There are few things comedians and personal finance writers agree on, but one comes up every holiday season: “Gift cards. For when you want to give someone money, except worse.” Like many topics in financial infrastructure, they’re a fascinating Gordian knot of user needs, business incentives, government regulation, and infrastructural weirdness. Let’s start unraveling it.
How the payments industry thinks of gift cards
The industry taxonomy for gift cards (and gift certificates, and pre-paid cards, and similar instruments) primarily splits them into open-loop and closed-loop systems.
Closed-loop gift cards are the classic retailer gift card, where someone buys a known value of future goods/services, typically paying 1:1 in cash, and those goods/services only come from the business which issued the card.
Open-loop gift cards are issued under the aegis of a payments network, like Visa or American Express, and are approximately as widely accepted as other cards carrying the same brand, not just with the company which directly sold them to the customer. (As always, there’s a fascinating level of detail hiding behind the word “approximately.”)
There is more product differentiation in open-loop gift cards than in closed-loop cards. Some are sold primarily for the traditional gift card use case, to enable non-cash transfers of funds in a convenient physical or electronic format between people who know each other. Others (like e.g. Amex Serve) are sold as financial facilitators directly to the end user; they effectively function as simplified bank accounts.
There are also some much quirkier options, including one which deserves an issue for itself as some point: “Medicare pays doctors using pre-paid gift cards” is certainly the most surprising sentence I’ve read recently, and being unsurprised by wildly off-label uses of payments infrastructure is my job.
The job to be done, or, users are less irrational than believed
Clayton Christensen, a Harvard Business School professor sadly no longer with us, popularized a framework for thinking about products called “jobs to be done”, which helps to conceptualize rational user behavior that looks surprising.
One example he frequently used was that McDonalds sells most of its milkshakes not to children as a dessert but to adults early in the morning. The job to be done of the milkshake was not, as it turned out, delivering the taste of chocolate. Milkshakes were an engaging and enjoyable meal substitute for people who had not had breakfast and needed to consume calories while driving to work.
Personal financial columnists and comedians do not understand the jobs that gift cards do. They are not cash-but-worse-in-every-way. Closed loop cards allow a giver to personalize a gift to the recipient. A Barnes and Noble gift card to a favorite niece tells that niece that you remember she is a reader, unlike those uncreative family members who would just give her cash.
If anyone’s psychology is being manipulated, it is likely the recipient, on a theory very similar to the one that causes many readers’ employers to offer a gym stipend instead of the equivalent amount of salary. You appreciate the money more, not less, because of the story about your relationship it comes with.
In a running theme for Bits about Money, gift cards are misunderstood because they are a financial product slightly outside of the financial mainstream. Most middle class users treat them as primarily a payments instrument, but they are also used to effect transfers.
In this regard it is not merely important that they look attractive in a birthday card but also that they’re available for cash everywhere, require no identification or ongoing banking relationship to purchase, do not charge a fee like e.g. Western Union, and can be conveyed over a text message or phone call. They're not worse cash, they're better Tide in the informal economy.
This makes them a fraud risk (and we’ll get to that later). Ransomware operators and fraudsters were using gift cards to move victim’s money from them through the financial system while evading controls long before cryptocurrency existed. But it also makes them extremely useful to some consumers at the economic margins.
My bank gives me free coffee and a smile to get me to come in more often; some consumers’ coffee shop gives them free banking and a smile for the same purpose. I can get coffee in many places; many of them cannot get banking elsewhere.
Open-loop cards are even more obviously designed, marketed, and described to regulators as low cost (... not really) bank account substitutes for people we’d prefer to be allowed to engage in commerce but who, for a variety of reasons, do not have bank accounts.
How closed-loop cards work under the hood
Back in the day, many retailers ran their own gift certificate programs, since the certificates were bearer instruments, relatively simple to print for a retailer, and relatively operationally easy to bookkeep, both at the corporate and POS levels.
Gift certificates got substantially more complicated as consumer-grade printers became capable of producing effectively indistinguishable forgeries, forcing retailers to verify them at the POS level, which implies an increasingly complicated supply chain to track each certificate to a database entry and verify it at will.
Gift cards exploded during roughly the same period; in addition to solving this issue by having the database more naturally integrated, they offered a superior user experience (you could re-use them) and a superior experience for the business (you never had to make change with actual currency or take the customer experience hit implied by refusing to do that).
But if retailers had issues running paper certificate supply chains, running card networks was even more obviously a non-starter, and almost all of them ended up outsourcing the manufacture, bookkeeping, payments stack, POS integrations, fraud monitoring, and compliance issues to dedicated gift card processors. In the U.S., one of the major ones is run by Fiserv, an absolutely mammoth infrastructure company that few people have heard of. (It is a miniscule portion of their total business.) There are many others and, unlike the card payment networks, they are largely not consolidated into regional or worldwide entities.
Closed loop card providers are in the business of moving bits, not in the business of holding money. Generally speaking, for a closed loop card which is sold directly from its own stores, the business hopes the money never goes out the door again. Things are slightly more complicated for e.g. buying a Chipotle gift card from the rack at Walmart, but those funds quickly move from Walmart to Chipotle rather than resting at Chipotle’s card provider.
Why businesses love gift cards
Geeks in every field love describing the world through the lens of their own field, and it’s very tempting for a payments geek to wax laconic about the financial underpinnings of gift cards, but retailers will describe, at substantial length, why they have gift card programs, and most of the reasons are not the financial stack.
They’re good at achieving the only three goals of marketing: they bring in new users, they bring users back, and they increase basket sizes. That would, by itself, justify the huge investment in gift card programs. The following factors are more of icing on the cake, for all but the largest programs.
“Float”
Many people are fans of Warren Buffet and describe any arrangement where a user pays for services in advance of receiving them as generating “float” which the business can invest, hopefully profitably.
This is not a terrible mental model for gift card accounting, but it breaks down in the details, and while Warren Buffet spins a very appealing yarn about insurance industry accounting, trying to understand gift cards through that lens is a bit like learning long division in reference to floating point numbers.
When a company sells a gift card, they book a liability to the user (they’ve made a promise to provide something of value in the future) and an asset (cash). This is revenue neutral. When a transaction happens in the future, the liability goes down (the promise having been fulfilled) and revenue is recognized.
In between the present and the future, the company has cash. In insurance, by regulation and practice this would be invested in a portfolio of largely low-risk highly-liquid assets, and the insurer would keep the returns generated by that portfolio, allowing it to be profitable potentially even if it had eventual claims higher than the premiums it took in. This is the core engine of (part of!) the insurance industry.
Most retailers do not have sufficient gift card liabilities and do not have sufficiently sophisticated treasury teams to make a meaningful amount of income off an investment portfolio. Also, they have a much better option. Unlike insurers, who must maintain reserves by regulation, most businesses issuing closed loop gift cards are not required to maintain reserves. They can simply use the cash as a source of working capital for the business, similar to other sources of working capital, except substantially free. Even in a capital-drenched economy, it is tough to beat free.
(Though, who knows, perhaps negative interest rates will get retailers to start issuing reverse gift cards. “Here’s some money if you promise to buy a coffee later! Please, please, take it off our books!”)
Breakage
What happens if gift cards aren’t redeemed, or are only partially redeemed? The remainder is deemed as “breakage” after a few years. The business gets to recognize it as revenue and keep it.
Historically, there was a heuristic that businesses were allowed to use to determine that the possibility of redemption was remote, but these days computers are better and accounting standards require that retailers or their partners use historical norms of actual redemption behavior to age card balances and recognize breakage.
Breakage is free revenue… except in those jurisdictions where it isn’t.
Many jurisdictions have complex rules governing the treatment of lost property. Most gift cards worldwide are issued in the United States, and many American states consider an unused gift card a special case of unused property. They require the card issuer to escheat (remit to the state) funds which have been deemed abandoned, so that the state can hold them in safekeeping for the original owner or their heirs.
That’s the theory. In practice, because gift cards are often sold anonymously for cash, very few gift cards escheated will ever be returned to their original owners or the heirs. The rules for accessing escheated assets are also complicated and have a high frictional cost, often requiring e.g. multiple documents to be notarized, which tends to make them non-viable at typical gift card sizes.
(Surprising no one who knows me, I was so fascinated by escheatment when I learned about it that I had to try. I found the great state of Missouri had been helpfully sitting on $12 overpayment of a utility bill for almost 20 years after university, and spent about 6 months and $75 in notary fees and certified mailings prior to getting the $12 back. Thanks, Missouri.)
The broader practice of escheatment is less odious than it is for gift cards specifically; most usage by value is for actual financial accounts whose owners may have e.g. passed away without informing their heirs about the accounts. There is actually some societal value in having a department of people tasked with maintaining records for generations (in many states, they’re charged with doing it forever), answering letters, and disbursing funds.
Breakage is much lower than non-professionals believe. In the U.S., the industry estimates that approximately 2-4% of the ~$100 billion in annual sold cards will break. This is not a dirty secret or cynical PR play; the numbers are maintained extremely accurately by computer systems. You can read them in the annual report of your favorite retailer, where they’re almost always far below the level of materiality.
One exception, because of its mammoth size: Starbucks. Japanese Internet companies often buy banks intentionally. Starbucks made a mid-sized bank mostly by accident. In FY2020 they had $1.5 billion in “deposits” and $145 million in breakage revenue. This is higher breakage than typical due to small average card sizes (less incentive for users to work to retain partially spent cards), small ticket sizes, and relatively anomalously successful use of the cards as a corporate gift method in e.g. swag bags, employee traveling, and similar.
The joys of gift card compliance
Escheatment is the primary compliance headache for closed loop gift cards, and neither your local pizzeria nor Target want anything to do with it, so it gets outsourced to the infrastructure providers (and then to the government).
Gift cards are also a money laundering risk, and they’re relatively under-regulated given the degree of it. They’re cash equivalents. The features which make them attractive to legitimate users at the fringes of the financial system also make them attractive to bad actors at the fringes of the financial system.
There was a fascinating article which described one Eric as a modern day currency broker, swapping Bitcoins for gift cards and back again, earning a spread on transactions. Currency brokers are paid for offering liquidity and taking inventory risk. Eric was paid for neither. He was part of the fraud supply chain.
The Bitcoin part is almost entirely a red herring. In one extremely literal example of regulatory arbitrage, some states require closed loop gift cards to be redeemable for cash. The supply chain constantly recalculates ways to turn misappropriated value into physical gift cards located in these states, then sends a casher out to the store to collect clean cash. There was once a Reddit comment from an extremely frustrated retail clerk wondering why people in the neighborhood made him spend so much time counting out refunds of $500 gift cards.
Much more on this later. Until then, enjoy the winding down of the year, and hopefully financial infrastructure brings a tiny bit of joy this holiday season.
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I write about the intersection of tech and finance, approximately weekly. It's free.