11 Feb 2021
Buy now, pay later (BNPL) operators - despite a small market share - have shaken up traditional banks and financiers and commanded the attention of investors. This has been reflected in high stock market valuations and notably the proposed acquisition of Australian BNPL Afterpay by US payments giant Square. But what are the longer-term prospects?
The financial product of BNPL will survive in various guises. It’s been around in some form for (almost) ever. The brilliance of the new operators has been in identifying gaps in the market for existing offerings and using modern payments technology to exploit that.
“Buy now, pay later was a new, different, product, attractive to consumers, that banks weren’t offering, enabling additional middleman costs to be offset.”
But the longer-term survival of independent BNPL operators is quite uncertain.
This lies in the business models involved, which are not just providing “credit” to retail customers but are inherently interconnected into the payments system (as the P in BNPL suggests). Their models involve an additional, unnecessary, layer in the plumbing (or electronic pipes) of the financial system, which is not costless.
Banks, as fundamental participants in the payments system, are able to offer competitive BNPL style products which avoid extra layers and costs. Some are already beginning to do so.
To understand the inherent payments system weakness in the business model of independent BNPL operators, it’s useful to examine a recent report from the Reserve Bank of Australia (RBA). It’s a bit tricky, so it’s best to first consider what happens in the absence of BNPL.
Normally, when a merchant receives a payment from a customer via a card or other digital method, their bank account will be credited with the proceeds. The customer’s bank account will be debited, either immediately, or later when a credit card transaction is ultimately paid for.
The “plumbing” enabling this transaction may be either a global authorisation network such as Visa or MasterCard, or the near real time New Payments Platform (NPP), or domestic debit systems like eftpos in Australia. While this electronic digital “plumbing” has dramatically reduced costs compared with the now-antique cheque or paper system, there are still costs associated with the operation and maintenance of this plumbing.
According to the RBA, the BNPL operator interposes itself into the plumbing between the merchant and its bank, and between the customer and their bank. The BNPL operator draws on funds from its own bank account to pay the merchant immediately via a transfer into the merchant’s bank account. When the customer makes the deferred payments to the BNPL operator, funds are transferred from the customer’s bank account to the BNPL operator’s bank account.
Since interposing that additional layer involves some additional costs, why has the BNPL model proven successful to-date? The simple answer is BNPL is a new, different, product, attractive to consumers, that banks weren’t offering, enabling additional middleman costs to be offset.
(That offset was primarily via the significant merchant charges which merchants agree to in the hope of attracting or retaining customers wanting BNPL facilities).
However, as we have already seen, banks are responding by offering similar products which essentially cut out the need for the middleman. No-interest credit cards, with monthly fees only if the card is used in, or not paid off at the end of, that month have already appeared.
So do BNPL operators have some other competitive advantage that might see them survive when banks offer virtually equivalent products?
Flash marketing and mobile apps have given them initial appeal, particularly to younger customers. But whether there is any customer loyalty that can’t be offset by the banks is another matter.
Another possibility is BNPL operators may be better able to assess and minimise possible losses from customer defaults than the banks. At the moment, they are able to economise on customer credit assessment. This is because BNPL is, inappropriately, not legislated as provision of credit.
BNPL operators escape the responsible lending obligations (RLOs) and other requirements of the National Consumer Credit Protection legislation.
Despite the current government wanting to remove RLOs, it seems unlikely that any such advantage – which consumer advocates argue puts vulnerable consumers at risk – will persist for long.
The most likely scenario for initially successful BNPL operators is eventual acquisition by a bank or other important participants in the payments system who find acquiring new customers and using product design and technology from the BNPL operator attractive. The acquisition of Afterpay by Square is one such example of this scenario.
BNPL operators have essentially done the financial sector and its customers a service by incentivising banks to consider and offer different financial products and services. But like in many other cases, the innovators may shine briefly until their reward comes from being “swallowed” by the large incumbents.
Kevin Davis is Emeritus Professor of Finance for The University of Melbourne
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
11 Feb 2021
26 Aug 2019