Bank Stories (1): Private Banks Built On Plastic

NOTE: The following is Scoop's first bank story. Owen has earned himself a double pass to The Bank movie, coming to a cinema near you soon. See... Scoop Interactive: Do You Hate Banks? for info on how you too can bend an ear or two and score a double pass to The Bank.

World travellers of the nineteenth century took it for granted that their wallets were stuffed with bank notes which came not only from different countries but from different private banks within those countries. Banks not only had the power to create money - they were also allowed to print it. By the end of the twentieth century most of us now take the idea of central banking for granted. The notion that banks should be allowed to print their own bank notes seems bizarre. Yet new developments in electronic technology are taking us down the track towards privately generated currency.

There are essentially three types of card-based alternatives to cash. The advent of wide bodied jets and computer reservation systems drove the Diners Card (until then no more than a convenient means of payment for an American Club of diners) into the global market place. Other cards soon followed; American Express, Visa, Mastercard and others are recognised and accepted world wide. These are true credit cards in that they allow the card-holder to “pay later”.

More recently, as electronic cash registers became connected to central computers through the telephone lines, the transfer of electronic funds at the point of sale (EFTPOS) became widely available. These systems encouraged the entry of new or modified cards which could be used to make payment directly from deposit balances. EFTPOS cards are true debit cards - the user must “pay now”.

The third and most recent development is the stored-value card. While such cards can be quite dumb or very smart all such “stored value” cards demand that the user must “pay before”.

Stored-value cards carry some form of electronic memory (a magnetic strip or electronic chip) which stores pre-paid value which can be drawn down by the user to make a purchase. The telephone card is a storedvalue card in which a simple magnetic strip card is limited to a single loading and to serving a single function - in this case making phone calls. When the denominated value is used up the card can be thrown away. Truly smart cards contain an embedded electronic chip which can be loaded and re-loaded at any time and with any amount. Such smart-cards can be used for a host of daily transactions such as parking meters, buses, taxis, Lotto tickets and indeed any of the purchases for which we presently use small change and notes. One of the objections to predictions of cashless societies has been the need to carry loose change to deal with these low value transactions. Smart cards diminish the weight of these arguments.

Smart cards can also be used to pay for more expensive services such as restaurant meals or hotel bills and in any currency at the exchange rate of the day. The scope of smart-cards is limited only by the willingness of traders to provide a card-reading facility at the point of sale.

Debit cards always require verification of the availability of funds or credit before the transaction will be completed and the necessary transfer of information is expensive. Smart-cards eliminate the whole process and so smart-card transactions are estimated to be at least 70% cheaper than the nearest card-based alternative.

Smart-card systems can be designed to provide real benefits where speed is the key - such as in public transport or taxis. In such environments smart cards are no longer just substitutes for notes and coins - they can provide a definite improvement in service. They may also prove to be a boon for the blind, deaf of otherwise physically handicapped. All this means that a truly smart-card can claim to be the electronic equivalent of a wallet full of cash - which is why it is sometimes called “an electronic purse”.

Could such cashless systems finally displace notes and coins in the near future? Regular currency remains alive and well even in the developed world. The available data indicates that notes and coins account for about 80 - 90 percent of the total number of transactions, with a further 5 - 8 percent using electronic transfers, while cheques and other paper based methods account for the balance. These figures suggest that cards have a long way to go. However, cash accounts for only about 10 percent of the total value of transactions in modern economies and that there is a strong move away from cheques towards credit cards. For example, in Australia there were 30,466 EFTPOS terminals in place in 1993. This represented 16% more terminals in a single year; but the number of debit card transactions rose by 46% over the same period.

Telecommunication companies have taken an early lead toward issuing private currency with their phone cards. Many telephone companies around the world are gearing up to expand the scope of their cards to deal with public transport and other transactions. The end result is that such communications companies will soon be taking on the same role as the private banks of the 18th century who printed their own bank notes. The Telecoms of the world will be printing plastic cards in which a tiny chip "promises to pay on demand". It makes sense. If the telecommunications companies are going to lose the cash flow generated by debit and credit card transactions over the phone lines they may as well generate new profits from this new service. Major airlines and international hotel chains will soon print their own smart currency - so that travellers will no longer need travellers cheques or have to pay high margins to exchange money at government owned bank counters in airports around the world. In June 1994 both Mastercard International and Visa International announced their agreement to establish a global standard for smart cards to be used in financial transactions.

All this means that central banks are about to loose their present monopoly over the production of the hand-to-hand medium of exchange. This may sound like a major revolution. And indeed those central banks who depend on a requirement to hold a proportion of wealth in the form of deposits may become quite agitated. The "light-handed" regulators such as the Reserve Bank of New Zealand have no such requirement for central deposits and depend on the issue of Treasury Bills and the like to soak up surplus money from the market.

Central banks presently monopolise the production of notes and coins and make profits by issuing currency which pays no interest while purchasing interest bearing assets with the proceeds. These profits, known as seigniorage, are added to the general tax base and help to fund public expenditure. The move to a cash-less society will deprive governments of these funds.

Curiously most central banks have been remarkably silent on the potential of smart cards to break their monopoly over currency - which is doubly remarkable given the way they have jealously guarded this monopoly over most of this century.

The Reserve Bank of New Zealand is a notable exception. An article in the Reserve Bank Bulletin Vol 57, No 4 1994. pointed out that debit cards have few of the attributes of currency although they meet the test of being standard and anonymous. (See Box) Private electronic purses may meet the tests of negotiability, anonymity and convenience but probably not the test of being risk-free, universally negotiable and standardised.

The Attraction of the Currency of the Realm.

Currency is a standard product and is easily recognized and identified. Currency is risk-free in that the Central Bank stands behind it. (Of course it can be lost or stolen)

Currency is fully negotiable. Possession alone establishes right of use. Currency permits anonymous use and its use is not directly traceable. Currency is convenient and efficient for making small payments. Currency is a valid consideration in all places and circumstances and (unless forgery is suspected) its status cannot be questioned - at least in its country of origin.

When it comes to the crunch currency is the only "real money". These attributes of the currency of the realm explain why currency continues to be generally accepted and remains in widespread use. Hence private smart cards are likely to remain more like debit cards than currency although the Reserve Bank noted that a smart card issued by a central bank could be set up so to pass all the above tests.

A key distinction between privately issued smart cards and currency is that currency is guaranteed by the central bank. It is not clear where the liability for different private pre-paid cards will rest, but they will obviously not carry any government guarantee. The public will need to be realize that the the value on their card is only as solid as the organisation standing behind it. We should not need reminding that even banks can fail.

The Reserve Bank article concedes that the argument for a statutory monopoly rests more on the desire of monarchs and governments to keep the siegniorage revenues to themselves.

But in a low inflation, low interest rate environment the profit on the currency issue may be insufficient to cover the production and administrative costs involved. The Reserve Bank article emphasises that maximising seigniorage should not be its prime policy and concludes:

Rather the Bank's role is to facilitate and encourage overall payment system efficiency by continuing to offer currency as just one payment technology amongst several. Alternative payment technologies and innovations can be freely allowed within this framework and users can be allowed to choose freely amongst those competing technologies.

The Reserve Bank of New Zealand, at least, sees no threat from such pre-paid cards and even if it did so, the article suggests that:

he appropriate response would not be to seek to control or prevent such developments but that it is much better to adapt the monetary policy operational framework to the realities of the marketplace than to seek to do the opposite.

The Reserve Bank of New Zealand has taken the position that its independent status and New Zealand's light-handed regulatory environment adds up to an environment which is conducive to innovation in the market-place and which allows the Bank to take a more relaxed attitude to change than their equivalents in many other jurisdictions. So we can conclude that in many countries the public debate will heat up when Governments notice that their seigniorage is slipping away or when the next bank to collapse drags a trail of valueless smart-cards in its wake. New Zealanders may well be able to watch such goings-on with a suitable measure of disinterest.

Owen McShane

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