HOW TO REGULATE ISSUERS OF E-MONEY?

Draft Report*

Background

This report is part of a broader study seeking to answer questions formulated by the European Parliament concerning the outlook for electronic money and electronic commerce. It deals more specifically with the issue of the rules and regulations for the issuers of electronic money. [rappeler la question]Its objective is to answer the following question: "How to regulate issuers of electronic money?"

The scope of the study is to definereport reviews the which rules are to beunder which imposed upon issuers of electronic money should operate. It analyses the proposals and determine if of the European Commission's Commission on the subject matter. Proposals are a sufficient answer to the need to regulate issuers of e-money.

The report is structured in three parts: Its Objectives areThe first part ly to give alooks at possible initial definitions of the e-money and provides an overview of the American and of the Japanese approaches to e-money. The second part Secondly to highlight the key points of the European Commission's Directive Proposal [title]. The third part seeks to And finally to formulate some preliminary observations and conclusions.

The study report is based on existing data documentation and on interviews with selected experts (see Annex). Details on those data and interviews are available in the annex at the end of the document.

Electronic money and electronic payment: elements of a definition

The traditional approach to money is to divide it into two categories: When observing the monetary mass of a country, two kinds of money can be marked out: cash and scriptural money. The first one is issued by the Central Banks, while the second one is created by private banks. The rapid development of electronic payment systems, such as interbank payment systems, and instruments such as debit cards and stored value cards, raises a question: is a new category of money, electronic money or e-money, emerging ? Experts appear deeply divided over the question. Some features of e-money make it appear like cash, while others allow it to be assimilated to scriptural money. At the same time, some forms of e-money are issued by non-financial institutions and can be transacted outside the traditional banking systems. Hence the interest of regulators ofand monetary policy managers. A "new kind" of money appeared 6 years ago: electronic money. But is e-money really a new money kind? Some features of e-money are close to cash, while others are clearly belonging to scriptural money. Some experts pretend e-money is not even money.

The term electronic money is often used to refers to a wide variety of proposed retail payment mechanisms. E-money products can be defined as "stored-value" or "prepaid" products in which a record of the funds or "value" available to a consumer is stored on an electronic device (hardware and/or software)e] in the consumer's possession. [Utiliser les définitions standards et citer leurs sources ! Ne pas prétendre de tout inventer]

The electronic value is purchased by the consumer and is reduced whenever the consumer uses the device to make purchases. Many stored-value devices, in all probability, their great majority, isare used for In contrast to the many existing single-purpose purchases prepaid card schemes (such as those offered by telephone callcompanies). Such single-use devices are not considered, e-money, which should be used as products are intended to be used as a general, even universal, multipurpose means of payment.

Two other important distinctions are:

- Account-based e-money, when transaction involves a double entry into accounts on various electronic supports (card, readers and servers) vs. token-based e-money, wheren. value is embodied in a software, which can circulate freely, without firm linkage to a bank account. The circulation is carried out by transfer from one electronic device to another one. Complex networks of exchange and clearing can be established outside the traditional financial system. Token e-money is often referred as "digital cash". However, e-cash does not present all the features of cash. For one thing, there is potentially an infinite number of issuers of e-coinsash. Another distinction is the need for specific infrastructure of readers and application software, which clearly limits the. These two characteristics limit the potential acceptance of e-cash. [Mentionner au moins brevement l’échec du Digicash].. Another key difference is that e-cash allow the traceeability of the owner. The degree of anonymity in e-cash is a hotly debated issue.

-- Stored-value products and access products, which are fundamentally security devices. The chip on the French debit card does not store value only the security device allowing the user to access the payment systems which then effects the transaction. Many Internet banking products are in fact the security devices allowing to make a credit card payment or to transmit instructions to make funds transfers between bank accounts overt the Internet. Moreover, the definition covers both prepaid cards, called "electronic purses", and prepaid software products that use computer networks such as the Internet, sometimes called "digital cash" or "virtual purses". Access products may use similar mathematical methods and electronic support as stored value products and are of interest. However, they do not raise the same concerns as e-money schemes.

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E-money as just defined, differs from so-called "access products", which are products that

allow consumers to use electronic means of communication to access otherwise conventional payment services. For example, use of a standard personal computer and a computer network such as the Internet to make a credit card payment or to transmit instructions to make funds transfers between bank accounts. These access schemes major feature is the communication method (e.g. the use of a computer network rather than a visit to a bank branch) and so, although they are of interest, they do not raise the same concerns as e-money schemes.

While "access products" appear clearly as simple transaction means for scriptural money, e-money sounds more like cash. E-coins exist on their own and do not need any bank account to be deposed on. E-money is just stored in the memory of an electronic device and, during the transaction, transferred from one device to another one. However, e-money does not present all the features of cash. On one hand, digital money can not be used for all purposes: an adapted device is necessary to collect the money and many systems do not allow peer-to-peer transactions. In addition, unlike cash, in most schemes currently available, electronic money received by the beneficiary can not be used again. On the other hand, e-money do not fully preserve anonymity. A transaction realised with e-money can hence be considered as an "exchange" of a good or a service against a credit issued by a given organisation (mainly by private banks).

Various approaches to electronic money

Various e-money schemes are being developed and they differ considerably in their

features, many aspects of which are still to be finalised. Firstly, e-money products differ in their technical implementation. To store the prepaid value, card-based schemes involve a specialised and portable computer hardware device, typically a microprocessor chip embedded in a plastic card, while software-based schemes use specialised software installed on a standard personal computer.

Secondly, products differ in the way in which value is transferred. Some e-money schemes

allow transfers of electronic balances directly from one consumer to another without any involvement of a third party such as the issuer of the electronic value. More usually, the only payments allowed are those from consumers to merchants, and the merchants in turn have to redeem the value recorded (for example, at the end of the day they transfer the total value to their bank, which then credits their bank account with the funds).

Thirdly, in most e-money schemes currently being developed or pilot-tested, the "value"

stored on the devices is denominated only in the national currency. It is possible, however, for balances to be held and payments to be made in several different national currencies.

In the traditional theoretical frameworkFrom a theoretical point of view, there is no room for e-money as a distinct category. can not be considered as cash or as scriptural money and not even as money in general. Generally accepted academic definition of money actually describe money it as an universal instrument accepted for the settlement of all transactions. That is clearly not , what is clearly not the case for e-money. On the other hand, the development of electronic payment systems and instruments raises serious concerns among regulators and central bankers [citation] to the extent that it modifies the traditional architecture and relationships within the banking system.

In practice, many central banks try to consider e-money as a new kind of scriptural money. According to Banque de France, e-money is very closed to traveller checks, except that checks are not divisible. No new status or regulation has have been required for traveller checks, and therefore no new status should be created for e-money. E-money is just scriptural money stocked stored on an electronic device and does not require separate treatment. should be integrated in scriptural money aggregates.

Various e-money schemes are being developed and they differ considerably in their

features, many aspects of which are still to be finalised. Firstly, e-money products differ in their technical implementation. To store the prepaid value, card-based schemes involve a specialised and portable computer hardware device, typically a microprocessor chip embedded in a plastic card, while software-based schemes use specialised software installed on a standard personal computer.

Secondly, products differ in the way in which value is transferred. Some e-money schemes

allow transfers of electronic balances directly from one consumer to another without any involvement of a third party such as the issuer of the electronic value. More usually, the only payments allowed are those from consumers to merchants, and the merchants in turn have to redeem the value recorded (for example, at the end of the day they transfer the total value to their bank, which then credits their bank account with the funds).

Thirdly, in most e-money schemes currently being developed or pilot-tested, the "value"

stored on the devices is denominated only in the national currency. It is possible, however, for balances to be held and payments to be made in several different national currencies.

International approaches

On the international level, sSeveral e-money projects are being developed outside Europe. Foreign cRegulators in countries, where such projects are being implementing those new systems are monitoring them with interest. thinking about approaches approach to follow, regarding e-money regulation. Those approaches are different but have a common feature: currently e-money issuance is not forbidden to non-banks.Let’s us consider the situation in two countries: United States and Japan

In the USA approach

In the United Sstates, a growing number of limited area electronic stored-value schemes(using the Belgian Proton and/or Mondex technology) are being developed in controlled environment, such as on college campuses, sports stadiastadiums or, military bases (using the Belgian Proton technology) etc. While the various agencies of the government monitors closely those experiences, the official position is that According to the American government there are is no immediate need to regulate electronic money issuance and there is, at present, no restriction on who can issue it. This approach is partly based on the judgement that these development are unlikely to affect the overall structure of the payment system [quote (Weininger study)].continuing high usage of cheques as a preferred means of non-cash payment. In May of this year [which year]1998, an interagency Task Force on Electronic Payments, chaired by the Office of the Comptroller of the Currency, was of the opinion that government regulation at this time could adversely affect competition and innovation in an industry that is still in the early stages of development and could increase the costs of electronic money products unnecessarily (source: European Commission) [reference].

In Japan

Japan has probably the most ambitious and far-reaching electronic money scheme in the world today, The issue is currently being examined in Japan where a number of large pilot schemes are

already in operation or will come on line in the near future. One of the main proposals

being considered is the introduction of a regulatory structure for non-bank issuance of

electronic money. The most interesting and ambitious project scheme is managed by NTT, the largest telephone operator in the world, with the participation of 34 companies [caractéristiques].. The overall concept is to create a highly secure electronic money system. The Electronic Money will be both anonymous and traceable. It will be issued by an Issuing Institute, a wholesale institution, to which only the commercial banks will have access. Settlement will take place between the Issuing Institution and banks. These will distribute the Electronic Money and deal with customers, who will charge electronic Money on smart cards and use it for purchases digital content in virtual shopping malls.

The overall scheme of the Electronic Money experiment is shown abovebelow.

JAPANESE SYSTEMJapanese Electronic Money System Architecture

From the technological standpoint, the project is based on a proprietary NTT technology which allows speedy encryption, considerably quicker than the existing methods. The project raises substantial institutional issues such as: Who will the Issuing Institution ? Will the virtual money be fungible ? What is the likely impact of the project on monetary policy and bank intermediation ? At present, NTT is widely seen as the Issuing Institution. The project is closely followed by the Bank of Japan, which supports its implementation. However, BOJ has not fully determined what are implications of NTT becoming the Issuing Institution. In all probability, it would entail setting up a separate subsidiary, which could then be supervised by the BOJ.

European Commission proposal on e-money issuers regulation

Why is there a need for a directive?

[START WITH DETAILS: WHAT ARE YOU TALKING ABOUT ] In [] In September 1998, The European Commission has issued a [directive/proposal [title]proposal for European Parliament and Council Directives on the taking up, the pursuit and the prudential supervision of the business of electronic money institutions.. This proposal is a result of several years of discussion between official bodies and between the public and private sector. Through this document, European Commission tends to propose a legal framework concerning regulation of e-money issuance by potential non-bank actors.

Payment sector has always been considered as very sensitive economical sector in which, customers confidence plays a very important role. If the payment instrument does not suit customers needs, they will not use it. This refusal can have negative effects on the global economy by slowing exchanges speed.

The financial integrity and the operations of electronic money issuers must hence be secured. On the one hand, the stability and soundness of issuers of electronic money must be ensured. Systemic failure should be prevented in order to avoid On the other hand, it must be ensured that the failure of any one individual issuer does not result ina loss of confidence in this the new and developing means of payment.

Currently, the supervisory and regulatory approaches to the issuance of e-money have developed on an ad hoc, national basis throughout the Union. There is no clear legal framework for electronic money issuance and if the regulatory issues are not addressed, innovative payment schemes cannot be implemented. this business can be carried out on an unregulated basis [NOT TRUE !!! NOBODY V+CAN ISSUE MONEY WITHOUT GOVERNMENT PERMISSION. It is neither in the interests of consumers nor markets generally that this situation be allowed to continue.

The European Commission also insists on the importance of e-money regarding the introduction of Euro. Electronic money represents an opportunity for consumers to familiarise themselves with the concept of the single currency during the transition period. This will also contribute to the growth and development of electronic money as a simple means of cross-border payment.

Acceptance of non-bank issuers

In order to ensure the soundness of e-money issuers, a prudential supervision is needed. That is why the Commission draft proposals for directives on the issuance of electronic

money are very much calibrated modelled upon the existing banking directives.

However, in its most recent proposal, Commission departs from an earlier view that only banks should be allowed to issue e-money. oes not sustain the proposition of European Central Banks to impose banking status to all e-money issuers. The supervisory regime applied to banks is too huge heavy and complicated and can discourage initiatives from non-banking sector and thus hamper the development of new payment instruments. MoreoverThus, European Commission considers that only a restricted limited prudential control should be sufficient to ensure the soundness of e-money issuing activities. The main thrust is to provide for the application of those elements of banking legislation, and only those, which are pertinent to the provision of e-money and to the risks associated with it while at the same time ensuring, from a monetary policy perspective, that both stability and a level playing field as between issuers are realised.

For those reasons, European Commission has decidedproposes to "create" a new status for electronic money issuers.

Prudential supervision

The principal differences between the application of the First and Second Banking Co-ordination Directives to banks and electronic money institutions lies in the initial capital

and on-going own funds requirements and the investment limitations imposed on them.

The initial capital requirement for banks is 5 million ECU while that proposed for

electronic money institutions is set at 500,000 ECU. On an on-going basis banks are

required to maintain a minimum own-funds requirement of 8% while the figure proposed

for electronic money institutions is set at 2%.

For the taking-up and the pursuit of business, e-money institutions are subject to same conditions as credit institutions: prior authorisation - minimum capital requirement (adapted) - fit and proper management - sound and prudent operation - initial and ongoing owner control.

An option is left to Member States allowing for a waiver of the provisions of the proposals commensurate with the risks inherent is small e-money schemes. The waiver may only be applied to e-money institutions underpinning relatively small schemes.

Comments on the proposal

Definition issues

In the directive proposal, European Commission adopts a definition of e-money completely somewhat opposed different from the academic one (see p. above) to the widely accepted one. Generally, money is considered as an universal instrument, helping to settle any kind of transactions. European Commission define e-money as a multi-purpose instrument. With In other words, commission define e-money as a payment instrument helping to settle more than one kind of transaction, while the widely accepted definition of money imposes an universal dimension to money.

The point is to actually define which of those definitions should be the more accurate to separate issuing institutions, needing to be regulated, from others that should not. The chosen definition should not be too broad, and include systems like public phone cards, but not too narrow too, and let e-money institutions escape regulation.

Definition from European Commission can maybe be considered as too broad. For example, according to that definition, Club Méditéranée cards allowing to pay various kind of products within holiday villages should be considered as electronic money and Club Méditéranée should be considered as an electronic money issuer, respecting legal requirements imposed by the directive. And this, even if it remains possible for owners of such a system to ask for a waiver on certain provisions of the Directive to their National State (if the overall unredeemed e-money does not exceed ECU 10 million). Another example is, what should be the status of a telecom operator issuing cards to be used both with public phones and GSM?

On the other hand, using the widely accepted definition of money should prove to be inaccurate too. As a matter of fact, that definition imposes an universal dimension to money, while none of current electronic money system is de facto accepted for all kinds of transactions. Although, some of them are universal in scope.

Using multipurpose criteria to determine which payment instrument must be considered as electronic money or not causes problems. Added other systems features to the definition should help to settle their status in a more accurate way. A suggestion, should be to determine the acceptance level of the payment instrument, by considering the wideness of the underlying clearing system. [Good paragraph but need to be more diplomatic].

Settlements and clearing

As its title mentions it, the Directive Proposal clearly focuses on the regulation of e-money issuers. It does not mention any recommendation concerningdiscuss the regulation of settlement and clearing process and institutions, the way money transactions are settled between those who issue the money and those who accept it.Those institutions are extremely important in the payment area, as they determine the acceptance level of a payment. And yet, in the money circulation and acceptance, clearing and settlement arrangements are as essential in the determination of the scope of acceptability and universality as the issuance approaches. An analysis of electronic money is incomplete without the consideration of its settlement and clearing aspects. It would be interesting to study their implications in the e-money schemes and the possible advantages of including them in the Directive Proposal.Furthermore, it is in this area that the widespread use of Information Technology has had the strongest impact.

Ifn an unregulated not taking into account monopoly situation, multiple issuers and acquirers of electronic money are coexisting on the same market, using similar the same technologyies for issuing their “currencies”. With some electronic products however, a consumer would have the option of receiving a refund for an unused electronic money balance and having the proceeds deposited in aa traditional bank account account, typically on already linked to the device by the issuer. . If the bank account were not located at the issuing institution, a clearing and settlement process would be required to redeem the issuer's stored value obligation.

As in any other As in other retail payment systems, electronic money products typically involve a collection process whereby a merchant's account at an acquiring institution is credited with funds received for payments from consumers. In some systems, in which most or all transaction information is truncated at the point of sale, merchants may simply deposit a single accumulated balance on their terminal through a connection between the terminal and the acquiring institution. For other systems, transaction details are transmitted from the merchant terminal to the acquiring bank, where they are routed to a clearing centre.

It is the clearing and settlement system that determine the acceptance level of a given payment instrument.In the absence of a clearing system between issuing institution and acquiring one, no transaction can take place between customers from both institutions. Those institutions are extremely important in the payment area, as they determine the acceptance level of a payment. Customers Users of such instruments from a given financial institution can only realise transactions with customersmerchants from another one if thoseboth issuing and acquiring institutions are part, directly or indirectly, of a common clearing scheme.

Current electronic payment systems are all based on banking clearing centressystems, directly or indirectly. Even E-money companies likesuch as Cybercash are working with banks to settle transactions realised via their system. It would be extremely hard, if not impossible, for a proprietary system to grow up to a certain pointgain a wide acceptance without a direct or an indirect access to wide banking clearing centres. The system is complex and hierarchical, with various systems for various payment categories (check/card, retail/wholesale). At the same time, those systems are interconnected by common membership and interoperability agreements. Clearing and settlement activity is closely supervised by Central banks, which are often directly involved in operating such systems. This is particularly the case for large-value interbank systems such as TARGET, which is used to settle large cross-border in euros and which is operated by the European Central Bank. Indeed it can be argued that for central banks, maintaining the integrity of clearing and settlement system has become a mission-critical function, on the par with its “lender of last resort” responsability.

The European Directive Proposal deals with one of hindranceobstacles for non-financial institutions to issue electronic money: the status, but does not tackle the majorkey question problem of acceptance of the issued electronic money. It does not address the issue of , by regulatingon of alternative transactions settlement and clearing operationssystems, which could be created outside the traditional systems. . By doing so, it leaves to institutions recorded by clearing centres, namely financial institutions, the right to decide the level of acceptance of each systems.

Of course, it remains to non financial e-money issuers the possibility of building up their own clearing centres. An example of such a system This have already been observedcan be found in mobile telecommunications in the GSM world with companies such as MACH, a Luxembourg-based organisation. MACH core business is the clearing of call data generated by the international and national roaming activities of GSM mobile phone users. Each roaming call creates a liability of a network of a GSM terminal holder toward the network used by this holder. MACH facilitates settling of these liabilities on bilateral and multilateral basis. Clearing services include comprehensive data checks and all related management reports. MACH processes, converts and reconciles between Transferred Account Procedure (TAP) and Cellular Intercarrier Billing Exchange Roamer (CIBER) Record formats to facilitate transactions between roaming partners using different technical standards.

If suchmore such clearing centressystems were created by non-financial money issuers, it would be interesting for European Commission and the monetary authorities to evaluate the implication of the development of such systemsstudy the opportunity of including them in the Directive Proposal and to define their status. . Do they create significant new risks ? Who would guarantee their performance and integrity ? It would actually exist a major difference between those kind of proprietary clearing systems and current ones from banking sector. Banking clearing systems have a link to Central Banks, which play a role of lender of the last resort. In proprietarynon-bank clearing and settlement systems, Central Bank would normally not appearnot get involved. It would thus be interesting to determine who would guaranty the whole system and the importance of systemic risk in such a system.Is there a need for new regulation in this area ? If yes, what would be its principles.

Dangers of accepting non-bank issuers

Need for standards

According to manypractically all experts from the banking sector, electronic commerce will not be achieved without creation of universal payment means for transactions realised on electronic networks. Letting non-banks issue money can lead to the creation of a multiplicity of proprietary incompatible systems which will slow the development of e-commerce. Consulted French experts are convinced that in the end, only universal systems promoted by banks will remain, evincing or absorbing proprietary systems developed by non-banks. According to the French central bank, restricting issuing field to financial institutions, should not hamper the development of technological initiative. Customers and merchants are primary looking after universal payment means and not incompatible private initiatives.

Customers confidence

Given the degree of uncertainty about future technological and market developments in electronic banking and electronic money, it is important that supervisory authorities avoid policies that hamper useful innovation and experimentation. At the same time, it is crucial that along with the benefits, electronic money activities carry risks for banking organisations and these risks must be balanced against the benefits.

Among all risks that a bank must face when implementing a new payment system, reputational risk is one of the most hazardous. Reputational risk is the risk of significant negative public opinion that results in a critical loss of funding or customers. Reputational risk may arise when systems or products do not work as expected and cause widespread negative public reaction. A significant breach of security, whether as a result of external or internal attacks on a bank's system, can undermine public confidence in a bank. Reputational risk may also arise in cases where customers experience problems with a service but have not been given adequate information about product use and problem resolution procedure. Mistakes, malfeasance, and fraud by third parties may also expose a bank to reputational risk. Reputational risk may not only be significant for a single bank but also for the banking system as a whole. If, for instance, a globally active bank experienced important reputational damage concerning its electronic banking or electronic money business, the security of other banks' systems may also be called into question. Under extreme circumstances, such a situation might lead to systemic disruptions in the banking system as a whole. For that reason, banks are very concerned each time they need to share their activities with non-banking institutions because, which are not obliged to respect all the security constraints imposed to banks.

Moreover, according to French experts, instead of slowing the development of effective e-money systems, restricting e-money issuance activity to the banking sector can speed-up customer acceptance regarding the new payment instrument. In principle, in a market economy, it is the task of the creditor to assess the creditworthiness of his debtor. As regards issuing institutions, most customers cannot assess the quality of these institutions, due to the asymmetric availability of information and a lack of understanding of the technical security features of the payments systems. That is why they will logically turn themselves towards institutions they know perfectly and that seem to be the most reliable: banks. Moreover, the development of an universal (or at least European) system bearing logos from the banking sector (well known and trusted sector) should increase customers confidence and should ease his acceptation of the product. When observing the market, it can be noticed that e-money issuers are currently (before any regulation) principally actors from the banking sector or are working together with that sector. For example, Discount Investment Corporation (DIC), a non-financial institution which has bought a Mondex franchise for Israel, is deploying its system together with Israeli banking sector.

Some facts

Position of the European Central Bank (ECB)

The position of ECB is firm. With a view to the transition to Economic and Monetary Union, the issuance of electronic money should be limited to credit institutions as defined in Article 1 of the First Banking Co-ordination Directive. The ECB would see great merit in pursuing an amendment to the First Banking Co-ordination Directive so as to include all issuers of electronic money in the definition of credit institution along with institutions which receive deposit or other repayable funds from the public and grant credit for their own account.

RRedeemability

By non-redeemability, we consider the situation in which the issuer is only obliged to reimburse the retailer presenting electronic value, but refrains from redeeming the customer. European Commission Directive Proposal does not deal with redeemability aspects. According to European Central Bank (ECB)