An e-money account is often the first and most frequently used financial product for low-income customers. As e-money continues to play a key financial inclusion role in emerging markets, policy makers are increasingly concerned about protecting the balances that customers keep in their e-money accounts. The question arises: Should deposit insurance cover e-money accounts?
There are valid arguments in favor of extending deposit insurance to e-money. For example, deposit insurance could increase customer trust in e-money and encourage new customers to open and use an e-money account. Deposit insurance could also help minimize the financial losses of low-income customers, who are typically unable to weather losses due to the failure of an e-money issuer or a deposit-taking institution holding e-float.
There are also valid arguments against deposit insurance for e-money. The cost of premiums could strain e-money issuers. Additionally, deposit insurance could divert authorities’ attention and resources away from financial institutions that engage in a wide range of activities toward e-money issuers that perform a narrow set of activities.
While there is no single answer for all countries on whether deposit insurance should cover e-money, we are sure about two things that apply across markets.
1. Prudential regulation and supervision should be the first line of defense for e-money
Our recent publication, “Deposit Insurance Treatment of E-Money: An Analysis of Policy Choices" (CGAP 2019), aims to help authorities analyze under what circumstances they may need to extend deposit insurance to e-money. Based on global research and in-depth analyses of eight regulatory frameworks (Colombia, Jamaica, Kenya, Mexico, Nigeria, Peru, the Philippines and the United States), the report emphasizes that the first line of defense for e-money customers must be sound, risk-based prudential regulation and supervision. This is a key requirement for any deposit insurance regime to be effective without creating excessive moral hazard.
If the first line of defense is effectively set up for e-money issuers, there may be no need for deposit insurance. This is the approach in most countries. Fund safeguarding measures, including ring-fencing and segregation, are components of effective e-money regulation and supervision that considerably reduce the risk of customer losses if an e-money issuer fails. The segregation requirement asks for the e-float to be kept separately from other funds, including the e-money issuer’s own funds. Segregation may be accomplished in one or more separate float accounts held at deposit-taking institutions.
The ring-fencing requirement offers an additional layer of protection by mandating that a float account be a trust, custodial or other similar account. This type of account protects e-float from creditors of the e-money issuer and segregates e-float from other assets of the trustee or custodian managing the account on behalf of e-money customers.
2. Deposit insurance may be appropriate as the last line of defense for e-money, but implementation is challenging
Even when an e-money regulatory and supervisory framework is in place to ensure the effective implementation of fund safeguarding requirements, e-money customers may remain exposed to some level of risk of losing money. This is what we call "residual risk." Let's say a customer’s e-money is in a float account held in trust at a bank that fails. If deposit insurance does not cover trust accounts operated by firms, this customer may lose his or her money if the bank is liquidated and its assets are insufficient to pay off its liabilities.
Each authority must look at its context and analyze the residual risks associated with two crisis scenarios: the failure of an e-money issuer and the failure of a deposit-taking institution holding a float account. High residual risks may justify the adoption of deposit insurance as a last line of defense for e-money accounts.
There are two deposit insurance approaches to e-money accounts that may be implemented to address residual risks:
- The direct approach aims to address residual risks from the failure of an e-money issuer by making each e-money account eligible for deposit insurance coverage.
- The pass-through approach aims to address residual risks from the failure of a deposit-taking institution holding a float account. It does so by allowing the coverage to pass through the float account (held at an institutional member of the deposit insurance system) and reach each e-money account.
Each approach brings implementation issues and complexities. For example, adopting the direct approach may require expanding the size of the deposit insurance fund and increasing premiums or setting up different premiums for e-money. The pass-through approach may require regulators to set up complex reimbursement methods for a subset of customers affected by the failure of one of many institutions holding e-float.
Authorities should decide which approach is most appropriate based on country-specific factors, such as legal framework and technical capacity. They may also consider whether a combination of approaches is possible and desirable. At this stage, it is not possible to affirm which approach is the best. Both are recent developments, and their cost-effectiveness in a real crisis scenario has not yet been put to test.
In-depth country-level research is needed to shed light on challenges and potential solutions involved in implementing first and last lines of defense for e-money. Topics for further research include legal and regulatory frameworks for trusts and how trusts may protect customers if a deposit-taking institution fails, civil law legal requirements and formalities needed to implement the pass-through approach to deposit insurance and implementation challenges in the use of trusts or similar accounts to segregate and ring-fence e-float. Crisis simulation exercises could test the protection of e-money accounts, and consumer research is needed to assess e-money customers’ views on deposit insurance and fund safeguarding measures.