May 04, 2004

Since 1996, smart card advocates have been trying to make a case for smart cards as payment devices. Despite dedicated efforts on the part of financial institutions, card associations and merchants, none of the smart card pilots attempted to date in the U.S. have been a success. What popularity smart cards have enjoyed has been due to their cutting edge image, not functional applications.

In 2001, the smart card industry made another attempt, this time with loyalty as the rallying cry. Led by a major new initiative at Target Stores, smart cards would enable a new level of customer service and personalization, and financial institutions could use private label relationships with other retailers to push smart cards into the marketplace.

Unfortunately, this venture ended up just like the others had. On March 3, 2004, Target announced that it would be phasing out its smart card program because it "experienced limited use." Despite being one of the largest smart card portfolios in the United States with over 14 million cards in circulation, very few of the chips on those cards were ever used to download paper coupons as intended.

However, there are alternative applications for smart cards that do not rely on loyalty and that have already achieved some success in the U.S. as well as overseas. These niches have characteristics that play to the strengths of smart cards.

  • Time-sensitivity: a high rate of customers per hour requires that payment be made quickly.
  • Security-conscious: high risk of fraud or theft requires stronger security than can be achieved with a magstripe card.
  • Closed system: a single company or small group of companies controls both card issuance and acceptance, and can control which payment methods customers use.
One such niche is transportation, where smart cards have begun to make serious progress. In Hong Kong, the Octopus Card has replaced subway and bus tokens, with more than 10 million Octopus cards in circulation, generating over 7.9 million transactions per day, worth HK$53.6 million ($6.88 million). Similar systems are being planned and/or implemented by many public transit authorities in the U.S., such as in Washington, D.C., where 350,000 commuters are using smart fare cards.

We believe that the retreat of Target from the smart card market signals the long-term decline of general purpose payment-oriented smart cards in the United States. Loyalty-based smart cards were essentially all from Target, so they will be completely phased out by 2007. Contactless transit cards will continue to grow, eventually making up 70.5% of payment-oriented smart cards in the U.S. by 2007. Bank-issued smart cards will decline steadily from a peak of 21 million in 2002 to 8.5 million in 2007, making up the remaining 29.5%, as chip cards expire and are not replaced. Note that there are many other applications of smart cards, such as network and facility security, that are not accounted for here, because they are not used in payments.

Unfortunately, transit smart card fare systems tend be closed loop and proprietary, leaving little opportunity for financial institutions to participate, except in a support function. MasterCard has been promoting its PayPass technology, based on a successful trial in Orlando, Florida. However, there are reasons to be skeptical about the potential of a contactless card; McDonald's recently announced that it would no longer accept Mobil Speedpass, heretofore the most successful contactless payment system, at its restaurants in favor of traditional magnetic stripe cards. Ironically, Visa and MasterCard themselves may have undone contactless payments by upgrading their networks for split-second response time, making magnetic stripe cards a much more attractive proposition for fast food restaurants and other merchants needing fast settlement.

We remain reluctant to endorse smart card investments by financial institutions until there is a clearer business case for doing so, and do not see how such a case could be made in the U.S., absent a dramatic increase in fraud rates. Banks should focus their card IT investments elsewhere, such as stored value cards.

Aaron McPherson is Research Manager, Payments for Financial Insights (Framingham, Mass.)