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Wednesday, April 23, 2014

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Update Newsletter: Spring 2007

General-Use Prepaid Cards: The Path to Gaining Mainstream Acceptance

Prepaid cards are characterized by a model where funds are preloaded onto a card for later spending. There are many different kinds of prepaid cards. For example, “closed-loop” prepaid cards are redeemable only at a specific merchant location. Closed-loop prepaid cards are most often retailer-specific gift cards, which have replaced paper gift certificates. By contrast, “open-loop” prepaid cards are branded with the logo of one of the payment networks (Visa, MasterCard, American Express, or Discover) and are redeemable at any retailer accepting that network’s cards. In contrast to the success of some closed-loop cards, open-loop cards have not taken off as quickly as many pundits expected. In his new paper, “General-Use Prepaid Cards: The Path to Gaining Mainstream Acceptance,” PDF James McGrath investigates the business case for issuing general-use prepaid cards. These cards are branded by one of the payment networks and can be used for purchases where the brand is accepted, can have additional funds added to them (they are “reloadable”), and can generally be used to get cash at ATMs. As a result, these cards are functionally similar to traditional debit cards, but they can be delivered outside of traditional banking relationships.

McGrath compares the highly successful closed-loop gift card market to its open-loop counterpart. Single-retailer gift cards have several advantages over open-loop gift cards. For the retailer, they provide a lower cost and more consumer friendly replacement for paper gift certificates. Retailers also benefit from the profit margin on all goods they sell and are said to enjoy a “sales lift” of increased purchases from gift card recipients. By contrast, open-loop network-branded gift cards are more costly because of more complex processing requirements, consumer protections provided by the networks, and customer service requirements. Revenues are limited. Some are derived from “interchange” fees and float value, but, of course, the banks that issue these cards do not benefit from the sales-related profits that accrue to merchants. To generate sufficient revenue, issuers of open-loop gift cards have instituted fee structures that make the cards more expensive for consumers. Despite the wider acceptance of these cards, when positioned as gift cards, general-use prepaid cards do not realize the same level of success as the retailer-issued alternatives. McGrath argues that this example illustrates the challenges to prepaid programs that do not offer consumers a compelling alternative to other, similarly functioning products.

At the same time, he contends that network-branded prepaid cards can create successful solutions in the same way that closed-loop gift cards have: by replacing especially costly and inefficient structures with cheaper and more consumer friendly alternatives – that is, solving real problems and creating real value. He outlines four examples of such applications in government benefits, disaster relief, health care, and payroll disbursements. In each case, he shows how prepaid cards can replace costly older systems with cheaper solutions that provide additional value to payment participants.

General-use prepaid cards are also a promising opportunity for providing financial services to unbanked or underbanked consumers outside of traditional banking relationships. As already noted, a general-use prepaid card is functionally similar to a debit card but presents very limited credit risk for issuers and often more appeal for consumers than a traditional checking account. Despite these advantages, prepaid cards targeted to unbanked consumers remain an emerging application. Some of this is undoubtedly due to unfamiliarity with the cards, but McGrath also points to other factors that are slowing adoption. For example, no single prepaid card integrates the array of various financial services – from deposits of government benefits to payments of bills – that unbanked consumers might use. Therefore, multiple and distinct cardbased solutions may be required in order for a single consumer to meet his financial services needs, thus increasing the cost and limiting the convenience of the instruments.

Considering the broader prepaid market, McGrath discusses other features that have the potential to increase the economic viability of general-use prepaid cards and add consumer value. Most important, in his view, is the need to extend the useful life of the card itself. Every application involves significant fixed costs to produce and distribute cards and to educate consumers about using them. As in traditional banking relationships, the economics of general-purpose prepaid cards improve over time as fixed acquisition and start-up costs are recovered.

For example, giving employees the option to retain the same payroll card when switching employers would likely increase the length of the customer relationship, particularly since many industries that have adopted payroll cards have high employee turnover. Going further, if consumers could load funds from different sources onto the same card, the resulting product could, according to McGrath, add value for the consumer and further strengthen the relationship with the card issuer or sponsor.

In addition to all of these considerations, a number of legal and technological impediments to general-use prepaid cards remain. McGrath sees many positive developments in these directions, such as the clarity and greater certainty created by the Federal Reserve’s final ruling on Regulation E protections and payroll cards. He concludes that the further success of these cards will depend on innovations that can displace costly legacy systems and provide added value to consumers.