Your money's not as safe in no-account e-payment services

The good news about the Internet is that it allows entrepreneurs to create new kinds of businesses without having to battle government regulations that slow progress.

That's the bad news, too.

Some of the hottest online businesses allow people to pay for things in newfangled ways. PayPal, ecount and PayMe, to name three, allow you to use a credit card to send and receive money by e-mail. You can use these Internet-based payment services to split a restaurant tab with friends or to buy stuff in a Web auction. When you receive money, you can let the service hold your balance so you can spend it later, or you can transfer it to a checking account.

The services are cheap, easy and convenient. But federal regulations haven't caught up with the technology. You might not have as much protection as you assume you have:

• Your money isn't covered by federal deposit insurance, and
• Some transactions aren't covered by Regulation E, the complex federal rule that governs electronic money transfers.

Most customers never have a problem with these services (I've used PayPal without a glitch). Still, the Feds eventually will get around to regulating Internet-based payments, especially if a big scandal hits the industry. Before that happens, regulators have to update the definitions of some common words and phrases for the Information Age: terms such as "account" and "access device."

What? No account?
Internet-based payment services use easy-to-understand language in their terms and conditions. You can't accuse them of trying to confuse people. PayPal's terms state that it's not a bank and not subject to banking regulations. Ecount stresses that your balance "is not a deposit" and is uninsured. PayMe goes further, stating that the company "does not maintain an account for you." In other words, you're on your own. It couldn't be much clearer than that, right?

Maybe, except for that pesky word "account." The word means one thing to you and another to federal regulators.

When you pay for things and receive payments through a service like PayPal, you keep track of your money through an "account." When you log onto the service's Web site, you can view your "account status." But your money isn't in your own account, according to the definition of the word under federal banking regulations.

According to the regs, it's an account if:

• It's kept by a financial institution, and
• Your money is kept separate from everyone else's.

The online payment services don't consider themselves financial institutions. They don't maintain a separate account for each customer (that's why PayMe says that it "does not maintain an account for you."). Instead, your money is pooled with other customers' money in a liquid investment, gaining interest that the payment service keeps as profit.

And that means your "account" is really just a record of the debt that the payment services owes you. It's kind of like when you pay your friend's lunch tab: She owes you the money and she might either pay you back or buy your lunch next time, but you don't have an account with her. If she's hit by a bus on the way out of the restaurant, you might never see your money again unless you're crass enough to grab a wad of bloody bills out of her purse as she awaits an ambulance.

No FDIC insurance
"When you don't have an account in your name, the question is whether it will be there when you want it," says Sarah Jane Hughes, an Indiana University law professor. "When you don't have deposit insurance, you have to depend on the solvency of the company that has your money."

She is not questioning the financial stability of any Internet-based payment services. She just points out that when these businesses hold your money, it is not backed by federal deposit insurance. Ecount mentions this explicitly in its terms and conditions.

PayPal insures its customers' money, but only against theft.

What happens if an Internet payment company goes belly up? You get in line with other creditors, hoping to get most or all of your money back. There are no indications that any of these companies are having financial problems.

Regulation E
Even trickier is the question of what is covered under Regulation E, which governs some, but not all, electronic transactions. This is the regulation that spells out the procedures a bank must follow if you complain that an automated teller machine shortchanged you and sets the maximum amount you can lose if someone steals your ATM card and password.

Regulation E applies in cases involving financial institutions. Right now the Federal Reserve is trying to untangle the knotty problem of whether an Internet company is a financial institution if it just keeps track of your various bank, credit card and brokerage accounts and helps you move money back and forth.

That debate centers on the dreary question of what an "access device" is. While you're doing something interesting at work, regulators are drinking potfuls of coffee so they can remain awake to ponder whether your home computer or a Web site count as access devices, like ATMs.

"Depending on what the Federal Reserve opines, I think that will go a long way toward more certainty" about whether Internet-based payment services are governed by Regulation E, says Doug Johnson, an economist with the American Bankers Association.

Meantime, if you use a payment service to send $10.13 to an auction seller, but forget to insert a decimal and send $1,013 instead, you apparently aren't protected by Regulation E. Instead, you have to hope that the payment service can solve the problem through contract law.

Most of these services deal with mistakes by freezing users' accounts until disputes are settled. That drives frequent users crazy. Izzy Goodman, a computer salesman and consultant who owns Complete Computer Services in Far Rockaway, N.Y., complains of "accounts frozen with no warnings and no explanations. Terms that change daily and changes made retroactively." He cites PayPal in particular.

"Do consumers benefit from no regulation? Absolutely not," Goodman says. "Is PayPal benefiting? In the short term, absolutely. In the long term, after the lawsuits and the customers leaving in droves, I don't think so."

With any luck, it won't go that far, and the government will strike a fair balance between regulation and innovation. In the meantime, says Hughes, "if the consumer is confused, I understand that."