UK: No time for change - Contactless Smartcards have Arrived
– It’s Time to Explore the Opportunities Ready or not...

A payment revolution

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 more successful second-generation schemes, such as Holland’s ChipKnip, still used contact technology, but achieved high market penetration by developing strong partner relationships and attracting an extensive merchant network. Well-targeted and sustained promotion, giving consumers a clear picture of the convenience benefits, helped to encourage take-up and usage.

Interestingly, 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 cross-sell access to merchant products and services on the back of the initial application. Consumers are obliged to pay for their fares on the transport network using the Octopus card, so take-up of the e-purse for products and services was rapid once the merchant network was in place.

The technology to enable contactless payments is increasingly mature, widely available, reliable and cost-effective. Recent alignment around a proximityenabled standard, ISO 14443, has brought the payments industry closer to a single technological solution and helped the deployment of proximity applications. The cost of a card with a chip in it has fallen to less than $1.

Contactless payment differs from conventional credit and debit card technology. The card does not need to be physically ‘swiped’, but instead the user simply positions the device containing a smart chip close to the reader and just ‘taps and goes’. Typically this takes 2-4 seconds, but can be less than half a second, compared to the 16 seconds for a traditional credit card¹. In fact, the card doesn’t have to be a card at all! The smart chip can be installed in a key fob, mobile phone, or almost any device a consumer finds convenient.

Not surprisingly, many organisations are positioning themselves to capture new markets with this new technology.

The phenomenal success of the contactless smart card ticketing system launched by Transport for London (TFL) under the ‘Oyster’ brand name in 2003, demonstrates that rapid, near-universal adoption is a real prospect. By January 2005, over two million Londoners were using an Oyster card to pay for Tube and bus fares.

Oyster is currently a closed scheme in which the cash balances stored in the e-purse can only be used to buy tickets for TfL services. However, the company believes there is considerable opportunity to enhance its offering. TfL is actively exploring the idea of extending the scheme to enable Oyster card holders to use their card for small cash payments for consumer goods or services.

Deloitte has worked with TfL from the conception of the scheme, advising on a wide range of issues from strategy and operations to regulatory compliance.

The new generation of contactless payment systems rely on minuscule RFID (Radio Frequency IDentification) chips. Technological advances have made these small, cheap, reliable and easy to produce in a way that can be incorporated on a whole range of carrier devices including:

• Conventional plastic cards – dedicated pre-paid cards issued by branded schemes, stored-value functionality integrated into loyalty cards, citizen cards.

• Dedicated stored-value devices – such as Dexit’s key fobs or security badges.

• ‘Hidden’ chips – integrated into portable everyday personal items, from watches to mobile phones, as in the recent PayPass trial with Nokia.

So there’s no need for any scheme to offer ‘just another card’ to clutter up people’s purses or wallets, when so many more innovative solutions are possible.

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 micropayments:

• Top-up groceries.

• Spending at confectionery, tobacco and newsagents outlets.

• Payments in pubs and bars.

Fast food, taxis, pre-paid mobile phone topups, 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.

Mapping frequency of transactions against their average size for different categories of expenditure shows where payment schemes can target the volume they require to achieve critical mass.

It is also important to determine the transaction value thresholds that trigger consumers to pay by cash. In 2002, 63% of all cash payments were under £5.00.

Although the introduction of direct payment of state benefits will erode levels of demand and use of cash, only a modest fall in cash volumes is predicted over the next ten years.

Large-scale adoption is a critical component of the business case for any contactless payment scheme. Fortunately, there are many benefits for both consumers and merchants. But both groups need reassurance that any scheme is secure, inexpensive, widely accepted and simple to use. Service providers who are first to market in their sector with contactless payment functionality may realise significant benefits.

For many consumers, contactless payment is an attractive alternative to cash for low-value transactions. The reasons are simple: speed, convenience and security.

Contactless payment can be up to eight times faster than a conventional credit or debit card transaction. Consumers will not need to ‘sign up’ for schemes, as stored value cards can be bought off the shelf and topped up with cash at the customer’s discretion.

It’s easy to see smart card benefits in today’s hectic world: shorter queues, no need to fumble in your wallet to find the right change, and no need to visit an ATM and be charged to withdraw cash if the smartcard is linked to a bank account.

Many proximity-enabled devices also offer consumers increased security over cash, with options to personalise security settings with password protection or daily spending limits.

Millions of people around the world have already begun to use contactless payments. In London over two million people use the Oyster card to access public transport, and in the USA more than six million motorists have bought petrol using Exxon’s Speedpass. Looking ahead, industry analysts at TowerGroup predict that there will be over 30 million users of contactless payment cards by 2007².

Trials of American Express’ ExpressPay, Visa’s VisaWave and Dexit in Toronto have all demonstrated the willingness of consumers and merchants to adopt the new technology and in some cases – such as MasterCard’s PayPass – trial results show that consumers have higher than average spending per transaction using PayPass than on cash and card previously.

Merchants (retailers and service providers) can expect a number of benefits by accepting contactless payments, in return for a relatively modest investment in technology infrastructure. These can include:

• Reduced cash handling costs. 

• Significant improvements in security – holding much less cash on the premises reduces their attractiveness as a target for robbery.

• Reduced till shrinkage – as there is no opportunity for staff to siphon value.

• Increased loyalty, insight into customer purchasing behaviour and revenues.

• Opportunities for co-branding and promotions; for example, launching a dedicated ‘Olympics 2012’ smartchip that included event access, transport tickets and money to buy food and drink at the concession stands.

• The prospect of a cheaper alternative to debit/credit cards for low-value transactions.

The potential benefits are clear. But any organisation that plans to get involved in e-payment should tread carefully. A scheme that involves actually issuing e-money (where value is transferred outside a single, closed organisation) will probably need to create a dedicated business entity or company to do so. The remit of this entity is strictly limited and tightly controlled by the regulatory authorities (see A question of compliance ).

Careful structuring of the issuer-distributormerchant chain and any related commercial partnerships is essential, not only from a technical legal point of view, but also to enable the optimisation of everything from marketing to back-office processes. Dexit, for example, has engaged fixed-line operator Bell to acquire merchants and manage the technology distribution, while Octopus has adopted an almost entirely proprietary model.

At the heart of any scheme business plan, a compelling revenue model showing how everyone in the chain can make money is essential.

Several elements need to be aligned to successfully overcome the barriers to entry into the micro-payments marketplace.

While speed to market is critical, cards or other devices need to be deployed to customers, who in turn need to be educated on value propositions. Typically it takes at least 18 months to issue or renew cards or other payment devices.

Merchants work on an annual trading cycle, with a total freeze on any changes in the three months leading up to Christmas, and budgeting cycles with anything up to 14 month lead times. Point-of-sale devices need to be upgraded, just at the time that many merchants in the UK are just getting over the introduction of Chip and PIN.

Other stakeholder groups, including commercial partners, banks and technology providers, also need to be included in the planning cycle.

This highly successful scheme began as a contactless transit payment card with e-purse functionality and has developed rapidly into a general purpose low-value, stored-value payment card accepted by both transit operators and general consumer goods merchants. There are currently over 11 million cards in circulation, accepted at 15,000 retail points including McDonalds and 7-Eleven. Also available as a watch, or on mobile phones, Octopus can now be used for access to the office and the home, as well as to a range of civil amenities.

Octopus users make around 8.6 million transactions a day, resulting in an average daily transaction value of HK$60.3 million.

EZ-Link is a subsidiary of the Singapore Land Transport Authority – its core business is the sale, distribution and management of EZ-link cards as well as the clearing and settlement of transactions generated in transit and non-transit (retail/merchant) applications. There are in excess of 6 million EZ-Link contactless cards in circulation today. Over 4 million financial transactions are processed daily using the system, a number that is growing with the proliferation of the EZ-link card in the non-transit payment arena.

A number of high profile retailers have signed up to and are accepting EZ-Link for payments. These include, amongst others: F&N Coca Cola Vending Machines, McDonald's Restaurants, Singapore Pools and 7-Eleven. Recently EZ-link extended the use of the card to schools for applications ranging from purchases in the school canteen and bookshop to marking attendance, accessing rooms and facilities to checking daily calorie intake and temperature. A further facility on the card is the e-Savings plan, whereby parents can open an e-Pocket money account.

Commuters at selected pilot stations can now top-up their EZ-link card while on the go via their mobile phones, by authorising payments from their credit cards or bank accounts.

Until recently, the cost of processing low-value transactions using payment methods other than cash has been prohibitive, particularly for merchants. With credit card companies reluctant to reduce their commissions for smaller transactions, merchants have understandably had to deter customers from using cards in these situations. The new-generation e-payment solutions should overcome these issues. But what will the cost and revenue models look like?

Experience drawn from e-purse schemes around the world shows that the key revenue driver is merchant fees. These can be negotiated on a subscription or rental basis, or as a one-off fee. Commission can be accrued on every transaction.

The other potential sources of revenue are:

• Fees for using the ‘real-estate’ on the card or other payment device – where partner companies pay for co-branding and/or functionality.

• Value left on cards but never used – the regulated balance reclaimed from unused cards or ‘breakage’ can generate significant revenue.

• Investing the unspent ‘float’ – although some schemes in other countries, such as the Starbucks card, are thought to generate considerable revenues in this way, in the UK the FSA puts significant restrictions on how scheme operators can invest the float. Unfortunately these low-risk investments deliver correspondingly low returns.

• Licensing intellectual property – or franchising the scheme.

American Express is currently piloting its ExpressPay solution in Phoenix (Arizona), New York and Singapore. The Phoenix pilot includes participating locations at pharmacy chain CVS, Carl’s Jr., Fry’s (Kroger) supermarket, Blimpie Subs & Salads, ChevronTexaco, Dairy Queen, Cold Stone Creamery, Ritz Camera, Schlotzsky’s Deli and many others. American Express plans to extend ExpressPay’s availability to consumers nationwide in 2005.

Based on the pilot results, American Express has concluded that ExpressPay provides significant value for consumers and merchants. Thousands of consumers are using ExpressPay in the pilots and they have conducted hundreds of thousands of transactions, which are proving faster than both cash and traditional card payments. In addition, ExpressPay customers increased their average transaction size by 20% to 30% compared with their cash spending.

The total costs for any scheme are driven by the volume of transactions and the number of partners and customers involved, as well as the number of merchants.

Costs break down into a number of areas including:

• Card or device costs – the physical costs of producing and personalising the carrier device, as well as the licensing fees for card applications.

• Issuance costs.

• Transaction payment processing, settlement and clearing.

• Costs associated with the loading and unloading of value.

• Regulatory compliance costs, such as reporting to the FSA and additional staff training.

• Customer service activities.

• Promotions and marketing.

• Costs involved in attracting and signing up merchants, as well as on-going account management.

• Other back-office costs, from risk and fraud management to disaster recovery.

Where potential scheme providers are planning to roll out contactless payment as an additional offering – for example as part of a portfolio of mobile phone services or an add-on to a travel or sporting season ticket – a number of the infrastructure costs outlined above will already largely be covered. The challenge is to rework existing business processes and systems to integrate contactless payment without incurring unnecessary additional cost or adding too much complexity.

Visa Wave is a ‘Combi’ chip card with both contact and contactless interfaces. Users can make payment transactions in contactless mode at Visa Wave terminals, as well as in traditional contact mode at 22 million locations worldwide, by either swiping or inserting the card into a smart card reader.

Malaysia was chosen for the trial roll out of the world's first Visa Wave contactless payment between April and August 2004. Before the trial, Visa carried out extensive focus group research among consumers to test the appeal of contactless card products. The majority of consumers in the research found the concept of contactless payment appealing.

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.

E-purse schemes in Europe are covered by two EU Directives: 2000/28/EC and 2000/46/EC, which were implemented in the UK by the FSA’s Electronic Money Sourcebook. The regulatory authorities are justifiably concerned that the issuing of e-money – effectively a new kind of medium for cash – could have an effect on consumer and business confidence in new means of payment. While the regulations governing stored value payment schemes are nowhere near as onerous as those faced by banks, there are still many possible traps that e-money issuers could fall into.

The bottom line is that if you issue e-money in the UK, you will need to be authorised by the Financial Services Authority (FSA) to do so. Even an existing financial services provider (like a bank) that wants to set up its own scheme will need specific FSA permissions.

However, not all e-purse schemes technically issue e-money. This is quite tightly defined as monetary value, as represented by a claim on the issuer, which is:

• stored on an electronic device;

• issued on receipt of funds; and

• accepted as a means of payment by persons other than the issuer.

The regulated activity relating to e-money is issuing e-money. Where an originator creates e-money and then sells it to other distributors, the issuer of e-money is the originator and not the distributors.

This fine distinction is crucial, and it is vital to take the regulatory and compliance issues into account from the beginning of any planning, particularly when it comes to structuring the business model.

The key issue is whether the proposed scheme is ‘closed’ or ‘open’.

Single-provider schemes – where the same entity issues and redeems the value – are generally seen as ‘closed’. A staff restaurant card or a loyalty card that stores value so you can buy a cup of cappuccino in your favourite coffee bar without the need for loose change would probably fall into this category.

However, as soon as a scheme allows users to take their stored value and spend it elsewhere they are effectively transferring value. More than one party is involved, and a clearing and settlement function comes into operation. This is more likely to be classed as an ‘open’ scheme, which falls under the FSA’s remit.

Dexit is creating an alternative payments network designed to be fast, light, easy and secure, and to change the way users buy everyday items, as well as being cheaper and more flexible for merchants.

The Dexit tag is available in multiple forms: a key tag, a sticker to be attached to a cell phone or security access card or student card, or a chip embedded in a cell phone. The associated ‘cool’ factor is expected to help differentiate Dexit.

The service is now accepted at over 400 merchants in and around downtown Toronto, including McDonald’s, Imperial Parking, Pharma Plus Drugmarts and Timothy’s. Merchants have reported average transaction values rising by 10% – 20% for Dexit users. There are almost 50,000 users.

The scheme allows merchants to have electronic payments enabled and processed, without having to use the Card Association infrastructure. This innovative product is delivered in conjunction with Bell Canada, TD Canada Trust, National Bank of Canada and TELUS Mobility.

The FSA also has a small e-money issuer scheme, which places much less stringent rules on schemes that are limited in terms of the geographical area they cover, the number of users and the value of e-money in circulation.

Whatever scheme you may be considering, the rules are complex and it’s worth getting expert advice. For example, some schemes that might appear at first glance to be closed, turn out in fact to be open.

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

• Capital structure and liquidity – including the initial capitalisation and ongoing 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.

Credit card company MasterCard is trialling PayPass cards and devices, featuring an embedded computer chip and radio frequency antenna. The pilot versions use the credit card transaction functionality by passing the credit card information to a special contactless receiver attached to a standard payment terminal. Card protocol standards also allow for off-line terminal transactions. McDonalds restaurants in US have announced that they will support the product and will roll out readers.

PayPass trials in Orlando, Florida have shown an 18% increase in active cards and a 28% increase in weekly spending, while a pilot implementation in Dallas, Texas highlighted the importance of consumer device convergence, particularly with mobile phones, as a convenience factor.

The rules governing indirect tax as applied to e-purse schemes and transactions are complex, and depend on a whole range of factors including:

• Whether the scheme is ‘open’ or ‘closed’.

• Whether all or part of the goods or services supplied are subject to VAT or exempt.

• The number and nature of the ‘events’ involved in the process of issuing and redeeming the stored value.

• The exact nature of the relationships between the parties involved, and how the transactions are arranged between them.

• How VAT should be accounted for in relation to the commission paid to the issuer by the merchants.

Particular consideration needs to be given to tax when this payment medium is used internationally since this could give rise to unwanted obligations.

Expert tax advice is essential when it comes to structuring the transactions and relationships.

Our international experience of e-purse trials and live roll-outs shows that there are many critical success factors. Taking these issues into account from the start can make all the difference.

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.