why has stored-value not caught on? Advances in computing power, electronics, and telecommunications have improved the way we live. Now such advances have started to change the way we pay. Technological advancements now make it possible for consumers to purchase goods with electronic bits of information representing money, commonly referred to as stored value. The value may be stored on microchips embedded in plastic cards that look similar to credit cards. This type of stored value device is called a smart card. According to an article seven years ago, ‘Smart cards are set to revolutionize payment systems and provide a plethora of new opportunities’ [Talmor and Timewell (1997)]. Another article in the popular press stated that ‘Cash is dirty, inefficient, and obsolete. Smart cards, digital cash and a host of electronic currencies will soon replace pocket money’ [Gleick (1996)]. This article asks the question: Why have general-purpose stored-value cards not been widely adopted as some analysts had expected? I will compare the credit card industry’s success in meeting three conditions necessary for widespread adoption with the stored value issuers’ failure in meeting these conditions to date in the United States. Financial analysts have predicted the death of cash and other paper-based payment instruments for many years. Cash usage has started to decline. According to an American Bankers Association/Dove Consulting Study, cash usage has declined from 39 percent to 32 percent for in-store payments [Sapsford (2004)]. Part of this decline results from greater acceptance of payment cards, such as credit and debit cards, at merchant locations that traditionally had not accepted them. In the United States and most parts of the world, limited-use stored-value cards have been successful as cash substitutes for some niche markets, such as transportation systems, university campuses, and military bases. Smart card issuers along with producers of the technology have made sizeable investments to establish smart cards as a viable payment instrument. The migration to chip cards from magnetic stripe ones have been aided by the reduction in the cost of producing smart cards. Payment card organizations, such as MasterCard and Visa, along with banking and nonfinancial institutions have invested significant amounts of money into stored-value technology in an effort to provide electronic substitutes for government-issued physical cash. MasterCard reportedly had invested over U.S.$150 million to purchase 51 percent of Mondex International, an electronic cash system developed in the United Kingdom by National Westminster Bank [Hansell (1998)]. National Westminster spent more than U.S.$100 million developing Mondex [Stouffer (1996)]. Stored-value issuers hope to earn interest from outstanding stored-value balances, earn fees from merchants, and possibly revenues from advertising on the physical card. However, issuers will have to convince consumers and merchants why they should use stored value. Issuers argue that their product would be more convenient for consumers and reduce costs of processing payment for merchants. Most analysts agree that the two largest U.S. stored-value trials, the Atlanta Olympic Games and the Upper West Side of Manhattan, failed in convincing consumers and merchants of the benefits of using stored value over existing payment alternatives. The Economist (1998, 73) concluded that, ‘Electronic money has thus turned out to be a solution in search of a problem.’ While general-purpose stored-value has not been successful in the United States, many European countries have implemented such payment instruments with varying degrees of success. This article will address some factors that have lead to adoption of stored-value payment instruments in some countries but not others. The necessary conditions Consumers and merchants are reluctant to change their preferences towards payment instruments. In the context of the issuance of new coinage, Jevons (1875) wrote, ‘No one can possibly understand many social phenomena unless he constantly bears in mind the force of habit and social conventions. This is strikingly true in our subject of money.’ Furthermore, Evans and Schmalensee (1999) observe that in the last 4000 years there have been only four major innovations in the way 2 General-purpose stored-value payment cards are defined as those that are widely adopted by merchants and consumers where the value resides on the card and is transferred to the merchant’s terminal at the time of purchase. Unless otherwise stated, stored-value cards will be short for widely-accepted stored-value cards in this article. 40 The Journal of financial transformation Why has stored-value not caught on? we pay. These four major innovations are: coins (4,000 years ago), checks (800 years ago), paper money (more than 100 years ago), and the payment card (over 50 years ago). Three important conditions must be met before stored value is widely used. Firstly, consumers and merchants need to be convinced that stored value is superior to existing payment instruments for certain types of payments. Generally, stored value payments substitute for cash payments. Stored value has been a successful alternative to cash in closed loop systems, such as transportation service purchases, coffee purchases at certain popular coffee chains, and for purchases on university campuses and military bases. Nilson (2003) estimates that prepaid cards, which include stored-value cards for limited use and phone cards, accounted for U.S.$55 billion in 2003 and predicts that this figure will grow to U.S.$146 billion in 2007. Secondly, as with the introduction of any new payment instrument, to achieve critical mass, consumers and merchants need to be convinced simultaneously. That is, consumers will not use stored value unless a sufficient number of merchants accept it and merchants will not accept it until a sufficient number of consumers use it. An example of the inability of a payment instrument to overcome the chicken-and-egg problem is the Susan B. Anthony dollar coin. Because coins remain in circulation much longer than bills, they are less expensive for currency issuers to provide in the long run. Unlike most countries, the United States has been unsuccessful in replacing lower denomination bills with coins. McAndrews (1997) argues that Canada, like other countries, was eventually successful with its dollar coin because the central bank started to withdraw notes from circulation. Thirdly, with any payment instrument, consumers, merchants, and financial institutions are concerned with credit and fraud risk. For our purposes, credit risk is the risk that the payee is unable to convert a payment into good funds. The inability to acquire good funds may result from the payer, a payment intermediary, or the issuer’s inability to process or make good on its obligation to deliver. Fraud risk is the risk that an unauthorized user is able to use the payment system for financial gains or a participant in the payment process presenting a monetary claim that is not backed by the value stated. An important issue with credit and fraud risk is the allocation of monetary losses when it occurs. Consumers and merchants prefer that the liability lies with the payment service provider. Payment instruments with this characteristic may also penetrate the market quicker. In the case of credit cards, government regulations determine the maximum liability to the consumer if the card is used by an unauthorized user. Today, the card networks have further reduced the consumer’s liability for unauthorized use to zero.