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The electronic purse

Article in IEE Review · February 1995

DOI: 10.1049/ir:19920133 · Source: RePEc

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April 1995 Volume 1 Number 1

The Electronic Purse

John Wenninger and David Laster

The electronic purse, a new payments instrument offering advantages to both consumers and
merchants, may soon replace currency in many routine transactions. Widespread use of the
electronic purse could, however, raise concerns about consumer protection and the safety
and soundness of the instrument.

Today a U.S. consumer making a purchase can choose regional telephone companies have begun selling pre-
from as many as five principal means of payment: paid calling cards. Applications such as these, which
check, cash, credit card, debit card, or automated clear- offer only one or a few possible uses, are known as
ing house (ACH) debit. In recent months, several major “closed systems.” An “open system,” by contrast,
financial institutions have announced plans to develop allows consumers to use a single card in a variety of
yet another payments instrument—the electronic purse, locations for a broad range of purchases. When used in
or stored value card. The electronic purse is a multi- an open system, a prepaid card is commonly known as
purpose prepaid card the size of a credit card. If suc- either an electronic purse or a stored value card.
cessful, it might fundamentally alter the way in which
An electronic purse system might work as follows.
people spend money, much as automated teller
A bank issues stored value cards to its customers, who
machines (ATMs) have changed the way that individu-
then transfer value from their accounts to the cards at
als conduct business with banks.
an ATM, a personal computer, or a specially equipped
This edition of Current Issues explores how an elec- telephone. The electronic purse card might also func-
tronic purse system might work, why such a system tion as an ATM card or a credit card. When making
should prove attractive to consumers, merchants, and purchases, customers pass their cards through a ven-
issuers, and what difficulties it might present. The arti- dor’s point of sale terminal. No credit check or signa-
cle also reviews several interesting policy issues raised ture is needed; validation, when required, is by per-
by the introduction of the electronic purse in the mar- sonal identification number. Funds are deducted
ketplace. directly from the cards and transferred to the vendor’s
terminal. Merchants can transfer the value of accumu-
lated transactions to their bank accounts by telephone
How an Electronic Purse Works as frequently as they choose. When the value on a card
For more than a decade, prepaid cards have been used is spent, consumers can load additional funds from
in the United States in a variety of single-purpose and their accounts to the card.
limited-purpose applications. The mass transit systems
of New York, San Francisco, and Washington all use Although no electronic purse system currently exists
prepaid cards. Prepaid cards are common on college in the United States, several such programs are under
campuses, where students use them for copying way in other countries. Denmark’s DANMONT card is
machines and at cafeteria checkout lines. Many now used in vending machines, phones, trains, buses,
CURRENT ISSUES IN ECONOMICS AND FINANCE

and parking meters. Finland’s Avant card, in operation because consumers would always have “exact change.”
in some cities for two years, is being phased in to cover The electronic purse would also be more convenient
the entire country. than checks or debit cards for smaller transactions.
Because it functions independently of a bank account,
Because of their modest data processing require-
the electronic purse would afford users both greater
ments, closed systems can generally operate using a
privacy and freedom from the need to record expendi-
magnetic stripe card such as those now used for credit
tures in a checkbook. The electronic purse could even
cards and ATM cards. An open system is different. To
promote budgeting because a user can spend only the
provide sufficient flexibility and protection against
amount on the card.
fraud, open systems will probably need to employ
Electronic purses also offer advantages to recipients
of government benefits. Several local government
To succeed, an electronic purse system will
agencies have begun using electronic transfers (direct
need to offer enough features of value to its
deposit) to issue benefits, and many others are explor-
three constituencies —consumers, merchants, ing the possibility. To assist recipients without bank
and issuers— to induce them to bear its costs. accounts, an agency could set up a master account at a
bank with subaccounts for its beneficiaries. Smart
smart card technology. A smart card is a plastic card, cards issued to the beneficiaries would serve as both
with or without magnetic stripe coding, that has one or account access devices and electronic purses. Rather
more computer chips embedded in it. Capable of stor- than cash a check for the full amount of their benefits
ing, retrieving, and manipulating data, smart cards are once a month at a check cashing establishment, often
used in a variety of applications such as health care and for a high fee, beneficiaries could use their cards to
security systems. withdraw funds as needed. This would reduce their
exposure to loss or theft of benefits. In providing a safe
It is not yet clear what standards fledgling electronic and convenient store of value and medium of
purse systems will adopt. System designers must exchange, electronic purses could also help benefit
choose, for example, between two distinct types of recipients in other ways. Specially programmed ATMs
smart card representing incompatible technologies: could eventually offer these cardholders new payment
contact cards, which touch a card reader when register- options, such as low-cost money orders and the pay-
ing a transaction, and contactless cards, which need ment of routine bills by ACH.
only come in proximity to a card reader. Another issue
under discussion is whether electronic purse transac- The electronic purse should also prove attractive to
tions should be traceable. Keeping a record of each merchants. It saves time and money in the handling of
transaction would help law enforcement officials track cash. Prepaid cards will likely have lower transaction
down fraudulent or black market uses of electronic fees than on-line debit cards and, unlike checks, offer
purses. Some maintain, however, that the record keep- assured payment. In addition, the electronic purse can
ing would be unduly burdensome and expensive, and reduce theft, open new markets (for example, pay-per-
could represent an invasion of privacy. They argue that view television or vending machines selling $4.98
for an electronic purse to be an attractive alternative to items), facilitate the collection of market data, and
currency, it must mimic currency’s main attributes— serve as the backbone of customer affinity programs
ease of use and anonymity. such as frequent flier miles.
Issuers of electronic purses can reduce cash han-
What the Electronic Purse Offers dling costs and combat fraud, save on-line network
To succeed, an electronic purse system will need to charges, and gain new sources of fee income from mer-
offer enough features of value to its three constituen- chants and consumers. Of potentially greater signifi-
cies—consumers, merchants, and issuers—to induce cance, issuers can collect “float,” the right to invest and
them to bear its costs. earn interest on the balances their customers hold on
electronic purses. As the uses for electronic purses and
In several market studies, consumers have expressed the number of cards issued multiply, so too will the
enthusiasm for the electronic purse concept and a gen- aggregate balances that consumers carry on the card.
eral willingness to pay either a per transaction fee of 2 The income from float could therefore be substantial.
to 5 cents or annual user fees. The major attraction for
consumers is convenience: using the card for small- Float is effectively paid by consumers and the U.S.
ticket purchases such as newspapers, coffee, and vari- government. To the extent that the balance on an elec-
ous vending machine items would reduce the need to tronic purse substitutes for demand deposits, cardhold-
carry loose change and would speed transactions ers forgo interest on their checking accounts. To the

FRBNY 2
extent that the balance replaces currency, the float (demand deposits) by an equal amount. Because the
comes at the expense of the U.S. Treasury. The reason reduction in vault cash constitutes a dollar-for-dollar
is that the Federal Reserve holds U.S. government reduction in reserves, and the lower level of demand
securities corresponding to the dollar value of currency deposits reduces required reserves by just 10 percent
in circulation and returns the interest income to the (the current reserve ratio), the bank will need to acquire
Treasury (more on this later). Over time, however, additional reserves. A withdrawal of funds into an elec-
competitive forces in the banking industry may reduce tronic purse, by contrast, merely substitutes one liabil-
the value of float to banks as banks lower fees or ity for another—an electronic purse liability for a
expand service to attract consumers and merchants to demand deposit liability. Thus, the transaction will
their prepaid card programs. have no effect on the bank’s reserve management oper-
ations provided that both liabilities are subject to the
same reserve requirements.
Some Drawbacks
As with any new technology, potential pitfalls abound. From the consumer’s perspective as well, the two
The cards or the terminals could malfunction, inconve- types of withdrawal differ conceptually. In both cases,
niencing consumers and merchants. Customers might the value withdrawn leaves a government-insured
balk at having to tie up funds and pay fees in order to demand deposit. With the currency withdrawal, how-
spend their own money. The treatment of lost and ever, the consumer receives legal tender issued by the
stolen cards could be another point of contention. Federal Reserve and backed by its holdings of U.S.
Finally, the market might fragment, creating a hodge- government securities. The value on an electronic
podge of incompatible systems requiring consumers to purse, by contrast, is not legal tender for all transac-
carry several different cards. tions. It is backed not by securities, but by the promise
If required to pay transaction fees and to buy new of the issuer to honor its value. If balances held on
card readers or retrofit existing ones, merchants could be bank-issued electronic purses were covered by deposit
reluctant to accept electronic purses as a mode of pay- insurance, however, they would be more equivalent to
ment unless their use generates enough new business to cash because their value would ultimately be backed by
justify the costs. System malfunctions could pose addi- the U.S. government.
tional problems. A failure to process transactions as
rapidly as promised would be especially troublesome for
businesses such as fast food chains and gas stations.
Issuers also face risks, of which fraud is the greatest.
If criminals learn how to counterfeit electronic purses,
the issuing banks might suffer heavy losses. Unlike
debit and ATM cards, whose transactions are con-
ducted on-line, electronic purse systems are off-line,
making it difficult to detect or track stolen or forged
cards. If this problem proves widespread, it could
destroy the profitability of issuing electronic purses.
Issuers are studying sophisticated cryptographic tech-
niques as well as the periodic recall and replacement of
cards as methods to prevent, detect, and contain fraud.

Comparison of Value Flows

The advent of the electronic purse raises the question
of how bank regulators will view the instrument. Will
the bank liabilities corresponding to the value held on
the card be reservable? Will they be subject to deposit
insurance? The accompanying figure clarifies these
issues by examining the flows of value that occur when
consumers withdraw funds from their bank accounts
either as cash or as value added to an electronic purse.
These two types of withdrawal affect a bank’s bal-
ance sheet in different ways. A cash withdrawal
reduces the bank’s assets (vault cash) and its liabilities

3
CURRENT ISSUES IN ECONOMICS AND FINANCE

Consider next the perspective of vendors. When accepted by other service providers. A more open sys-
accepting cash payment, a merchant must take reason- tem of this sort could arrange clearing and settlement
able care not to accept counterfeit currency, because through an affiliated bank.
the bank will refuse to accept counterfeit bills for
Nonbank issuance has been explored by policymak-
deposit. In contrast, the value of payments made by
ers in other countries. A May 1994 report by the
electronic purse accumulates in a card reader provided
Working Group on European Payment Systems proposes
to merchants by their banks. Once a bank’s card reader
that only banks be allowed to issue electronic purses.
accepts a card as valid, the transferred value becomes
The report cautions that cards issued by nonbanks would
the bank’s liability to the merchant, and the merchant
not be subject to the banking regulations, supervision,
need not worry whether the card was counterfeit.
and deposit insurance schemes that have traditionally
When the merchant finally deposits cash proceeds protected consumers. The absence of such safeguards is
in the bank, the bank experiences a simultaneous important because the failure of an electronic purse
increase in assets (vault cash) and in demand deposit scheme could undermine public confidence in other
liabilities. Because the bank’s required reserves rise electronic purse schemes, possibly causing a run on
only by the amount of the reserve ratio multiplied by them. Another issue the report discusses is fairness:
because banks are subject to regulations that do not bind
other firms, banks might be unable to compete on an
A May 1994 report by the Working Goup equal footing with nonbank issuers of electronic purses.
on European Payment Systems proposes Consumer protection. Electronic purses also raise
that only banks be allowed to issue electronic the issue of consumer protection under Regulation E,
purses. The report cautions that cards which limits consumer liability resulting from the
issued by nonbanks would not be subject to fraudulent use of ATM and debit cards. Would
the banking regulations, supervision, and Regulation E be applied to electronic purses? Like
deposit insurance schemes that have ATM and debit cards, the electronic purse would serve
traditionally protected consumers. as an account access device when downloading value
from the checking account to the card. This use would
appear to fall under Regulation E. Less clear is whether
Regulation E would apply when routine transactions
the increase in deposits, the cash deposit creates excess
are made: it could be argued that the bank’s liability to
reserves. When the merchant deposits electronic purse
the consumer has ended, leaving the consumer subject
value, however, the bank merely substitutes one liabil-
to the same risks posed by carrying cash.
ity (demand deposit) for another (electronic purse),
with no reserve management implications if both liabil- Issuers of electronic purses will also need to deal
ities are reservable at the same rate. with state escheatment laws. These laws require that
the funds in inactive bank accounts revert to the state
after a period of time if the depositors or their heirs
Other Issues
cannot be found. Hence, banks could be required to
Clearing and settlement. From the perspective of the
trace the ownership of the cards they issue and to pay
banking system, an additional issue must be resolved—
state governments the value of the funds on those cards
the clearing and settlement of transactions. Cash with-
that are inactive for several years.
drawals from ATMs require clearing and settlement
because the machine from which funds are withdrawn Money laundering. Currency is used extensively in
often belongs to a bank different from the one at which the underground economy and in illegal activities to
the cardholder has an account. Thus, banks settle daily evade taxes and the recording of transactions.
over networks for the net amounts they owe each other Participants in these activities, however, face logistical
because of the ATM transactions of their customers. challenges in moving bulky currency from one place to
Electronic purse payments will create the same need another and depositing the funds in the banking sys-
for clearing and settlement since merchants and their tem, where the money is safer, earns interest, and can
customers often bank at different institutions. be used in check transactions. It was to make such
operations even more difficult that the Treasury
Issuance by nonbanks. Organizations other than
stopped printing currency in denominations over $100.
banks might also want to issue electronic purses.
Telephone companies and mass transit systems, for Some fear that electronic purses would undercut such
example, could expand the use of the single-purpose efforts and make it easier to launder money. Value on
prepaid cards they now issue by arranging to have them these cards would be easier to move from one place to

4 FRBNY
another because a card could be more easily concealed Composition of U.S. Currency Outstanding
than a suitcase of currency. Nevertheless, it would still As of December 31, 1994
be difficult to deposit large sums undetected if federal
laws requiring the reporting of large cash deposits could Number
of Units Percentage of Dollar Value Percentage of
be extended to deposits of value from electronic purses. (In Billions) Total Number (In Billions) Total Value
In that case, those involved in these activities would Coin N.A. N.A. 21.8 5.4
only escape notice if they laundered the value through $1 5.8 36.8 5.8 1.5
businesses that could justify large deposits of electronic $2 0.5 3.1 1.0 0.2
purse value. The situation might be different, however, $5 1.4 8.7 6.8 1.8
for card systems that would allow person-to-person $10 1.3 8.3 13.1 3.4
transfer of value and transfers over specially equipped $20 3.8 24.2 76.3 19.9
phone lines. These features would allow holders of pre- $50 0.8 5.3 41.9 10.9
paid card value to move funds rapidly to remote loca- $100 2.2 13.7 215.7 56.8
tions where they could make several smaller, undetected Total 15.8 100.0 $382.5 100.0
deposits. Under these circumstances, electronic purses
could facilitate money laundering. Note: Taken together, all coins and currency in denominations of $10
and under account for more than half of units but only about 13 per-
Displacing currency. Electronic purses could even- cent of the total dollar value.
tually affect the amount of currency and coin outstand-
ing (see table), particularly the smaller denominations
is more likely to take the form of somewhat slower
used in routine transactions. Consider an extreme case:
growth than an outright reduction.
Were electronic purses to displace all coins and cur-
rency denominations $10 and under, they would substi-
tute for more than half of physical currency outstand- Conclusion
ing but less than 13 percent of its dollar value, or Rapidly advancing technology is stimulating the
roughly $50 billion. As the currency was retired, the growth of electronic forms of payment. Observers of
Federal Reserve would have to sell $50 billion of gov- retail banking refer to credit card transactions as “elec-
ernment securities, thereby losing the interest income tronic loans” and to debit card transactions as “elec-
on the securities that it normally turns over to the tronic checks.” The next year or two will likely wit-
Treasury. At a 7 percent rate of interest, the sale of ness the introduction of a complementary instrument,
securities would cost the Treasury about $3.5 billion of an electronic analogue to cash known as the electronic
in-terest income each year. This loss would be offset, in purse. This newsletter has described how an electronic
small part, by a reduction in the costs of maintaining purse system might work, examined its advantages and
the stock of currency. In practice, this $3.5 billion can drawbacks, and explored the issues that it will raise for
best be viewed as an upper limit because electronic policymakers. Although we cannot predict how rapidly
purses are only likely to displace a fraction of the and widely this new technology will be accepted and
smaller denomination currency and coins used in rou- just what forms it will assume, dramatic changes are
tine transactions, at least for the foreseeable future. clearly possible over the next several years in the ways
Hence, the impact of the electronic purse on currency that consumers make payments.

About the Author

John Wenninger is an assistant vice president and David Laster an economist in Payments System Studies,
Research and Market Analysis Group, Federal Reserve Bank of New York.

The views expressed in this article are those of the author and do not necessarily reflect the position of the
Federal Reserve Bank of New York or the Federal Reserve System.

5 FRBNY
 CURRENT ISSUES IN ECONOMICS AND FINANCE

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