As part of an ongoing program to discuss payments system developments and barriers to innovation with a range of parties, the Federal Reserve System's Payments System Development Committee (PSDC) hosted a roundtable discussion with industry leaders on stored-value cards and other prepaid products.¹ The roundtable discussion was held at the Board of Governors of the Federal Reserve System in Washington, D.C., on November 12, 2004. The roundtable focused on current and emerging designs for stored-value and prepaid products, lessons learned from the evolution of prepaid cards over the past few years, and emerging trends in usage. The participants also discussed challenges to future development.

The discussion began with an overview of the stored-value and prepaid industry, including market developments, current trends, and expected areas of growth. Following the overview, twelve industry experts, representing retailers, processors, networks, banks, and the legal profession, provided the PSDC with insights into these developing payment instruments.² The participants discussed three overarching issues: the business case for prepaid cards, infrastructure issues, and the legal and regulatory environment. This document summarizes the industry overview and the major themes from the roundtable.

Industry Overview

For purposes of the roundtable, the terms "stored value" and "prepaid" were specifically defined. The term stored value was associated with products for which prefunded value is recorded on the payment instrument. The term prepaid was associated with products for which the prefunded value is recorded on a remote database, which must be accessed for payment authorization. So defined, the term prepaid describes most of the products on the market today. There are a variety of applications for prepaid cards, including gift cards, payroll cards, flexible spending account cards, government benefit cards (such as food stamps), insurance claim cards, employee reward cards, travel cards, remittance payment cards, and transportation cards. Most prepaid cards serve a single purpose, but there are a few cases in which multiple prepaid functions are combined on one card. In addition, some cards, such as payroll cards, government benefit cards, and transportation cards, can be reloaded with value, while other cards, such as travel cards, insurance claim cards, and most gift cards, cannot.

Prepaid cards have largely served as a replacement for paper-based payment instruments and related devices, such as gift certificates, paper tickets and tokens, and check-based rebates. Closed-system prepaid products began in the early-1970s with transit and college campus cards.³ In the late 1980s, prepaid phone cards emerged in the United States, followed by closed-system gift cards in the mid-1990s. Open-system prepaid cards began in the early 1990s with Electronic Benefits Transfer cards replacing paper-based food stamps. Open-system gift cards were introduced in the mid-1990s. The highly-visible but unsuccessful VisaCash and Mondex stored-value card trials took place in Manhattan, N.Y., in 1997. Since the mid-1990s, providers have developed open-system prepaid cards designed to streamline payroll disbursements, facilitate remittance payments by immigrants to relatives through ATM networks, and simplify the disbursement of funds from pretax flexible spending accounts for health care expenses. Overall, closed-system products have been in existence for several decades and have been relatively successful in meeting particular market needs. In contrast, open-system products are still developing, and some providers are struggling to establish viable business cases.

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Participants in the prepaid market include end users, banks, processors, and networks. End users, which include employers, employees, retailers, and consumers, buy or sell the various prepaid products. Banks typically issue open-system prepaid products and provide services, including risk management and settlement of underlying payments, to end users (their customers). Processors offer services to banks and end users that include the processing of payment transactions, such as providing real-time payment authorizations and managing customer service call centers. Networks provide, among other services, the connection between the retailer or ATM and the processor for authorization of payment transactions. The parties to a prepaid transaction can realize different benefits, such as increased convenience, cost savings, or revenue generation, but can also face challenges, such as achieving a sustainable business case, funding system upgrades, and navigating an evolving legal and regulatory environment.

Although the overall popularity of prepaid products was noted as rising, participants predicted in the near term that the market would be fragmented and that sustained profitability may be limited to certain applications. At the same time, participants believed that there would be ongoing experimentation with products. Participants also thought that the most successful prepaid products would likely be closed-system gift cards, payroll/general purpose cards for the underbanked, remittance cards, and medical benefit/flexible spending account cards.

Major Themes

Business Case
Participants noted that, in general, prepaid products are less profitable to issuers than other payment instruments such as credit or debit cards. The profitability of prepaid cards appears to vary significantly by product type, such as gift cards and payroll cards. Profitability can also vary within the same product category, as in the case of gift cards. A participant reported that closed- and open-system gift cards have very different revenue and cost structures and that profitability for open-system gift cards in particular is limited. Another participant made the point that customer acceptance of gift cards does not indicate acceptance of all prepaid products and that acceptance will likely vary by individual product.

One participant suggested that some open-system providers are currently offering prepaid products at little or no profit because they see long-term potential for these products. Participants also mentioned that issuers and processors are developing agreements to share the implementation risk of prepaid products to help spread potential losses if they are not successful. Participants generally agreed that prepaid programs can be costly to operate. For instance, open-system providers find it challenging to recover customer service and marketing costs, which participants identified as two significant costs associated with prepaid cards. In addition, most prepaid cards have not achieved the same economies of scale as credit or debit cards. One participant suggested that in the future there may be a consolidation of processors leading to greater scale economies. One participant also emphasized the need to partner with providers to help defray costs.

Several participants expressed concern about fraud risks associated with open-system prepaid cards. Participants specifically cited fraud risks with transactions that occur internationally where fewer retailers perform on-line payment authorizations if the transaction value is under a certain value threshold. One participant noted that because profit margins for prepaid products are slim, even small fraud losses can adversely affect the business case for offering prepaid products.

At the same time, several participants were optimistic about the future development of the prepaid card market. One participant predicted that upcoming innovations would lead to more business-to-business prepaid products and more multifunction cards. Another participant believed that closed-system gift cards and flexible spending account cards showed the greatest potential for achieving a profitable business case. This participant, in particular, believed that regulatory changes could create significant opportunities to create new prepaid products, especially products related to health care.

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Participants also thought that the underserved market represented a significant opportunity for providers of prepaid products. An industry representative defined the underserved market as consumers who chose not to use banking services, who are only allowed to use specific services because of age restrictions, or who are unable to access banking services because of poor credit history or legal status in the United States. This participant believed that prepaid cards offered underserved consumers the ability to make Internet payments--purchases and bill payments--and to learn about financial transactions, fostering financial literacy and potentially facilitating the introduction of these consumers into the financial mainstream.

Payroll cards were specifically highlighted as one opportunity to aid the underserved. One participant, however, raised concerns about the value of payroll cards for this group. This participant's company had apparently chosen not to issue payroll cards to its employees because the company believed that the cost of the cards to the employees was higher than available alternatives. For example, providers may charge the cardholder fees to access the customer service call center, to withdraw funds at a bank branch or through a nonaffiliated ATM, and to make purchases at the point-of-sale. This participant estimated that the cost to recipients could potentially be hundreds of dollars annually depending on the program. One participant also thought that users of payroll cards were often unaware of these fees.

Infrastructure
In general, the dual existence of closed- and open-system gift cards, which use different infrastructures for processing, has created challenges for retailers, issuers, and payment networks. Participants mentioned that consumers’ expectations have often been set from their experiences with highly developed closed-system gift cards and that consumers expect similar services from open-system gift cards. Significant infrastructure investments, however, may be necessary to ensure that open-system gift cards function similarly to closed-system cards. In particular, open-system systems have typically been designed to process credit or debit cards and are still evolving in their processing of prepaid cards.

One participant, for example, mentioned the challenge of processing open-system gift cards when the amount of the purchase is greater than the balance on the card. In a closed-system gift card transaction, the balance on the card is automatically checked during the purchase. If the amount of the purchase is greater than the balance, the retailer will debit the gift card balance and use another payment method for the remaining amount of the purchase. In an open-system gift card transaction, however, the issuer will likely deny the purchase authorization if the purchase amount exceeds the balance on the gift card. In that case, the retailer (or customer) must contact the issuer to obtain the balance information and then resubmit an authorization request for only the amount remaining on the gift card. The balance inquiry may also be subject to fees, depending on the gift card agreement.

This participant also mentioned challenges when customers return or cancel a purchase made with an open-system gift card. Based on experiences with closed systems, customers frequently expect immediate credit. For open-system cards, however, it may take several days for the issuer to release funds unless the retailer calls the issuer at that time and provides information about the transaction. This participant, emphasizing how critical the point-of-sale experience is to retailers, stated that when problems with purchases or returns occur, customers frequently associate that poor experience with the retailer rather than the gift card issuer or the processing network.

Another participant noted that some issuers have begun to provide balance information in the denied transaction message to retailers. Many retail payment terminals, however, are not currently programmed to accept this information. Some participants suggested that issuers and networks should share the cost of upgrading this infrastructure instead of placing the costs solely on the retailer.

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One participant also raised the issue that retailers have little choice but to accept open-system gift cards if they also accept debit cards because of conditions imposed by the card networks. Another participant expressed frustration with the cost of accepting open-system gift cards. This participant believed that the merchant fees assessed to retailers were excessively high for a product that was paid in advance to the issuer and thus carried lower risk than, for example, credit cards. For these reasons, this participant explained that retailers have little incentive to upgrade their infrastructure to facilitate open-system gift card use, especially because open-system cards compete with retailers’ gift cards.

One participant suggested that, in hindsight, more information could have been provided at an earlier stage to consumers and retailers regarding the current features and limitations of open-system gift cards. The same participant also mentioned a continuing need to better inform retailers about new products. Another participant recommended that it would help to consult retailers about future developments of open-system prepaid cards.

Laws and Regulations
Participants cited a lack of clear and consistent federal or state legal and regulatory requirements for prepaid products. Participants stated that uncertain legal and regulatory conditions may stifle innovation in the industry, as compliance with an increasing number of laws and regulations, particularly at the state level, may make products too expensive to offer. Participants also remarked that current regulations do not adequately differentiate between types of prepaid products, which may have very different risk characteristics for the general public.

The growth and development of prepaid products have increasingly gained the attention of federal and state legislators and regulators. Over the past several years, states in particular have introduced an increasing number of laws aimed at prepaid products. States have also attempted to clarify whether existing laws cover prepaid products. Participants stated that the proliferation of laws and regulations has caused significant confusion for the industry. One participant noted that because laws and regulations are being enacted piecemeal, they conflict with each other at times, making adherence to all rules and regulations difficult and costly. Another participant predicted that if all prepaid card programs were regulated at the federal level, and not the state level, that the cost of regulatory compliance would ultimately decrease. Other participants expressed concern that greater federal and state regulation could hinder market development. These participants instead stressed the need for greater consistency among existing laws and regulations and their interpretation.

Participants cautioned that additional regulations could ultimately lead businesses to discontinue offering some products and could reduce the development of new products. They noted that some providers are hesitant to provide new prepaid products because of regulatory cost concerns and warned that if certain proposed changes to regulations were implemented, some providers would exit the prepaid market. Participants highlighted three examples of laws and regulations that they believe could increase operating costs and potentially inhibit future innovation in the prepaid market: an expansion of Regulation E’s periodic statement requirements, an FDIC ruling that funds underlying prepaid products constitute deposits for FDIC purposes, and the uncertain applicability of some state money transmitter laws.

One participant noted concerns about the periodic statement requirement in Regulation E, which would apply to payroll cards if the Federal Reserve Board adopts its proposed rule.⁴ Some participants stated that payroll cardholders tend to be more transient than the general population and thus it is likely to be costly and challenging to supply periodic statements through the mail. One participant argued that by the time the cardholders received the account information, it would be out of date and thus of little use. Another participant stated that because payroll cards are not deposit accounts, there should be greater flexibility in providing periodic statements.

Participants also raised concerns that the periodic statement requirements in Regulation E would be applied to other types of prepaid products, specifically gift cards. Participants warned that providers would exit the gift card market if periodic statements became mandatory. Participants also noted that providers have no way of knowing the identity of the gift card receiver and often do not track the identity of the gift card purchaser, thereby making it difficult or impossible to provide periodic statements.

Several attendees mentioned the FDIC proposal to consider funds underlying prepaid products as deposits for FDIC purposes.⁵ While one participant thought that this proposal was inconsistent with the FDIC General Counsel’s previous opinion, it appeared that participants were somewhat less concerned with the specific proposal as it might be applied by the FDIC than with the widespread implications of the proposal for other regulatory authorities. For instance, one participant noted that some regulators, particularly state regulators, were suggesting that their regulations should conform to the FDIC’s definition of deposit. Following the FDIC proposal, some states began claiming that the issuing and reloading of prepaid products constituted accepting deposits, which implies that issuing locations may be engaged in branch banking. This participant explained that the intent of the FDIC proposal was to define the underlying funds as deposits for FDIC purposes only and not to define the funds as deposits for all purposes. Another participant recommended that the Federal Reserve Board issue a clarifying statement in light of the FDIC proposal regarding the definition of a deposit under Regulation D, which relates to reserve requirements.

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Some participants also expressed concerns over state money transmitter laws as they relate to prepaid products. In 2001, a provision of the U.S. Patriot Act amended the United States Code on crimes and criminal procedure, making it a federal crime to illegally operate an unlicensed money transmitter business in a state that requires a license–regardless of knowledge of the state law. Some state money transmitter laws, however, are not clear about whether they apply to prepaid products. This lack of clarity is a significant concern for nonbanks and state-chartered banks. One participant also noted that one state is challenging whether national banks should be subject to its money transmitter requirements, if the bank offers prepaid products in its jurisdiction. This participant expressed the view that national banks should not be subject to money transmitter requirements because federal law preempts state law requirements. This participant further stated that the only way to confirm that there is federal preemption for national banks might be to sue the state, something that banks are reluctant to do.

Conclusion

Significant changes are taking place in the payments system.⁶ The growth of electronic prepaid products over the past few years is just one example of the changes taking place. This change is the result of changing payment habits and business opportunities, new technology and innovation, and the evolving legal and regulatory framework.

The prepaid card industry is growing, but several challenges remain for market participants. One critical challenge is for providers to achieve economies of scale that would help decrease the costs of providing prepaid products. Currently, prepaid products vary widely in cost and revenue potential, and some products are apparently only marginally, if at all, profitable. Providers also face the challenge of funding upfront investments in technology, infrastructure, and consumer education. Such fixed costs can be difficult for providers to absorb in the short term until the public widely adopts new products. In the past, however, consumers have moved slowly in adopting new payment innovations. Failure to reduce costs, increase profitability, and address some of the business challenges noted above could lead to fewer providers and might ultimately hinder innovation.

Because prepaid products vary significantly, a "one size fits all" regulatory approach may not best fit the needs of the industry or best address the risks associated with these products. The committee encouraged the industry to continue to educate lawmakers and regulators on prepaid products and their characteristics. The committee does not believe that regulation should unduly hinder innovation. The committee also recognized that the industry is concerned about the potential connection between the FDIC proposal to define funds underlying prepaid products as deposits and Regulation D. The FDIC’s rule implements a different statute (the Federal Deposit Insurance Act) with a different purpose than does Regulation D, which implements the reserve requirement provisions of the Federal Reserve Act. The committee noted that the FDIC’s definition of deposit would not necessarily predetermine the definition of that term under Regulation D.

In concluding the roundtable, the committee requested that the participants stay in touch with Federal Reserve System staff on developments in the prepaid industry. It also encouraged the participants to identify areas where the committee and other relevant authorities may help to support development of payments system innovation.

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1. The Board of Governors of the Federal Reserve System established the Payments System Development Committee in July 1999. The committee serves as a forum for the analysis of technological and market trends, provides a mechanism for consultation with payments system providers and users, and advises the Board and other Federal Reserve System officials on medium- and long-term public policy issues relating to consumer, government, and corporate payments. In particular, the committee seeks to work collaboratively with the private sector to help identify barriers to innovation in the payments system, identify strategies to enhance the long-term efficiency of existing U.S. payments systems, and develop strategies for transition to the next generation of electronic payments. The members of the committee are Roger Ferguson (co-chair), Vice Chairman of the Board of Governors of the Federal Reserve System, Gary Stern (co-chair), President of the Federal Reserve Bank of Minneapolis, Michael Moskow, President of the Federal Reserve Bank of Chicago, Christine Cumming, First Vice President of the Federal Reserve Bank of New York, and Patrick Barron, First Vice President of the Federal Reserve Bank of Atlanta. Return to text.

2. The organizations represented at the roundtable were American Express, Bank of America, Federated Department Stores, First Data Corporation, J.P. Morgan Chase, KMZ Rosenman, McKinsey & Company, Morrison and Foerster, TSYS Prepaid, Visa U.S.A., Wegmans Food Markets, and WildCard Systems. Return to text.

3. "Closed-system" or "private-label" prepaid products are limited to a defined merchant or location (or set of locations), such as a specific retailer or retail chain, a college campus, or a subway system. "Open-system" or “general purpose” prepaid products, such as gift cards, payroll cards, and travel cards, can generally be used at any location that is connected to the particular card network, such as Visa, MasterCard, American Express, or Discover. Although still considered open-system prepaid products, some products restrict where and how the cards may be used. For example, a flexible spending account card can only be used for eligible medical purchases. Return to text.

4. See Federal Register: September 17, 2004 (Volume 69, Number 180). Return to text.

5. See Federal Register: April 16, 2004 (Volume 69, Number 74). Return to text.

6. See the 2004 Federal Reserve payments study. Return to text.