Waiting on line at Starbucks this season, you’ll probably be hoping the woman ordering the cafe latte in front of you isn’t going to fish out change, use a credit card that will require authorization and a signature, or worse yet, pull out a checkbook. No, you’d be better off if that person has a Starbucks card. With one swipe of this prepaid “stored value” card, money will be deducted from her balance, without any required signature. And when the purchaser gets back to the office, she can add funds to her card online.
The stored value card – like its higher-tech cousin the smart card, where value is stored on the card’s computer chip rather than on a server – is just one of the emerging technologies currently gaining momentum while paper check usage is in decline, according to a new study by the Federal Reserve. Until now, it was widely believed that Americans write about 60 to 70 billion checks a year. The number is actually closer to 50 billion (including government and business checks), with consumers writing the majority. Electronic payments – which range from credit cards, debit cards and electronic benefits transfer to online bill payment, stored value and “smart” cards – are estimated at 30 billion a year in total transactions. The study, based on data collected by the Federal Reserve System and referred to as the Check and Electronics Payment Research Project, is the first comprehensive analysis of the retail payments market in more than 20 years.
The results come as no surprise to many economists, who for years have been writing the obituary of the paper check and predicting the rise of electronic payments. In their informative history of the payment card industry, Paying With Plastic: The Digital Revolution of Buying and Borrowing, authors David Evans, a senior vice president of National Economics Research Associates, and Richard Schmalensee, dean of the Sloan School of Management, show just how inefficient checks are compared to electronic forms of payment – notably debit and credit cards. The authors imagine a future where cash is a thing of the past, checks are all but obsolete and “smart cards” let you “download” money from an ATM. The question on everyone’s mind is not when the technology will exist – forms of it already do – but when it will gain acceptance by consumers and merchants alike. In many ways, this is the same “chicken and egg” problem faced by early bank card programs and debit cards: Merchants only want to accept forms of payment that consumers use; consumers won’t embrace payment methods they can’t use.
While debit cards, also known as “check cards,” and electronic payments methods like direct deposit are clearly replacing paper check payments, no one cash substitute dominates. Smart cards have had much more success in Europe, where chips were added to cards in 1990. According to Loretta Mester, senior vice president and director of research at the Federal Reserve Bank of Philadelphia, this is not so much a testament to Europeans’ forward-thinking as much as it is a response to a technological problem. In the U.S., “telephone service is good and less expensive, and so our credit card authorization is relatively cheap,” she says. “In Europe, when the smart card was first developed, telephone lines were relatively scarce and expensive, so off-line transactions with a smart card were advantageous …”
In the U.S., smart cards haven’t quite lived up to expectations. Despite the millions of smart cards currently in circulation, Carl Pascarella, the president of Visa U.S.A., recently told The New York Times that “there isn’t a lot of utility associated with these cards.” Trials of smart cards in Manhattan and Canada in the late 1990s saw disappointing results; merchants needed to be offered incentives to sign up and consumers showed little interest.
Meanwhile, according to Mester, consumers are becoming savvier about their payment choices as economic pressures push them to go electronic. “Until recently I didn’t explicitly pay for the cost of using checks. [These days] I can go to the bank and see how much [I will have to pay] for check-writing privileges. It is becoming more apparent to the customer that electronic payments are cheaper,” she says.
Age, income and education all influence consumers’ choice of payment method, Mester adds. Computer banking, not surprisingly, remains more popular among the younger, richer, college-educated set, but more households across the board are relying on at least one form of electronic payment. One other note: it costs money to mail in a check, even as recent events like the anthrax attacks have caused mail delays. And while the anthrax scares may be behind us, they served to highlight our dependency on the mail system.
It remains to be seen whether proprietary store cards – which are like a cross between a store credit card and a gift certificate – will take off, or whether smart cards issued by the credit card networks will dominate. Some stores are experimenting with both: Target offers a gift card which stores up to $1,000 as well as a new Target Visa smart card. The company is currently giving away smart card readers to help users connect the cards to their PCs.
“My guess is that the universal smart card is more likely to take off, just as the universal credit card overtook retail, store specific credit cards,” says Wharton finance professor Nicholas Souleles, who has done extensive research on consumer credit. “If you go back 20 or 30 years, retail store credit cards were important, but gradually the universal credit card overtook them. At one level it is just a matter of practicality. Say you shop at 10 retailers. Who wants to carry around 10 cards? Now with prepaid smart cards, who wants to have to charge up 10 different cards? Another advantage of universal cards is that they might allow people to more easily make small transactions at the news stand or the local food truck. For small transactions, the universality of [use] seems to be particularly important.”
Nevertheless, as the Fed study indicated, credit cards dominate in the electronic payment space, accounting for about half of all transactions. But continued growth of credit card volume may slow as new electronic payment schemes develop. Peter Burns, director of the Payment Cards Center at the Federal Reserve Bank of Philadelphia, believes that small dollar transactions will pose the biggest challenge for the credit card networks. “These payments need to go through something less complicated and expensive than the credit card network.”
Visa and MasterCard have faced several legal challenges in the past few months which might result in significant changes in the way payment cards evolve. In October, a New York federal court ruled that Visa and MasterCard must allow their member banks to distribute rival cards, like American Express and Discover. The ruling is being appealed but, if upheld, will create more competition for Visa and MasterCard in dealing with bank issuers. In another suit, Wal-Mart and other large retailers accuse the bank card associations of using their dominant market positions to force merchants to accept their relatively more expensive debit cards. Under the Visa and MasterCard “honor all cards” rules, merchants must accept their debit cards if they accept credit cards with the Visa or MasterCard logo. The retailers would like to limit consumer use of debit cards to those offered by rival networks that carry substantially lower transaction fees. The case has yet to be heard, but pits some of the nation’s most powerful retailing companies against the two largest payment associations for what could be an important legal battle. “The credit card industry has done a wonderful job of getting plastic accepted,” says Burns. “But the power is shifting away from the banks. Merchants want more say in what they pay.”
For the Federal Reserve study, completed in November 2001 with a final version due at the end of January, approximately 1,300 financial institutions, including banks, thrifts and credit unions, and 89 electronic payment processors responded to three surveys that looked at methods and volumes of retail payments.
“The Federal Reserve Banks conducted the study to gain a better understanding of the dynamics of the retail payment system,” said Roger W. Ferguson, Jr., vice chairman of the Federal Reserve Board, in a press release last November. “We believe the results clearly paint a picture of a payments system in migration. The data show strong growth in electronic payments since the early 1980s and lower than expected check volumes.”
Since 1979, the total number of non-cash retail payments has doubled from about 37 billion to 80 billion. The number of checks has grown about 55% from the 1979 estimate of 32 billion. Although checks remain the dominant form of non-cash payment, over the last 20 years electronic payments have replaced checks in large numbers, the study says.
Among the study’s other findings:
- Checks have declined from about 85% of non-cash payments since 1979 to about 60% today.
- Consumers write about 50% of all checks and businesses receive about half of all checks. More checks are written for bill payment than for any other purpose (25.7% of check volume), followed by use of checks at point–of-sale (19% of checks written) and income payments, such as salary and benefits payments, from business and governments to consumers (about 17.8% of all check payments).
Credit card transactions represent about half of electronic payments (15 billion, worth $1.23 trillion). Debit cards remain the second most dominant electronic instrument with 8.3 billion transactions worth $348 billion.