Welcome to another installment in my ongoing tour of the major payment methods, how they work, and the issues and controversies surrounding them. Earlier articles in this series can be found here. In this article, I will be explaining prepaid cards, a variation of debit cards that deserve a full article in their own right. One of the major reasons for this is that prepaid cards are emerging as an alternative to traditional banks, a development that has profound implications for the banking and payments industry.
Modifying the Five Actor Model for Prepaid Cards
Prepaid cards, also known as “stored value cards,” “gift cards,” “top up cards,” and more, differ from debit cards in that they carry their own dedicated account, which is typically funded when the card is purchased at a store. For this reason, the five-actor model for prepaid cards looks much like the model for debit cards, except now we must replace the issuer with a prepaid program manager, and add a prepaid processor as a sixth actor.
The prepaid processor administers the software that establishes and tracks all of the sub-accounts that tie to each prepaid card. Generally, there is a master account that supports the whole program, which is held at a bank, and numerous sub-accounts which are virtual. In order to allow its cards to work over the existing credit and debit card networks, the prepaid processor also licenses ranges of card numbers from various banks, in a practice known as “BIN rentals,” where BIN stands for Bank Identification Number.
If you look at a credit or debit card, you will see that the 16 digits are divided into four groups. The first four digits identify the card network; the next four identify the bank, and the last eight are specific to the individual card. It is these last eight digits that are licensed to a prepaid processor, from a range allocated by the card networks. I sometimes call these banks “arms merchants,” because they sell access to the card networks to companies that then compete with other banks. Some, like Metabank and Sutton Bank, have built substantial businesses supporting companies like Vanilla Gift. Others, like Green Dot, issue their own prepaid cards as well as supporting third parties.
Open Loop Prepaid Cards
Prepaid cards that work on one or more of the major card networks are referred to in the industry as “open loop” cards. Sometimes these are sold as gift cards, but they are also sold as a banking alternative. For many consumers, this is ideal; younger people may never write or receive a check in their entire life, and low-income people often avoid bank accounts because overdraft fees are so expensive (up to $39 per charge, which can add up if you have multiple bill payments hitting at the same time). In fact, Congress had to pass legislation preventing banks from paying the highest value items, like rental payments, first, because these would cause all of the smaller payments after them to hit the overdraft line, incurring a fee each time. This was once a major revenue item for some banks.
Types of Prepaid Cards
Prepaid cards are not only gift cards. Increasingly, they are used for specific purposes, like rewards, payroll, and benefits. Often, such cards are restricted in some form using what is called a restricted authorization network, or RAN. For example, a Health Savings Account (HSA) can come with a linked prepaid card that can only be used at pharmacies and doctors’ offices. Prepaid cards are also distinguished by who loads them: an individual, company or government agency. As noted, many prepaid cards are self-loaded by people who want a low-cost alternative to a traditional bank account. Some common types are:
- Payroll Cards – loaded by a payroll company on behalf of an employer, often as an alternative to paper checks. Some gig economy companies, such as Uber, offer such cards, so they are growing in importance.
- Benefit Cards – there are a range of possibilities here, from disaster relief to insurance payouts and government programs such as food stamps. Using prepaid cards reduces stigma from government benefits, while preserving the program focus through a RAN.
- General Purpose Reloadable (GPR) Prepaid Cards – can be reloaded to serve as an alternative to a credit card or traditional bank account.
- Teen/Student Cards – loaded by a parent, these cards can be restricted via a website or app to apply to only certain types of merchants as defined by merchant category codes. The most prominent example right now is Greenlight.
- Campus Cards – another type of RAN card, these cards are usually loaded by a school in loco parentis, and restricted to vendors on campus. Companies with large campuses occasionally issue similar cards, for use in the cafeteria and other local businesses.
- Gift Cards – while most gift cards are restricted to a single merchant (see closed loop, below), some organizations do issue them as incentives to salespeople, customers, or other employees. Friends and relatives may also send them as gifts, although they are usually not reloadable, which is what distinguishes them from GPR cards (above).
Blurring Lines between Debit and Prepaid Cards
With the introduction of GPR cards, open loop prepaid cards became indistinguishable from debit cards, for all practical purposes. Many person-to-person (P2P) payment networks, such as PayPal or Venmo, also have “linked debit cards,” which are really prepaid cards, because their source of funds is the balance in the P2P account. eCommerce has led to the virtualization of prepaid cards, to the point that the Consumer Financial Protection Bureau (CFPB) passed a regulation in 2016 subjecting P2P networks to the same rules as prepaid cards, and restricting the offering of features like overdraft accounts, which it considered to be too close to debit cards. This has become an issue with prepaid providers who want to offer banking as a service (see below), and is not finally resolved.
Closed Loop Prepaid Cards
Of course, many prepaid cards do not work on the Mastercard, Visa, American Express or Discover networks. These are referred to in the industry as “closed loop” cards, because they operate over proprietary networks. Usually, they do have sixteen digits, but these can be assigned however the prepaid processor wishes; the format is designed to be compatible with existing card processing software.
In the case of closed loop prepaid cards, the roles of the issuer and acquirer are consolidated in the prepaid processor, so there are really only four actors.
Gift cards are the most common form of closed loop prepaid card, but even here there is complexity, as gift cards can be used for a variety of purposes. For example, many merchants now provide gift cards in cases where the original method of payment is no longer available. A variety of platforms offer gift codes as rewards for loyalty, and you can exchange loyalty points for gift cards. Closed-loop cards can even be bought and sold on marketplaces like CardCash, so an unwanted gift card can be converted into cash or a more useful gift card. In fact, many closed loop cards have no physical representation, and exist only as strings of letters and numbers, either in ASCII format or as QR codes and/or bar codes. These are referred to as “virtual gift cards,” and Blackhawk networks found that 69% of U.S. consumers have used a virtual gift card.
Banking as a Service
In recent years, prepaid processors such as Green Dot, Galileo, Blackhawk Networks and others have begun to build out their prepaid platforms to provide additional banking capability, such as bill payment, mobile check deposit, and even overdraft lines. These processors are becoming “arms merchants” in their own right, enabling non banks such as Google and Walmart to offer “bank” accounts without the direct participation of a bank. Many analysts have started calling this “banking as a service.” Of course, there is always a bank somewhere in the background; only banks can access the Federal Reserve and the money supply. This is why I always complain about the term “disintermediation.” Technically, the term disintermediation refers to a strategy of removing the middleman, such as when movie and TV studios release content directly through a proprietary streaming service (like Disney+) rather than through distributors, movie theaters, and TV stations.
What is happening in this case is intermediation, because an intermediary (in this case a prepaid processor) is interposing itself between a bank and the end customer. All fintechs are intermediaries in this sense. While banks may not like losing the direct customer relationship, they can make very good money off of BIN rentals and transaction fees. In this way, prepaid cards have become quite disruptive. In future articles, I will go into some of the current controversies and legal ambiguities facing the industry as it moves beyond its traditional role.