The difference: Electronic Money Institution vs Bank
The use of electronic money has grown exponentially since its introduction in the late 1990s. In the United Kingdom, 4 per cent of adults now use it for payments and, according to statistics provided by the Financial Performance Control Authority (FSA), it has increased by 3 per cent. Despite increasing uptake, there is evidence that many of these clients may not know that they are using electronic money, and they clearly do not understand the difference between e-money and deposits: and between the e-money institution and the Bank as a whole with respect to the protection they enjoy in the event of the issuer’s insolvency.
Since, as far as we know, this topic remains under-researched, we have decided to write this article explaining how deposits differ from electronic money from a client’s point of view as to how banks and VMEs “use” and “protect” the money first, their protection in case of insolvency of these firms, and where they keep their accounts. It can be argued that the difference between electronic money and deposits is almost entirely limited to comparing the “e-money institution versus the Bank” in terms of their balance sheets.
Where does e-money come from
Emissions generally refer to the creation of an obligation (such as debt) in the issuer’s balance sheet. The company that issues corporate bonds registers the debt in its balance sheet; similarly, when you and I borrow from the bank to buy a house, we have – whether we know this or not – mortgage obligations, debt to the bank for the next 20-30 years. All financial instruments are issued by an entity, and this is no different for deposits and electronic money.
The issue of deposits (sometimes referred to as “taking over”) as an activity is tightly regulated mainly by credit institutions. It is important to recognize that not all credit institutions issue deposits (EBA, 2014), and not all deposits are issued by credit institutions.
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 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.
In order to understand the difference between these two financial instruments and understand the theme of Electronic Money Institution vs Bank, it is necessary first to dispel a widespread misconception about the nature of the current account. According to a survey conducted in Austria in 2020, 68 per cent of the 2,000 respondents believed that money and bank deposits were provided with gold. Another survey of 2,000 British people in 2009 found that 74 per cent of respondents considered themselves the rightful owners of money in their current account.
These two beliefs are probably 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’!
What about Electronic Money Institutions? They are very similar in this respect, as electronic money is a loan claim of the holder of the Electronic Money Institute and a debt of the Institute to the holder of electronic money. An electronic money institution promises to buy/transfer funds on demand, as a bank does, and society considers electronic money to be the equivalent of bank deposits for practical purposes, and both are used to make payments and buy things.
Another important aspect is that deposits and electronic money are different, and this is related to the way credit institutions and electronic money institutions are allowed to balance sheets.
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.
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).
Unlike e-money institutions, the funds that a credit institution owes to its depositors (who, as mentioned, are creditors) are largely secured by illiquid loans and less liquid assets. If everyone decided to ask their banks to give back their money, the banks would not have been able to keep the promise had it not been for emergency assistance from the central bank (lending to the central bank reserves or storing cash on generous terms and quantities).
On the other hand, electronic money institutions have all the means necessary to satisfy the hypothetical sudden demand of all their clients to withdraw or transfer 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).
In any case, the fact that electronic money institutions have all the means necessary to meet the hypothetical sudden demand of all their clients to withdraw or transfer money, and that, in the case of insolvency, these funds may be distributed between purse holders may partly explain why, unlike electronic money, bank deposits in most countries are guaranteed by the Government. This is another difference between the Electronic Money Institution and the Bank.
To sum up
The main differences between the two financial instruments, which seem almost indistinguishable to the public, can be found on the balance sheet of the enterprises that issue them. That is, the question boils down to a comparison between the Electronic Money Institution and the Bank.
Taking into account that obligations for electronic money transfers (promise of repayment on demand) issued by electronic money institutions are “supported” by an equal amount of funds on the assets of their balance sheets, Deposits and electronic monetary instruments held by electronic money institutions in credit institutions accounts, Deposits and electronic monetary instruments (as well as a promise of repayment on demand) issued by credit institutions are secured by loans and, to a lesser extent, are kept in the bank in the form of cash and reserves that credit institutions hold for clients.
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