Is the payment revolution indebted to buy now, pay later?

Andrew Cornell

Past Managing Editor, bluenotes

In this age of cryptocurrencies, buy now pay later schemes, eCommerce deposits, platform payment networks, thousands of payment cards and myriad other choices - even cash - it seems there is an almost infinite number of ways to actually pay for some product or service.

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But there’s not. In fact, there is three: you can pay before you get the product or service; you can pay when you get the product or service; or you can pay after you get the product or service.

“BNPL is genuinely disruptive, offering users what they may justifiably regard as a better product. Regulators should think twice before they seek to discourage it.” – Ross Gittins

Pre-paid gift cards or your account with a tollway operator are examples of something you pay for before. Using cash or a debit card means you are paying now – you get the good, your money’s gone to the merchant. Pay later means you are being granted credit – it might be a mortgage, it might be a credit card, it might be buy now, pay later (BNPL).

Now the structure of the payment instrument may differ, there may be all manner of bells and whistles, of marketing involved. The fees and charges associated with each instrument will vary – because none are free, by the way – but ultimately as the person doing the spending you are either choosing to advance credit (pay before), exchange directly, or accept credit.

The new ways to pay are variations on old themes.

Hire purchases

Even BNPL. In years past, a scheme where you paid a fraction of the purchase price, took the good or service, then paid the rest later was called “hire purchase”. (Not lay-by where you didn’t get the goody until after you’d finished paying all the instalments.)

The difference with BNPL is the scheme is paid for by merchants not consumers. If a consumer makes the instalment payments on time, there are no extra fees and charges. (If they don’t, there are fees.) The merchant pays a relatively high – often around 4 per cent – merchant service fee to the scheme organiser.

This is unusual but inversions of fee structures are not that unusual. In the early days of the EFTPOS debit system in Australia some merchants – the largest, like big retailers and petrol chains – were actually paid to use the system. (Smaller merchants still wore the charges.)

This was called “negative interchange” and it did make sense – at least initially – because it was a way to build a network effect. Without negative interchange, not enough merchants would accept EFTPOS which would discourage consumers from taking it up.

What we’ve seen with BNPL is a similar insight. Conventional fee structures can be inverted if there is a benefit. In this case, BNPL providers argue they can bring merchants enough new customers (again, who aren’t charged – so long as they pay the instalments on time) to justify the merchant service fee.

And indeed, this is what happened. Consumers, particularly younger ones, flocked to BNPL (and often because traditional credit wasn’t a palatable alternative).

Payment revolution

This novel business model was enough for some to consider BNPL a payment revolution. Some credible commentators, including The Age/Sydney Morning Herald economics writer Ross Gittins (arguably the best mainstream media economics writer going) have argued BNPL really is different.

Drawing on research by the equally credible Australia Institute (admittedly in this case commissioned by a high profile BNPL scheme) Gittins makes the case BNPL is a highly competitive and innovative challenge to traditional, usually bank managed, credit schemes – especially credit cards.

He reckons BNPL “is genuinely disruptive, offering users what they may justifiably regard as a better product. Regulators should think twice before they seek to discourage it”.

There’s no doubt BNPL is innovative. Nor that, for approaching a decade, betting against BNPL was a widow maker trade for investors. However, the world has shifted. BNPL share prices have cratered. And it’s forced a reassessment of just what BNPL offers. Just another way to pay? Or a whole new commerce ecosystem?

Moreover, even if it’s the latter, can the business model survive an abrupt shift in the economic cycle?

Threat of regulation

BNPL models have been assaulted on multiple fronts. One is the threat of regulation. Early on regulators were content to watch the evolution of BNPL until it became big enough to pose a threat to financial stability. It is now likely BNPLs will face some kind of regulation as credit providers while merchants will be allowed to apply a surcharge to consumers to recoup some of the merchant service fee charged – as they are with credit cards.

The threat of greater regulation was itself a blow to valuations but it is growing at a time when BNPL players – and there are thousands, from tiny fintech startups to the major brands – also face the headwinds of macroeconomic and monetary conditions turning against startups.

Interest rates are rising which foretell both funding squeezes and deteriorating credit conditions. Because the vast majority of BNPLs were in a growth phase they are not profitable – which is fine only as long as investors can see a payoff in the future. Once that payoff is riskier, because of rising rates making safer investments more inviting, and credit problems loom, investors sell.

And we have seen many BNPLs shed 80 and 90 per cent of their value in recent months. Meanwhile, bad debts in the sector are indeed surging, already topping 20 per cent of the loan book in some US markets. This coming winter will chill not just BNPL but the broader lands of fintech.

As The Economist noted: “Rising interest rates and the threat of an economic slowdown are hanging over the industry. Many listed fintechs have seen their market capitalisation crash by more than 75 per cent since July 2021; private firms are being forced into ‘down rounds’ that value them at less than their previous worth. In recent weeks a sorry cast of multi-billion-dollar fintechs, from Klarna, a BNPL firm, to Wealthsimple, a trading app, have announced layoffs.”

Stepping into the ring

Then there is competition. As BNPL started to gather momentum, established payment schemes like Visa and MasterCard either rolled out or bought BNPL offerings. As did some banks. This did dent valuations but the heaviest punch came this month when Apple added a BNPL function to its massively popular Apple Pay product.

Users of Apple Pay Later can now simply elect to pay off a purchase in instalments. BNPL valuations were hit again. Apple is essentially offering BNPL free to merchants.

For the disinterested, what has happened is a fascinating test of the question of whether BNPL is actually a whole new innovation in payments or just another clever fintech which has had its moment.

Supporters – and Gittins makes this case – argue BNPL’s true value is it is an ecosystem, not just a payment instrument. That is, it brings together buyers and sellers by way of a community. Buyers are offered special deals and other attractions; sellers a more engaged audience and considerably more behavioural data about them. The kind of data Google, Facebook, Apple and others have been hoovering up.

That could be right. The future will tell but, in my view, what we are seeing is very much like what we saw in Australia in the 1990s when mortgage originators entered the market and at one point were writing nearly one in four mortgages.

Their attraction was their innovation in unbundling the mortgage product. They didn’t have expensive branch networks, necessary to raise the deposits banks used to fund mortgages. Instead, they packaged up their mortgages and sold them on markets via securitisation.

They did change the mortgage market forever and consumers were the winners: around 250 percentage points were cut from the cost of a mortgage. Today those original firms have either transformed into something else, been bought by bigger players or failed. Their models didn’t survive economic cycles and competitive responses.

The innovation carried on, the business model that delivered it didn’t.

Andrew Cornell is Managing Editor of bluenotes

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.