May 6, 2022

Buy Now, Pay Later

Today's discussion is on Buy Now, Pay Later (BNPL). BNPL is a novel alternative to credit card debt that's grown dramatically in recent years. We discuss how BNPL makes money, the impending regulatory crackdown, and why the enthusiastic reception by consumers and businesses alike begs a lot more attention. Please enjoy this breakdown of buy now, payer later.

Hey friends -

Much has been written about Buy Now, Pay Pater (BNPL). Most are focused on the service as it exists today.

Some like Bits about Money author Patrick McKenzie emphasize that it can expand access to credit for those at the margins of society and allow them to better control their spending than traditional credit products. Others, like SFGATE, publish articles titled 'Buy now, pay later' is sending the TikTok generation spiraling into debt. The CFPB, the US regulator responsible for consumer protection, seems to be coming down on the side of SFGate - they recently opened an inquiry into the five largest BNPL players in the US.

BNPL matters because it's a new type of payment option - it can touch almost every consumer and merchant. Specifically, it's a type of deferred payment option that allows the consumer to split a purchase into four or fewer installments with a 25% down payment due at checkout.

BNPL has been on a tear, going through hypergrowth rarely seen in any industry, much less payments. It's worthwhile to examine the extraordinary growth of BNPL, but I want to focus our attention on the customer experience. Purchasers and merchants alike are signaling - with their wallets phones - that they're interested in a new way of transacting.

That's a much bigger story than just BNPL.

In this week's letter:

  • Buy now, pay later: BNPL hypergrowth, credit in sheep's clothing, customers voting with their wallets phones, and the road ahead for incumbent card networks
  • Stripe processed $680 billion in payments, earn $100K+ per year tattling on NYC drivers, and more cocktail talk
  • The Manhattan Island for when it's not warm enough for tiki, but it's too cold for winter cocktails

Total read time: 13 minutes, 43 seconds.

BNPL Hypergrowth

I enjoy investment banker financial projections. Not because they're useful (they're not), but because of the utter lack of humility. One would think that after endlessly projecting "up and to the right" and rarely getting it right, some retrospection would be in order. But with the unfazed confidence of Jim Kramer, they keep on coming.

Jefferies' 2020 predictions for BNPL were no exception.

Ah yes. Good old banker blue for everything.

300%+ purchasing growth is simply a silly prediction. Industries don't grow that fast. Except, apparently, BNPL.

2021 estimate was as of Sept 21. Actuals were $97B.

We did all of the Jefferies-predicted purchasing growth - and 33% more - in a single year! It's growth on a scale rarely seen in such a nascent industry. Big growth means big revenues, over $5 billion globally for BNPL companies in 2021.

Such growth naturally attracts more entrants:

  • PayPal doubled down on its 2008 acquisition of Bill Me Later with an enhanced PayPal Pay Later offering,
  • Bloomberg scooped that Apple is developing an Apple Pay BNPL service with Goldman Sachs,
  • Amazon and Shopify both signed strategic partnerships with US BNPL giant Affirm, and
  • Block (né Square) stole the show with the $29 billion acquisition of Australian BNPL company AfterPay.

What we're seeing and will continue to see is significant market share competition in a rapidly growing market.

AfterPay was acquired by Block (Square). PayPal not included for some reason.

They're not just competing over the new revenue stream. They're competing over access to the consumer.

BNPL rewires the payment flow

BNPL rewires the payment flow so the BNPL company is the primary interface between the merchant and the consumer. A merchant agrees to accept payments through the BNPL firm similar to how they agree to accept credit card payments. When a customer uses BNPL, the BNPL firm pays the merchant and the customer pays back the BNPL firm.

The standard BNPL setup is Pay in 4. A customer's purchase is split into four equal payments over 6 weeks: the customer pays 25% upfront and another 25% every two weeks until the full amount is paid off. It's free for the customer - zero interest and zero fees as long as the payments are made on time. Magic, right?

I’ve watched this more times than is healthy.

Not quite (spoiler alert - the merchant funds BNPL). It helps to briefly revisit credit cards to see how it works.

A traditional credit card payment is a series of IOUs all conveniently orchestrated by a card network like Visa. When the consumer swipes their card, it sends a message to their card-issuing bank that authorizes the payment. Some days later, the merchant bundles the last few days' IOUs and collects the payments. The card-issuing bank requests payment from the consumer every 30 days or lends them money (another IOU) and differs full payment.

How is money made in the traditional credit card model?

  • Merchants get more customers than if they only accepted cash. They pay ~2.5% per credit card swipe to a combination of the payment processor and card network.
  • Card networks charge interchange fees - they collect most of the 2.5% merchant fee.
  • Payment processors charge a little bit on top of the interchange fee. They get access to highly detailed cashflows for merchants and can offer other products.
  • Banks lend consumers money at high-interest rates so the consumers can differ full payment on their purchases.
  • Consumers get reward points and other card perks like travel insurance paid for by the card-issuing bank and card networks, funded by the loan interest and interchange fees.

BNPL keeps much of this structure. It has to for adoption. Too different and no one will use it.

BNPL has replaced the card network as the main interface.

There are some key differences:

  • The BNPL firm, like AfterPay, pays the merchant instead of the merchant submitting a payment to the card network.
  • The BNPL charges the merchant ~2x the cost of a card payment.
  • Buyers pay in four installments instead of at the end of the month.

You might think that the card networks dislike BNPL because consumers are no longer using the card networks. It's a mixed bag, but on the whole, it can actually drive more revenue for the card network - the network processes four payments instead of one for every purchase. The processing fee - formally called the interchange fee - is partly fixed and partly variable. It's four times the fixed and the same variable compared to traditional card payments.

Banks similarly like BNPL because it can generate more high-interest loans. The mechanics here require digging a little bit deeper into who actually funds the "pay later" half of BNPL.

BNPL wants to be tech and banks want to be banks

BNPL companies want to be technology companies, not financing companies. Banks are better suited as financial companies, not technology companies. The BNPL model is funded by their partnership.

Patrick McKenzie at Bits about Money did a great job breaking this down. I'll let him explain:

The BNPL provider looks for capital partners. There is a substantial amount of variation and nuance here, but broadly the counterparty is a large pot of money which seeks attractive yields at low but non-zero risk.

“If you came to me [the capital provider] tomorrow with a loan for $100 at 25% APR, since I trust you to underwrite good loans, I’d buy that loan from you. I have very few opportunities to buy low-risk 25% APR debt in the current interest rate environment. I don’t need to trust that loan, per se, I need to trust you, because I intend us both to be repeat players on this transaction and we both understand how statistics work. I am not buying the performance of that loan, I am buying the performance of random samples from your loan-creating machine.”

Multiply that intuition by a lot, and that’s BNPL financing in a nutshell.

Where did that 25% come from? To save you from having to prove this to yourself in Excel, here’s the intuition. A $100 pay in four transaction needs $75 of capital backing it for six weeks (because the user immediately pays a quarter upfront). The average amount of capital required over the term of the loan is half of that, due to repayment. If the BNPL was willing to pay 2% of the original transaction (sliced from their fee) to the capital provider in lieu of interest, the capital provider would receive $77 in repayments for their committed capital for 6 weeks, representing about 2.67% yield on $37.50 over 6 weeks. This works out to 25% annualized, give or take.

Bam. You have just invented a relatively high-interest consumer loan out of nothing, without charging the customer a penny more than their purchase naturally costs.

Patrick follows the economics to the logical conclusion - why doesn't the BNPL also sell the consumer a bank-powered product that can facilitate the installment payments, like a card?

The [BNPL issued] debit card typically comes with two options. One is less interesting as a product: it works virtually the same as any other debit card, making a withdrawal against your bank account via whatever local mechanism there is for that sometime after purchase. In this case, the BNPL only earns interchange revenue.

The more interesting one is that they make it trivial to turn those debit transactions into credit transactions, generally after they’ve been made, within the linked app.

And with that, we're back to a credit product we already recognize! But how are those pay in 4 installments any different from the credit product? They're not!

This whole time we've been calling it buy now, pay later, but it's just a loan by another name. Yes, the payment flow is different and consumers don't pay interest as long as they pay on time. But it's still a loan.

It's a loan in sheep's clothing.

A Loan in Sheep's Clothing

Buy now, pay later is an entire industry built on regulatory arbitrage.

The Truth in Lending Act requires lenders to provide clear, transparent information about their interest rates and the total cost of their loans. But it only applies to loans with five or more installments, hence the pay in 4 model.

None of the five largest BNPL businesses in the US do a hard credit pull when they allow consumers to purchase. Until recently, BNPL didn't even show up on credit reports.

What BNPL businesses claim is that they are simply coordinating and facilitating installment payment plans on behalf of the consumer, not issuing loans like traditional lenders.


If you don't pay, your "not loan" is sent to collections. If you fail to pay on time, you're hit with interest charges and/or late fees. The details vary by business, but all of this sounds oddly loan-like to me.

Credit bureaus and regulators seem to agree.

BNPL becomes a loan product

The three big US credit bureaus have all waded into the BNPL space.

Experian announced in January that it will collect information about an individual's outstanding BNPL loans including the number of loans, the value of those loans, and the status of payments. TransUnion made a similar announcement.

Neither Experian nor TransUnion is as of yet updating their credit models to include the data - it'll be reported separately. Equifax by contrast is updating its model.

That may have interesting consequences. 15% of a FICO score is based on the length of credit history. Paying back a short-term BNPL loan means that you're closing a line of credit. It could negatively impact your score unless the FICO model is updated.

Unexpected credit score impacts are a real concern, but it doesn't even crack the top three for the CFPB. Regulatory arbitrage unsurprisingly does, but the other two concerns are derived directly from how BNPL is already being used today.

The regulator is concerned about accumulating debt - "the ease of getting these loans" - and how consumers can end up spending more than anticipated. The numbers bear this out. The average online cart size when purchasing through Affirm, a BNPL vendor, is 2.5x the average cart size on the internet. Over 90% of consumer loans issued in California last year were buy now, pay later loans. Both are big numbers.

With such traction comes control, control that makes the CFPB concerned about data harvesting. BNPL companies are no longer just offering their services embedded in the checkout flow, they've created apps that are the starting place for shopping. An almost unbelievable 30% of Affirm's loan volume comes from buyers who start their product search in the Affirm app. The regulator is concerned about how that data may be abused, especially with "young audiences."

The CFPB will likely take a more active role in policing the rapidly growing industry in the not-so-distant future. They're currently collecting "information on the risks and benefits of these fast-growing loans" via orders sent to the five largest BNPL businesses. That's rarely a good sign.

But despite the concern and despite the regulatory arbitrage, it's clear that merchants and customers alike love buy now, pay later. That 300%+ growth spike came from voluntary, opt-in use of the product. There's almost $100 billion in annual spending - 2% of all consumer credit - that screams "this product is better than the alternatives."

The question is why.

BNPL Means Control, Customer Acquisition, and SKUs

Buy now, pay later means more control for consumers, more and better customers for merchants, and SKU data for lenders. It's good business for everyone.

A simple four-installment payment schedule over exactly six weeks on a per transaction basis gives consumers significant control over their finances. Six weeks is a horizon over which most consumers can reasonably predict their ability to pay. The per-transaction credit decision means that consumers should be less likely to take on unnecessary loans - it's only being used for specific transactions rather than as the de facto model as in the case of credit cards.

For the many consumers who don't qualify for a credit card, BNPL has even more value as the only affordable, generally available differed payment model.

Merchants also benefit despite the higher costs relative to credit card transactions. The transaction cost is more often than not offset by the increased average cart size and new additional customers. Merchants view BNPL as an alternative to increased advertising spending or discounted prices. Viewed through that lens, the higher transaction costs are a revenue-generating mechanism that the merchant only pays for when a product is purchased.

Merchants benefit again when you compare the financing structure of BNPL relative to traditional merchant-provided financing like car loans. With a traditional model, the merchant has to finance sales today for which they won't receive payment for many weeks. That's an expensive way to run a business if you're not a financial services company. By contrast, BNPL creates the same differed-payment benefit for the customer but offloads the financing challenge to a BNPL business.

Buried in the model is this idea of transaction-level financing. It's a fundamentally different underwriting model than credit cards. Card networks and banks have only limited insight into what products are being purchased from whom. BNPL businesses have deep insights - they're rapidly making per-transaction underwriting decisions. That's valuable data that can be easily monetized through special financing programs with product manufacturers and elsewhere. Through a partnership, you could imagine LG embedding a buy now, pay later offering in its TV purchase.

BNPL is creating real, tangible value by changing the user experience. Consumers can "create" zero-interest differed payment plans for individual product purchases that give them greater control over their finances. Merchants can acquire new, more valuable consumers more cost-effectively than with traditional advertising. Product manufacturers can embed payment plans in their products.

It should scare the bejesus out of card networks.

BNPL will disintermediate card networks in time

BNPL will realize what many big merchants have already - paying card network fees is expensive. Every time a consumer pays one of those installments through the BNPL firm, the firm pays the card network an interchange fee.

The Bitcoin Lightning Network, Polygon, and other Layer 2 cryptocurrency networks offer a viable alternative to the card networks. As I highlighted in the New Payment Network letter, they're rapidly gaining adoption and the point of sale terminal is a key battleground. BNPL is already embedded at the point of sale - Square even acquired AfterPay. They're right where they need to be to switch off the card networks and switch on the crypto-powered alternatives.

The eventual model is likely some combination of what Square's AfterPay and PayPal offer today. AfterPay is available to every Square merchant. Square intends for BNPL payments to be managed through the Cash App which is already Lightning Network enabled. But Square still generates BNPL revenue directly from merchants in the form of fees and consumers in the form of late fees. I expect that to disappear.

PayPal is out ahead on the revenue model. Their Pay Later offering is free - zero cost, zero interest, and zero fees. PayPal recognized that BNPL drives more and bigger purchases, purchases that the company already generates revenue on. It's worth forgoing the additional BNPL revenue to increase adoption and usage.

AfterPay will realize the same thing in time. It has the additional advantages of being bundled with the Square point-of-sale terminals and Square's cash app, real competitive differentiators against PayPal and the other BNPL businesses.

When that happens, it'll be the first real and comprehensive alternative to the existing card networks. Consumers will be able to purchase goods like they do today, differ payments like they do today, and the merchants will still get paid upfront. Yet the flow of funds may bypass the card networks entirely.

Expect fees charged to merchants to compress. As the cost of payments goes to zero (Bitcoin Lightning, etc. are near zero-cost), merchant fees will increasingly be determined by the cost of loan capital and charge-offs for the BNPL vendor. Time will tell how low those fees can go.

Other industries will be watching closely. BNPL is largely concentrated in Gen Z purchases for high-margin, discretionary purchases like clothing. It's the best fit for what remains an expensive option for merchants. As fees come down and transaction-specific underwriting models improve, more and more products will be available buy now, pay later.

There's room to improve it. Regulators are right to be wary of any credit product that's grown as rapidly as BNPL has. I won't be surprised if new regulations require better disclosures, compliance with Truth In Lending, and more thoughtful handling of customer data. Those will be healthy changes that may slow growth temporarily but will ensure the industry succeeds in the long term.

As long as consumers and merchants keep voting with their wallets phones that they want this new payment method, it'll be here to stay.

Cocktail Talk

  • Stripe processed $680 billion in online payments last year and counts 60% of the companies that went public in 2021 as customers. With such reach, it's always worth keeping an eye on where they're investing. Highlights include embedded finance (duh) and the creator economy. (Stripe)
  • If you're in the startup world and not reading Tomasz Tunguz's blog, it's your loss. His succinct commentary on how startups are valued, written from his perspective as a venture capitalist, is particularly poignant in light of the ongoing unraveling of public market tech company valuations. (Tomasz Tunguz)
  • Chef José Andrés was first a chef, then a celebrity, and now the reason over 70 million meals have been delivered in disaster zones across the world since 2010. His mission is to feed the world and he's well on his way to doing so. He's a complex character doing good on an extraordinary scale. GQ's Brett Martin captures it all. (GQ)
  • Looking to earn $100,000+ a year? Move to NYC and record trucks idling for 3 minutes. Submit it to the city and you'll collect 25% of the fine. Be careful of the fine print - nothing is ever easy with bureaucracy. Thanks to Liberty for sharing. (NY Times)

Your Weekly Cocktail

A cognac forward Manhattan variation.

Manhattan Island

2.0oz VSOP Cognac
1.0oz Sweet Vermouth
2 barspoons Luxardo Maraschino Liqueur
3 dashes Angostura Bitters

Pour everything into a mixing glass. Add ice until it comes up over the top of the liquid. Stir for 20 seconds (~50 stirs) until the outside of the glass is frosted. Strain into a rocks glass.

Manhattan Island

It's more alcohol-forward cocktails for me as I wait for spring. Manhattans are my go-to, but I was looking for something a bit more fruity that would just begin to hint at the warm weather. This cognac-based variation does it beautifully. The little bit of maraschino keeps the sweetness in check and the extra dash of bitters brings back the spice normally delivered by rye. It's a great drink, but I'm still hoping for tiki season.


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