21 December 1997
Thanks to Ian Grigg

LONDON BANKERS CLUB
Seminar on Electronic Money, hosted by the Bank of England

# Electronic Money: a European Perspective

by
Henny van der Wielen
Deputy Director of the central bank of the Netherlands
London, 4 February 1997

Table of Contents

- I. Introduction
- II. Why central banks are involved
- III. Risks of a `laissez faire' approach
- IV. Minimum requirements: the Dutch example
- V. Differences in implementation
- VI. Challenges in the years ahead
- VII. Questions frequently raised
- VIII. Summary

## I. Introduction

1. Mr Chairman, ladies and gentlemen, today I am not here as the chairwoman of the present EMI task force on electronic money, since the work of the task force is still in its very early stages. I am primarily here as a central banker and as such I feel honoured to be able to address this distinguished group of bankers. I also feel challenged as London bankers are well-known for their sophistication in economic and financial matters. What makes it even more challenging is the thought that you probably see me as yet another of those trustworthy but stuffy, dogmatic central bankers who if they get any new ideas at all, should be watched with suspicion. These mixed feelings of trust and suspicion are beautifully illustrated in the cartoon on this year's Christmas card that I received from the Bank of England, and that you might have received as well. (slide) You are probably familiar with the scene. Almost two hundred years ago the Bank of England, due to the state of the reserves and under the threat of an invasion by the French, stopped payment of its banknotes in gold. This measure met with considerable mistrust from some while others were willing to keep their trust in the central bank and to accept the banknotes.

2. Today we are talking not about paper money but about electronic money. I will not discuss the various electronic money schemes as other speakers today have already done so. From their presentations it has become very clear that the rapid innovations in chipcard and network technology that we are witnessing today, hold out prospects for dramatic changes in payment services to customers which in turn herald a revolution in the retail payment sector. These developments will affect all economic agents, including banks and central banks.

3. In the next 15 minutes I will first explain why electronic money goes right to the heart of central banking and what risks are run if electronic money schemes are not properly supervised. I will then set out which aspects are important to central banks and which requirements have to be met by electronic money schemes in the Netherlands. I will touch on the differences in institutional set-up between Europe and the United States and on the different ways to achieve central bank goals. Finally, I will indicate the major challenges that lie ahead of us and will touch on some of the frequently heard questions.

## II. Why are central banks involved ?

4. Central banks are involved because electronic money, when widely usable, represents purchasing power. It is just another form of fiduciary money, which will only be accepted by the public if there is complete trust in the issuer. It was precisely because of the lack of trust in the issuers of the first form of fiduciary money (banknotes) that central banks were created and that central banks became the sole issuers of banknotes. Over the years, as the public increasingly accepted commercial bank liabilities as a means of payment, commercial banks have to a large extent taken over the role of issuers of money and central banks have found other ways of safeguarding public confidence in the national currency: supervising credit institutions, providing settlement facilities, operating and/or overseeing payment systems and conducting monetary policy.

5. These very core functions of modern central banking are at the basis of the European Monetary Institute's report on prepaid cards published in May 1994, of which you are undoubted aware. In this report, the EU central banks formulate four objectives with respect to multi-purpose prepaid cards: (1) to protect consumers against the risk of failure of the issuer; (2) to protect the integrity of the retail payment system; (3) to facilitate the conduct of monetary policy and (4) to ensure a level playing field for issuing institutions.

6. The report concludes that these objectives would best be met by requiring that issuers of multi-purpose prepaid cards have the status of credit institutions. The underlying idea is that credit institutions are already under adequate supervision for activities which, in an economic sense, are very similar to prepaid card issuance, namely deposit-taking.

7. The EMI report deals with prepaid cards only. Since its publication, developments have moved on to network-based electronic money. Understandably, considering the enormous potential of network money in many respects, these developments have drawn considerable attention from the authorities and international bodies, the EMI included. The discussions on this topic will still take some time but it is my personal view that what I have said about the core functions of the central bank and about the objectives to be met by card schemes, holds equally well for electronic money stored in and transported by computer networks. Not only is the type of carrier for money irrelevant from the perspective of the "central bank mission" but it would in practice even be impossible to make a distinction by type of carrier. Not only would card schemes enabling card-to-card payments over the telephone come very close to Internet-like systems, it is also likely that systems will develop which will accommodate both types of carriers. So much for the similarities between electronic purses and network money in terms of central bank tasks. I will come back to the implications for central bank policy later. Before that I would like to elaborate briefly an the question of the risks that would be involved in a `laissez-faire, laissez passer' attitude.

## III. What are the risks of a `laissez-faire' approach ?

8. Put differently: what are the risks if central banks don't do what they were set up to do. That is what it boils down to if legislators ask for a risk analysis in their search for material to support new laws or amendments to existing laws. But not only legislators ask for a risk analysis. The banking and the non-banking community ask for it as well if they fear interference by their supervisors. Even central banks ask themselves this question as part of an analytical exercise in order to come to grasp with the new phenomena and to ensure effective policies.

9. The first part of the answer is that the clock would be set back a few hundred years. The holder of electronic money would run the risk that the issuer would not be able to meet his obligations. There would be no mechanism aiming at the management of funds in such a way that obligations could be met, as there would be no rules to counter e.g. solvency and liquidity risks.

10. The second part of the answer is that there would no longer be a safeguard for the reliability and security of the retail payment system. After all, electronic cash (on cards or networks) is an attractive instrument for many parties for reasons of cost efficiency and float income. If electronic money is issued by parties with a less than sound credit standing and/or relatively high-risk asset management there is an increased risk of failure, either because of reasons of mismanagement or because of a design weakness in the operating system of a widely used chipcard or because of the use of inferior chips that permit fraud. Public trust could be compromised not only in electronic money schemes but eventually also in other parts of the payment and financial system.

11. The third part of the answer is related to monetary policy. The money stock will expand without the central bank being able to monitor it. Of course, the holder of electronic cash only substitutes one form of money for another, but if a non-bank acquires additional assets the economy's overall purchasing power increases. If such a development were to occur on a large scale, monetary analysis would be hindered. In addition, the adequacy of monetary instruments would be affected.

12. On the assumption that everybody is convinced that `electronic' money is still money and should be treated as such, I will continue to explain what aspects in electronic money schemes are considered important by central banks. I will do so with the aid of the Dutch example.

## IV. Minimum requirements: the Dutch example

13. For your information: in the Netherlands, at present, we are witnessing fierce competition between two major chipcard initiatives. Legal opinions have confirmed that multi-purpose prepaid cards and network money are equivalent to deposit-taking. This means that issuers of electronic money need a banking licence and are subject to supervision.

14. In order to screen the new electronic money initiatives, a checklist was drawn up in order to obtain information on the implementation of the schemes with respect to: the general characteristics of the schemes, the institutional and organisational setup, the legal aspects, the issuing, accounting and administrative processes, float management, security, technical and infrastructural features.

15. On the basis of these reviews, we formulated a number of minimum requirements. Some of them are part of the normal supervisory framework, some are additional:

- the management of the issuing institution and the operator of the scheme should possess the requisite competence and integrity;

- reporting and capital reserve requirements are applicable;

- a sound legal basis should be established where responsibilities for all parties are well-defined and communicated;

- the issuing institution should enable the central bank to extend its supervision to scheme operators, if not banks, and to subcontractors;

- relevant international professional standards, such as accounting standards, best practices and security standards should be applied.

16. This might sound all rather vague to you. But each of these requirements has been specified in detail. Let me give an example for the minimum requirement on technical security. With respect to technical security our central bank wants to be satisfied that electronic money schemes include adequate technical and other safeguards to prevent, contain and detect threats to scheme security, particularly the threat of counterfeit. Security measures must meet relevant international standards. Contingency arrangements should be in place in the event of failure of technical and operational systems. Electronic money schemes should provide for adequate accountability and audit trails. A security officer must be assigned to each scheme.

17. I believe it was Oscar Wilde who once said: `If the Gods want to punish us, they will answer our prayers'. After hearing the requirements of my central bank, you might feel that they come in the category of the prayers. Nevertheless, I consider a framework of minimum requirements for electronic money schemes to be a helpful instrument focusing attention unambiguously on the subject matter, thus enabling the central banks to ensure that the overall goals are achieved while at the same time avoiding unnecessary institutional barriers. It might be interesting for you to know that in the Netherlands operators for both schemes are non-banks. The framework of minimum requirements enables the central bank to ascertain that the activities of scheme operators are safe and sound. At the same time the funds are on the books of the banks and are managed by the banks. Minimum requirements focusing on the subject matter might also help to bridge the gap in institutional arrangements between Europe, on the one hand, and countries like the United States, on the other.

## V. Differences in implementation

18. With a measure of simplification, one could say that the European central banks have thus far required issuers of electronic money to be banks, while the United States has thus far been in favour of a no-further regulation approach. When comparing the regulatory approaches adapted by countries, it is important to allow for the historical and cultural differences that are reflected in the regulatory frameworks.

19. Looking more closely at the situation in the United States, one sees that US regulation is very much goal-oriented. Separate legislation provides for separate regulatory goals. Issues such as consumer protection, deposit insurance and banking supervision are all dealt with in separate laws, creating a considerable number of regulatory institutions with strictly defined missions. Furthermore, there is regulation of banks and payment processors at both state and federal level. The current feeling amongst US regulators might therefore be summarized as no more regulation as opposed to no regulation.

20. In Europe, for a long time, only banks or governments acted as the operators of payment systems. The issue of supervising electronic money is therefore naturally viewed as a question of adapting or using the banking supervisory rules. This does not necessarily imply a rigid approach, as I hope the Dutch example has made clear.

21. But even within Europe it is not crystal-clear that the legal framework in the different countries is appropriate for implementing central bank policy decisions. Legal definitions of money, deposit-taking and banking concepts differ among countries as do legal interpretations of the definitions. Apart from questions related to the applicability of existing national legislation to electronic money activities, there is a set of questions related to law enforcement. The point here is that even where national legislation does extend to issuance of electronic money through networks, it may be difficult in practice to exercise control over such activities. This is particularly if when they are undertaken from across the border.

22. Although there are strong legal and institutional differences between the United States and Europe and even between European countries, I am convinced that within these different set-ups, the goals pursued by the authorities are very much the same. At the end of the day, the monetary authorities want to preserve public confidence in the national currency and in the financial system.

## VI. Challenges in the years ahead

23. The major challenge that the authorities will have to face in the years ahead is to identify the common goals and to make sure that these goals can also be reached where electronic money is concerned. In doing so, the existing institutional framework will have to play a significant role. This is very important ! Institutions cannot be changed overnight. The greatest danger for Europe would be to adopt a wait-and-see attitude, to lame-duck so to speak the existing institutions thereby creating a vacuum, merely because of the fact that the same things are handled differently somewhere else. If in Europe the responsibilities of the monetary authorities and/or the institutional framework demands that certain activities should be licensed, that approach will be the way to go forward. If in the United States potential problems stemming from electronic money activities can be adequately tackled by existing legislation, nothing more needs to be done.

24. At the same time, it is important to reach a broad consensus on the common goals for electronic money. Minimum requirements, as I described for the Netherlands, can be a helpful instrument both in identifying these common goals and in determining the best ways to achieve them within the existing frameworks. Minimum requirements might, for the very same reasons, even prove to be a helpful instrument within the European Union.

25. All this requires international coordination. At the EU level international cooperation in the field of payment systems has intensified in recent years in the wake of the transition towards the single currency and the European Central Bank. Although European central banks focus their attention primarily on large-value payments, common approaches towards retail payments will be adopted when the financial reliability of payment systems or the implementation of monetary policy would be at stake, while e differences in approaches would jeopardize the level playing field. The 1994 report on prepaid cards, which I mentioned earlier, is an example of such a common approach.

Studies for a common approach on the new electronic money instruments are now underway. Cooperation on electronic money issues among central banks is also being established at the broader level of the Group of Ten which has contributed to a common understanding of the issues and problems involved.

## VII. Questions frequently raised

26. One of the frequently raised questions is whether the European prepaid card approach does not stifle competition.

This question was prompted in the past by the rather widespread belief that the central banks were limiting the issuance of prepaid cards to existing banks. This, however, was not and will not be the case. The market is also open for those who are prepared to establish a bank or to involve a bank in the project in such a way that it bears full responsibility for the money flows involved. At our central bank, we have often pointed out that, although all banks are subject to the same requirements in terms of liquidity, solvency, reporting et cetera, this should not be seen as prohibitive for non-banks to enter the prepaid card market. After all, if a market participant would choose to do no more than receiving the monies loaded on prepaid cards and hold the float in a liquid form -- like bank deposits or government securities -- only a relatively small part of existing requirements would be applicable to such a market participant.

27. Furthermore, events in the Netherlands have shown that competition is not reduced at all. On the contrary, competition is fierce. So far, the battle for market shares between the parties involved has proved beneficial, in particular to card acceptors. Not only have prices come down considerably relative to what had been planned initially, but there is also been an increase in card functionality: combining payment functions with other functions such as loyalty programs.

28. Another frequently heard question is whether the European approach is not a bit heavy for smaller electronic schemes.

As you are aware, the EMI report distinguishes between single and multi-purpose cards. Only multi-purpose cards are considered to represent general purchasing power, or in other words are considered to be money. Many of the smaller schemes involve single-purpose cards which are explicitly outside the scope of the report. Questions whether thresholds should be applied to multi-purpose schemes, and if so, what demarcation lines should be used, are still being debated.

## VIII. Summary

29. To sum up:

- Electronic money is still money and should be treated as such;

- Money involves the central banks as the guardians of public trust in the national currencies;

- Electronic money has potentially a `global' rather than a `European' character;

- Traditional instruments and institutions might not be such as to permit identical action by the supervisory authorities on a global scale;

- This should not prevent the EU countries, where instruments and institutions are more alike, from formulating a common policy. Not to do so would be dangerous;

- International cooperation on a global scale should focus on the identification of the common goals in respect of electronic money. Formulation of a set of minimum requirements, as was done in Netherlands under the Banking Supervisory Act, might be helpful.

30. Mr Chairman, to end this speech, let us go back to the slide. Two hundred years ago, the British people trusted the central bank. They were proved right. Today you still trust the central bank. But you will still have to trust us two hundred years from now. That was what this talk was all about. Thank you very much.