If you\u2019re in search of financial products that harm consumers, you don\u2019t have far to look. From leveraged spread betting platforms<\/a>, to ETFs that automatically self-destruct over time<\/a>, to cryptocurrency scams<\/a> and ruinous payday loans<\/a>, there\u2019s a long list of candidates.<\/p>\n With a pre-paid card, consumers are at little risk<\/p><\/blockquote>\n But sometimes beneficial financial products really do appear. Pre-paid debit cards are an obvious example.<\/p>\n With a pre-paid card, consumers are at little risk of hurting themselves. The cards incentivise financial responsibility: you can only spend the money you\u2019ve loaded onto the card, meaning there\u2019s no concern about accruing a large debt at high interest rates.<\/p>\n You can pay seamlessly and quickly, using tap and go. You no longer need to handle cash, an increasing benefit in the post-Covid era. And with the pre-paid cards that are designed for foreign travel, you can improve on the rip-off foreign exchange rates typically charged by banks.<\/p>\n Yet at the end of June, in a knock-on effect of the Wirecard fraud, some pre-paid cards showed an unexpected vulnerability: the cards stopped working and their users lost access to the money they had saved<\/a>.<\/p>\n The funds freeze, imposed by the UK financial regulator in an attempt to protect consumers\u2019 interests during a potentially complex corporate insolvency, hit pre-paid card users from across the spectrum.<\/p>\n The cryptocurrency rich<\/a>, freelance programmers<\/a>, low-paid benefit recipients<\/a> and owners of small businesses<\/a> all suddenly found themselves unable to spend their own money.<\/p>\n Although the affected funds were soon unfrozen<\/a> by the regulator, the episode has created nervousness about the safety of virtual currency held on cards. It has also raised broader questions about the prospects for financial technology, a key area of global economic competition<\/a>.<\/p>\n Meanwhile, financial regulators seem caught between two stools: promoting innovation and competition and clamping down on risk.<\/p>\n Cards from Newcastle<\/strong><\/p>\n To understand why a temporary freeze on a hitherto obscure Wirecard subsidiary had such a dramatic knock-on effect on some debit card users, it\u2019s necessary to go back two decades.<\/p>\n The first electronic money (\u2018e-money\u2019) directive was issued by the European Union in 2000, with the objective of providing a \u2018technology-neutral legal framework\u2019 for virtual currency.<\/p>\n E-money was defined broadly and included\u00a0digital\u00a0coins, pre-paid online accounts and pre-paid cards.<\/p>\n But there were competitive barriers stopping those wanting to join the e-money boom.<\/p>\n \u201cIn those days, to be a member of Visa or Mastercard you had to be a bank,\u201d David Parker, a payments expert and director of Polymath Consulting, told New Money Review<\/em>.<\/p>\n \u201cAnd none of the banks wanted to issue pre-paid debit cards,\u201d he said.<\/p>\n At the time, British banks were raking in money from the lucrative issuance of credit cards with inbuilt payment protection insurance, a mis-selling scandal that cost them up to \u00a350bn in fines and compensation a decade later<\/a>.<\/p>\n In 2005 a firm called Cashplus found a way to upset the cosy club of bank credit card issuers.<\/p>\n It managed to create the UK\u2019s first pre-paid card by using a third party with a banking licence to gain access to the Mastercard system.<\/p>\n \u201cPayment cards are the first step towards making cash obsolete,\u201d the Independent<\/em>\u2019s David Prosser wrote, perceptively, at the time<\/a>.<\/p>\n “Our first target is the customer who has been disenfranchised by the financial community,” Rich Wagner, chief executive of Cashplus, said in 2005, a decade before cryptocurrency promoters took up the same theme.<\/p>\n Sponsoring access to banks<\/strong><\/p>\n Cashplus\u2019s innovation was to find a \u2018sponsor\u2019 to play the role of accessing the banking (and hence the payment card) system.<\/p>\n This intermediary provided the first six digits\u2014called a bank identification number or \u2018BIN\u2019\u2014of a sixteen-digit credit or debit card number.<\/p>\n BIN number on a Cashplus card<\/em><\/p>\n The \u2018BIN sponsor\u2019 model proved wildly popular. Soon a financial institution in the north-east of England had become the issuing bank for over 150 new card schemes, branded in the names of a variety of market entrants like Cashplus.<\/p>\n \u201cWe are the leading pre-paid cards provider in the UK and Europe,\u201d Newcastle Building Society boasted in its 2008 report and accounts<\/a>.<\/p>\n But, like other banks and building societies, Newcastle was soon caught up in the financial crisis and had to raise cash.<\/p>\n In 2011 Newcastle Building Society sold its pre-paid cards operation<\/a> to an upcoming \u2018international provider of products and services for electronic payments\u2019\u2014Wirecard Card Solutions Limited, a subsidiary of Munich-based Wirecard AG.<\/p>\n Hard to replace<\/strong><\/p>\n Though Visa and Mastercard soon changed their scheme membership rules to broaden access to e-money and other fintechs, the concept of an intermediary to gain access to the banking system lives on.<\/p>\n Some large fintech firms have passed through the stage of using a third party to access the major card schemes: in 2018 both Revolut<\/a> and Monzo<\/a> gave up Wirecard as the issuer of their in-house cards. For Monzo, the move went hand-in-hand with a regulatory upgrade from e-money issuer to full banking status.<\/p>\n According to Polymath Consulting\u2019s Parker, BIN sponsorship still makes sense for a large number of e-money issuers.<\/p>\n \u201cWe are increasingly seeing people use a BIN sponsor even when they have their own e-money licence,\u201d Parker told New Money Review<\/em>.<\/p>\n \u201cWhy? Keeping the BIN sponsor makes sense for a number of reasons. First, the card schemes have collateral requirements. Second, the schemes fine people quickly when they get things wrong. Third, Mastercard, for example, publishes up to 30 updates a month for scheme members. Who\u2019s going to sit and read them?\u201d<\/p>\n But the Wirecard Card Solutions freeze showed an unexpected dependency in the pre-paid card market, suggests Parker.<\/p>\n \u201cThere aren\u2019t that many BIN sponsors out there. And most sponsorship contracts are for 3-5 years,\u201d he told New Money Review<\/em>. \u201cIt\u2019s not easy to move away.\u201d<\/p>\n Safeguarding nerves<\/strong><\/p>\n As the UK\u2019s Financial Conduct Authority (FCA) gave permission on 29 June for Wirecard\u2019s Newcastle subsidiary to resume its activities<\/a>, concerns over potential weak points in pre-paid card schemes\u2019 infrastructure may seem overblown.<\/p>\n But the FCA\u2019s green light came with a little-noticed condition: the regulator specified that Wirecard must \u201ctake all necessary steps to ensure that all other monies held in banks by it overseas are transferred to accounts held at credit institutions authorised by the Prudential Regulation Authority (PRA) in the United Kingdom\u201d.<\/p>\n Customer funds held by e-money and payment services firms are supposed to be \u2018safeguarded\u2019\u2014held separately from the firms\u2019 own assets. The UK regulator\u2019s own safeguarding rules<\/a> specify that any European Economic Area bank can hold those customer funds.<\/p>\n \u201cOur primary objective is to protect the interests and money of consumers\u201d<\/p><\/blockquote>\n So why did the FCA feel the need to tell Wirecard to transfer the money back to the UK? The regulator did not respond to a request for clarification.<\/p>\n However, when freezing Wirecard\u2019s UK activities the FCA hinted at concerns that customer money could be siphoned off to Germany to meet a cash shortfall at the now-insolvent parent company.<\/p>\n \u201cOn 26 June, we took additional measures to require the firm to cease all regulated activities in order to further protect customer money,\u201d the FCA said.<\/p>\n \u201cThis now means customer money cannot be accessed. Our primary objective is to protect the interests and money of consumers who use Wirecard.\u201d<\/p>\n Client money missing<\/strong><\/p>\n In past financial company insolvencies, such as Lehman and MF Global, the failing firms were found to have failed to comply with the rules on keeping clients\u2019 funds separate from those of other creditors.<\/p>\n And differences in national insolvency rules have also complicated past attempts to recover client money.<\/p>\n In the case of Lehman, administrators for the investment bank\u2019s European operations questioned why $8bn had been transferred to New York from London just before the bank collapsed<\/a>.<\/p>\n \u201cThe sums of money claimed by [Lehman UK] investment bank\u2019s clients were vastly greater than the sums segregated by Lehman as client money,\u201d said accountancy firm Deloitte<\/a>.<\/p>\n While Lehman\u2019s UK clients eventually received all their cash back, those caught up in the collapse had to wait: the administration of the failed investment bank took eleven years to complete.<\/p>\n FCA’s new safeguarding rules<\/strong><\/p>\n Last week the FCA released new guidance<\/a> on how e-money and payment services firms should safeguard customer funds.<\/p>\n Under the new rules, the FCA said, e-money and payment firms will have to undertake a number of extra steps to ensure that customer funds are kept separate from those of the service provider.<\/p>\n In particular, the FCA said, firms should be able to identify what relevant client funds the firm holds, \u2018at any time and without delay\u2019.<\/p>\n Payment firms\u2019 accounting records should enable a third party, such as an insolvency practitioner, to distinguish clients\u2019 funds from the firms\u2019 own money, and the funds of one customer from those of another, the FCA said.<\/p>\n And payment and e-money firms should also obtain written assurance from the banks holding safeguarding client funds that those banks have no interest in or access to funds held in the customer account, the regulator said.<\/p>\n A nascent legal regime<\/strong><\/p>\n According to Jonathan Herbst, global head of financial services at law firm Norton Rose Fulbright, the legal framework for e-money firms\u2019 customer funds is still being worked out.<\/p>\n In a webinar held earlier this week<\/a>, Herbst contrasted the safeguarding rules for e-money with the rules governing client money at traditional investment firms, which are known as the \u2018CASS rules\u2019.<\/p>\n \u201cThe safeguarding regime for e-money is somewhat similar to the CASS regime for client money but it\u2019s far less developed,\u201d Herbst said.<\/p>\n New Money Review<\/em> asked Herbst to comment on the FCA\u2019s decision to require Wirecard to repatriate pre-paid card customers\u2019 funds to UK banks.<\/p>\n \u201cI suspect it is just a quest for safety in sensitive circumstances given the situation,\u201d Herbst said.<\/p>\n No single safeguarding model <\/strong><\/p>\n Complying with the FCA\u2019s new guidance for customer fund safeguarding may come as a challenge for many fintech firms.<\/p>\n According to Martin Threakall, interim chief product officer at Modulr, a London e-money firm, there is a wide variety of safeguarding practices across the sector.<\/p>\n \u201cWhether or not customer money flows directly into and out of a safeguarded account depends on an individual firm\u2019s supply stack,\u201d Threakall told New Money Review<\/em>.<\/p>\n \u201cFor example, it depends on how the firm accesses the payment schemes it\u2019s using,\u201d said Threakall.<\/p>\n \u201cIf it is using card acquiring services, how does it receive funds from the card acquirer? If it\u2019s issuing cards, how does it settle transactions with Visa and Mastercard\u2014via a direct membership of a card scheme or using an intermediary? And it depends on how the firm is interacting with systems like faster payments and BACS,\u201d Threakall said, referring to two of the UK\u2019s wholesale payment infrastructures.<\/p>\n According to one of the pre-paid card firms caught up in the funds freeze, Wirecard\u2019s UK subsidiary did not allow it to identify all the accounts where its customers\u2019 funds were held.<\/p>\n \u201cWe only had partial visibility into the safeguarding accounts: we knew that the account into which Anna Money\u2019s clients\u2019 funds arrived was with Barclays, but we didn\u2019t know about the rest,\u201d Boris Dyakonov, co-founder of Anna Money, told New Money Review<\/em>.<\/p>\n Risks of killing fintech<\/strong><\/p>\n Tony Craddock, director general of fintech trade body the Emerging Payments Association, warned of wider repercussions from the FCA\u2019s Wirecard intervention.<\/p>\n \u201cThe FCA undertook an extraordinary and unprecedented act in asking for the funds in safeguarded accounts to be put into a PRA-registered UK-based bank account,\u201d Craddock told New Money Review.<\/p>\n \u201cIf this were to become normal, the range of options available to fintechs across Europe would become limited in a way that\u2019s unhealthy. It would also set a precedent for other countries to behave in the same way. If everybody pulls up the ladder, the market fails,\u201d Craddock said.<\/p>\n According to the trade body chief, the events of the last few weeks have come as a shock.<\/p>\n \u201cWhat Wirecard has done is raise fears that there\u2019s risk in this sector,\u201d Craddock said.<\/p>\n \u201cI just spoke to a chief executive of a money remittance firm whose BIN sponsor banks with Lloyds,\u201d he went on.<\/p>\n \u201cYesterday they got a letter saying, \u2018We are no longer banking you and we want you to stop all transaction processing now\u2019. That\u2019s abuse of market power, bullying, fearmongering and it\u2019s altogether wrong,\u201d Craddock said.<\/p>\n \u201cIf you overregulate this sector, you will kill it,\u201d Craddock said.<\/p>\n According to Modulr Finance\u2019s Threakall, there’s huge uncertainty about where the dividing line lies between legal and illegal activity.<\/p>\n \u201cIf an e-money firm ends up dealing with a criminal or terrorist, the anti-money-laundering regulations make it clear that the e-money firm is on the hook,\u201d he told New Money Review<\/em>.<\/p>\n \u201cBut it\u2019s a grey area whether a bank providing clearing services to that e-money firm is off the hook, even though the end customer is not the bank\u2019s own customer.\u201d<\/p>\n The risk for banks in getting it wrong is obvious. In recent years, they have been fined billions for stepping on the wrong side of the rules.<\/a><\/p>\n It’s two decades since new European regulations were put to good effect. The new e-money framework helped launch a two-decade long financial technology boom across the region. Consumers benefited from safer, good-value new products like pre-paid cards.<\/p>\n But recent market events hint at lurking risks in the fintech sector. For policymakers, striking a balance between innovation and consumer protection will be harder than ever.<\/p>\n![\"\"](\"https:\/\/newmoneyreview.com\/wp-content\/uploads\/2020\/08\/Cashplus_Credit_Business2_AW_Set1.png\")
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