Information technology is contributing to rapid changes in the business environment generally but also, in particular, how we do business. Over the last number of years there have been several new and innovative products which have lead to developments in electronic commerce. Progress in technology has contributed to the development of a new kind of payment instrument – electronic money. This may be in the form of value stored on a technical device such as a chip card or, indeed, a computer memory. Prepaid cards used as an electronic purse have the potential to replace a substantial part of cash payments over the long term. So-called Network money or software money, transferable from a personal computer, is emerging as the payment instrument for the growing electronic commerce on the Internet.
These developments have implications for the European Union both in terms of completion of the internal market and regulatory and supervisory concerns associated with the issuance of electronic money. The European Council at Cardiff invited the Commission "to table a framework for action by the time of the Vienna European Council to improve the single market in financial services, in particular examining the effectiveness of implementation of current legislation and identifying weaknesses which may require amending legislation." The Commission proposal for a directive on the business of electronic money institutions is in the spirit of that mandate. It recognises that there is a legislative loophole in relation to electronic money issuance and aims to plug that loophole. It aims at improving the single market in financial services by introducing minimum harmonised rules and, more specifically, by introducing for electronic money institutions the concept of the single passport. It will create legal certainty, encourage new market entrants, encourage competition, and contribute generally to the development of electronic commerce.
What is electronic money?
For the purposes of this proposal electronic money can best be conceived as a digital form of cash since it has many of the characteristics of cash. The primary similarity is that to use electronic money authorisation is not required from a bank or other third party. Customers buy the electronic equivalent of coins and notes i.e. they exchange cash, on a one for one basis, for monetary value. The customer, in effect, has exchanged cash for another means of payment. Instead of using a debit card (which requires a bank account) or a credit card (which requires first the agreement of the credit card company or bank and second the appropriate advance of funds) the customer has purchased a non-cash means of payment which can be used in much the same way as cash or other forms of card payment but without the requirement of third party authorisation.
This monetary value is stored either on a "chip" card, for example on a card similar to a phone-card, or in the form of computer software, which can be stored on the customer’s PC and can be used to buy both "virtual" products over the Internet (such as music, books, computer programmes etc.) or "real" products which will be delivered to the customer’s home or place of work.
Chip cards generally replace small amounts of cash and are used mainly for small purchases such as newspapers, minor grocery purchases, petrol etc. One of the benefits that electronic money has over cash and other payment instruments is the ability to make very small electronic payments, such as ¼ or ½ of 1 EURO cent for downloading a page of information on the Internet.
Another major similarity with cash is anonymity. No account with a financial institution is required. Consumers can continue to purchase goods with electronic money in the same way as they can use cash without details of their name, bank, etc being disclosed to the retailer. (The Moneylaundering Directive will, of course, apply to electronic money institutions.)
The amount of electronic money, which can be stored on a chip card, is generally limited. For 19 schemes in operation in the EU the maximum limit of stored value is below 250 ecu.
Multi-purpose pre-paid cards
The most common form of pre-paid card is a phone card. This is a single purpose card. It represents a prepayment to the ‘phone company for intended ‘phone calls by the customer. However, a multi-purpose card is accepted by businesses other than the issuer of the card. This card (or computer software as outlined above) can be used in exactly the same way as cash or other means of payment such as a credit card. For example, a multi-purpose pre-paid card can be used to pay parking fees, to make ‘phone calls, to purchase newspapers and magazines etc. subject only to the amount of monetary value stored on the card and, of course, acceptance by merchants.
This proposal is concerned only with multi-purpose electronic money. The directive will not cover, therefore, single purpose cards like telephone cards. The same is true for credit cards, as they do not represent stored money value.
Electronic money and its issuance is only one small, albeit important, element in the overall sphere of electronic commerce. Electronic commerce is, by its very nature, a global issue. A number of other issues, apart from electronic payments, are being discussed at international level and in various fora such as the WTO, the OECD etc. These issues concern, inter alia, encryption (security and confidentiality of information) electronic authentication (electronic signatures to facilitate certainty and security) privacy and protection of personal data, taxation, customs duties, intellectual property rights etc. Government leaders in the G7 and G10, amongst others, encourage positive developments in electronic commerce.
As regards electronic money different approaches are being adopted. In the US for example there are no immediate plans to regulate electronic money issuance and there is, at present, no restriction on who can issue it. This approach is, in part, based on the continuing high usage of cheques as a preferred means of non-cash payment. Moreover, the size and complexity of the US economy make establishing a nation-wide system more difficult. There are, however, a growing number of limited area schemes being developed such as on college campuses, sports stadia, military bases etc.
In May of this year 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. They recommended that issuers of electronic money products continue to explore and develop meaningful self-regulatory approaches to deal with such key consumer issues as privacy, consumer disclosures and protection.
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 European Union now has the opportunity to establish a framework that could become the benchmark for prudential and regulatory developments in this area on the wider international stage.
The need for a Directive
In relation to electronic money, the aim and mandate of the Commission is to build and help unfold the single market in financial services. The focus is on removing barriers for carrying on financial business activities across borders, to follow developments of new techniques and products, allowing their free circulation without unjustified burdens. At the same time the Commission is conscious of the regulatory and supervisory issues associated with electronic money issuance.
The financial integrity and the operations of electronic money issuers must be secured. On the one hand we must ensure the stability and soundness of issuers of electronic money. On the other hand we must ensure that the failure of any one individual issuer does not result in loss of confidence in this new and developing means of payment.
The development of e-money schemes in Europe started in the late 80s/early 90s with pilot schemes in a small number of Member States. However, projects developed rapidly from the mid-1990s. For example, in the early stages of development there were only small pilot schemes in three Member States. This had increased to 24 multi-purpose money schemes operating in the Union by the end of 1996 with only three Member States having no scheme at all. In is anticipated that with increasing usage even more new schemes will be developed.
Against this background, 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 this business can be carried out on an unregulated basis. It is neither in the interests of consumers nor markets generally that this situation be allowed to continue.
Apart from commitments given in previous Communications from the Commission to introduce a regulatory regime for the issuance of electronic money there are other reasons why this issue should be addressed without delay.
The Commission has therefore decided to take a proactive approach to this issue. This proposal will create a harmonised single market in the provision of electronic money in the European Union. It will reinforce stability and substantially eliminate the associated prudential risks. The proposal is timely not only to create legal certainty for potential market entrants but also from the perspective of the single currency.
The Regulatory issues
There is much debate about the potential for electronic money, both card based and computer based. In terms of electronic commerce expectations are very high. For example, the results of research by one organisation suggest that Internet payments will grow from approximately $518 million in 1998 to $6.6 billion by the year 2000. These figures are not untypical of other research results.
The level of individual payments can be quite small and, indeed one of the attractions of electronic money is that it can be used to make micro-payments (for example, 0.5 of one EURO cent per page on the Internet). However, in terms of overall exposure it is evident that a substantial amount of electronic money could be in circulation exposing consumers, but especially traders and retailers, to failure and, in this event, the possibility of systemic risk.
The present proposal deals only with the prudential and regulatory issues concerning electronic money issuers and sets out requirements to be applied to issuers of electronic money products in order to ensure their stability and soundness. The legal and contractual relationship between consumers and electronic money institutions is being examined separately and is dealt with in more detail below.
As well as considerations concerning completion of the single market and the removal of barriers to trade, the Commission is conscious to ensure a level playing field between different types of institution. It is clear that traditional credit institutions too will play an important role in this segment of retail financial business and therefore, the fundamental rules concerning free circulation under the principle of mutual recognition and the supervisory regime to which they are subject, such as authorisation, capital requirement, supervision etc. should also be applied in an appropriate way to electronic money institutions.
The regulatory regime must be such so as to achieve the highest degree possible of a level playing field between different types of institution while at the same time not being overly burdensome so as to impede or hamper the development of this new industry. This is the aim of the current proposal.
The Banking Advisory Committee as well as financial institutions, electronic money institutions, service providers and other interested parties were consulted on the general framework proposed. While there was not unanimity, there was broad agreement on the general approach being adopted.
In preparation of this proposal it emerged that due account must be taken of the potential implications of e-money issuance for the conduct of monetary policy. Concern was expressed that the possibility must exist for central banks to impose reserve requirements on all issuers of electronic money, in particular in order to be prepared for a substantial development of electronic money with a material impact on monetary policy.
The Governing Council of the European Central Bank recently identified three main functions which a minimum reserve system could usefully perform in Stage 3 of EMU. One of those main functions was that "….such system could contribute to enlarging the demand for central bank money and thus creating or enlarging structural liquidity shortage in the market; this is considered helpful in order to improve the ability of the ESCB to operate efficiently as a supplier of liquidity and, in the longer term, to react to new payment technologies such as the development of electronic money."
The proposal by the Commission to amend the definition of credit institution in the First Banking Directive to allow institutions, which are not willing to enter into full banking operations to issue electronic money under the fundamental rules governing all other credit institutions will promote the harmonious development of the activities of credit institutions throughout the Community, in particular as regards the issuance of electronic money, and will avoid distortion of competition between electronic money institutions even as regards the application of monetary policy requirements. The ECB has got the necessary powers to apply, or not to apply these requirements.
Why a different regime for non-banks ?
In the area of banking, the single market in the provision of services was achieved by introducing the single licence regime based upon a minimum harmonisation of prudential supervision. The Commission draft proposals for directives on the issuance of electronic money follow that same route and are very much calibrated on the existing banking directives. 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.
This approach is in line with the principles followed until now. European banking legislation always acknowledged that there are differences between institutions. For such targeted regulation reflecting peculiarities of certain institutions it is of course important that it does not undermine the level playing field. The suggested supervisory regime is certainly less cumbersome than that applying to banks. However, competitive advantages in terms of reduced compliance cost are balanced by stringent restrictions, both in terms of business activities and investments of non-bank providers.
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%.
The business activities and investment capabilities of electronic money institutions are substantially different from those applying to banks. On the one hand it is important to set an initial capital requirement at a level that will not discourage new market entrants and one which reflects the relative risks involved while on the other hand it is important to limit the on-going own-funds requirement to a level that will not adversely affect profitability. These lower thresholds for electronic money institutions are balanced by strict limitations on their investment portfolio.
The Banking Advisory Committee was consulted and acknowledged that investments of funds by electronic money institutions must reflect the fact that the funds serve as the necessary backing in order for the issued e-money to be accepted as a reliable, cash equivalent payment means but cautioned against an overly complex approach. At a technical level National experts generally agreed that the indicated amounts were of a reasonable order.
By using this approach the Commission aims to promote competition in the evolving European e-money market and to allow that market to drive the pace of development and innovation and to offer a quality product that meets the expectations of consumers and is competitive at the wider international level while at the same time not distorting competition between credit institutions issuing electronic money.
The objective of the proposals is pro-competitive; it will naturally be important to monitor the development of the e-money sector to see if specific interventions are necessary in order to promote or maintain competition.
On July 9th 1997 the European Commission published a Communication "Boosting Customers’ Confidence in Electronic Means of Payment". That Communication referred to the link between electronic commerce and new payment instruments which had been highlighted in an earlier Communication, "A European Initiative in Electronic Commerce" It identified four main areas where "a substantial contribution by public authorities is called for as regards electronic payments". Those four areas are set out again here.
- Action (i) They must define the supervisory framework appropriate for the issuance of electronic money so as to ensure the stability and soundness of issuers;
Response: This is the content of the current proposal.
- Action (ii) They must provide guidance for issuers and users, on transparency, liability and redress procedures, in order to ensure the full confidence of users.
Response: Attached to the Communication was addressed a Recommendation to the Member States concerning transactions by electronic payment instruments and in particular the relationship between issuer and holder. Amongst the issues addressed in that Recommendation were transparency of conditions for transactions, including minimum information on terms and conditions; obligations and liabilities of the parties to a contract including obligations and liabilities of the issuer and holder; and settlement of disputes procedures.
Member States were invited to implement the terms of the Recommendation no later than December 31st 1998. The Commission has undertaken to examine the implementation of that Recommendation by the Member States and will take whatever action is necessary in light of that study.
- Action (iii) They must clarify the application of the Community’s competition rules so as to achieve an appropriate balance between interoperability and sound and vigorous competition in these markets.
Response: The Commission, in the light of notifications already received, is currently examining the competition rules governing interoperability.
- Action (iv): They must tackle the risks of fraudulent use and counterfeiting, by improving security.
Response: On July 1st 1998 a Communication from the Commission on A Framework for Action on Combating Fraud and Counterfeiting of non-cash means of payment was issued. The aim of the Joint Action plan contained in that Communication is to ensure that fraud and counterfeit of non-cash means of payment is recognised as a criminal offence in all Member States and set out a range of measures to be taken at National level. There is a commitment for an assessment of the implementation of the framework by the Council based on a report from the Commission by the end of 2000.
In the context of consumer issues it is appropriate to emphasise that the electronic money instruments covered by the current proposal do not represent a deposit. Unlike a depositor, a user does not advance funds to an issuer in order to ensure their safe keeping and handling. Neither the issuer nor the customer pursues this objective. The underlying contract between the customer and the issuer is that the user will get value for the electronic money from those merchants that accept it and that the issuer will honour his commitment to give value.
The issue of reimbursement does not arise in the normal course of events. The customer is making an advance payment for, as yet, undetermined goods and services in the same way as a customer who purchases a ‘phone card has not determined when or where the calls will be made.
The nature of the contract between the issuer and the holder will clearly establish the legal relationship between them. Specific terms, conditions, and other transaction rules, including the possibility of reimbursement, if any, may be determined under the contractual agreement of each electronic money scheme. The contractual provision of reimbursement, if convened, does not change the nature of the contract, because the purpose of the contract does not change; it remains the purchase and sale of electronic money and related payment services.
This proposal is concerned with the prudential and regulatory issues of electronic money. Nevertheless, the consumer related issues will be addressed in a separate Communication followed by specific legislation, if necessary.
Electronic money has the potential to develop into an efficient and effective means of payment; it can play a significant role in the development and improvement of electronic commerce; and it can be an important tool in the completion of the single market and monetary union. The Commission is of the view that it is in the interests of both business and consumers alike that electronic money develops within a regulatory environment that instils trust and confidence in this new and developing payment instrument. At the same time it is vital that development is allowed to take place unimpaired by strict technological rules which will hamper innovation and restrict competition.
The Commission proposal on the taking-up, the pursuit and the prudential supervision of the business of electronic money institutions introduces the regulatory regime necessary to ensure the financial integrity of non-bank issuers without stifling developments in the domain of electronic money and will help to cultivate an environment in which the development of this new means of payment is promoted in the interests of business and consumers.
Outline of the draft directives.
The amendment to the First Banking Directive defines electronic money institutions as credit institutions thus submitting them to the provisions of the First and Second Banking Co-ordination Directives thereby allowing them the European Passport. At the same time it creates a level playing field as between different types of credit institution. Because of the limited scope of the business of electronic money institutions some of the provisions of the banking directives are not applied or are more limited in their application. These provisions are set out in the ad hoc directive.
As regards the ad hoc directive itself, in line with the Commission’s proposed regulatory approach Article 1 suggests a limited scope of application restricting harmonisation of regulation to ‘electronic money institutions’, i.e. non-bank providers of e-money services.
Electronic money is defined in such a way as to cover prepaid cards and network money, however, only if issuance is within a 3-party system, i.e. if the electronic monetary value is accepted as a means of payment by undertakings other than the issuing institution(s).
The business of electronic money institutions, other than the issuance of electronic money, is restricted to the provision of closely related financial and non-financial services, such as administering electronic money; performing operational or ancillary functions; issuing and administering other means of payment. The provision of non-financial services delivered through the electronic device is permitted.
Application of Banking Directives
Responding to the specific nature of e-money institutions and corresponding regulatory needs Article 2 fully or partly waives application of some of the 40 Articles of the First and Second Banking directives. Yet, for the taking up and pursuit of business, e-money institutions are subject to the same conditions as credit institutions. Requirements as for credit institutions apply notably with respect to
Article 2 clarifies that, except for the Money Laundering Directive and the Consolidated Supervision Directive, other EU banking legislation does not apply to e-money institutions unless this is specifically provided for.
Thus, subject to compliance with the requirements pursuant to Articles 3 to 6 regarding notably restrictions of activities, limitations on investments and adequate own funds, e-money institutions would fully benefit from the freedom of establishment and provision of services as provided for in the 2BD.
Article 2 also provides that the contractual arrangements must specify if the stored value is redeemable and, if so, the specific contractual conditions.
Initial Capital and on-going Own Funds Requirements
Article 3 introduces ongoing own funds requirements. These requirements are necessary in order to ensure that e-money institutions have own funds commensurate with the size of their operation. The suggested yardstick is set at 2% of the higher of the institution’s current amount or the average of the preceding 6 months total amount of unredeemed e-money issued by the institution in question. In any event the amount may not fall below the initial capital requirement of 500,000 ECU.
Limitations of Investments
Article 4 proposes limitations on investments that reflect the need for a prudent investment policy of issuers of e-money, to contain in particular the exposure to liquidity risks of issuers. Accordingly, the proposal requires that funds received in exchange for issued electronic money should be invested only in highly liquid assets which attract a 0% credit risk weighting in accordance with the Solvency Ratio Directive. Hedging of market risks by highly liquid exchange-traded derivative instruments subject to a 0% credit risk capital charge would also be allowed.
In addition, electronic money institutions may invest in other highly liquid debt instruments and have ancillary liquidity in the form of sight deposits held with Zone A credit institutions. However, such investments are subject to a ceiling of twenty times the institutions’ own funds and subject to large exposure limitations as least as stringent as those imposed on banks.
The limitations on investments respond to the need of imposing a relatively low-risk investment policy, which appropriately reflects the liquidity risks to which electronic money institutions are exposed. The imposition of this low-risk investment requirement helps to ensure the stability and soundness of the issuers thereby protecting the e-money system and consumers in general.
Article 5 imposes a requirement on competent authorities to verify compliance by e-money institutions with Articles 3 and 4 at least twice each year while Article 6 emphasises the obligation to have sound and prudent operations.
Article 7 affords an option to the Member States allowing for a waiver of certain of the provisions of the proposals commensurate with the risks inherent in small e-money schemes. The waiver may only be applied to e-money institutions underpinning relatively small schemes.
The underlying considerations are that the overall unredeemed e-money does not exceed ECU 10 million of unredeemed e-money and that the storage device has a capacity of ECU 150 of maximum loading amount.
The waiver only applies to business activities (Article 1(4)), application of the First and Second Banking Directives (Article 2(1)), initial capital and own funds requirements (Article 3(1)) and Article 8 which requires existing electronic money schemes to submit information to the competent authorities.
Such small schemes will not benefit from the passport provisions. They will, however, continue to be subject to the other provisions such as limitations on investments, limited ongoing own funds requirements, an obligation to have sound and prudent operations, semi-annual reporting requirements and application of Money Laundering Directive etc..
Article 8 provides for a grandfathering as regards the authorisation requirement for e-money institutions already operating at the date of the coming into force of national provisions implementing the European regulation.
The remaining Articles are the standard implementation and notification