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Update Newsletter: Fall 2004

Prepaid Cards: How Do They Function? How Are They Regulated?

In the last half century, payment cards – first credit cards and later debit cards – became established methods by which consumers paid electronically for goods and services. Since then, consumers have progressively migrated to electronic payments. Indeed, according to a recent Dove Consulting and American Bankers Association study, in 2003, for the first time, electronic payments surpassed traditional paper (cash and check) as a percentage of total consumer in-store payments.

A small portion of these electronic payments were attributed to a relative newcomer to the payments system: the prepaid card. A prepaid card is essentially a payment card with an amount of preloaded value. It offers a "pay early" value proposition, rather than the debit card's "pay now" or the credit card's "pay later" model. One of the first prepaid card applications, and also one of the most popular, is the merchant-issued gift card. Forty-five percent of U.S. adults have purchased at least one of these cards. Consumers' adoption of the notion of "prepaid" has led to a range of new types of prepaid cards, all leveraging the idea of preloaded value.

This growing popularity and proliferation suggest that prepaid cards are gaining traction as a convenient payment alternative for many consumers. Prepaid card applications are also attracting policymakers' attention.

To promote dialogue on this subject, the Payment Cards Center hosted the conference "Prepaid Cards: How Do They Function? How Are They Regulated?" at the Federal Reserve Bank of Philadelphia. The Center invited participants representing a wide range of perspectives in order to better understand specific prepaid business models, including gift, payroll, and flexible spending account (FSA) cards. More generally, the conference probed critical policy issues associated with prepaid cards: the market challenges faced by prepaid card issuers, the laws in place and under consideration to regulate this payment product, and the protections afforded to consumers who use these cards.

Ron Congemi, president of Debit Services and Star Systems for First Data Corporation, provided the event's keynote address, during which he characterized the prepaid market as one of significant opportunity in terms of purchase volume growth, consumer adoption, and diversity of offerings. At the same time, Congemi emphasized that the ultimate success of prepaid applications lies in market participants' ability to address these challenges: dealing with an increasing number of new industry participants, some of which will prove to be "rogue" players; making the right technology and marketing investments; resolving legal and regulatory uncertainties; and managing new fraud vulnerabilities.

The Federal Reserve Bank of Philadelphia's president, Anthony M. Santomero, welcomed the conference participants and opened the day's discussions. He emphasized that the people in the room represented a broad set of perspectives and a diversity of experience invaluable to collective efforts to ensure continued and healthy growth in this payment channel. Santomero challenged the assembled group to engage in open dialogue aimed at achieving a shared goal: protecting consumer assets while at the same time encouraging growth in this important new segment of consumer payments.

Beginning the formal sessions, Jack Williams, of National Processing Corporation, characterized prepaid applications as a market of extraordinary opportunity but also one of growing regulatory uncertainty. He highlighted the potential for prepaid cards to provide real value to under- and unbanked consumers. In this sense, he argued that prepaid cards could act as a bridge to building more traditional banking relationships with this relatively underserved segment of the population.

The discussion continued with a focus on specific types of prepaid cards and the ways in which they function. The conference summary provides an analysis of the most popular prepaid card program – the gift card – as well as two emerging prepaid applications: the payroll card and the flexible-spending-account (FSA) card.

Gifts cards can be issued by merchants typically as a "private" program or by financial institutions using the more recently introduced "open" program. Private programs are restricted in that the recipient can use the card only in limited locations. Open programs, however, allow the recipient to use the card anywhere the cards of the sponsoring network (i.e., Visa or MasterCard) are accepted. Generally, payroll cards allow employers to credit paycheck dollars to a prepaid card product while FSA cards act similarly for qualified pre-tax dollars in company health plans.

Addressing the "unsettled" regulatory environment, Judith Rinearson, former counsel to American Express' prepaid card business, aptly described prepaid cards as standing at the intersection of multiple kinds of laws. Federal lawmakers and state legislators are considering new statutes and applying existing statutes to prepaid card applications. Primary areas being addressed include protecting the preloaded value before it is spent by the consumer, establishing consumer liability limits in the case of fraud, determining ownership for unused portions of preloaded value, and clarifying the role and regulation of nonbanks operating in the prepaid card industry. The general discussion of these issues focused on how differently many of these legal and regulatory issues affect the wide variety of applications.

At the end of the day, participants shared a general feeling of optimism about the opportunities presented by prepaid applications, including their use as a mechanism to encourage participation in the payments system by the traditionally under- or unbanked segment of the population. They also generally accepted that prepaid applications – leveraging the concept of preloaded value – can apply to a wide range of business models. As such, regulation of this payments category presents a challenge because any regulations formulated need to consider this diversity. At the same time, participants agreed that a degree of regulation can aid stakeholders in structuring a prepaid market that provides greater accountability for issuers, harmonizing state law applied to these products, and continuing to provide all consumers with a breadth of prepaid products in a cost-effective and safe manner.

For a more detailed summary of the day's discussion, please see the conference summary entitled, "Prepaid Cards: How Do They Function? How Are They Regulated?" PDF on the Center's web site.