he business case for prepaid (aka stored value) cards, already deemed a difficult sell, soon might become even tougher as state and federal governments seek to tighten the regulatory grip on this emerging market. State legislatures introduced at least 100 bills during the first half of 2004 that addressed prepaid cards, research firm TowerGroup estimated. And in a research note released in December 2004, the firm predicted this whirlwind of activity would surely intensify.

So far statutes in more than a dozen states have been amended to address at least some types of prepaid cards. Attorneys general in at least a half-dozen states are suing prepaid card issuers over various fees and practices.

On the federal front, Sen. Charles Schumer (D-NY) introduced legislation in the last Congress to restrict servicing fees on bank-issued gift cards. No one has introduced anything similar in the current Congress yet, but don't rule out the possibility.

Meanwhile, across town at the Federal Reserve Board, policy makers ponder changes in the legal interpretations of federal EFT law to explicitly cover one specific type of prepaid product: payroll cards. And the Federal Deposit Insurance Corp. (FDIC) is also considering a rule change that would treat many prepaid products as deposits subject to the protections of federal deposit insurance.

If either or both of these proposed regulatory steps are taken, the business case for banks in the prepaid card market will certainly take a hit, experts warn. "Even a small alteration to the regulatory structure could unintentionally have outsized results on one or more [prepaid card] products," TowerGroup analysts wrote.

Sizing a Nascent Market

Prepaid cards come in a variety of shapes and sizes. Among them: merchant/mall-branded gift cards, Visa- and MasterCard-branded debit cards and bank-issued payroll cards. While many prepaid cards are issued, not all cards are used with regularity. Gift cards, for example, usually are used only a few times and then discarded.

Prepaid cards that are branded and either sold or issued bearing the name of a bank (e.g. prepaid debit and payroll cards), are used with the most regularity, and they are indistinguishable from any other Visa or MasterCard presented at the point of purchase. Counting only prepaid cards that are used regularly, research firm Financial Insights (FI) estimates consumers had 800 million in their wallets in 2003. By 2008, the firm expects consumers to have 2 billion prepaid cards in their wallets. FI estimates that prepaid cards were used to ring up $93.9 billion in sales in 2003. By 2008, total spend on prepaid cards will top $300 billion, FI analyst Aaron McPherson predicted in a report last summer.

Payroll cards hold the greatest potential for banks interested in the prepaid market, McPherson suggested, estimating that the average payroll card is loaded with $900 a month. He figures 1.5 million payroll cards were in circulation in 2003; taken together, those cards were used to ring up $16.2 billion in sales. He also predicted payroll cards would be a $93.2 billion market in 2008, and that the universe of payroll cards in circulation will grow by nearly 40% to total 8 million cards in 2008.

To Be or Not to Be Reg E

The Fed's proposal, circulated for comment last fall, would stipulate that prepaid cards used to access wages and other forms of routine employee compensation (and the accounts tied to these cards) are subject to the dictates of Regulation E (Reg E), which implements consumer EFT law.

This would be the case regardless of whether employers, banks or some other third party establishes the accounts, the Fed proposed. Reg E, among other things, requires specified consumer disclosures and periodic account statements, and limits cardholder liability for unauthorized transactions ($50 max).

On its face, the Fed's proposal seems logical: Reg E covers payroll direct deposit transactions; payroll cards are a variation on the theme. But Reg E compliance carries a hefty price tag, which bankers fear could wipe out what little profitability exists in this still budding market.

In a letter to the Fed that echoed the sentiments of many, Visa asked the Fed to consider a "Reg E Lite" approach to payroll cards. Wells Fargo & Co. warned of "unintended consequences" should the plan be adopted. Wells' executives also took issue with suggestions that payroll card accounts are the same as checking accounts.

"Payroll card accounts are not offered as a substitute for checking accounts to employees; payroll cards are offered in lieu of payroll checks. That distinction is significant," the bank wrote in a comment letter to the Fed. "Financial institutions market payroll cards to employers primarily so that employers may efficiently issue payroll."

Even credit unions, those non-profit "peoples' banks," have balked at the Fed's proposal. The Credit Union National Association (CUNA), a leading credit union trade group, insisted in a letter to the Fed that Reg E applies only to natural persons. The Fed should scrap its current Reg E proposal, CUNA wrote, "because these accounts can be operated or managed by someone other than the consumer."

Clearly, the Fed understands these concerns, and the implications of industry efficiencies. But it also has an obligation to watch out for consumers and to watch out for the economy. A person's earnings are core to his or her ability to spend. A consortium of consumer organizations drove home this point in a comment letter to the Fed. The letter urged the Fed to expand Reg E coverage to other types of prepaid cards, "which hold funds important to consumers and families, including prepaid debit cards marketed or used as account substitutes, child support cards, unemployment cards and tax refund related cards."

The FDIC's proposal, meanwhile, stems from a long-standing banking law that requires deposits insured by the FDIC be backed by reserves maintained on deposit at the bank's local Federal Reserve Bank office. Payroll cards are tied to deposit accounts at financial institutions, typically in pooled accounts, but in deposit accounts nonetheless. Banks aren't keen on the idea. No surprise there: Reserves are non-interest earning assets. So now it's up to the Fed and the FDIC to strike a balance between the need to protect consumers from financial loss and the desire to encourage market innovation and economic growth. Expect the Fed to provide a final interpretation this spring, with implementation delayed by perhaps as much as a year. While the Fed is sure to listen to industry concerns, it's not about to scrap the proposal.

Prepaid cards will be subject to some increased regulation. It's testimony to the immense popularity of these new instruments of payment.

Patti Murphy is Contributing Editor to The Green Sheet and President of The Takoma Group. E-mail her at patti@greensheet.com .