Non-cash payments

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Bankovní institut vysoká škola Praha

Non-cash payments

Bachelor’s degree work

Eldar Rafailov April 2015

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Bankovní institut vysoká škola Praha Banking Management

Non-cash payments

Bachelor’s degree work

Author:

Eldar Rafailov

Banking Management Supervisor: Ing. Marcela Soldánová

Praha April 2015

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Declaration:

I declare that I elaborated my bachelor´s degree work independently and I stated all the literature used.

I attest by my signature that the submitted electronic version of the work is identical with its printed version, and I am aware of the fact that the work will be archived in the library of the BIVŠ, and further, made accessible to third persons through the internal database of electronic university works.

In Prague Eldar Rafailov

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Acknowledgement

Therefore I would like to thank my supervisor Ing. Marcela Soldánová for her time, instructions and advice that were very helpful and essential during writing of this thesis.

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Annotation

This bachelor’s degree work attends to non-cash payments. In the first chapter theoretical aspects and basic facts about non-cash payments are discussed. The second chapter contains the description of payment cards, their functionality and usability in the modern world. One of the main parts of the second chapter is statistical analysis of payment cards in Europe. The third chapter includes analysis of the electronic money and virtual currencies. The forth chapter is dedicated to the problems and challenges of non-cash market. In this relation it is necessary to investigate the market of alternative payments and challenges of this market. The future estimations and possibilities of non-cash market development are represented in this chapter.

The objective of the thesis is to define key aspects of non-cash payments; analyse non-cash payments in the EU; to specify security side of non-cash operations and development problems in non-cash payments sector.

Key words: non-cash payments, payment card, payment system, non-cash market, Bitcoin

Annotation

Tato bakalářská práce je věnována bezhotovostním platbám. V první kapitole jsou probírány teoretické aspekty a základní fakta o bezhotovostních platbách. Druhá kapitola obsahuje popis platebních karet, jejich funkčnost a použitelnost v moderním světě. Jednou z hlavních částí druhé kapitoly je statistická analýza platebních karet v Evropě. Třetí kapitola obsahuje analýzu elektronických peněz a virtuální měny. Čtvrtá kapitola se dále věnuje problémům a výzvám nepeněžního trhu. V této souvislosti je třeba zkoumat trh alternativních plateb a výzvy tohoto trhu. Budoucí odhady a možnosti rozvoje na peněžním trhu jsou uvedeny v této kapitole.

Cílem práce je definovat klíčové aspekty bezhotovostních plateb; analyzovat bezhotovostní platby v EU; specifikovat bezpečnostní stranu bezhotovostní operace a problémy rozvoje v sektoru bezhotovostních plateb.

Key words: bezhotovostní platby, platební karta, platební styk, bezhotovostní trh, Bitcoin

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Content

INTRODUCTION ... 8

S

ELECTED METHODS OF ELABORATION

... 9

1 THEORY AND BASIC FACTS OF FUNCTIONING OF NON-CASH PAYMENTS ... 10

1.1 H

ISTORICAL BACKGROUND OF NON

-

CASH PAYMENTS

... 10

1.2 T

YPES OF NON

-

CASH PAYMENTS

:

THEIR ADVANTAGES AND DISADVANTAGES

14 2 PAYMENT CARDS ... 21

2.1 H

ISTORY OF PAYMENT CARDS

... 21

2.2 D

EFINITION OF PAYMENT CARDS AND PAYMENT SYSTEMS

... 24

2.3 C

LASSIFICATION OF PAYMENT CARDS

... 28

3 VIRTUAL CURRENCY AND ELECTRONIC MONEY ... 31

3.1 V

IRTUAL CURRENCY SCHEMES

... 31

3.2 B

ITCOIN AS A VIRTUAL CURRENCY SCHEME

... 35

3.3 L

ITECOIN AS A VIRTUAL CURRENCY SCHEME

... 41

4 PROBLEMS AND POSSIBILITIES OF NON-CASH MARKET ... 46

4.1 P

ROBLEMS

... 46

4.2 P

OSSIBILITIES

... 49

CONCLUSION ... 49

LIST OF LITERATURE ... 51

I

NTERNET SOURCES

... 53

LIST OF GRAPHS ... 55

ANNEXES ... 56

A

NNEX

1. ... 56

U

SE OF MAIN PAYMENT INSTRUMENTS IN THE

E

UROPEAN

U

NION IN

2000-2013,

IN BILLION TRANSACTIONS

... 56

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Introduction

The non-cash payments contribute a great part of settlements nowadays. Although cash payments still seem to be traditional and widely used by customers, but still the sphere of non-cash payments is growing rapidly. Dynamically developing informational and payment technologies are the main reason of this trend. While cash payments have the same forms and mission, non-cash payments are in the process of constant development and improvement.

Together with banks and other traditional financial organisations other providers of payment services and non-cash payments appear and contribute to its comprehensive development.

Together with electronic money and other standard types of non-cash payments, there appear alternative money or cybernetic money, such as Bitcoin. This is a relatively new stream of settlements, which can be regarded both as barter and as investing tool.

The objective of the thesis is to define key aspects of non-cash payments; analyse non-cash payments in the EU; to specify security side of non-cash operations and development problems in non-cash payments sector.

The structure of the thesis is the following:

In the first chapter theoretical aspects and basic facts about non-cash payments are discussed.

Primarily we are interested in the history of non-cash payments development up to nowadays.

The second chapter contains the description of payment cards, their functionality and usability in the modern world. Payment cards are commonly accepted almost in all points of sale:

shops, state and commercial institutions, on the Internet. One of the main parts of the second chapter is statistical analysis of payment cards in Europe (turnover, index of annual growth etc.).

The third chapter includes analysis of the electronic money and virtual currencies. This chapter shows some alternative approaches to non-cash payments.

The forth chapter is dedicated to the problems and challenges of non-cash market. In this relation it is necessary to investigate the market of alternative payments and challenges of this market. The future estimations and possibilities of non-cash market development are represented in this chapter.

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According to the structure of the thesis I would like to mention all methods of investigation and research that constitute thesis analysis. First of all, this is literary research needed to conduct theoretical research. Secondly, according the statistical information on European central bank we conduct statistical analysis of payment cards and non-cash turnover in Europe. Then, it is interesting to compare non-cash payments in Europe and in the United States.

Besides, thesis includes empirical cycle of research: observation, induction, deduction, testing and evaluation. To start my empirical research I would like to state two working hypothesis that will be evaluated and approved/disapproved during this analysis.

Hypothesis 1: Payment cards and their penetration in Europe are lower than in the United States, i.e. non-cash payments market in the United States is more developed so far.

Hypothesis 2: Alternative currencies and electronic money are not so widely spread in Europe, however the trends are growing.

Selected methods of elaboration

The methods used for writing this thesis will include theoretical overview, synthesis of data, statistical analysis, comparative analysis, deductive thinking, and forecasting. They will help deeply investigate the data related to the topic of the research, and draw comprehensive conclusions in accordance with the aim of the thesis.

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1 Theory and basic facts of functioning of non-cash payments

For the purpose of running practical research of non-cash payments, it is fist of all worth forming a strong theoretical background of the key aspects related to the essence, characteristics and functioning of non-cash payments.

1.1 Historical background of non-cash payments

In order to analyze the historical course of development of non-cash payments, it is first of all necessary to understand the definition of this term. As of today, there are different explanations of what a non-cash payment is in the scientific literature, depending on each particular author’s vision, classification methods and the perspective used to analyze this field of payment relations. The most widely used definition of the concept of non-cash payment states that it is a method of payment for goods, services or works performed, sold or rendered to an individual or legal entity without any involvement of exchange of cash. Thus, a non- cash payment is contrary to a cash payment where the respective transaction is performed using cash as the method of payment.¹

“Non-cash payments the use of one or more banks to complete a transaction. Non-cash payments are not accomplished merely by exchanging the payment instrument between payer and payee, but transferring deposit money between the payer’s bank and the payee’s bank.

Non-cash payment instruments provide the mechanism for this bank-to-bank transfer. Non- cash payment instruments, such as checks, must specify the payment amount, the names of the payer and the payee and their banks.”²

Historically, development of non-cash payments started with the development of trading activities in the ancient society. The first forms of non-cash payments were cheques and bills

1 STACEY, Schreft. How and Why Do Consumers Choose Their Payment Methods? Darby: DIANE Publishing, 2001. ISBN 978-143-79-3457-1, p. 21-22.

2 Modernizing Payment Systems In Emerging Economies. In: World Bank Official Website [online]. 2012 [cit.

2015-04-14]. Available from WWW: <http://www1.worldbank.org/finance/PUBS/LISTFLD/list201b.htm>.

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of exchange which later evolved to their form which is currently used on the market and led- to appearance of new non-cash payment tools.

One of the first non-cash payment instruments was called adesha. Adeshas were commercial instruments, which gained wide spreading in India in the IV-II centuries BC. In fact, an adesha was an order drawn on a banker to pay a certain amount of funds to a third party.

Adeshas were actively used in the field of trade, and Indian merchants largely applied adeshas as bills of exchange. This instrument helped promote trade between large Indian cities and made it possible for merchants to build up close partnership ties, thus developing the overall trading infrastructure in the country.

Those instruments were much popular during the Buddhist period. They were largely used by merchants as letters of credit provided to each other for making payments. In the early XVI century, cheques gained wide usage in the Netherlands, which was particularly due to the rapid development of trade in the country and the role of Amsterdam as a major international maritime center. The large amounts of money accumulated by the Dutch population were deposited in the local cash offices for the purpose of avoiding the risks associated with the storage of money at home.³

Romans used the so-called praescriptiones in the I century BC. Praescriptiones were a form of cheque. An instrument like this was a sheet of paper stating the issuer’s obligation to pay for a certain product or service in the future. This instrument was a privilege of patricians, i.e. rich people with a high hierarchical position in society, and was used in a wide range of trading activities helping develop trade not only within the Roman Empire, but also with other countries on the international scale.

In the III century AD, Persians used letters of credit known as sakks. A sakk was a commitment to pay a certain amount of funds against which supplies of certain products were made. The sakk gradually evolved and was later largely used by the Abbasid Caliphate in the IX century AD. In the Caliphate, Sakks were used for trade with distant territories in order not to transport cash funds. As the threat of being robbed in the route was quite high, merchants preferred to take paper sakks instead of paper money. Thanks to the rapid development of trade in Asia, the sakk quickly became an important payment instrument on the regional scale.⁴

3 VAIDYANATHAN, Kanan. Credit Risk Management for Indian Banks, p. 1-3

4 FRIEDBERG, Barbara. Personal Finance: An Encyclopedia of Modern Money Management, p. 43.

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In the XII-XIV centuries AD, the Knights Templar introduced a system of cheques for pilgrims traveling to the Holy Land or across Europe. Such a pilgrim was able to deposit his funds at a chapter house maintained by the Knights Templar and then withdraw his funds at any other chapter house of the Knights Templar around the globe by simply giving the draft received during the deposit of funds. Such operations allowed safely using funds without anyhow incurring risks of theft or loss during the voyage, at the same time allowing developing financial cooperation between distant geographical territories.⁵

In Venice, Europe’s greatest merchant of the Medieval Age, bills of exchange gained their wide spreading in the XIII century AD. They were used by merchants for the purpose of carrying out international trading activities without the need to transport large amounts of gold and silver. This allowed not only intensifying partnership ties with foreign merchants, but also significantly reducing the overall amounts of expenses. Thanks to the positive experience of the Venetian merchants, bills of exchange rapidly gained wider popularity in other European countries.⁶

In the XVI century, people started actively depositing their cash funds with bankers thanks to the rapid development of foreign trade and intensification of production activities. The competition between the Dutch bankers made them offer additional services to the clients for the purpose of gaining larger benefits. Thus, bankers introduced written orders for their depositors to use as a payment mechanism in their trading activities. Such payment orders helped not only promote foreign trade, but also build up the entire financial sector of the Netherlands, which gained the leading positions on the European continent.⁷

The first ever handwritten cheque appeared in Great Britain in the mid-XVII century, and was credited to the Bank of England which delivered it. The word cheque itself appeared in Great Britain as well, and the main novelties associated with this payment instruments were made by the Bank of England. Namely, serial numbers stated on cheques were first implemented in Great Britain. Their main aim was to avoid frauds and to guarantee the highest level of security of payment transactions performed by the customers of the English banking system.

However, the growing amount of transactions on the national scale made it impossible for the

5 STACEY, Schreft. How and Why Do Consumers Choose Their Payment Methods? Darby: DIANE Publishing, 2010. ISBN 978-143-79-3457-1, p. 55-56.

6 KHIAONARONG, Tanai. Banking on innovation: modernisation of payment systems. 1st ed. London:

Springer, 2009. ISBN 978-379-08-2333-2, p. 80-82.

7 PEITZ, Martin. The Oxford handbook of the digital economy: modernisation of payment systems. 1st ed. New York: Oxford University Press, 2012. ISBN 978-019-5397-840, p. 205.

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English banks to effectively work with such large amounts of cash which needed to be transported, and therefore required not only additional financial expenses, but also significant amounts of time. Therefore, banks stared exchanging cheques drawn on them for the purpose of avoiding such additional costs. This system later evolved, and clearing houses emerged on the financial market.

In the XVII century, the so-called drawn notes were widely used in England as an instrument of non-cash payments. Those were sheets of paper using which customers were able to draw on the funds they had deposited at an English bank. Thanks to the drawn notes, customers were able to make immediate payments to counterparties without any need to use cash funds directly. In the XVIII century, the drawn notes evolved into cheque papers: this instrument was already pre-printed, and not handwritten. Bank customers received numbered and protected cheque papers and were able to subsequently use them for all payments in non-cash form. A seller that received a cheque paper for payment was able to withdraw his funds from the bank that had issued the document. Clerks of English banks regularly held meetings in order to run the set-off of checks and settle all balances for such cheques.⁸

In the early XIX century, the Commercial Bank of Scotland became the first financial institution to use personalized bank cheques. The bank printed the name of the account holder on the pre-printed cheque form, thus making it possible only for the respective account holder to use this financial instrument. In the mid-1800’s, the Bank of England introduced cheque books containing 50 to 200 pre-printed personalized cheques each for customers actively using this form of non-cash payments in their economic or other activities. In the late XIX century, English and other European authorities carried out massive work over the elaboration of legislation governing the field of non-cash payments, namely the use of bills of exchange and negotiable instruments.⁹

In the late XIX century, after the invention of telegraph, banks started using wire transfers of funds as another new method of non-cash payments. Customers obtained an opportunity to transfer funds to each other remotely, without any need to travel abroad or send any documents. Moreover, the time required for such operations was very short, which intensified the turnover of trading activities around the globe.

8 RYAN, Joan. Personal Financial Literacy. Kentucky: Cengage Learning, 2011. ISBN 978-084-00-5829-4, p.

189-190.

9 MILLER, Frederick, The lawyer's guide to modern payment methods: ACH, debit, credit and more. 1st ed.

Chicago: American Bar Association, General Practice, Solo, and Small Firm Section, 2007. ISBN 978-159-03- 1819-5, p. 186-189.

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In the first half of the XX century, with the industrial revolution and the rapid implementation of technological innovations in the banking sector, debit and credit cards emerged on the market as substantially new non-cash payment instruments. Such cards allowed paying for any products or services through dedicated bank terminals only by applying special chips transmitting information directly to the internal systems of banks. Debit and credit cards simplified transactions in all fields and made bank services and non-cash payments accessible to almost everyone. Moreover, the rapid development of banking technologies eased much the set-off of funds between banks, thanks to which the entire banking sector started developing at an even higher pace.

The subsequent evolution of information technologies and the invention of the Internet allowed for the implementation of an absolutely new means of non-cash payments, namely electronic commerce. This instrument first emerged in the 1980’s, and has since then been gradually increasing its share in payments made by individuals and legal entities in their activities. E-banking allows making payments remotely from one’s home just by using the Internet access to physical bank accounts. As of today, this is the fastest and most convenient form of non-cash payments, which allows for a 24/7 access to banking services around the globe.¹⁰

Annex 1 to this thesis provides information on the most widely used payment instruments in the European Union in the XXI century. As can be seen from the chart, electronic payments have the greatest share, and are growing against the use of traditional payment instruments.

Having analyzed the key milestones of development of non-cash payment methods, in the next chapter of my thesis, I would like to focus on the types of non-cash payments, their advantages and disadvantages.

1.2 Types of non-cash payments: their advantages and disadvantages

A payment instrument is commonly referred to as a system of mechanisms and procedures aimed at ensuring the transfer of funds between individuals and entities. Different payment instruments have different functions and parameters, and may significantly vary dependingon

Springer, 2009. ISBN 978-379-08-2333-2, p. 230-232.

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the particular transactions in which the payer and the payee engage. In the scientific literature, they are most often divided into cash and non-cash.¹¹

Non-cash payments have their own specific life cycle:

1. selection of payment instrument, and submission of instruction. For the purpose of performing a payment transaction, the payer needs to submit his instruction to the bank, with the specification of the amount and payment instrument to be used for that purpose.

As of today, the electronic form of payment is gaining an ever-growing usage, which is particularly due to the rapid spreading of the Internet and online technologies. Thus, banks get an ability to manage all such transactions more effectively;

2. internal processing of the payment at the bank. The bank sending the payment needs to verify the payment instrument for the purpose of checking it compliance with the current legislative norms in force, and for verifying the availability of funds required for the respective transaction on the customer’s account. Thereafter, the bank prepares clearing and settlement instructions for the payment to be made;

3. interbank transaction processing. The payment sent is transmitted and reconciled prior to its ultimate implementation, which may also include netting and the creation of final positions for effecting the transaction. Such operations on the interbank level can be carried out either via a system of correspondent bank accounts or via different payment systems;

4. interbank payment settlement. The sending bank transfers the payment to the receiving bank;

5. internal processing at the receiving bank. The payment is credited to the final recipient’s account;

6. communication. The payment receipt is delivered to the beneficiary.¹²

Springer, 2009. ISBN 978-379-08-2333-2, p. 28.

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During the course of their historical evolution, many different types of non-cash payments were formed which are currently used in the financial sector for simplifying transactions between individuals and entities.

There are the following main classifications of non-cash payment instruments:

1. Based on physical form:

- paper based (traditional;

- electronic.

2. Based on the party which submits the payment:

- credit-based payment instruments. Such instruments are submitted for processing by the payer. Credit-based payment instruments include credit transfers, which are among the most popular payment instruments on the financial market;

- debit-based payment instruments. Such instruments are submitted for processing by the payee. Debit-based payment instruments include cheques, direct debits and card payments.¹³ Furthermore, this sector is in constant evolution, and therefore new forms of non-cash methods still emerge on the market with the development of the Internet and mobile technologies, combination of achievements from different fields of research, implementation of new equipment in telecommunications, etc. However, all such non-cash payment methods can be reduced to several key ones which are most widely used in banking and other transactions. Those are namely wire transfer, direct debit, letter of credit, payment cards, cheque, e-money and mobile payments.¹⁴

1. A wire transfer or credit transfer is an operation in the course of which the transferor transfers funds from his account at a financial institution to the beneficiary. In order to perform such a transaction, the transferor sends his transfer order to the bank or any other financial institution where he holds an account, with a demand to debit a certain amount of funds from his account and send this amount to the beneficiary’s designated bank account. Thereafter, the transferor’s bank credits the respective amount of funds to the beneficiary’s account at his bank by withdrawing it from the transferor’s account.

The main advantage of this non-cash payment method is its speed and reliability. Large

12 KOKKOLA, Tom. The Payment System: Payments, Securities and Derivatives, and the Role of the Eurosystem. European Central Bank, 2010. SBN 978-92-899-0632-6, p. 35.

13 KOKKOLA, Tom. The Payment System: Payments, Securities and Derivatives, and the Role of the Eurosystem. European Central Bank, 2010. SBN 978-92-899-0632-6, p. 29-30.

14 KONDABAGIL, Jayaram. Risk management in electronic banking: concepts and best practices. Hoboken, New York: John Wiley, 2007.ISBN 04-708-2243-0, p. 245-248.

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payments can be received by the beneficiary within several business days, which significantly accelerates the entire process of commercial cooperation between the respective counterparties. Moreover, this method is secure, as all transactions are carried out directly between banks, and therefore the risk of frauds leading to loss of funds is minimized. Thanks to the availability of reliable international payment systems, wire transfers are also widely used for cross-border non-cash payments.¹⁵

2. Direct debit is another form of non-cash payments widely used for both domestic and transborder transactions. A direct debit is an operation in the course of which the transferor of funds submits a written transfer order to his bank to debit funds from the account of a third party and credit them to the transferor’s account. I.e. the transferor is at the same time the beneficiary.¹⁶ The third party from whose account funds are debited gives its consent to such transactions in advance, thanks to which the transferor is able to withdraw the stipulated amounts of funds from such third party’s accounts only by submitting a written order to his bank. After such transfer order is received, the entire procedure is similar to the one implemented in the case of wire transfer. This non-cash payment method is beneficial thanks to its speed, and the transferor’s ability not to rely upon any guarantees of the third party, but use its funds directly. At the same time, the respective third party incurs significant risks which can be mitigated by conclusion of contracts expressly stipulating all the terms and conditions of such direct debit.¹⁷

3. A letter of credit is another major non-cash payment method widely used in domestic and foreign transactions. This payment method has gained an especially wide spreading in foreign trade operations thanks to its reliability. When issuing a letter of credit, the purchaser of certain goods or services allocates the respective amount of funds requested as the payment fee by the seller, deposits it to his bank account and gives an instruction to his bank to transfer such funds to the beneficiary’s bank accounts against particular confirmation of supply of goods or services. After a contract is concluded

15 EUROPEAN CENTRAL BANK. Eurosystem: Virtual currency schemes. [online]. 2012 [cit. 2015-04-14].

Available from WWW: https://www.ecb.europa.eu/pub/pdf/other/virtualcurrencyschemes201210en.pdf

17 ANDERLONI, Luisa. Financial Innovation in Retail and Corporate Banking. Northampton: Edward Elgar Publishing, 2009. ISBN 978-184-84-4718-9, p. 120-122.

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between the seller and the purchaser, and the purchaser allocates the funds to the letter of credit, such letter of credit is supplied by the purchaser’s bank to the seller.

Thereafter, the seller supplies the goods or services to the purchaser, and presents the letter of credit together with a confirmation document (for instance, bill of lading) to the seller’s bank. The latter then sends a transfer order to the purchaser’s bank, and funds from the purchaser’s account are credited to the seller’s account. This form of non-cash payments is particularly advantageous to the purchaser, as he has all guarantees that he will receive the goods or services, and his funds will be transferred to the seller only in case that all of the latter’s commitments are fulfilled and sufficient evidences are presented to the bank. However, it has some considerable disadvantages for the seller, as the latter receives payments only a certain period of time after all the supplies are made.¹⁸

4. A cheque is a payment document presented by the payer to the seller instead of cash funds. Cheques are secured by the payer’s bank’s commitment to charge the respective amounts of funds from his bank account and transfer them to the seller’s account.

Cheques are beneficial thanks to the fact that they simplify transactions between counterparties, however the seller incurs additional risks when accepting a cheque due to the high risk of fraud.¹⁹

For payers, cheques are particularly beneficial, as they get a certain delay of time between the submission of the cheque and the withdrawal of funds from the target account when using this payment instrument. Therefore, by using cheques, they are able to spare their time expenditures. For the payee, there is a threat regarding the creditworthiness of the payer, i.e.

regarding the fact that the amount stipulated in the cheque is backed by real funds. As a result, the payee incurs additional risks. In developed Western countries cheques have gained a far wider usage as compared with developing states, which is due to the level of development of their national financial markets. However, despite being widely used, cheques are the most costly among the non-cash payment instruments currently used in the banking practice, and

18 LITAN, Robert. Moving Money: The Future of Consumer Payments. New York: Brookings Institution Press, 2009. ISBN: 978-081-15-70378-5, p. 317-319.

19 PEITZ, Martin. The Oxford handbook of the digital economy: modernisation of payment systems. 1st ed. New York: Oxford University Press, 2012. ISBN 978-019-5397-840, p. 75-77.

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therefore banks tend to use more electronic instruments for providing their services to customers.²⁰

Travelers’ cheques are a specific type of cheques issued in their particular denominations for restricted purposes, namely for business and traveling. Under travelers’ cheques, there are no particular payees, and they cannot be transferred to third parties. Therefore, they can be used only by their ultimate owner. Such cheques are most often accepted not only by banks, but also by many retailers such as hotels or cafés.

A bank draft is another specific form of cheques drawn by banks on themselves. Such cheques are issued by banks and other financial institutions for their own internal needs, but can also be used by customers for the purpose of fulfilling their liabilities to particular payees.

Their main difference from ordinary cheques lies in the fact that in this case, there is no doubt regarding the payer’s creditworthiness, as the amount of the cheque is guaranteed by the respective banking institution.²¹

5. Payment cards are widely used for both commercial payments in trading activities and ordinary payments made by individuals. Thanks to the wide availability of POS terminals and ATMs at stores, shopping centers, restaurants, etc., non-cash payments are actively used in everyday life by most people. Payment cards are in fact instruments allowing transferring funds from the transferor’s to the seller’s account within the seconds by simply entering the verification code (PIN code). This non-cash payment method simplifies transactions for all parties involved. It will be considered more in detail in the next chapter of my thesis.²²

6. Electronic money (or e-money) is a specific type of non-cash payment methods which only emerged with the rapid development of the Internet in the 1980’s, and has since then been constantly increasing its share in the financial sector. E-money is in fact a monetary value stored electronically or digitally on a specific device such as a personal computer, chips in watches or cars, etc. This non-cash payment method allows using one’s funds without storing them physically. Thanks to e-money, online trading

22 RADU, Cristian. Implementing electronic card payment systems. Boston: Artech House, 2003. ISBN 9781580538039, p. 120-123.

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activities are performed over the Internet, and people have a wide access to cross-border purchases through special trading platforms by only using dedicated online payment systems. I will consider e-money as a form of non-cash payments more in detail in the third chapter of my thesis.²³

7. Mobile payments are another widely used form of non-cash payments. Individuals most often use mobile payments for domestic payments. A mobile payment is a transfer of funds in compensation for certain goods or services made through cell phones or other similar mobile platforms where funds can be stored on SIM cards, chips or other similar storage devices. The main advantage of this type of non-cash payments is that the buyer gets an opportunity to quickly transfer the funds available on his mobile device without any need to fill in any transfer forms, send transfer orders, and so on. However, mobile payments are almost unused in the corporate sector, and therefore do not cover the entire range of payment activities in the financial sector.²⁴

Having analyzed the most prominent types of non-cash payment methods, in the next chapter of my thesis, I would like to focus more in detail on payment cards.

23 BELLOVIN, Steven. Applied cryptography and network security: 6th international conference, ACNS 2008, New York, NY, USA, June 3-6, 2008 : proceedings. New York: Springer, 2008. ISBN 35-406-8913-3, p. 142- 144.

24 EUROPEAN CENTRAL BANK. Eurosystem: Virtual currency schemes. [online]. 2012 [cit. 2015-04-14].

Available from WWW: https://www.ecb.europa.eu/pub/pdf/other/virtualcurrencyschemes201210en.pdf

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2 Payment cards

As payment cards are one of the most widely used methods of non-cash payments, it is worth analyzing more in detail the history of their development, and classification of different payment cards.

2.1 History of payment cards

The history of payment cards started in the early XX century, with the intensification of industrial production around the globe, and thus growth of purchases and sales on the global scale. In the early 1900’s, some American and West European oil companies used specially designed paper cards as credit instruments for their customers. Back then, payment cards had a very limited circulation, and were mostly aimed for creating brand loyalty, and not for convenience. However, even with such a limited scope of use, payment cards showed their potential success on the global market, and have since then been gradually developing, with changes in both their physical form and destination of use.²⁵

In 1946, the first ever bank card was issued by the American banker John Biggins. The card was called “Charg-It” and was used for everyday purchases by people. Thus, by showing a

“Charg-It” card to the seller, a customer was able to buy certain products in credit. His bill was then forwarded to the bank owned by John Biggins. The latter paid the bill, and was thereafter reimbursed for the charges by the customer, who also paid a commission fee for the bank’s services. Although “Charg-It” was an important milestone in the history of development of payment cards, this card could only be used locally, and its owners needed to have an account at Biggins’ bank for the purpose of using it as a payment tool.²⁶

The next step on the way toward the development of payment cards was made in the United States of America in 1949, when another new payment card was issued. The idea was born during a friendly conversation between the CEO of the financial company Hamilton Credit Corporation Frank McNamara and his corporate lawyer Ralph Schneider. The product invented was named Diners Club, and was initially aimed for payments for diners. Diners

25 CARBO-VALVERDE, Santiago, The Economics of Credit Cards, Debit Cards and ATMs. Fundacion BBVA, 2009, p. 66-69.

26 Credit cards.com. 2015. The History of Credit Cards. [online], Available at:

http://www.creditcards.com/credit-card-news/credit-cards-history-1264.php (Access 2015-04-30)

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Clubs cards were initially aimed for settlements as credit cards, but soon thereafter, the debit card variant was issued as well, and the funds for meals could already be debited directly from the customer’s account. The first payment cards were non-bank products, and were made of cardboard, and not of plastic, as their modern variants.²⁷

The success of Diners Club helped rapidly promote the popularity of the new financial product, and first American Express, and then many American banks entered the new market with their own payment card products. The first banks to widely introduce card payments in their business activities were the two largest US banks, namely the Bank of America and Chase Manhattan Bank. In 1951, New York’s Franklin National Bank issued an unprecedented payment card for loan customers. However, all such bank products could only be used locally, just as their predecessors, which significantly narrowed the potential of their further development, and players on the financial market started making attempts to bring the use of payment cards to an absolutely new level.²⁸

In 1959, American Express launched the first ever plastic card on the market. By that time, the company was already largely involved in the market of financial payments, and namely in its sector of payment cards. The corporation had a specially dedicated card which could be used by tourists traveling abroad for purchases in over ten countries. Also, by the late 1950’s, Diners Club already had over 200,000 users, which testifies the great popularity of payment cards during that time. In 1959, both Diners Club and American Express implemented an option for payment card holders to maintain revolving balances on their card accounts. This was made in order to abolish the obsolete “closed-loop” system used in the financial sector, and make payment cards available to a far greater number of people. Although this step meant greater responsibility borne by the financial corporations, it allowed providing the customers with greater flexibility in their everyday and commercial activities, thus only further raising the popularity of payment cards as a bank product.²⁹

27 JUŘÍK, Pavel. Platební karty: Velká encyklopedie - 1870-2006. Prague: Grada Publishing a.s, 2006.. ISBN 978-802-47-6391-0, p. 38=42

28 PRAGER, Robin. Interchange fees and payment card networks: economics, industry developments, and policy issues. Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, 2009, p. 111-113.

29 JUŘÍK, Pavel. Platební karty: Velká encyklopedie - 1870-2006. Prague: Grada Publishing a.s, 2006.. ISBN 978-802-47-6391-0, p. 29-30.

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In 1966, a group of banks established the InterBank Card Association, which is now largely known as MasterCard. This card association was an absolutely new milestone in the history of financial services. Thus, it was the first “open-loop” system allowing the customers to use payment cards for settlements around the globe, regardless of whether they had an account at a particular bank. It was enough to have an account at one of the banks belonging to ICA in order to make payments using a payment card. Thereafter, set-offs were made between the members of the InterBank Card Association. The new system used for payment card significantly simplified all transactions for payment card users, and also largely promoted trade around the globe. It was beneficial not only to customers, but also to sellers of products and services, as the latter obtained an opportunity to run simplified card settlements by receiving funds directly to their bank accounts, regardless of the bank which was used by their customers. Soon thereafter, another similar interbank association called Visa emerged.³⁰

In 1968, ICA grew to the international level by establishing an association with the Mexican Banco Nacional. Next, several European and Japanese banks joined the InterBank Card Association, and by the 1970’s, the association already featured members from Australia and Africa. The rapid expansion of the geographical coverage of ICA testified the demand which payment cards had among people around the globe, and the trends obviously showed that further growth of the payment cards market could be expected in the future.³¹

In the 1970-1980’s, the geographical coverage of MasterCard and Visa payment systems further grew, and the range of services offered became larger. In 1983, prepaid telephone cards were introduced by STMicroelectronics. In 1990 gift cards gained their wide spreading instead of gift certificates at stores. In 1997, payroll cards were implemented in major global corporations for the purpose of simplifying the payment of salaries to employees. In the 2000’s, the main vector of development on the segment of payment cards was the increase in the level of their processing, creation of contactless cards, implementation of new chips, and

30 ANDERLONI, Luisa. Financial Innovation in Retail and Corporate Banking. Northampton: Edward Elgar Publishing, 2009. ISBN 978-184-84-4718-9, p. 163-165.

31 DEGENNARO, Ramon. Merchant Acquirers and Payment Card Processors: A Look Inside the Black Box: A Reprint from the “Economic Review”. Darby: DIANE Publishing, 2008. ISBN 978-143-79-0044-6, p. 157-159.

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so on, which steps were mainly aimed at increasing the level of security of payment cards, and customer convenience.³²

Having investigated the key milestones of development of payment cards, in the next chapter of my thesis, I would like to focus on the users and functions of payment cards.

2.2 Definition of payment cards and payment systems

A payment card can be defined as a personified payment instrument providing its holder with an ability to carry out cashless payment of goods and services, and to receive cash funds in banks’ branches or offices, as well as in ATMs. Such branches, offices, ATMs and other service points make up a payment card service network.³³

A payment card is generally a plastic card of standard dimensions (85.6 mm x 53.9 mm x 0.76 mm) made of special mechanically and thermally resistant plastic material. Any payment card contains the bank holder’s details for identification purposes. Such details generally include the logos of the issuing bank and payment system, the bank holder’s name, his account number, the expiry date of the payment card, and sometimes his photo, signature or some other personal data. Payment cards usually provide two identification options: visual identification (using the aforementioned holder’s details) and barcode which can be read using specially designed card readers.³⁴

In the literature dedicated to payment systems, the term payment system if often commonly referred to as an interbank fund transfer system. However, in practice, a payment system is large, and includes the entire range of tools, participants, procedures, and processes used for the purpose of completing money transfers and thus ensuring a higher effectiveness of money supply and multiplication in a particular region. Taking into account the inherent specificities of payment systems, the main components of payment systems are as follows:

1. payment instruments used for submitting payments and authenticating them. This component includes the means used by the payer for giving his instructions to the bank in order to transfer funds to the payee’s bank;

32 Charles Goldfinger. Economics of financial applications of the smart card: a summary overview. [online].

2015. [cit. 2015-04-28]. Available from: www.econ.tuwien.ac.at

33 SCHNEIDER, Gary. Electronic Commerce. Kentucky: Cengage Learning, 2014. ISBN 978-130-51-7765-9, p.

50.

34 BRAGG, Steven. Treasury Management: The Practitioner's Guide. New York: John Wiley & Sons, 2010.

ISBN 978-047-05-9120-8, p. 168-169.

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2. processing. This component include the instructions exchanged by banks for performing the respective transactions;

3. means of settlement. The payer’s bank is to compensate the payee’s bank for the respective payment amount either on a direct basis or involving multilateral agent agreements.³⁵

A payment system is the entirety of methods and subjects implementing them within a uniform system for the purpose of using bank payment cards as a payment means. I.e. a payment system is in fact a unified system destined to implement card payments and settlements within the framework of regulated payment tools and mechanisms. Thanks to the use of payment systems, payment cards can be used within open-loop systems allowing the customers to run payments using cards from different banks. This is convenient for both customers and sellers of products and services, as the implementation of unified payment systems considerably simplifies commercial interaction between all subjects of economic relations.³⁶

Each payment card system has its own constituting elements such as bank card issuer, card holder, acquirer bank, settlement bank, processing center and communication centers.

Payments can be classified based on the number of the respective actors participating in transactions:

1. A one-to-one payment is a transaction which involves only two actors: the payer who sends the funds and the payee who receives them. This type of payments is most widely spread on the market.

2. A one-to-many payment is a transaction where the payer transfers some amounts of funds to different payees. Most often, such payments are performed between legal entities, households and governments, and they may include payments of social contribution, refunds, etc. One-to-many transactions are most often used in large quantities at once.

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“In many-to-one transactions, several payers transfer funds to a single payee, usually on the initiative of the payee. These are typically transfers from private households to businesses or governments – for instance utility or tax payments.”³⁷

A bank card issuer is a bank that issues plastic payment cards and provides them to customers for the purpose of simplifying transactions. Such actions are made by the bank card issuer for a commission fee amount paid by each customer. A card holder is a person which holds a payment card under an agreement entered into with the issuing bank. Bank card holders can include both individuals and legal entities. Bank card holders can use their payment cards for effecting payments for goods or services and for receiving funds from other payment system participants. An acquirer bank provides the full range of services for interaction with payment card service points such as processing of authorization requests, transfer of funds, acceptance of paper and electronic documents, etc.³⁸

A settlement bank ensures quick set-off of funds between acquirers and issuers through the use of correspondent accounts. A processing center is an organization ensuring technical processing of authorization requests and transaction protocols received from acquirers. For this purpose, processing centers maintain databases with information on banks participating in the respective payment system. Finally, communication centers provide payment system participants with access to data transmission networks.³⁹

Based on the settlement methods, the following four types of payment systems can be pointed out:

- Real time gross settlement systems which ensure the continuous processing of individual settlements throughout the operational day. This is the most widely spread type of financial systems;

- Designated-time settlement systems. Such systems run the settlement of payments between different subjects in predefined periods of time. They are predominantly used for the processing of retail payments;

38 PEITZ, Martin. The Oxford handbook of the digital economy: modernisation of payment systems. 1st ed. New York: Oxford University Press, 2012. ISBN 978-019-5397-840, p. 123-124.

39 SHIM, Anique. The International Handbook of Electronic Commerce. New York: Routledge, 2013. ISBN 978-113-59-6201-2, p. 99-102.

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- Designated-time gross settlement systems. Within such systems, the ultimate transfer of monetary funds is held at the end of the operational day on a transaction-by-transaction basis with each bank;

- Hybrid systems. Such systems combine the feature of two or more systems described above, and have their features at once.⁴⁰

Payment cards as a financial instrument have a wide range of functions destined to ease trade between individuals and legal entities. All such functions can be classified into several groups which can differ depending on each particular researcher’s classification approach. As of today, the most widely used classification approach assumes division of such functions into the following main groups:

 simplification of transactions: payment cards significantly accelerate the implementation of all transactions, thus allowing to spare the time of both customers and sellers of products and services;

 intensification of the financial market: payment cards are one of the most widely used services provided by banking institutions, which to a large extent supports the functioning of the financial market;

 generation of financial profit: through commission fees paid by bank card holders, financial institutions gain additional profits which are thereafter used for financing their activities;

 prevention of frauds: thanks to the new security features, payment cards allow efficiently monitoring the flows of funds, thus preventing their misuse or concealment of transactions.⁴¹

Having analyzed the key theoretical aspects related to payment cards and payment systems, in the next chapter of my thesis, I would like to focus on the classification of payment cards.

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2.3 Classification of payment cards

Despite the fact that all payment cards perform the same key functions, there can be different types of this financial instrument, depending on the particular classification criteria used.

Such criteria include the range of bank card holders, specificity of purposes for which bank cards are used, type of payment card construction, type of data storage mechanisms applied, type of customer preferences rendered under a particular payment card, etc. The wide range of classification approaches used for grouping types of payment cards are predefined by the historical course of development of financial instruments during which new types of bank cards emerged as a response to the objectively existing market conditions.⁴²

1. Depending on the purpose and mechanism of use of funds on payment cards, they can be divided into credit and debit cards. Debit cards are the most widely used financial instruments. A debit card holder simply uses the funds available on his card account for the purpose of performing transactions such as payments for goods or services or transfer of funds to individuals or legal entities. In contrast to debit cards, credit cards allow overusing funds currently available on a bank card holder’s account. In fact, the mechanism of overuse of funds on a bank card account is similar to the mechanism of bank loans provided to individuals for short-term periods.⁴³

2. From the perspective of the types of customers, payment cards can be conditionally divided into individual and corporate. Individual payment cards are cards used by individuals in all their operations, while corporate cards are payment cards delivered to companies, firms or enterprises. Based on its corporate payment card, a company may provide its employees with individual cards tied to the single corporate payment card account. All liability for such individual employee payment cards is borne by the corporation holding the respective corporate bank card account.⁴⁴

42 MILLER, Frederick, The lawyer's guide to modern payment methods: ACH, debit, credit and more. 1st ed.

Chicago: American Bar Association, General Practice, Solo, and Small Firm Section, 2007. ISBN 978-159-03- 1819-5, p. 70-75.

43 SHIM, Anique. The International Handbook of Electronic Commerce. New York: Routledge, 2013. ISBN 978-113-59-6201-2, p. 177-180.

44 VIRTUE, Timothy. Payment Card Industry Data Security Standard Handbook. New York: John Wiley &

Sons, 2008. ISBN 978-047-04-5691-0, p. 269-271.

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3. Based on their type of construction, payment cards can be classified into magnetic strip cards and cards with a built-in chip. Magnetic strip cards have a magnetic strip on their reverse side, where data required identification of the bank card holder are stored. Such data are read from the magnetic strip when the payment card is used in ATMs or payment terminals. A payment card with a built-in chip is a device storing written information which can be updated when a payment transaction is effected. This expands the functional features of the payment cards, and also allows increasing the level of its security. However, payment cards with built-in chips are much more expensive than magnetic strip cards, due to which their use in practice is much less cost-efficient for customers.⁴⁵

As different data storage mechanisms are used in different payment cards, they can be divided into optical, induction payment cards, etc. Based on the type of such mechanisms required for each particular scope of application, such different payment card types can be used in security systems, medicine, industry, and other economic or social sectors.⁴⁶

4. Finally, based on the preferences provided by particular payment cards to their holders, they can be divided into ordinary, silver and gold payment cards. An ordinary card is a card for a usual customer, which doesn’t provide any preferences to its holder, but just offers the typical range of services inherent of this particular product. A silver card is a card provided to customers which are authorized to use the funds within elevated limits. Finally, gold payment cards are provided to the most important clients of particular banks, gold cards allow unlimited loan funds, simplified payment of services, free health insurance, or a wide range of other preferences or advantages which are beneficial to the customer.⁴⁷

The services of card payment schemes are sold to two main groups of users. The first group comprises cardholders using their plastic cards for purchasing certain products or services.

The second group is constituted by merchants providing their clients with an opportunity to settle payments using their plastic cards. Those two groups of users in fact constitute the two

45 MCCALISTER, Erika, GRANCE, Tim, SCARTFONE, Karen. Guide to Protecting the Confidentialty od Personally Identifiable Information. Recommendations of the National Institute of Standards and Technology.

[online]. 2015. [cit. 2015-04-28]. Access from: http://csrc.nist.gov/publications/nistpubs/800-122/sp800-122.pdf

47 CARBO-VALVERDE, Santiago, The Economics of Credit Cards, Debit Cards and ATMs. Fundacion BBVA, 2009, p. 124-125.

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parts of the market in which they interact. Those markets which make it possible for the two groups of end users to effectively interact are commonly known as two-sided markets, and the intensiveness of activities on such markets is very high.

The prices set by card schemes aim to increase the amounts of transactions, and the ultimate total profits generated by the participants in the card schemes. For the purpose of setting such prices the card schemes take into consideration the demand existing on the side of customers and merchants. Also, the elasticity of prices on both sides is taken into account, just as its forecasted change in the future. This is important, as, for example, an increase in the prices set by card schemes leads to a reduction in cardholders’ demand, and as a result, to a decrease in demand on the side of merchants. The structure of prices therefore significantly depends on how each of the market sides responds to the changes in prices existing on the market. The side which has a lower indicator of price elasticity will accept higher prices for the respective services as compared with the side with a higher price elasticity. As a result, the prices for merchants may be more expensive than the ones for cardholders.⁴⁸

Different types of bank cards based on different classification criteria can be combined for the purpose of reaching a higher degree of satisfaction of customer needs and requirements. Thus, changes in customer habits and preferences in the field of payment cards drive the development of this sector of financial services.⁴⁹

Having investigated the main types of payment cards and the key theoretical aspects related to them, in the next chapter of my thesis, I would like to focus on virtual currency and electronic money.

49 VIRTUE, Timothy. Payment Card Industry Data Security Standard Handbook. New York: John Wiley &

Sons, 2008. ISBN 978-047-04-5691-0, p. 311-312.

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3 Virtual currency and electronic money

In contrast to the traditional means of non-cash payments, virtual currencies and electronic money represent the most up-to-date non-cash systems which use online technologies for servicing the needs of customers. Therefore, it is worth analyzing virtual currencies and electronic money more in detail as the most up-to-date trend in the financial sector.

3.1 Virtual currency schemes

The development of the virtual currency market has lately reached significant growth, and is becoming more and more important in the transactions between both individuals and businesses. This has become possible thanks to the rapid growth of the Internet connectivity penetration, and thus the wider access of people around the globe to the use of online technologies.⁵⁰

Graph 1: Internet penetration and its growth, as of 2011

Source:EUROPEAN CENTRAL BANK. Eurosystem: Virtual currency schemes. [online]. 2012 [cit. 2015-04- 14]. Available from WWW: <https://www.ecb.europa.eu/pub/pdf/other/virtualcurrencyschemes201210en.pdf>.

50 MARTHINSEN, John, Managing in a Global Economy: Demystifying International Macroeconomics.

Kentucky: Cengage Learning, 2014. ISBN 978-130-51-7615-7, p. 27.