Prepaid Cards in Europe: Applications, Business Models and Risk

There is a high level of interest in prepaid cards in Europe, largely because of the size and growth of the US market: from zero in 1999, the US market in 2007 has been estimated at more than seven billion transactions and US$175bn in volume¹. Most of the literature on the prepaid cards business assumes that it is a single industry, fairly similar in all markets. The words ‘prepaid card’ imply that the focus is on the card itself and the functions that it offers, rather than the account that lies behind the card.

When we look in more detail, however, not only the applications but also the regulatory structure and business models are likely to be quite different in Europe from those in the US. It is only by analysing individual user segments and their likely or possible evolution that useful forecasts can be made; even then the margin for error is considerable because of the potential impact of regulation and technology development.

Legal Framework for Prepaid Cards in Europe

In the US, prepaid grew from two separate products: closed-loop retailer ‘gift cards’ and bank-issued corporate products such as salary cards. Scheme-branded cards came later (but are growing much faster). In the US, banks and quasi-banks issue all open-loop prepaid cards; they represent access to deposits. In Europe, prepaid cards – other than closed-loop cards – are (by definition) e-money (see box below).

Card issuing is not (in most countries²) a regulated activity – but e-money issuing and deposit-taking are. E-money may be issued by licensed e-money issuers, by banks that have permission to issue e-money (they must seek specific permission to do this), or by small schemes that have an exemption. Some implications of this framework include:

• There is a limited number of eligible issuers (but almost any bank could become eligible).
• The UK is the only country that has licensed significant numbers of e-money issuers (including banks with a variation of permission), which is why most prepaid issuers in Europe are based in the UK.
• E-money issuers have a European passport and so can offer products and services in any European country. They also enjoy lighter regulation than banks.
• Many of the financial risks are carried by customers rather than shareholders; e-money issuers are excluded from deposit insurance.
• The e-money issuer generally depends on other parties (e.g. card issuer, scheme manager) to set up and police appropriate rules, and to run the systems; the risk management is very dependent on these third parties.

The international card schemes’ rules see prepaid cards as debit cards, or sometimes even as credit cards, even though the account behind the card operates to quite different rules. However, the schemes are now becoming aware of specific issues with prepaid so are imposing some restrictions (e.g. on the use of these cards for gambling).

Applications and User Groups

Prepaid cards are usually designed to meet one of three needs:

• Corporate customers who want to reduce costs or improve control.
• Provide a payment instrument to underserved customer groups who are otherwise restricted to costly, inconvenient or socially unacceptable methods.
• Address a particular application for which a prepaid card or account is more suitable than a current or credit account.

Only the third of these is really visible to acquirers; but transactions from the others also pass through acquirers’ systems – they look like debit transactions.

Applications: corporate focus

• Payroll cards are still important in the US but are not widespread in Europe, where direct payments to a bank account are greatly preferred by employers and tax authorities.
• Insurance claims represent a growing market; they allow the issuer to restrict claimants to specific outlets and goods. Cards are particularly valuable for travel insurance; the card is issued before travel and can be loaded by the insurer remotely if a claim (particularly for lost or stolen money) is made.
• Card-based incentives and bonuses are not widely used; potential tax impacts can deter employers from moving away from recognised structures.

Underserved customer groups

• Know Your Customer money-laundering rules make it difficult for many people (including students, temporary workers and those who have recently moved) to get a card. Such people often live in defined communities: issuers need to penetrate that community.
• Under-18s are not allowed to use credit cards, and often face restrictions on their debit cards. This has led to many small prepaid brands with ‘hip’ marketing or co-branding links. This has been seen as a high-spending group but may be reaching a plateau; innovative propositions are needed to maintain its growth.
• Those with poor credit records need to rebuild their record. This is not a popular market position but can be very profitable; it is addressed directly by loan consolidators and indirectly through overlap with other segments.
• Most elderly people do have access to standard accounts and instruments, but they are often deterred by barriers of language and procedures; minor disabilities exacerbate the problem. Prepaid cards are often sold and used in familiar outlets, and explained by people they know, which can make them attractive. There is probably an opportunity for contactless prepaid cards here, because of their simple operation.

Applications that need prepayment

• Overseas remittances account for large sums (e.g. from UK the total is £2.3bn). This application needs distribution networks at both ends of the chain, avoiding dependence on ATMs.
• Gambling faces ‘moral risks’ as well as new rules from the card schemes.
• Gaming is safer but faces competition from online accounts run by the game operator.
• Universities, colleges and schools are expanding from closed-loop to scheme-branded in order to allow acceptance off-campus. This offers opportunities for acquirers as well as issuers.
• For Internet shopping, prepaid cards limit the risk if the account is compromised; many debit-card holders say they want such limits but few have moved to prepaid in practice.
• Travel cards are convenient for customers and offer the issuer income from foreign exchange and float as well as card issue: often one subsidises the others.
• Gift cards are increasingly moving from closed-loop (retailer-issued) to scheme-branded. They can be sold in ‘gift card malls’, which simply offer a choice of brands to the purchaser.
• Loyalty and rewards cards may be limited to closed-loop and business-to-business, as selective authorisation is often needed.
• Mobile payments are being used in trials; there is a long association between mobile and prepayment.
• Many people still like to use ‘electronic biscuit-tins³‘ to manage their spending in different categories (travel, snacks, holidays).
• Cartes ville, issued by a municipality for use on local services, are popular in France and Spain but not yet elsewhere.

Business Structures

The underlying business model for prepaid cards appears quite attractive: revenue comes not only from card issuing fees of up to £10, monthly charges up to £5 and transaction fees up to 20p or more⁴, but also from the float interest and ‘breakage’ – amounts left on the card at the end of its life, which often amount to 5% or more of the value loaded. Costs can also be quite high, however, and few scheme-branded cards have yet reached sufficient volumes to drive these costs down.

Many players co-operate to deliver a prepaid card. This long value chain means that what profit there is is being divided between several players, and with the barriers to entry very low (as demonstrated by the large number of schemes operating in the UK) profit margins are probably not very large for any player in relation to the risk they are taking.

Risks Around Prepaid Cards

Prepaid cards avoid many of the risks associated with credit cards. However, this does not mean that there are no risks. Banks in particular may see a loss of business from their credit or debit cards as transactions move to closed-circuit schemes, or become add-ons to a transport card which can subsidise payment transactions. The strict controls on prepaid cards may lead to unnecessary declines.

Prepaid cards can still be counterfeit (although from 2010 they will in most cases be covered by the Payment Services Directive mandate to use Chip). In the case of lost and stolen cards, the terms and conditions generally require the issuer to restore any funds on the card. Issuers must ensure that they are compliant with Know Your Customer money-laundering rules, and schemes are still subject to merchant fraud and internal fraud; the chance of direct attacks on the issuer and e-money host remains underestimated by most issuers.

For corporate cards (the most profitable segment), there is a risk that the scheme fails to deliver the expected benefits (often because of an unknown counterparty). And a specific risk arises when prepaid cards are exchanged for goods, which are then exchanged for money.

Managing and Limiting the Risks

All of these risks can be managed using existing controls and tools. However, acquirers and merchants accepting prepaid cards should:

• Ensure they know which card numbers (BINs⁵) are prepaid, what business models are available, how cards are being used and current fraud modes.
• Track the percentage of prepaid in their network and at particular merchants or outlets, in order to understand their exposure.
• Pay particular attention to load transactions passing over their network; what additional data are needed to authenticate the transaction in this case?
• Look very carefully at any offline-only estates or terminals with any form of dispensation in relation to online authorisation (it may be necessary to apply BIN-blocking on those terminals, e.g. motorway tolls, telephones, ferries).
• Lobby the card schemes to require a separate AID for prepaid on chip so that different business rules can be applied to these transactions.

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