Partners (Fall 1996)

Smart Cards
Have Arrived
by Mike Todd

The rapid growth and advancement in technology and communications have created new opportunities in the electronic payments system. One of the newest products is the stored-value or "smart" card. While technology in this card has been around since the 1970's, the stored-value cash card was officially rolled out in the United States at the 1996 Summer Olympic Games in Atlanta by Visa Corporation.

What is a stored-value card?

A stored-value card derives from smart card technology. A smart card is a card that contains a microchip in which information can be stored and processed instead of utilizing a magnetic stripe. In other words, the intelligence resides in the card and is extracted from this point. Another feature of smart card technology is the ability to encrypt the stored information as a way to combat fraud.

Smart card technology, which was introduced in France in the 1970's, did not gain a foothold until the 1980's. Worldwide, these cards perform as identification cards, health care cards, and transit cards. The smart card, with its specific technology, has multiple capabilities of a financial and nonfinancial nature. Hence, not all smart cards carry stored value, and not all stored value cards utilize smart card technology.

This article will focus on the stored-value smart card, which has the ability to store denominations of currency for future remittance. In the recent Atlanta pilot, the cards sponsored by Visa were known as "Visa Cash" cards. Partners with Visa in this project included First Union National Bank, Wachovia Bank, and NationsBank. The banks issued disposable cards in increments of $10, $20, $50, and $100. NationsBank also issued approximately 95,000 commemorative cards in $5 denominations during the Opening Ceremonies of the Olympics.

How do the cards work?

The cards can be purchased at a participating bank or at a terminal that has been converted to dispense or reload the cards. Participating merchants are equipped with a special machine to record purchases made with the card. When a consumer makes a purchase, the merchant runs the card through a terminal that debits the purchase amount from the card. The merchant, through a portable balance reader, can also tell the consumer the balance remaining on the card. To further illustrate this event, think of the chip as having the ability to keep a running ledger.

Benefits

Probably the most difficult question that those who market the stored-value card will face is, "Why do I need this card? I have a credit card, checks, and an ATM card." There are several benefits being touted.

The current strategy behind the card is to replace small denomination transactions and to offer multiple applications. Since the information is stored inside the card, some cards do not require connection with a host computer to complete the transaction. This off-line capability circumvents the potentially time consuming on-line authorization. Designed to serve as a substitute for cash and coin transactions of $20 or less, the cards eliminate the need for making change and physically handling bills and coins, which speeds up the purchasing process. Another benefit to the consumer is that it removes the hassle of finding exact change for vending machines, toll booths, trains, taxis, coin laundries, and pay telephones, for example.

The true savings to merchants is questionable, however, since the merchant pays a fee based on card purchases, similar to fees charged by credit card sponsors. However, the benefit to merchants in the form of lower transaction handling costs through time saved, and lower losses from robberies, is more apparent.

Security issues are still being addressed. However, technically, the smart card has an advantage over the more widely used magnetic stripe card; magnetic stripe cards are more easily counterfeited. Unlike traditional magnetic stripe cards, the smart card has the ability to encrypt information stored on the chip, which serves to make duplication more difficult.

Current Concerns about Stored-Value Cards

Like most other products, some degree of scrutiny must be undertaken to determine its impact in the financial markets. Major concerns raised about stored-value cards include their potential impact on the ability of the Federal Reserve to conduct monetary policy, and the entrance of nondepository institutions. If stored-value cards eventually make up a significant portion of all monetary transactions and are issued from several private sources, it will pose new challenges for measuring and monitoring the money supply. The emergence of nondepository institutions issuing stored-value cards raises the question of applicable rules and laws. Would the playing field be even for all competitors? Could this interrupt the financial system? Should nondepository institutions even be allowed to issue the card? While these are only a few key issues, many more will likely be raised as the market grows.

Risks Associated with the Card

Like cash, the current stored-value cards can be used by another individual if lost or stolen. The "cash card" feature of the disposable card does not carry a PIN (Personal Identification Number), which would restrict access to its owner. However, losses are limited to the amount stored on the card, a maximum of $100 at the present time. Although being touted as highly secure and virtually impossible to counterfeit, the possibility of counterfeiting stored-value cards exists, since criminals eventually catch up with and break the latest technology. If this were to happen, detection would be difficult and large sums of money could be lost in those transactions performed off-line. Currently, none of the cards meet the requirements of the FDIC definition of an account; therefore, they are not insured.

One of the greatest systemic risks is in the payment system. Depending upon how large the market for stored value becomes, and to what extent transactions occur outside the currently regulated financial sector, the merchant could assume a high degree of risk in payment dislocation and settlement. Consumers could lose their money if merchants decided to stop accepting a card. Other risks include legal risk (taxes, money laundering, and liability), market and liquidity risk, and technology risk. One can imagine the complexity of issues that lie ahead.

Summary

Will the stored-value card catch on and grow? No one knows yet. According to Business Week magazine, however, approximately $1.8 trillion was spent on purchases under $10 worldwide in 1994. The U.S. accounted for $560 billion of that amount. With over 75% of those purchases made with cash, the evidence suggests great marketing potential for stored value cards.

The next big marketing rollout of stored-value cards is set to occur in New York City by the end of the year. This will be a pilot with MasterCard and Visa in conjunction with Chase Manhattan and Citibank. The cards in the New York pilot will not only serve as a stored-value card, but will simultaneously serve as a debit card and credit card. (The stored-value could still be accessed off-line.) The lure of attracting the masses could be the convenience of a single card that can perform all of the functions that now require several cards. Initially, the keys to success lie in consumer awareness and comfort with security. In addition, big name merchants capable of using the technology must sign on, which would create a market, and ultimately, a national network. The smart card has enjoyed success in Europe and Asia, and with a strong showing here, universal adaptability could be right around the corner.

Mike Todd is an examiner with the Federal Reserve Bank of Atlanta. His assignments have given him an opportunity to evaluate some of the risk in smart card technology as it applies to the financial system.

 
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