UK: A Payment Revolution – The First Viable Alternative to Small Change - Securities and Banking Update May 2005

Commentators have been talking about the end of cash and its replacement with an "e-purse" for years but now, finally, some schemes are actually delivering on the hype. Louise Brett and Peter Simon examine what it takes to make chips do the work of coins.

A tiny chip is set to replace a fistful of coins and notes for many everyday low-value payment transactions. Demand for the latest generation of contactless payment solutions is likely to be driven by consumers and retailers. Widespread consumer adoption will not just depend on maximising ease of use; creating contagion requires ubiquitous merchant take-up and a profitable business model.

Industry commentators, technology companies and banks have been talking up the possibility of universally accepted "e-purse" systems for small transactions for almost two decades now. So far the reality has never lived up to the hype.

Advances in smart card technology and falling unit costs mean that the technical barriers have all but disappeared. Consumers are much more attuned to the idea that a tiny chip incorporated on a card, or within another everyday device such as a phone, could be used to store money: allowing them to pay for a daily paper, a cup of coffee, a bus fare, a lunch or a pint of milk without having to carry around a pocket full of coins.

Early systems, such as Proton in Belgium, relied on contact technology where the card had to be physically swiped across a reader to pay for goods or be topped up with cash. The new generation of smart cards utilise contactless technology: users simply tap and go.

The potential benefits are significant for many types of organisations ranging from conventional financial services providers to retailers, transport, telecoms, utilities, sports stadia and local councils, to name just a few. This means the market could rapidly become a crowded place as various organisations look at different ways to make money from this new product. Nevertheless, there are many strategic, logistical and regulatory challenges for organisations to overcome along the way, many of them interrelated and extremely complex.

Early attempts at electronic purse applications resulted in some high-profile flops, such as the trials of Mondex in Swindon. The technology was cumbersome, expensive and unreliable, and implementation costs were too high. Some schemes failed to implement a strong strategy to attract merchants and anchor them. First-generation schemes used contact card technology, which is just as slow as a conventional credit or debit card transaction.

The new breed of successful contactless schemes focus on a clearly defined target population: such as the users of mass transit, in the case of Hong Kong’s Octopus card. While the primary scheme is used for public transit access, it now provides crosssell access to merchant products and services on the back of the initial application. Consumers are encouraged to use the scheme as they must pay for their fares on the transport network, so take-up of the up e-purse for products and services was rapid once the merchant network was in place.

Where do people spend "real" money?

In the UK economy, cash is still king. According to APACS, people use notes and coins for 75% of all transactions by volume, and although cash accounts for a smaller proportion of transactions by value (42%), there is little danger of it disappearing in the near future as a favoured method of payment. Unless, of course, contactless payment schemes can make big inroads by targeting key areas for "micro-payments".

Deloitte research indicates that not only are 63% of all cash transactions less than £5 but around half of all "micro-payments" (transactions of less than £15 in value) are accounted for by just eight key categories of spending. In London, for example, the top three categories account for 25% of micro-payments:

• Top-up groceries.

• Spending at confectionery, tobacco and newsagents outlets.

• Payments in pubs and bars.

Fast food, taxis, pre-paid mobile phone top-ups, public transport fares and off-licence sales make up a further 25%. Only by targeting the most popular types of transactions, can scheme providers build the volumes they need to make their service economically viable.

Regulatory and tax implications Any organisation considering a stored value payment scheme needs to tread carefully. The regulatory authorities in the UK have far-reaching powers when it comes to monitoring e-money issuers and ensuring that they comply. It is essential to structure your business from the start in a way that enables compliance.

FSA rules set out stringent requirements for e-money issuing entities in these key areas:

• Capital structure and liquidity – including the initial capitalisation and on-going requirements, whether debt can be used to fund the scheme, and how you are allowed to invest the "float".

• Senior management team and their roles – under FSA’s "Approved Persons" rules, the members of the senior management team have strictly defined roles and responsibilities. They must be appropriately trained and skilled to carry out those roles, and have personal liability for their actions in this capacity.

• General systems and controls – everything from IT and disaster recovery systems, to risk management processes must be geared to prevent fraud, ensure accurate reporting and maintain security.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.