Electronic Money Institution vs Bank? Let’s look under the hood
The use of e-money has been rising exponentially since it was introduced in the late 1990s (see Fig. 1). In the UK, 4% of adults now use it to make payments, and it is an increase of 3% according to statistics provided by the Financial Conduct Authority (FCA). Despite the increasing adoption, there is evidence suggesting that many of these customers may not actually know that they’re using e-money, and they definitely have a poor understanding of the difference between e-money and deposits – and between Electronic Money Institution vs Bank more generally – with regard to the protection they enjoy in the case of insolvency of the issuer. Recently, the FCA saw it proper to issue a letter to CEOs of Electronic Money Institutions asking them to be forthright with their customers in explaining the difference.
Since, to our knowledge, this topic remains underexplored, we have decided to write this article, in which we clarify how deposits differ from e-money from the perspective of the customer in respect to how banks and EMIs “use” and “safeguard” the former’s money, their protection in the event of insolvency of these firms, and where they hold their accounts. Arguably, the difference between e-money and deposits boils down almost entirely to the “Electronic Money Institution vs Bank” comparison in terms of their balance sheets.
This article should be illuminating for holders of deposit and e-money accounts, as well as to Electronic Money Institutions, both existing and newcomers to the e-money market.
Who issues e-money and deposits?
Issuance is generally understood as creating a liability (e.g., a debt) on the balance sheet of the issuer. A company that issues corporate bonds registers a debt liability on its balance sheet; similarly, when you and I borrow from a bank to buy a house, we have – whether we know it or not – a ‘mortgage loan’ liability, a debt to the bank for the next 20-30 years. All financial instruments are issued by some entity, and this is no different in the case of deposits and e-money.
Issuing (sometimes called “accepting”) deposits as an activity is strongly regulated, one that is largely confined to credit institutions. It is important to recognise that not all credit institutions issue deposits (EBA, 2014), and not all deposits are issued by credit institutions. With regards to the first point, some credit institutions do not issue deposits, but they do issue ‘other repayable funds’ and grant credits on their own account, which makes them qualify as ‘credit institutions’.
With regard to the second point, a good illustrative exception is that of post office giro institutions (POGIs), also known as “postal banks”, some of which we know have the capacity to accept (issue) deposits (see Article 1(2) of Regulation (EU) No 1074/2013; EBA, 2014), even though in many countries they fall outside the definition of ‘credit institutions’.
In the EU, the credit institutions sector is composed of commercial banks, credit unions, credit cooperatives, mortgage banks, building societies, savings banks, post office savings banks, and others. Fig. 2 shows the composition by country in terms of their share in the number of legal entities (left) and assets (right).
In the case of e-money issuance, the type of entities that engage in this activity is broader than that of deposits. E-money issuers include:
- Electronic Money Institutions
- Credit institutions (e.g., banks)
- Post office giro institutions (a.k.a. “postal banks”, like the Post Office in the UK)
- Central banks and public authorities when not acting in their capacity as a monetary authority or other public authority
In practice, credit institutions (which are part of the Monetary Financial Institutions or MFI sector) issue the vast majority of e-money, as shown in Fig. 3 below.
In other words, as of today, e-money co-exists with sight deposits on the liability side of credit institutions’ balance sheets. In some cases, entities that may have started out as Electronic Money Institutions are eventually granted the deposit-taking license, thus, becoming part of the MFI sector.
This is the case, for example, of Revolut Ltd, which has used its Lithuanian banking license to offer protected deposit accounts in Bulgaria, Croatia, Cyprus, Estonia, Greece, Latvia, Malta, Romania, Slovakia and Slovenia, but not in the UK where it continues to operate as an Electronic Money Institution (see here and here).
Comparing the balance sheets of issuers: Electronic Money Institution vs Bank
In order to understand the difference between these two financial instruments and comprehend the topic of Electronic Money Institution vs Bank, it is necessary to first dispel a widespread misconception regarding the nature of a current account. According to a survey conducted in 2020 in Austria, 68% of the 2,000 respondents believe that cash and bank deposits are backed by gold. Another survey among 2,000 Britons in 2009 revealed that 74% of respondents believe they are the legal owners of the money in their current account.
These two beliefs are provably false. It is a well-established fact in the legal scholarship that bank deposits are actually loans to banks. The word ‘deposit’ can be misleading in this regard, for it connotes safe-keeping, custody, bailment, or trust. On the contrary, the deposit contract is commonly worded so that the bank does not hold deposited funds in custody for the depositor; the funds are not earmarked or segregated. Rather, the bank is allowed to commingle (mix) the funds with its own (which become its property) and to use them in whatever way they may think best on the condition that they will repay the equivalent amount of funds to the depositor.
Therefore, depositors who deposit their money with a bank are no longer the legal owners of this money. Instead, they are just one of the general creditors to whom the bank owes money. The funds you hold in an account with a credit institution are a debt of that institution to you. It promises to repay you, and that promise is what we as a society consider ‘money’! (If I were to promise to pay you money on-demand, you wouldn’t consider that money, would you?)
What about Electronic Money Institutions? They are quite similar in this regard, for e-money is a credit claim of the holder on the Electronic Money Institution and a debt liability of the Electronic Money Institution towards the e-money holder. The Electronic Money Institution promises to redeem/transfer the funds on-demand, as a bank does, and society considers e-money equivalent to bank deposits for practical purposes, and both are used to make payments and buy things.
In another important regard, deposits and e-money are different, and this has to do with the way the balance sheet of credit institutions and Electronic Money Institutions are allowed to be arranged.
A key difference between credit institutions and Electronic Money Institutions is that, while the former can commingle (mix) the funds deposited by customers with their own funds and use both for their own purposes (e.g., “to grant credit on the own account”), the latter must ring-fence all funds received from customers and keep them separate from their own on “segregated accounts”. While Electronic Money Institutions do have access to customer funds, they are forbidden from using them for purposes other than purely transactional ones involving the issuance and redemption of e-money.
What this means in practice is that whereas banks may hold £1 in funds (e.g., reserves with the central bank or nostro balances with other banks) for every £10 of deposit liabilities (what is known as “fractional reserve banking”), Electronic Money Institutions must keep £10 of safeguarded funds for every £10 of e-money liabilities they have issued, i.e., they must maintain a one-to-one correspondence or parity at all times. (This is stipulated, for example, in Articles 21 and 22 of The Electronic Money Regulations 2011 and Article 7(1) of Directive 2009/110/EC).
Also, unlike credit institutions in the case of deposits, Electronic Money Institutions are not allowed to grant credit from the funds received in exchange for e-money, and if they do, it must be ancillary and granted exclusively in connection with the execution of a payment transaction. (This is stipulated, for example, in Article 32(2) of The Electronic Money Regulations 2011 and in Article 6(1) of Directive 2009/110/EC).
This is best understood by looking at and comparing the balance sheets of Electronic Money Institutions (Fig. 4) and credit institutions (Fig. 5). The balance sheet of Electronic Money Institutions is much more constrained than that of credit institutions; the parity they must maintain between e-money liabilities and safeguarded funds assets gives them little room for having other stuff on their balance sheets.
As mentioned, for every £1 of e-money (liability) issued to customers, they must maintain £1 in funds (assets) safeguarded and separate from their own funds (i.e., parity). Typically, Electronic Money Institutions hold safeguarded funds with other credit institutions or central banks and, to a lesser extent, invested in high-quality liquid assets (it is also possible to use insurance as safeguarding method (also known as PSD Bond), click to read about safeguarding requirements for electronic money institutions in more details).
Since, by law, the credit institution is allowed to use the money deposited by depositors with it, that money can be used to fund loans and can leave the bank, and be replaced by higher-yielding assets like loans (that is the business of banks, taking deposits and paying a deposit rate below the rate they charge their borrowers on loans). The balance sheet of a credit institution may look something like that shown in Fig. 5 below.
In contrast to the case of the Electronic Money Institutions, the funds that the credit institution owes its depositors (who are creditors, as mentioned), are backed mostly by illiquid loans and, to a lesser extent, liquid assets. If everyone decided to ask their banks to return their money, banks would not be able to deliver on the promise, absent extraordinary assistance on the part of the central bank (lending them central bank reserves or vault cash on generous terms and volumes).
Electronic Money Institutions, on the other hand, do have all the funds required to meet a hypothetical sudden demand by all of their customers to withdraw or transfer the money.
Things become a bit complicated here, since where do Electronic Money Institutions hold the funds (their asset)? You guessed it: typically with credit institutions (banks), who – as mentioned – do not keep the exact corresponding amount in equally liquid funds (say with the central bank). There is some controversy surrounding the issue of whether a customer would lose the money they hold in e-wallets if the bank where the Electronic Money Institution holds its safeguarded funds would go bust (i.e., to become insolvent). Our view is that e-money holders would stand to lose money, for deposits held by financial institutions (including EMIs) with credit institutions are not covered by the Financial Services Compensation Scheme (FSCS) (note that, even if these deposits were covered, they are only covered up to £85,000 and EMIs typically keep millions worth of customer funds in pooled accounts, so the protection would be ineffective).
At any rate, the fact the Electronic Money Institutions do have all the funds required to meet a hypothetical sudden demand by all of their customers to withdraw or transfer the money, and that in the event of insolvency these funds would be available to be distributed to e-wallet holders, may partly explain why, unlike e-money, bank deposits are guaranteed by the government in most countries. In the UK, the Financial Services Compensation Scheme (FSCS) protects depositors for amounts up to £85,000. This is yet another difference in the Electronic Money Institution vs Bank comparison.
What about credit institutions that issue both deposits and e-money? This is a relatively obscure subject on which little has been written. To the best of our knowledge, under UK regulations, segregation requirements do not apply to credit institutions when they issue e-money (nor, as mentioned, when they issue deposits) – they only apply to Electronic Money Institutions and credit unions (see Chapter 10 here).
Not so many banks issues e-money in the EU and there are not much information about their balance sheets. However, there are some examples. For instance, we found that PayPal (which has a banking license in Luxembourg but seemingly only issues e-money) was allowed by the Luxembourg Commission de Surveillance du Secteur Financier (the “CSSF”) to use 35% of the funds deposited – by what we believe are e-money holders – to grant credit (see p. 37 here).
Based on this fragmentary evidence, we can speculate that the balance sheet of credit institutions that issue both deposits and e-money could look something like this (Fig. 6).
Conclusion: e-money vs deposits boils down to the Electronic Money Institution vs Bank comparison
Although this article is far from exhaustive, we have identified the main differences between two financial instruments that for the public appear virtually indistinguishable – and that difference is to be found on what is on the balance sheet of the entities that issue them. That is, the question boils down ultimately to the Electronic Money Institution vs Bank comparison.
Whereas e-money liabilities (a promise to repayment on demand) issued by Electronic Money Institutions are “backed” on the asset side of their balance sheets by an equal amount of funds held by the Electronic Money Institutions in accounts with credit institutions, deposit and e-money liabilities (also a promise to repayment on demand) issued by credit institutions are backed by loans and, to a lesser extent, vault cash and reserves with the central bank that credit institutions hold to meet customer withdrawals and transfers.
But loans are illiquid, and borrowers can default. As general creditors to banks, depositors stand to lose money if the bank goes under in the event of large scale loan defaults. The same rules apply when these two financial instruments are issued by the same entity.
The reader will find more information on this topic in our articles. Like this one explaining what is e-money, or this one discussing e-money license vs banking license, and this one, where e-money is compared to stablecoins.
How can PSP Lab help you?
Electronic Money Institution vs Bank is a quite a complicated topic, and, if you are an existing Electronic Money Institution or a newcomer to the business, you may want to contact PSP Lab, since we are a niche consultancy company that helps companies in getting e-money licenses in the EU and the UK. We can also help you better understand the operational and legal aspects of safeguarding, safeguarding accounts and the e-money issuance business more generally. We’re here to help you not only navigate the complex Electronic Money Institution licensing landscape but also to help you understand how you can develop your e-money business.
Contact us for a free consultation and we will identify and analyse your possibilities of obtaining the license in Europe as well as help you to understand the regulatory requirements related to the electronic money licensing process in the most suitable jurisdiction for you.