Kohlbach Making Sense of Electronic Money
Journal of Information, Law and Technology
Making Sense of Electronic Money
Manfred Kohlbach
Institute for European Legal Development
University of Graz
This is a refereed article published on: 30 April 2004
Citation: Kohlbach, 'Making Sense of Electronic Money', 2004 (1) The Journal of Information, Law and Technology (JILT). <http://elj.warwick.ac.uk/jilt/04-1/kohlbach.html>.
Abstract: This article offers (1) a comparative overview of electronic money regulation in America and Europe as well as (2) a second-level questioning of the value of such regulation. The FSA’s recent decision to classify PayPal (Europe) Ltd. as an electronic money issuer is critically discussed, revealing some of the shortcomings of the European regulatory regime (definitional uncertainty and, paradoxically, limited consumer protection; lack of financial incentives for European ‘start-ups’). It is in light of these shortcomings that the American system is presented as a superior approach to regulating, and making sense of, electronic money.
Keywords: Electronic Money, Electronic Commerce, Digital Cash, PayPal, Micropayments, Smart Cards, Relevance of Regulation.
1. Introduction
Electronic money products and electronic money regulation have been around for years, but scholarly interest in the subject is a much more recent phenomenon and has only just matured. Much of the existing academic commentary traces the genesis of the EU’s Electronic Money Directives (Batalla 2001; Chuah 2000; and Vereeken 2000), or provides detailed accounts of subsequent Member State implementations (for the UK see Long & Casanova 2002 and 2003; and, more recently, Bamodu 2003). What is still missing is a comparative, international analysis of these efforts as well as a second-level questioning of the value of these efforts.
This article seeks to address both perceived shortcomings. A short historical sketch of two divergent electronic money paradigms (section 2) will pave the way for a comprehensive presentation of European, British and American regulatory regimes (sections 3-5). This threefold presentation will, in turn, provide the basis for a critical perspective on the value of regulation in Europe (sections 6 and 7). The text will focus on the UK’s recent decision to classify PayPal (Europe) Ltd. as an electronic money issuer. The PayPal classification is instructive and will illuminate a number of issues – some of them serious – that face European regulation as it stands. Three main problems will be identified. They will consolidate (section 8) the article’s implicit thesis that the American system offers a superior approach to regulating, and making sense of, electronic money.
2. Electronic Money Defined
When electronic money (or ‘e-money’, for short) was first presented as an integral part of the ‘digital revolution’ in the 1990s (Levy 1994; Steinert-Threlkeld 1996) most products were based on the metaphor of the ‘electronic wallet’. ‘Digital coins’, stored offline on smart cards or on user’s hard disks, were the ruling paradigm. ‘Micropayments’, small value purchases for online content (newspaper articles, say; or music clips), were seen as electronic money’s defining application. Despite the technological hype, consumers were apathetic, merchants were unimpressed, and most schemes disappeared as quickly as they had surfaced. Still, a number of risks were identified, and possible legal regulation based on ‘digital coin’ metaphors and smart card technology was debated.
Today, payment systems (such as PayPal) and services offered via mobile phones are electronic money’s new paradigm. The technology is online and predominantly account-based. Payments are ‘macro’ rather than ‘micro’. And consumers and merchants seem much more impressed with available services and solutions. Electronic money has come of age.
This shift has affected e-money’s definitional characteristics. Under the old paradigm it was natural to define electronic money as ‘monetary value charged and stored on an electronic support, in the form of a smart card or incorporated into the memory of a computer’ (Batalla 2001, p. 81). The emphasis was on electronically stored value – value in opposition to information to substitute one contractual debt for another, as in the case of credit cards; or value in opposition to information to instruct a bank to transfer money from an account, as in the case of debit cards (Robertson 1999, pp. 250-1; Solomon 1997, pp. 64-5). Definitions under the new paradigm, by way of contrast, are often technologically neutral and focus on structural characteristics of electronic payment systems. According to the structural view an e-money issuer sells tokens of electronically stored monetary value upon receipt of funds from a customer, a bearer. The bearer buys these tokens using any payment system other than the e-money system in question (cash, cheque, credit card, debit card; a different e-money system even), and may then purchase goods or services from any vendor who accepts the tokens. Upon receipt of the tokens the vendor can either use them to buy goods or services herself, or ask the issuer to redeem them (i.e. to exchange them for physical cash, for a cheque, etc.). The issuer, in turn, has four principal ways to make a profit in this system: (1) she may add a surcharge to any sale of tokens, (2) she may decide to redeem tokens at a discount, (3) she may invest the funds she receives (the interest earned is called seigniorage), or (4) she may offer the funds she receives as credit to a third party.
Not all of these possibilities are without risk. Depending on the nature of the investment in (3) the issuer might generate a loss; the risk here is that she might not be able to redeem tokens. (This is only one possible scenario, of course; the issuer might fail to redeem tokens for other reasons also. In any case, consumer confidence would be shattered.) Offering credit in (4) increases an economy’s money supply; the risk here is that if the sums involved are not regulated inflation may occur.
3. Two EU Directives
In light of these considerations, it is plain why legislators might take an interest in regulating the issuance of e-money. Both e-money spending individuals and the economy as a whole are at a potential risk. Indeed, the European Union thinks that the risks involved are critical enough to justify a complex regulatory regime – at the heart of which are two Directives, Directive 2000/46/EC (‘the E-Money Directive’, or simply ‘the Directive’) and Directive 2000/28/EC. [1]
The way this regime is set up might seem confusing at first. Directive 2000/28/EC creates a two-pronged definition of ‘credit institution’ to be inserted as Article 1 (1)(a) and (b) into an existing Directive, The Banking Co-ordination Directive 2000/12/EC. Let us, for the sake of simplicity, refer to the first type of credit institution, which includes banks and building societies, as ‘type (a)’ and to the second type of credit institution as ‘type (b)’. With this distinction in place Article 1 (3)(a) of the E-Money Directive proclaims that it shall apply to ‘electronic money institutions’, which are defined as
an undertaking … other than a credit institution as defined in Article 1, point 1, first subparagraph (a) of Directive 2000/12/EC which issues means of payment in the form of electronic money
The upshot of this is that type (a) credit institutions, such as banks and building societies, may issue electronic money, but are regulated under existing provisions. The E-Money Directive itself applies to new type (b) institutions only. Conversely, inclusion of type (b) institutions under the Banking Co-ordination Directive’s definition of ‘credit institution’ is slightly arbitrary [2] (and somewhat awkward [3] ), but it allows the E-Money Directive to be brief, since many provisions pertaining to reserve requirements, money laundering, and the prudential operation of business are already enacted in existing regulations that apply to credit institutions in general. Article 1 (3)(a) is exhaustive: paragraph (4) stipulates that any institution that does not fall under either type (a) or type (b) is to be prohibited from issuing electronic money.
Electronic money itself is defined in Article 1 (3)(b) as
monetary value as represented by a claim on the issuer which is:
(i) stored on an electronic device;
(ii) issued on receipt of funds of an amount not less in value than the monetary value issued;
(iii) accepted as a means of payment by undertakings other than the issuer.
The wording in (ii) is designed to deter issuers from creating artificial value by giving out more e-money than customers pay for. The formulation (‘funds … not less in value’) allows issuers to give out less e-money than customers pay for however. This was identified in (1), above, as one of the ways for an issuer to make a profit (we will return to the other ways in a moment). The criterion in (iii) is designed to demarcate ‘electronic money’ in the EU’s definition from similar products such as tube tickets, phone cards, photocopy cards and ski passes, most of which are only accepted by one party – the issuer herself.
With the two initial definitions in place, the Directive next covers the applicability of the Banking Directives and asserts, in Article 2 (3), that a receipt of funds will not constitute a deposit within the meaning of Article 3 of Directive 2000/12/EC, ‘if the funds are immediately exchanged for electronic money’. This provision is important because special requirements (and special insurance covers) pertain to deposits under the latter Directive. Given its importance, some scholars (Chuah 2000, p. 183; see also Long & Casanova 2003, p. 11) have suggested that more guidance is needed with respect to the meaning of ‘immediately exchanged’. How is immediacy affected if there is a time lag between a consumer purchasing a smart card and the e-money tokens being activated for instance? What if e-money issuers wish to wait for payments to clear before they issue tokens in return? How immediate is ‘immediate’? The Directive is reticent. It is submitted that the most sensible approach to answering these and other questions would be a functional one. If there is a functional connection between a delay and a purchase the exchange should be viewed as ‘immediate’ within the meaning of the provision. Thus, a time lag between purchase and activation should not have any effect on Article 2 (3) if the lag is a result of the technology in use. In this case any delay involved is a function of the very act of purchasing. The same applies to any waiting period for payments (by cheque, for instance) to clear. The reason for such a delay is to make sure that the funds are actually received by the e-money issuer. Again, the delay is a function of the act of purchasing; and the exchange is ‘immediate’ in that (and as long as) it is effected as soon as the payment goes through and the funds are actually received.
The Directive continues with a number of restrictions and requirements. Article 1 (5) restricts all business activities of electronic money institutions outside of the issuing of e-money to (a) the provision of closely related non-financial services and (b) the storing of data on behalf of other undertakings or public institutions. [4] In addition, electronic money institutions are not allowed to have any holdings in other undertakings except where these undertakings perform operational or ancillary functions related to e-money. Logically connected to these requirements are strict initial capital and ongoing funds requirements in Article 4. Initial capital must be at least EUR 1 million. Ongoing own funds must be at least two per cent of the institution’s financial liabilities related to outstanding electronic money. [5] Surprisingly, investment limitations are stricter still. Electronic money institutions must have investments of an amount of no less than their financial liabilities related to outstanding electronic money; and these investments must be in assets with a zero credit risk weighting and with sufficient liquidity. [6] What’s more, the assets are valued conservatively at either cost or market value, whichever happens to be lower. [7] It is apparent that all this severely restricts an issuer’s potential return on investments, which was identified as an important source of income in (3), above.
What about other sources of income? In (2), above, we identified a discount at redemption as a possible source. It turns out that this, too, is restricted under the EU regime. Article 3 stipulates that redemption must be at par value in bank notes or coins, or by transfer to an account. The e-money issuer may only stipulate two conditions: she may charge for any costs necessary to carry out the operation, and she may set a minimum threshold for redemption (up to a maximum of EUR 10). The last source of possible income, identified in (4), above, is credit lending. Is it an option? Despite the fact that electronic money institutions are ‘credit institutions’ within the meaning of Directive 2000/12/EC the answer is a definite no. The relevant provisions in the Banking Directives are expressly excluded – electronic money institutions are not, Article 2 of the E-Money Directive stipulates, allowed to extend credit.
In light of these rather severe restrictions, it is almost paradoxical that within the same framework electronic money institutions should benefit from what is known as the ‘single passport’ – mutual recognition arrangements that enable a credit institution established in one Member State to operate throughout the EU. It almost seems as if the conjunction of investment restrictions, funds requirements and passport freedoms gives e-money issuers who can’t turn a profit in their own Member State a ‘licence’ to not make a profit in the rest of the Union either.