As the UK consumer credit market braces itself for the latest changes I am taking a look across the pond at the latest payment phenomenon in the USA the "Pre-Paid Card". At its current rate of growth it is predicted to have more than 50% of the payments market within 10 years - so what is it?… and what are the legal and regulatory challenges it faces?

What is a pre-paid card? With a credit card consumers purchase the goods or services today with a view to paying back the credit card company with interest at some point in the future – this can be summed up as "buy now – pay later". With a debit card consumers link their bank account to the payment card so that monies are deducted from their current account at the time of the purchase – this can be summed up as "buy now – pay now".

Turning now to a pre-paid card here, in the same way as with a mobile phone top up card, the consumer is required to pre load the card with cash in order to be able to use it to purchase goods and services up to the amount that has been loaded up onto the card - this can be summed up as a "pay now – buy later".

The benefit of the pre-paid card is that consumers, rather than racking up too much debt are able to manage their finances properly and sensibly without spending more than they can afford. This is exactly what the OFT and the government want – sensible financial management by consumers and a reverse in the trend of rising consumer indebtedness.

So what are the legal and regulatory challenges in setting up and running a pre-paid card?
The core of the new thinking in this area is e-money, as the prep-paid card proposition is in effect e-money being money deposited on a card. The implementation of two European Directives ("the Directive") by the Financial Services and Markets 2000 (Regulated Activities) (Amendment) Order 2002 ("the Order") which came into force in the UK on 27 April 2002 and which amend the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 are the way in which this area is regulated in the UK at present.

There are several objectives underlying the Directive. These include consumer protection and the promotion of consumer confidence in e-money by ensuring the financial integrity and stability of electronic money issuers ("EMIs"), the provision of a single passport so that EMIs authorised in one member state can issue e-money throughout the EU and ensuring that authorised credit institutions are not put at a competitive disadvantage by regulating all EMIs and restricting their activities and investments.

The Order begins by defining 'electronic money' as "monetary value, as represented by a claim on the issuer, which is (a) stored on an electronic device; (b) issued on receipt of funds; and (c) accepted as a means of payment by persons other than the issuer" – clearly this is a fitting description of a pre–paid card. The Order then provides that issuing e-money is a 'specified kind of activity' (which means that it is regulated under the Financial Services and Markets Act 2000 ("FSMA") unless the EMI has a certificate of exemption. The exemption is available to small EMIs which can satisfy certain criteria – i.e. the EMI does not issue e-money on devices which store more than €150 and either (i) does not have liabilities usually exceeding €5 million and never exceeding €6 million or (ii) does not have liabilities exceeding €10 million and the e-money is only accepted by its related companies or (iii) does not have liabilities exceeding €10 million and the e-money is only accepted by no more than 100 persons who are either located within a limited local area (for example, less than 4 km2) or who have a close business/financial relationship with the EMI.

The exemption does relieve small EMIs from most of the provisions of the FSMA (including the obligation to pay the full authorisation fee) but the EMI still has reporting obligations including the obligation to provide the FSA with information on request and is still subject to other regulations including the Money Laundering Regulations 2001 . Furthermore, the FSA has the power to revoke the certificate where the relevant conditions are not met.

The Order departs from the Directive in several respects. For example, the definition of 'electronic money' in the Directive includes the criterion that e-money is issued on receipt of funds "of an amount not less in value than the monetary value issued". The Treasury considers this to be a loophole in the Directive as the issue of e-money at a discount would therefore not be e-money and not fall to be a regulated activity.

For this reason the Order deals with the issue of e-money at a discount in a separate article, which provides that the FSA may make rules prohibiting the issue of e-money at a discount. The Financial Services Act Compensation Scheme does not apply to EMIs because the Treasury has taken the view that consumers and merchants are unlikely to hold significant amounts of e-money at any one time and the costs of funding such a scheme might act as a barrier to new entrants. Furthermore, the Ombudsman Scheme (which applies to other regulated activities under the FSMA and which might have had a positive impact on consumer confidence) is not provided for in the Order, although it is not required by the Directive.

However, whilst becoming an EMI may seem like a good way to run a pre-paid card program in the UK, its limitations on amounts that can be stored on devices and maximum liabilities mean it can only be used for small programs. Therefore, in order to run a program which could properly be scaled to meet the demands that are predicted, it is again left for the banks to take up the mantle and run them as part of their retail banking proposition as a bank you will need not only to have a FSMA deposit taking permission but also permission to issue electronic money.

In addition to the banking requirements to achieve national acceptance in the UK market, the issuers will need to offer a VISA or Mastercard product and run the program off of their platforms. Both of these card associations have already geared up for the launch in the UK with terms, conditions and regulations already in place awaiting the first entrant in the market. However, to date only one company is issuing, non gift card, pre-paid cards in the UK and they are issuing in a "closed loop" environment outside the card association platforms. Why is this? Quite simply no UK bank has agreed to run a pre-paid card and, without a bank that is a member of a card association, you cannot issue the pre-paid card.

However, the UK's gift card market is growing rapidly with closed loop EMI's issuing pre-paid gift cards and so it is unlikely that the banks will not see the opportunity and look for partners to launch with in the next year. In the US the Starbucks’ prepaid card pioneered a trend that leads Pelorus to predict US consumers to buy 400 million convenience (prepaid/stored-value) cards in 2004, rather than wait in line to pay for a coffee or food. With about 30 million US households (almost one in three) lacking a credit card, Pelorus identifies this group, together with the 25 million-plus teenagers, as “a prime target for stored value alternatives”. It is predicted that within three to five years, almost every retailer in the UK will offer gift cards to boost overall sales and foot traffic . Some UK retailers are beginning to implement the gift card as a profitable, achievable entry point in a comprehensive payments strategy that can easily encompass store cards, and later, scheme-branded cards. Gift-card holders typically spend about 18 per cent more than the value of a card at a retailer, and visit the store at least twice more to spend the total balance on the card, according to research by TSYS. Furthermore, gift cardholders not fully spending the value on their card, tend to leave 10 per cent of its value unspent, which is an excellent additional source of income for retailers provided the retailer has terms and conditions for dormant cards which allow them to collect the balance if it not spent within a certain time.

So what are the key lessons to be learned?

1. the banks and retailers that move into this market will make a high bounty .

2. the key markets for the product will be:
a. Youth market – 15-19 year olds (7.2 million consumers with a market size of approx £25 billion)
b. Non-Standard – 18 year old + (non status, non conforming, credit impaired, sub prime – 7.3 million consumers with a market size of approx £27 billion)
c. Migrant workers requiring a simple and cheap means of sending money to their families abroad (size of market unknown for UK)
d. Gift card market (size of UK market unknown)

3. The Government and OFT will be in favour of the product as it will encourage sensible spending within the consumers means.

4. With the additional regulation hitting the consumer credit market pre-paid cards will be the easier option for banks to issue.

A large chain store retailer could see third-party gift card sales surpassing $100 Million a year. At an average commission of 10%, that would be over $10 Million of new gross profit dollars to the bottom line with no product cost, no inventory and no shrinkage. Tefisto Partners
Youth Data, population statistics, 2001
Non-standard data report, Datamonitor 2003
Bain & Co estimated stored-value gift card sales for 2002 at USD 36 to USD 38 billion, a 20 per cent increase on 2001
Salomon Smith Barney believes gift cards to account for 5 per cent of total sales at major US retailers.