Electronic Purses, Interoperability, and the Internet
First Monday

Special Issue Update

This paper is included in the First Monday Special Issue #3: Internet banking, e-money, and Internet gift economies, published in December 2005. Special Issue editor Mark A. Fox asked authors to submit additional comments regarding their articles.

Back in 1998-1999, several players, including the European Commission, contended that the patchwork of over 20 domestic-only electronic purse schemes that existed in the euro-zone was untenable in the long run, and that making the schemes interoperable was a matter of urgency in view of the introduction of the euro coins and banknotes. In the article below, I argued that the lack of cross-border compatibility was no major barrier to the development of e-purses as payment instruments for the real world, and that there was no business case for standardization. Today, it can be observed that the CEPS standard, while underwritten by over 90% of the e-purse schemes that existed at the time, was in fact a deadborn child. To the best of my knowledge the first CEPS-compliant e-purses have yet to be issued in Europe and it is very uncertain whether any will ever see the light of day. Tellingly, the most recent press release on the CEPSCO site dates back from May 2001.

In the article I also argued that, unlike in the real world, the lack of interoperability would severely hinder the adoption of e-purses as payment instruments for the Internet - even on a national scale. I therefore concluded that "there [wa]s a real danger, especially in smaller countries like Belgium, that electronic purses w[ould] not succeed in breaking the chicken-and-egg deadlock" in the virtual world. Looking back six years later, it is interesting to note that Internet payments with Proton were discontinued in 2002. Using Proton for buying on the Web had become possible as early as December 1997, but met with limited success among surfers and e-tailers alike. At the height of its popularity, only some 20 Belgian online shops accepted Proton.

Elsewhere, e-purses can still be used on-line - in Austria and Germany, for example - but there too the response has been lukewarm. Part of the explanation for these failures lies in the persisting lack of interoperability, which restricts e-tailers’ ability to sell abroad. With CEPS not materializing, the window of opportunity for e-purses on the Internet is therefore becoming smaller and smaller. This said, e-purses have not been all that successful in the real world either. But that is a different story; see “Electronic Purses: (Which) Way to Go?”, elsewhere in this Special Issue.

Electronic Purses, Interoperability, and the Internet

These last few months the move toward the standardization of electronic purses has gained considerable momentum. Card issuers and newspapers present this move as crucial for crossborder transactions, and especially urgent for the Euro-zone. Starting from the network externalities theory, I argue that interoperability is more important for electronic commerce over the Internet than for real-world cross-border transactions.


The Move toward Standardization
The (Real) Reason Behind the Move
Network Externalities
Network Externalities and Interoperability
Purse Interoperability and the Internet

The Move toward Standardization

The standardization of electronic purses has gained considerable momentum in the last few months [1]. In June last year, Visa International announced that it had reached an agreement with ZKA (Zentraler Kreditausschuss, which represents the German banking industry and operates the Geldkarte scheme) and SERMEPA (the technology subsidiary of Visa España, which operates the local Visa Cash program), to create the "first truly international electronic purse standard" - termed Common Electronic Purse Specifications (CEPS) [2]. Commitments to adopt the new common specifications were also received from SSB, the Italian electronic purse operator, and from the Swedish banks supporting the Cash purse scheme (Visa International, 1998b). In July Banksys (the national EFTPOS operator owned by the majority of Belgian banks) announced that American Express, Visa International, and the Australian company ERG (which holds the Proton franchise rights for Australia) had become shareholders in the newly created Proton World International (PWI), a company formed by the spin off of Proton technology assets developed by Banksys. At the same time, it was announced that the new company would support and implement the Visa-backed CEPS "to ensure interoperability of electronic purse schemes worldwide" (Banksys, 1998). In September, Europay International announced that the Dutch and German banks would add Europay's Clip to their Chipknip and Geldkarte cards as the interoperable acceptance mark for crossborder transactions (Europay International, 1998a, 1998b). While this approach boils down to the formation of "federations" based on existing technology, as a second stage Europay plans to define a fully interoperable Clip purse that will be based on CEPS (Europay International, 1998a). In October, Interpay (the umbrella organization responsible for the EFTPOS network of the Dutch banks) became a shareholder of PWI (Proton World International,1998). Recent additions to the CEPS camp include NETS, Singapore's national ATM and debit card processor and operator of the CashCard electronic purse scheme - reportedly the largest purse program in the Asia Pacific area (Visa International, 1998d); the French Groupement des Cartes Bancaires [3]; and Europay Austria, which operates the Quick scheme (Visa International, 1998e) [4]. In short, already more than 90 percent of the world's electronic purse cards are expected to conform to CEPS and to become interoperable at some point in time (Visa International, 1998e). Part of the left-out minority is Mondex, the MasterCard International majority-owned purse, which thus appears to have been marginalized to some extent [5].

The (Real) Reason Behind the Move

Card issuers (and newspapers) primarily, if not exclusively, present the move toward standardization as being of crucial importance for crossborder transactions and, in view of the introduction of the euro, as being particularly pressing for the EU countries [6]. The main advantage of the new standard allegedly is that it "will allow cardholders to make purchases with electronic purses in euros when traveling around Europe" (Visa International, 1998b) [7]. In March, Hans van der Velde, president of Visa EU, even stated - and he was not the only one [8] - that the current situation, with over 20 incompatible electronic purse schemes in Europe, would become plainly untenable once people were able to use a common currency across Europe (Visa International, 1998a). Today, so the reasoning goes, Belgians on vacation in Spain have little trouble in accepting that they cannot use their electronic purses loaded with Belgian francs to pay for goods that are priced in pesetas - their BEF bank notes are equally of little use. Once the euro coins and notes are introduced, however, bankers will have a harder time selling their story (Hens, 1998; du Bois, 1998; European Card Review, 1998, p. 8) [9].

That press releases and newspaper articles focus on 'real world' cross-border transactions is surprising, since this type of transaction was never a real priority for card issuers in the past. When Mondex boasted about its unique multi-currency capability, for example, this was dismissed by Banksys as a (costly) device. Banksys (1995, p. 26) emphasized that "all opinion surveys show that 99% of electronic purse transactions will occur within 50 miles of the cardholder's house" and seized upon this result to argue that it made little sense to equip an electronic purse with a multi-currency function for use abroad, as Mondex had done. As three Banksys executives put it: "Rappelons [...] la vraie nature du porte-monnaie électronique: les achats de tous les jours (pain, ticket de bus, journal, ...), par des habitants dans leur voisinage proche" (Linkens et al., 1995, p. 279; my emphasis). Translated literally: "Let us bear in mind [...] the true nature of an electronic purse, which is routine daily purchases (bread, bus tickets, newspapers, etc.) by people in their immediate neighborhood" [10]. Wim Philippe, a product manager at the Kredietbank (now KBC), put it even more frankly: "Proton is a domestic payment system. We didn't consider international operability to be a real priority. More than 99% of the demand has to do with domestic transactions" (Philippe, 1997; emphasis in original). This was recently confirmed by Europay: " ... research clearly shows that purse transactions are, and will continue to be, mainly domestic" (Europay International, 1998a). In short, as Dave Birch of the U.K. consulting company Hyperion recently put it: "The cost of implementing cross-border compatibility is judged, by the national schemes, to be prohibitive given the small number of transactions" (Birch, 1998).

In the light of the above remarks it is hardly surprising that, in its 1997 report on interoperability, the European Committee for Banking Standards (ECBS) still argued convincingly that the three basic models it proposed were in fact only "models for the future. For now, the individual countries are busy with launching their national purses, with the migration of their terminal base and with putting additional applications like credit and debit on the chip" (ECBS, 1997b, p. 12; my emphasis) [11]. Indeed, card issuers still have a good deal of work to do at home, given that usage rates of electronic purses throughout Europe have so far been (very) low [12]. One strategy that card issuers are adopting is the addition of extra features to their cards. But cross-border interoperability is unlikely to be the 'killer application' that everybody is looking for.

Moreover, as the ECBS also notes, there are other solutions for interoperability besides agreeing on a common standard:

"At an intermediate stage, and in parallel to the development of the national purses, the practical solution for interoperability would be for the customer to buy a [disposable] local purse in the country he is visiting. [...] Implementation would be fairly easy and the solution seems very convenient as the customer is able to load the purse with the local currency via his debit or credit card" (ibid.) [13].

Also, it is not inconceivable that, in the future, a comprehensive city card might - even after the emergence of the euro - be a more attractive alternative to tourists than the electronic purses that they have brought with them from their home countries. A local city card could, for example, store special 'weekend tickets' for use on all modes of municipal public transportation, it could give discounts on visits to museums or theaters, and so on.

Another argument undermining the thesis that making cross-border purse transactions possible is a matter of urgency lies in the fact that a number of popular holiday destinations still do not have national schemes (or lack acceptance points). A salient example is France, which could remain a blind spot on the map for some time to come [14]. Finally, seen from a different angle, it could be argued that the still limited cross-border compatibility of debit cards is far more inconvenient for tourists and business people.

To sum up, the cross-border compatibility of electronic purses does not seem to be a pressing issue - not even in the euro-zone. It also lacks a business case. Why, then, are purse issuers pressing ahead with international standardization? Commenting on the recent developments, Daniel Skala, the PWI executive vice president for sales, justified the move as follows:

"Crossborder purse transactions won't generate even enough money to print the statement, but we can't imagine that euro notes will be interoperable and not electronic purse. So we'll show the way but we all know we'll lose money" (Rolfe, 1998, p. 14).

In my view, the real reason has to do with making, not losing, money. And that reason is electronic commerce over the Internet. In what follows I demonstrate that while the lack of cross-border compatibility is no major barrier to the development of electronic purses as domestic payment systems for the real world, it does severely hinder their adoption as Internet payment systems - even on a national scale. In demonstrating this, I rely heavily on the network externalities theory. I will therefore begin by briefly setting out what network goods are, why electronic purses classify as network goods, and how network externalities can be modeled [15].

Network Externalities

It is by now commonly accepted that many goods and services are subject to so-called network externalities. A network externality is said to exist if the value that a person obtains from the product increases as more people consume the product or, in other words, as the size of the 'network' associated with the product increases. Typical network goods have little or no value in isolation; they derive their value from the 'connection' with other goods. Examples include telephones, fax machines, and information systems such as the Internet. In the case of an e-mail network, for example, users want to be able to communicate with a large group. Accordingly, existing members of the network obtain direct gains from the addition of new members: each additional user enhances the value of the network to existing users because the number of people to whom they can send e-mail messages increases.

Intuitively, it is clear that the new electronic money products currently being introduced, such as electronic purses, are also examples of network goods. There is, however, an important difference compared to the e-mail example above. For most electronic purses, one user's adoption has no direct impact on the purse's utility for other users: cardholders are largely unaffected by the number of other holders of the same card simply because the card cannot be used for payments between consumers anyway [16]. There are, however, indirect network externalities: as more people use a particular type of electronic purse, more merchants will be induced to accept it. This in turn increases the value to customers of having an electronic purse [17].

In the academic literature, network externalities are modeled along the following lines. Consumers are assumed to be rational surplus maximizing individuals who, on deciding whether to purchase a given product, weigh its utility against its cost. If the difference is positive, the consumer will buy the network good; if there is no surplus, she will stay out of the market. In the least complex models, a consumer's purchase decision relates to a single period, and the price is given. On the other hand, the size of the benefit is, in most cases, uncertain. This is because whereas consumers care about the network benefits that they will receive over the entire lifetime of the good purchased, only the current size of network size is known to them when they make their purchase decisions at the beginning of the period. Consumers will thus have to form expectations about the size of the network during the period, as this determines the strength of future network benefits.

In the models, the utility of the network good, u, is usually denoted by an expression of the general form a + b(ne). In this expression the constant a represents the 'stand-alone benefit' or 'autarky value' of the product; that is, its value in a network of size 0. For so-called pure network goods - such as telephones - a equals 0. The second part of the consumers' utility function, b(ne), captures the actual network benefit. This is an increasing function of expected network size ne with b(0) = 0. As already mentioned, consumers compare the utility of the network good with its price, p, (which is taken as given) and buy the good only if a + b(ne) - p > 0. In a competitive setting where two incompatible network goods, say good 1 and good 2, compete for the same market, consumers will choose the good for which their surplus is greatest. If, for example, a1 + b(n1e) - p1 > a2 + b(n2e) - p2, all consumers will prefer good 1 to good 2.

To sum up, what is important to understand about the models is firstly that while other characteristics are of interest, the utility that users derive from consumption of a network good depends to a great extent on the size of the network; and, secondly, that consumers' current purchase decisions are based on their expectations about future network sizes. In other words, network size is critical in wooing consumers. Because of this, markets for network goods are different from markets for other, 'conventional', products and services and force firms to follow special strategies.

First quote

For one, if the expectations of the general public are low, the network good will not succeed in attracting enough users to make it sufficiently useful, and hence the network will simply not get off the ground. In this way, the models provide a formal underpinning for what is perhaps the most important problem that an issuer is faced with when launching an electronic purse: the so-called chicken-and-egg deadlock. The problem being: merchants will not invest in terminals without a sufficient number of potential users, while consumers will not use electronic purses unless there is sufficient merchant acceptance [18]. In order to break this vicious circle the issuer will have to succeed somehow in ensuring that the initial installed base of both merchants and consumers is greater than a minimum level - the so-called critical mass point. Without such a critical mass, there will be a negative feedback effect. As Worthington (1996, p. 33) puts it: "Few acceptance points means few cardholders. Poor usage means retailers withdraw their acceptance, leading to fewer cards and so on, until the scheme implodes". This explains why, in the early stages of the product life cycle, an electronic purse issuer will follow a business strategy primarily aimed at building the installed base. By way of an example, even when he is the only one in the market, an issuer has a clear incentive to use penetration or introductory pricing so as to attract as many early adopters as possible in an attempt to get the bandwagon rolling.

The significance of the installed base is not limited to monopolistic settings. It is equally important in a competitive setting where two or more incompatible networks compete for the same market. As has already been explained, rational consumers will choose the 'brand' for which their surplus is maximized. And for network goods, the (expected) size of the network can have a very large weight in this calculation. This is particularly true for payment cards since they are a clear-cut example of pure network goods for which the stand-alone benefit, a, equals 0. More formally, in the case of payment cards, the weighing of a1 + b(n1e) - p1 against a2 + b(n2e) - p2 (cf. supra) is in fact reduced to comparing b(n1e) - p1 and b(n2e) - p2, as a1 = a2 = 0. This explains why, in network industries, the early competition is a race for market share. A firm that can establish a large user base ahead of its rivals holds a significant advantage simply because the networks of the rival firms will be smaller and so less attractive to consumers. Moreover, the early periods in the product life cycle may have a decisive impact on the final outcome of the rivalry because the positive-feedback nature of the demand for network goods tends to magnify an initial advantage in adoptions: once a network gains an initial edge it tends to stay ahead, and even to increase its lead. Hence the importance of establishing a dominant market position as quickly as possible.

Network Externalities and Interoperability

Not surprisingly, the network literature also pays a great deal of attention to the motives that may induce companies to make their products compatible with other products on the market. Indeed, this is a strategic decision of the utmost importance: "When the network externalities are large, the choice of whether to make the products compatible will be one of the most important dimensions of market performance" (Katz and Shapiro, 1985, p. 434) [19]. When taking this decision, a firm has to weigh up two opposing effects on its profitability (Economides, 1991, pp. 8-9; Xie and Sirbu, 1995, p. 916). The positive effect is that after the unification of the networks, the firm's product will be valued on the basis of the total installed base rather than on its individual installed base alone. As a result, consumers' willingness to pay will increase [20]. This is the network effect. The negative effect is that the firm will face more intense price competition both because product differentiation is reduced (or, in other words, substitutability is increased) and because users are less likely to be locked-in to a single firm's product. This is named the substitution or the competitive effect.

In the network literature, the trade-off between network and substitution effects is analyzed predominantly in a duopolistic framework. The main conclusions of the different duopolistic models (Katz and Shapiro, 1985, 1986; Farrell and Saloner, 1985; Farrell and Shapiro, 1988) can be summarized as follows. A first important conclusion is that a distinction has to be made between a situation where the two firms are of equal strength - the symmetric case - and a situation where this is not so - the asymmetric case. In the symmetric case, both firms will always benefit from a move to compatibility. The actual size of the potential benefit - which determines whether the firms will in fact make the move - depends on the strength of the network externalities. If the externalities are weak, the move to compatibility will only have a modest impact on consumers' willingness to pay. Hence, the move will not be worthwhile (as the move to compatibility obviously entails costs as well). In the asymmetric case, the two firms have conflicting interests: the stronger firm - the one with the largest network, with a better reputation, or with a clear technological advantage - will oppose compatibility, while the weaker one will be in favor of it [21]. If compatibility can only be achieved through a joint decision - as is the case for electronic purses - the logical outcome is that the two networks will remain incompatible. The underlying intuition is self-evident: the dominant firm opposes compatibility because a merger with the smaller network would have little or no effect on the valuation of its product, so that the network effect would be outweighed by the adverse effect of increased competition [22].

A number of other papers study not so much a duopolistic market, but rather point out that (challenged) monopolists have to make compatibility choices too. Economides (1996) tries to determine whether, in a market with network externalities, it cannot be profitable for a monopolist to invite one or more competitors onto his market, even though he is the exclusive holder of a technology. Xie and Sirbu (1995) want to know what the optimum strategy for a monopolist/incumbent will be when he is challenged by a new entrant. Needless to say, there are large parallels between these problems and those mentioned in the previous paragraph. The conclusions are thus fairly similar. To start with the article by Xie and Sirbu, it will not come as a surprise to learn that a new entrant is better off if his product is compatible with that of the incumbent; this is especially so when the network externalities are strong and the incumbent's installed base is large. A less intuitive result is that, under certain circumstances, the incumbent may also be better off by permitting compatibility. The latter depends - once again - on the relative strengths of the network and the substitution effects. Xie and Sirbu's simulation results show that the first effect will overshadow the second if the product under consideration exhibits strong network externalities and if entry takes place before the incumbent has built a large installed base. This is because early in a product's life cycle the network externalities can still operate to the full. In all other cases, the former monopolist will realize lower profits under compatibility. Economides (1996) shows that a monopolist/innovator may fail to sufficient sales and sufficient network externalities on his own. Provided that the network effects are sufficiently strong, it can therefore be profitable for a monopolist to license his technology (even without charging for it). In markets with very strong network externalities, the monopolist will even benefit by paying a subsidy to the invited followers.

Finally, if there are more than two firms in the market, the compatibility problem is much more complex because coalitions can be formed. So far, very little research has been done on this issue. To the best of my knowledge, the model that is most relevant for the case at hand is the one by Matutes and Padilla (1994), which deals with ATM networks of banks which are competitors in the deposits market. In their model, Matutes and Padilla consider three banks with ATM networks of equal size. A first striking result, which contrasts sharply with the results of the duopoly models, is that the banks - despite the ex ante symmetry of their networks - will never agree on full compatibility: in equilibrium, either partial compatibility or total incompatibility will prevail [23]. The explanation for this is as follows: "If all banks share their networks none of them obtains a network advantage so that the only effect of compatibility is to reduce the effective degree of horizontal differentiation among banks. As a result, competition gets tougher and banks are unable to internalise the positive network externality which is then entirely appropriated by depositors. It follows that two compatible banks would always veto the entry of a third bank into their common network" (o.c., p. 1122). Which of the two possible outcomes, partial compatibility or total incompatibility, will come about depends, predictably, on the extent to which depositors value the greater accessibility to their funds - or, in other words, on the strength of the network externalities. If the latter are sufficiently strong, depositors will be willing to accept lower interest rates or to pay higher fees for their debit cards; hence, the profits of the banks willing to share their networks will increase.

Purse Interoperability and the Internet

Coming to the heart of my argument, the big question now obviously is: how do the theoretical arguments just set out apply to the standardization of electronic purses? Put more concretely, does the network effect outweigh the competitive effect, or doesn't it? Let me try to assess the size of the network effect first.

The Network Effect

The first point to be made is that the size of the network benefit generated by the move to compatibility depends on the strength of the network externalities associated with the use of an electronic purse. As the duopoly models show, if the network externalities are strong, the move to compatibility will have a large impact on consumers' willingness to pay (and vice versa). Intuitively, it is clear that electronic purses are indeed subject to strong externalities: wide acceptability is a vital attribute of any form of money. As McAndrews (1995) puts it: "In payment systems, as with local telephone service, consumers demand 'universal service'". In other words, consumers will expect to be able to use their electronic purses almost everywhere. If they have to worry about whether a particular merchant will accept their card, their valuation of the card will certainly diminish. It is thus safe to presume that the addition of acceptance points generates significant marginal utility for cardholders and, hence, that compatibility agreements between rival local purses can give a boost to the adoption of electronic purses - as was the case for debit cards in many countries (Van Hove, 1997). However, as already explained, card issuers' justification for the recent move towards standardization rests not on interoperability in the domestic market, but rather on crossborder interoperability. And, as I have argued earlier in this paper, for the majority of cardholders the extra utility created by the addition of foreign acceptance points will be low. Hence, the network effect generated by cross-border interoperability in the 'real world' appears limited.

Second quote

In my view, the network effect will therefore have to come from interoperability in the virtual world. Given that the Internet is a global market, the prevalent situation with several incompatible national schemes would most likely have proven to be equally as detrimental for the adoption of electronic purses as an Internet payment system, as local rivalry may be in the case of their adoption as a domestic real-world payment system. Or as Poynder (1998, p. 21) recently phrased it: "Until and unless a globally accepted purse architecture appears, or the main purse products are modified to be interoperable, then this situation will do much to prevent the successful international proliferation of e-commerce, especially when it relates to low value information".

As I have shown earlier in this paper, in the models in the literature, both consumers and merchants care about both the current size of the network and its future prospects for growth and market dominance. With regard to network size, it has to be stressed that incompatibility cuts up the global Internet market into smaller, essentially national markets [24] - or worse. This fragmentation obviously makes it harder to render an electronic purse sufficiently useful and thus makes it harder to break the chicken-and-egg deadlock [25]. In Belgium, Banksys made its CZAM/PC terminal available to the general public in December 1997 in cooperation with access providers EUnet Belgium and Ping, the online marketing company AdValvas, NetVision, and Microsoft [26]. The CZAM/PC is a card reader - equipped with a display - which can be linked to a PC in the same way as a mouse. The card reader can be ordered for 1,999 BEF (some 60 USD) from the AdValvas Web site. Using a C-ZAM card reader, Proton cardholders can reload their cards over the Internet and make online purchases. However, almost one year after start-up there are still only six online shops which accept Proton - all of which are Belgian. Part of the explanation for the hitherto limited merchant response undoubtedly lies in the fact that their ability to sell on a global market is restricted: "The nature of the Internet means that consumers from many geographical regions could be interested in products or services which are for sale. It is important for merchants to maximise their potential market by allowing as many consumers as possible to buy their products" (Tweed, 1998, p. 5). This implies that merchants may be willing to offer multiple settlement choices and to accept different types of electronic purses, but not if they need different software for each card - for one, because the fixed costs would most likely be prohibitive [27]. Obviously, few retailers also means few 'Internetable' cardholders because the number of online shops will be too low to warrant the purchase of a card reader. In short: no chicken, no egg.

As explained, consumers and merchants also care about a network's prospects for growth and market dominance, as this will determine the (relative) strength of future network externalities. For this reason the rational consumers of the network models are very afraid of joining the 'wrong' network - especially so when the switching costs are strong (see below). Indeed, "buyers who join what turns out to be a losing network must either switch, which may be costly, or else content themselves with smaller network externalities than those associated with the winner" (Besen and Farrell, 1994, p. 118). This implies that they will only join a network if they are convinced that it will eventually attain sufficient coverage or, in an all-or-nothing market, that the network is able to get a hold of the entire market. Clearly, incompatibility creates uncertainty among consumers and merchants. The multiplicity in electronic purse schemes makes selection difficult - take the case of a small American online merchant who has to choose between Mondex and Visa Cash - and encourages players to adopt a wait-and-see attitude rather than risk choosing the wrong scheme [28]. The recent move of so many issuers to one standard will obviously make it easier for merchants in the United States and elsewhere, who are unsure of what scheme to choose, to move ahead.

To recapitulate, our analysis has so far shown firstly that the network externalities associated with the use of an electronic purse on the Internet are strong (unlike for cross-border transactions in the real world), and secondly that incompatibility prevents these externalities from operating to the full, implying that a move to compatibility may indeed generate a significant network benefit for purse issuers.

The substitution effect

However, the theoretical analysis earlier in this paper has shown that whether the move to compatibility will or will not in fact take place, also depends on the size of the substitution effect and how this effect bears on the network benefit for each of the players in the market. Among other things this, in turn, depends on the relative strength of the players. A new entrant will clearly benefit from compatibility with the incumbent, but if the incumbent has already built a sizable installed base he, for his part, will oppose compatibility because his network benefit would be too small compared to the adverse substitution effect.

Third quiote

Looking at the current state of play, it is safe to conclude that where Internet usage is concerned, the electronic purse market resembles the symmetric case more than it does the asymmetric one. Online purchases with electronic purses are still largely virgin territory and no single issuer has really pulled ahead. Also, since the electronic purse market is prone to tipping, there are likely to be heavy losers under incompatibility. And apparently no issuer was confident that he would win in the end. The following statement by PWI's Armand Linkens, commenting on the creation of PWI, illustrates this distinctly: "Don't forget that if Mondex becomes the international standard, we can throw everything away here" (Mooijman, 1998; my translation).

In the duopoly models, the combination of a symmetric market and strong externalities invariably leads to compatibility. If there are more than two firms in the market - as is the case for the electronic purse market - the theory provides less support because of the limited amount of research so far. Relying on the model by Matutes and Padilla, it is tempting to see the current outcome of the compatibility talks as an anti-Mondex coalition. This is, however, a hazardous interpretation firstly because CEPS is supposedly an open standard [29], and secondly because it is unclear to what extent Matutes and Padilla's results for the three firms case can be transposed to the n firms case [30].

This said, the Matutes and Padilla model does point to the fact that a distorted view is the likely result of a study of the Internet market for electronic purses in isolation. The model shows that when firms offer a bundle of goods, the negative substitution effect need not be confined to the market of the product that has been made compatible. There may be downward pressure on the prices of other goods in the bundle too. In the case studied by Matutes and Padilla, for example, when two banks have a compatible network, depositors can credibly threaten their banks with a switch to a rival offering a better deposit rate, and still benefit from their ATM services (o.c., p. 1120). Thus, the elasticity of the supply of deposits increases as banks become better overall substitutes, and this may lead to more intense price competition on the deposits market. Transposed to the case studied in this paper, this means that as a result of the compatibility agreement, the electronic purses involved will become better substitutes not only on the Internet, but also in the real world. In other words, purse issuers not only face a substitution effect with regard to Internet usage - an effect which I assessed above as being small in relative terms given that no single issuer has the edge over any other - but, in theory, also stand to lose ground on their 'home market'. Clearly, the down-side risk of the national schemes may be a lot larger here since they have already built a sizable installed base.

Where Belgium is concerned, the Proton card is the only electronic purse on the market so far and as long as Banksys is able to discipline its member banks - which, it should be remembered, make up the majority of Belgian banks, domestic competitors are unlikely to emerge, and particularly because Banksys has also come to an agreement with Belgacom, the Belgian telephone operator (Van Hove, 1998b). Due to the increasing liberalization of financial services in the EU competition could, in principle, also come from abroad - when all comes to all foreign issuers could offer their purses over the Internet, but even then Proton's home market appears relatively safe in view of the existence of high switching costs for consumers and merchants [31]. It is true that for consumers, direct costs remain altogether limited: for a Proton card Belgian banks charge a fixed annual fee of 200 BEF (5.7 USD) at most. However, switching costs comprise more than just the direct investment; transaction costs etc. are also relevant. From the credit card literature it can be gathered that total switching costs - including, for example, the cost in time, effort, and emotional energy - are indeed significant in the case of electronic purses (Van Hove, 1997). Above all, it must be borne in mind that a reloadable electronic purse has to be connected in one way or another to a bank account. Switching to a competing electronic purse may thus imply having to change banks too (provided that one wants to avoid holding accounts at two banks). It is self-evident that changing banks entails significant transaction costs.

For a number of other purse issuers involved in the CEPS effort the situation is different from that of Banksys. In the Netherlands, for example, Interpay's Chipknip faces tough competition from the Chipper card, backed by PTT Telecom and the Postbank. In Germany, ZKA's main competitors are the telecom and public transport companies Deutsche Telekom, Deutsche Bahn and Verband Deutscher Verkehrsunternehmen (VDV), who jointly issue the PayCard. Interestingly enough, in most of these cases where there is competition in the domestic market, the local rival has not yet adopted CEPS [32]. So, in somewhat extreme terms it could be argued that in these cases the adopters of CEPS not so much will have to face a negative substitution effect in their home market, but rather a positive competitive effect in that interoperability will give Visa Cash an advantage over Mondex in the UK, and will make Chipknip more attractive compared to Chipper, etc. - especially with regard to Internet usage.


The recent move toward the standardization of electronic purses is presented mainly as being of vital importance for crossborder transactions in the real world, and especially in the euro-zone. Surprisingly little attention is being paid to the importance of purse interoperability for electronic commerce over the Internet [33]. Relying on the network externalities theory, this paper aims to demonstrate that the latter is far more important.

The network externalities theory shows that when deciding to make their electronic purses compatible, card issuers have to weigh the 'network effect' against the 'substitution effect'. On the one hand, consumers' willingness to pay increases because the unification of the purse networks increases the utility that they (expect to) derive from their purses; on the other hand, the issuers face more intense price competition because the purses become better substitutes.

The network effect generated by cross-border interoperability in the real world appears small. While overall the network externalities associated with the use of an electronic purse are strong, the addition of foreign acceptance points will create little marginal utility for (the majority of) cardholders, simply because the relative importance of cross-border transactions is low.

Purse interoperability in the virtual world, however, should generate a significant network effect. Fragmentary real-life evidence appears to underpin the argument that the prevalent incompatibility severely hinders the adoption of electronic purses as an Internet payment system. One reason is that incompatibility creates uncertainty among consumers and merchants as to the final outcome of the standards war. Incompatibility also cuts up the global Internet market into smaller markets. As a result, the networks of the different electronic purses may initially be too small to make them sufficiently useful as an Internet payment system, for consumers and merchants alike. Hence there is a real danger, especially in smaller countries like Belgium, that electronic purses will not succeed in breaking the chicken-and-egg deadlock.

Given that as far as online purchases are concerned, the purse issuers can reasonably be considered as being of equal strength, it appears safe to assume that for all players on the market, the adverse substitution effect will be smaller than the network benefit: since none of them has already built a sizable installed base on the Internet, they have little to lose (and a lot to gain) from a move to compatibility. This said, the substitution effect need not be confined to the Internet. It could also play in the real world. However, for some purse issuers the home market appears relatively safe (due to institutional factors and the existence of switching costs). For others, international interoperability is not so much a threat as an extra, potentially powerful weapon in domestic competition.

About the Author

Leo Van Hove is Associate Professor of Economics at the Vrije Universiteit Brussel (Free University of Brussels).

Web: http://econ.vub.ac.be/cfec/leo.htm
E-mail: leo [dot] van [dot] hove [at] vub [dot] ac [dot] be


1. I am indebted to Joan Daemen, Mike Lamb, and Léon Peeters for valuable comments on an earlier version of this paper.

2. The specifications are sometimes also referred to as ECBS/CEPS or CEPS/ECBS specifications, since the input from the European Committee for Banking Standards (ECBS) has been instrumental in establishing the specifications; see Visa International, 1998. "Common Electronic Purse Specifications to be published," press release (December 16).

3. In September 1998, Cartes Bancaires already signed an agreement with ZKA in order, among other things, "to define and adopt a single position on specifications and standardization in working groups" and to "demonstrate that technical inter-operability between electronic purses in France and Germany is possible" (Cartes Bancaires, 1998).

4. Apparently there is also an agreement in principle to integrate the Finnish Avant electronic purse and Visa Cash on the same chip (Automatia, 1998).

5. Note, however, that Amex is maintaining a middle position in the standards war. While Proton will be the primary electronic purse on Amex cards, depending on customer needs, the Mondex purse could be used instead. Amex will place either stored-value application on the Multos operating system backed by MasterCard and Mondex (Card Technology, 1998). Note also that the Wall Street Journal considers cooperation between the CEPS block and Mondex likely, "as both Visa and MasterCard are controlled by a group of large banks. Even MasterCard officials agreed that cooperation is the way forward" (Wall Street Journal, 1998). On the other hand, Banksys' Armand Linkens - who was appointed PWI's managing director - is convinced that Mondex will never be able to conform to CEPS because its concept is just too different (Mooijman, 1998).

6. "The 'federation approach' is designed to answer the immediate needs for interoperability and has been primarily requested by Member banks operating within the euro zone" (Europay International, 1998a; my emphasis); see also European Card Review (1998, p. 8) and Visa International (1998e).

7. See also Visa International, 1998c.

8. For example, Louis-Noël Joly, CEO of Europay International, was quoted saying that "the euro will change things. People will want to use their purse card when they travel, just as they do with Cirrus and Maestro cards" (Rolfe, 1997, p. 21).

9. Obviously the European Commission is all in favor - in part for political reasons - of electronic purses that can be used throughout the EU; see Troberg (1998).

10. See also Dean (1995, p. 96): "Whether there is a need for an international purse is questionable. [...] The vast majority of low-value transactions are carried out by people in a locality and only occasionally do they travel abroad".

11. An earlier ECBS report was even more outspoken:

"..., interoperability of electronic purses, at the moment, seems to be a non-issue, and would require substantial investments to be implemented. It is quite apparent that in the medium term the purse issuers see little demand and no business justification in enhancing their systems to provide for interoperability" (ECBS, 1997a, p. 3).

In its most recent report, the ECBS takes a neutral stance:

"The advent of the euro, and the current divergence of purse products in Europe, has urged the European banking community to developing a pan-European electronic purse, capable of operating in euro and domestic currencies" (ECBS, 1998, introduction).

12. See Van Hove (1998b).

13. See also Dean (1995, p. 96): "It might be much better to keep the card simple and for the occasional excursion, disposable cards should be available for visitors".

14. du Bois' (1998) example is thus somewhat unfortunate: "Short of French francs or euros while vacationing in Provence? Just load the card through a mobile phone and use the electronic purse to pay for your morning coffee and croissant".

15. Obviously, this is not the place to discuss the ins and outs of the theoretical models. My only aim is to give the reader a basic feel of the approach followed in the network externalities literature. See Van Hove (1997) for a more thorough discussion.

16. The only exception so far is the Mondex card. The Mondex technology not only allows for payments from consumers to merchants, but also - unlike any other electronic purse - for transfers between consumers. Hence, the Mondex card is subject to both direct (where person-to-person payments are concerned) and indirect network externalities (for 'over the counter' payments).

17. Katz and Shapiro (1985, 1994) call this 'hardware-software systems'. In its literal interpretation: as more units of a given type of hardware are sold, the variety of software for use with this hardware will increase, which in turn will increase the value of the hardware. Applied to payment cards: the card itself is the hardware, merchant acceptance of the card is the software, and the entry of an additional cardholder increases the supply of the software.

18. The other - and for issuers more pleasant - side of the medal is that the success of an electronic purse can become self-reinforcing once its adoption exceeds the threshold: the more people use the card, the more merchants will accept it, the more interesting it will become for as yet unconvinced consumers to start using it, and so on. According to Economides and Himmelberg, the explosive growth of the market for facsimile machines in the U.S. during the second half of the 80s is a good illustration of such a 'bandwagon effect': "[T]his tremendous surge in demand was not driven as much by outside shifts in consumer demand and price reductions as much as it was driven by the 'feedback' effect induced by both past increases and anticipated future increases in the size of the installed base" (1995, p. 16).

19. Note that in the case of payment card systems, compatibility can only be attained via a joint decision. In some markets, a company can act unilaterally to make its product compatible by constructing an adapter or a converter, but in the case of payment cards this is not an option. Visa, for example, cannot start issuing electronic purses that can be read by Proton terminals without having the authorization of Banksys to do so. This is because Visa would need access to Proton's clearing and settlement infrastructure.

20. In the notations introduced in the previous section: after the unification of the networks of goods 1 and 2, consumers will weigh a1 + b(n1e + n2e) against p1.

21. Katz and Shapiro (1994, p. 111) point out that this may also be the case for products that are not yet on the market: "... since systems competition is prone to tipping, there are likely to be strong winners and strong losers under incompatibility. Therefore, if a firm is confident it will be the winner, that firm will tend to oppose compatibility". This confidence may be based on the firm's reputation, on the fact that consumers have a strong brand preference for its products, etc.

22. Note that the analysis in the main text implicitly assumes that firms cannot make side payments to one another. Intuitively, it is clear that if they can - and this certainly is the case for payments systems, ATM interchange fees being one example - compatibility will be achieved more often. For this to happen, it suffices that "the change of the profits within the set that can make side payments to one another exceeds the joint costs of compatibility" (Katz and Shapiro, 1985, p. 434; my emphasis), whereas in the absence of side payments the products of two firms will only be made compatible if either firm benefits from the move (ibidem).

23. Note that Matutes and Padilla do mention two qualifications. A first is that "if banks were able to collude in deposit rates, full compatibility would be observed in equilibrium because banks could then fully extract the additional surplus generated by compatibility" (o.c., p. 1124). A second remark is similar to a remark made concerning the duopoly framework: the existence of interchange fees increases the possibility of a full compatibility outcome because by using such fees, banks can limit the substitution effect of compatibility and appropriate part of the network externality that they generate on depositors.

24. There is obviously another problem, too: the choice of the currency of the payment; cf. Poynder (1998, p. 21): "If trade takes place across currency borders, then which currency will be acceptable for settlement? That of the buyer, or that of the seller? Will sellers have to offer multiple currencies, or operate some complex exchange conversion facilities?"

25. Cf. Caskey and Sellon (1994, p. 84): "..., if there are several producers of a product subject to positive network externalities, people may resist using the product unless some or all producers agree to use compatible technological standards. Without such compatibility, the network of users for each producer's product might be too small to make the product sufficiently useful".

26. See http://proton.advalvas.be for more information.

27. In this respect it is interesting to mention the (abandoned) electronic purse trial in New York (Van Hove, 1999). In this test, two purses - Visa Cash and Mondex - operated on the same equipment. Although the technology worked, retailers still complained about the complexity of going through two different processes for the two cards (because there were literally two different technologies under the hood), and called for a move to a common standard, allowing all smart card readers to work off the same reader using the same process (Authers, 1999).

28. In the absence of an industry-wide consortium à la Banksys, ZKA etc., this also holds for banks: "Banks will be reluctant to build a network of smart-card readers if there is a risk they could quickly be superseded" (Authers, 1999).

29. Compare, however, with Linkens' point of view mentioned in note [2].

30. Note in this respect that Matutes and Padilla do conjecture that their partial compatibility/total incompatibility outcome will continue to hold with four banks, implying that at best two competing networks will coexist (o.c., p. 1124, note 22).

31. Note that the plan is for the publication of the CEPS specifications to be followed by pilots in 1999 and full roll-out by 2001. This leaves ample time for the different schemes to consolidate their home markets.

32. Australia is an exception because it is home to both ERG's Quicklink (now called ECARD) and Visa Cash - and Mondex, for that matter.

33. I have found two exceptions. One is Birch (1998) - whom I have treated somewhat unfairly earlier in the paper by citing only half of his statement: "The cost of implementing cross-border compatibility is judged, by the national schemes, to be prohibitive given the small number of transactions: I'm sure that this is true right now, but perhaps the rise of the Net will change the equation in a few years' time". The second exception can be found in a Visa International press release: "It is also crucial for the use of electronic purse cards over the Internet, since cardholders will be able to conduct international transactions without having to leave their homes" (Visa International, 1998b).


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