I recall last year hearing a CIO, when asked whether he should care about Paypal, reply – they are American aren’t they? In fairness, its worth performing a bit more detailed analysis, because as I will show there are issues, and they are not clearly understood. However I believe they are a real threat to all Banks, including the Citibanks, Barclays, and BofA’s.
Where next for PayPal? – Financial Services – Breaking Business and Technology News at silicon.com

Online payments company PayPal is looking to extend its reach beyond its online shopping beginnings.

Paypal are merely a blinding example of where payments as an industry can become a strong emerging competitor to banks. So taking examples from this article and others, lets consider the evidence:

1. In the UK alone, PayPal has 10 million user accounts. The company estimates 10 per cent of the UK population are now its customers and that one in three of the country’s 15 million online shoppers uses the service.
2. Paypal.co.uk handled payments worth £350m in the fourth quarter of 2004 but that was at a time when it only had around 80 million accounts around the world.
3. PayPal has recently partnered with Betfair, the online bookie for payments.
4. It works closely with Dell, iTunes and, being part of the same business family, eBay and Skype.
5. it also wants to change from being exclusively an online service to something you could use on the move – or on the high street
6. PayPal’s European CEO, Geoff Iddison, told silicon.com: “Our ambition is to become the preferred online payment method. But people also want access to their funds and will want to go to an ATM and pull money out. So there is going to be more presence offline over time.
7. Our biggest push at the moment is in the merchant space – getting it accepted by merchants other than eBay
8. In the US, PayPal has already launched its own credit card

But there is a lot of rhetoric in this, and not much in terms of specifics. In the short run, this next statement form Iddison, and comment from a Gartner analyst is meaningful.

He added: “The one from the US is MasterCard only. Any credit card we would issue would be branded MasterCard or Visa so there’s no direct competition with these companies. We have a very close relationship with them, and we’re one of their top merchants.”

Analyst Gartner recently argued that banks and vendors should sell PayPal payments to their customers, instead of trying to compete with the online company. It said PayPal can beat credit card pricing and merchants should ditch ‘outdated’ payment methods.

But Gartner research director Avivah Litan told silicon.com: “I think PayPal represents one of the only viable and real alternatives retailers have to bank card payments. The problem is that the PayPal system relies on funding from bank checking or credit accounts.

So we are left with tantalising hints that Paypal is out there with the potential to compete directly, yet, they complete the discussion with suggestions of partnership. Its therefore arguable that Paypal are merely a direct competitor to the worlds payment networks (e.g. First Date, Moneris, Paymentech, BT, LUUP, Checkfree etc – note to self, need to complete this list).

However, lets not forget that Paypal enable customers to maintain a balance with them. In effect they are a bank, and this has been the topic of some legal debate. This from the State of New York Banking Department (NYSBD) deals specifically with the customer option of leaving money with Paypal, and the NYSBD contention that this made them an illegal bank.

When a PayPal customer does not direct PayPal to immediately disburse said funds, PayPal provides two options: (a) sweeping funds to purchase shares in the customer’s name in the PayPal Money Market Fund (“Money Market Account”); or (b) pooling funds with other customer funds and placing them in a bank account denominated, “PayPal, Inc., as agent for the benefit of its customers” at one or more FDIC-insured banks (“FBO Account”).[3]

Option b) is the key one, and it appears Paypal successfully argued that they are not banking their customers, rather, they are merely hold their customers money as an agent. This sounds to me like a legal semantic. However the mystery deepens and …

Since it is only an agent, the FDIC has concluded that the funds in the FBO Account are eligible for FDIC pass-through insurance.

Paypal funds are in fact FDIC insured! and finally this poentially prescent comment form the NYSBD:

…. the Department concludes that PayPal is not currently engaged in illegal banking.

However, the Department remains concerned that PayPal is offering payment services to New York customers without being subject to supervision by a national or New York regulatory body. Given that PayPal’s business model is relatively new, continues to evolve and will likely go through several more iterations in the near future and PayPal’s intention to have a future physical presence in New York, the Department believes the best course for New York customers would be for PayPal submit an application to obtain a New York money transmitter license as soon as practicable.

Paypal make lots of money on the balances that are maintained with them because they pay no interest. If they establish a method to do that, and those funds are FDIC insured, then they are by any covention, a bank.

Relevance to Bankwatch:

Paypal are living (successfully) off legal semantics. Banks live mainly off balances, but their reliance on payment revenue is growing. Paypal will disintermediate banks on payments, because they are lower cost, and have large international scale.

On the (only) other Bank revenue generator, Paypal are different than the other payment networks, in that consumers can leave money with Paypal. The risk of balance run off is real with regard to Paypal, and that’s why they need to be watched.