The expansion of digital financial services is allowing a rapidly increasing number of financially excluded and underserved customers to make payments and to store value in tiny amounts using different types of products. This includes some products that challenge the traditional definition of a “deposit”–and that are making policymakers think differently about how they can reinforce consumer trust and promote financial stability.
Although digitally stored value may be small in absolute terms, it often represents a significant portion of a customer’s resources. It has become increasingly important to ensure that these funds are protected against the failure of institutions offering digital stored-value products.
Some policymakers are adopting an indirect (or “pass-through”) deposit insurance approach in order to protect customers’ digitally stored value. We see this mostly in countries where e-money is offered by mobile network operators (MNOs) or other firms that are not deposit insurance members. Under the indirect approach, e-money issuers have their pool of customer funds kept at a depository institution (which is a deposit insurance member) in the form of a custodial account, where the funds are held for the benefit of the underlying e-money customer. If the depository institution fails, the deposit insurance coverage “passes through” to each e-money customer whose funds are held in that account.
Pass-through deposit insurance is an extension of another concept that helps explain how it works. Some deposit insurance systems insure depositors based on the capacity in which they hold their accounts (e.g., as an individual or a joint accountholder). For example, say a depositor has an individual account for $1,000 and a joint account for $1,000. The deposit insurance system has a coverage limit of $1,000 per depositor regardless of the capacity in which his or her accounts are held. In that case, the depositor will only be covered for $1,000. However, if the system’s coverage limit is $1,000 per depositor’s capacity, then the depositor in our example will be covered for $2,000.
In the digital finance context, deposit insurers applying the pass-through approach identify that custodian as acting for the benefit of the individual e-money customers – not under the custodian’s own total capacity. Notwithstanding its benefits, the implementation of a pass-through approach imposes some basic requirements that may create challenges for all parties involved.
Challenges of implementing pass-through deposit insurance
Here are some considerations:
Does a legal framework exist? Not all countries have a legal framework in place that allows for custodial accounts and makes it viable for deposit insurers to provide pass-through coverage to customers storing value digitally with MNOs. And those that do may subject these custodial accounts to so many detailed legal procedures (e.g., how fund transfers and account ownership changes must take place) that implementation of the pass-through approach may not be practically or economically feasible.
What is required of depository institutions? The depository institution has to clearly indicate that the pooled customer funds are held at a custodial account, opened by a custodian for the benefit of others. In the case of e-money issued by an MNO, for example, the custodian could be a commercial bank that holds the funds of multiple MNO customers for their benefit. The custodian must maintain records which allow for identification at any time of the identity and the account balances of each underlying e-money customer or beneficial owner. Also, the deposit terms of the custodial account (e.g., interest rate, maturity) must match the terms promised to the beneficial owners, and clearly establish that these customers own a discrete amount in the pool of funds (and not a portion of the available funds in the pool).
What if the depository institution fails? Consider this example. Let’s say we are in a country where deposit insurance covers up to $1,000 for all aggregated funds a customer has at a bank. If a customer has a deposit for $1,000 at a bank that also holds $200 in a pooled account for the benefit of the same customer, only $1,000 would be insured if the bank should fail. This could call for important – but complex – consumer disclosures as to exactly how the deposit insurance limits will be calculated.
What if the e-money issuer fails? Even if all these challenges can be addressed, customers still face an additional uncertainty. Pass-through deposit insurance covers the failure of the depository institution holding the custodial account, not the failure of the e-money issuer. In our example, the deposit insurance would cover the failure of the bank holding the custodial account for the benefit of the MNO customers, not the failure of the MNO itself. As the MNO may also be responsible for managing the individual e-money accounts, its failure could leave a custodial bank and the deposit insurer without the information needed to settle customers’ claims.
Other potential implications for consumers
The pass-through approach not only allows for e-money to be covered by deposit insurance even when its provider is not a deposit insurance member. It also provides the deposit insurer, or other authority responsible for resolving failing financial institutions, with a more expedient opportunity to transfer the custodial account to another deposit insurance member in the event the institution holding this account fails. This could make it possible for the MNO, in our example, to maintain customers’ access to e-money accounts, and sidestep a lengthy process in bankruptcy courts.
Beyond the question of deposit insurance, the usage of custodial accounts to hold e-money customers’ funds may offer different levels and kinds of protection to consumers in the event that their e-money issuer fails, depending on the legal system and the nature of the custodial account. For example, in common-law jurisdictions that recognize the legal concept of a trust, a custodial account for the benefit of e-money customers could insulate its pooled funds from the creditors of the failing MNO e-money issuer (although the aforementioned accounting and record-keeping challenges could complicate the reimbursement of their funds).
At the same time, the implementation of the pass-through approach may have cost implications for institutions that are already members of the deposit insurance system. It may cause deposit insurers to reconsider how they assess premiums. And it is almost certain to require adjustments to a country’s legal framework, such as to provide for or clarify the treatment of custodial accounts. CGAP, with support from the Bill & Melinda Gates Foundation, intends to contribute to this research agenda in the coming months. These are important issues that merit further research, as they may lead to increased costs for customers rather than the greater financial inclusion that digital finance could bring.