hen PayPal burst upon the online scene in the fall of 1999, offering consumers $10 to start an account, a few pundits predicted that the company would change the world of Internet purchasing; few suspected how much impact it would have on financial services. But with the explosive growth of online retail sales, the effects are starting to be seen-and feared.

PayPal, now owned by eBay Inc., is no longer an upstart. PayPal's payment volume in 2004 was $18.9 billion. The company currently claims to have more than 86 million accounts and is adding 83,000 a day. PayPal is growing at an annual rate of 44%. EBay's President and Chief Executive Officer, Meg Whitman, recently told analysts that the company estimates that one in three online shoppers in America now has a PayPal account.

According to Gartner Inc. research, PayPal's recent micropayments initiative (announced Aug. 31, 2005) could lead to market domination. "PayPal's micropayment strategy may precede plans to manage more traditional payments as well as online transactions," said Avivah Litan, Gartner Research Vice President. "It's a sound business decision and one that is likely to lead to market domination."

"PayPal has recently lowered its micropayment transaction fees to 5% plus $0.05 because the company recognizes that, with this pricing, it can fit into a merchant's arsenal and grow its relationships with a variety of vendors who may not have considered accepting PayPal at first glance," said Dan Schatt, Senior Analyst at Celent, a market research firm.

"PayPal continues to win support among small and large online merchants alike," he said. "This is an opportunity for it to leverage a competitive advantage it has with merchants in the form of lower funding costs. It costs PayPal significantly less money to take money from a consumer's checking account than it costs a merchant to take money from Visa or MasterCard."

PayPal's recent moves show it's eyeing a horizon beyond the eBay community. "When we first started looking into the micropayment market, we looked closely at music downloads, Napster and iTunes for example, and what we found is that because of our payment pricing we can offer merchants a painless way to accept true download sales," said PayPal spokeswoman Sara Bettencourt.

"It just doesn't make sense to accept a $0.99 payment if the fees are too high. With our microprocessing fees, a true download model, rather than just a subscription model, becomes workable for merchants," she said.

In November, eBay completed its $370 million acquisition of VeriSign (see "EBay Has Eye on Payments Business," By Patti Murphy, Oct. 24, 2005, issue 05:10:02). The VeriSign deal allows PayPal to beef up its security and extend its reach beyond the eBay community. The eBay market, which is PayPal's main source of business, currently, represents only 20% of e-commerce payments, which some analysts point to as PayPal's biggest weakness.

"PayPal's acquisition of VeriSign's payment gateway, and the 100,000 merchants it services, will strengthen PayPal's market presence," Litan said. "PayPal's innovative uses of payment funding systems will likely be welcomed by small and midsize businesses that want less-expensive alternatives to credit card payments, and eventually by even the largest online merchants.

"The recent PayPal offering that allows merchants to accept both credit cards and lower-cost PayPal payments will likely prove attractive to small and medium-sized businesses and will clearly benefit merchants already using VeriSign services," she said.

First PayPal, Now Google

Some have surmised that the VeriSign deal may also be a preemptive strike against Google's announced but not yet released Google Wallet service (expected to be released in early 2006). Although details of Wallet have not yet been revealed, it is rumored that Wallet will, initially at least, be limited to individual-business transactions (unlike PayPal, which allows individual-individual transactions).

But like PayPal, it is believed that Wallet will be a stored value account. Google executives have said the Wallet service will not be a direct competitor to PayPal, but Wallet could very well limit PayPal's expansion beyond eBay and threaten PayPal's dominance in the online payments market.

"Google Wallet could significantly disrupt the market landscape," Schatt said. "Ultimately, scale and volume will determine the victors in this market, and Google's ubiquitous nature could serve it well." PayPal wasn't the first to try to create digital cash, but earlier attempts were too sweeping; their creators either envisioned a traditional bank-based system that accepted digital cash just like real cash, or relied on widespread and rapid adoption of the concept by consumers. Competitors have come and gone, while PayPal rocketed to success in the person-to-small-business payments universe by being more like a credit card payment system: limiting transactions to those who have joined the PayPal network.

Although PayPal's ambition now appears to be the global standard for Internet payments, in its early days, its creators, Peter Thiel, a former hedge fund manager and Max Levchin a 23-year-old programmer at the time, were more narrowly focused and more pragmatic.

Their concept was to provide digital payments, not digital cash, and to make the solution as easy as possible for individuals to use. They initially targeted person-to-person payments. Cash would be drawn from checking accounts or credit cards, and the individuals' accounts could be settled in two ways, through e-mail and infrared rays passed between Palm Pilots.

The Palm Pilot idea didn't pan out, but the online payments took off, overwhelming the start-up with 20,000 new members per day before it was even a year old, a pace it maintained until eBay purchased it in October 2002, soon after eBay's IPO.

A New Target Market?

Until recently, most of PayPal's transactions occurred between individuals or individuals and merchants whose volume was so small that they couldn't qualify for a merchant account anyway, but recently PayPal has alarmed ISOs by going after small to medium-sized businesses.PayPal has virtually saturated eBay's auction sales and is now believed to be targeting non-eBay businesses with between $250,000 and $5 million a year in transactions to fuel its next growth spurt. "In the past year we've started to really emphasize our merchant services business," Bettencourt said. "SMBs [small and medium-sized businesses] are a market that PayPal is starting to target.

"We're reaching out to the merchants outside of eBay, typically those that are a little larger, more sophisticated, that want to seamlessly integrate payment options into their online operations."

A PayPal press release announcing the VeriSign deal stated, "With the acquisition of VeriSign's payment gateway, which processed more than $40 billion in total payment volume in 2004, PayPal plans to accelerate its merchant services business by expanding its customer base to tens of thousands of new small and medium-sized business customers online."

"PayPal could eventually replace credit/debit cards as the dominant online payment mechanism, if it can maintain low merchant rates while increasing customer service, responsiveness and chargeback ease so that its policies and practices are as consumer-friendly as are the card companies," Litan said. "The card companies will need to fight back with rate decreases to hold their e-commerce market share."

MasterCard International-owned TowerGroup, an industry research firm, said that large nonbank providers of payment processing services, such as PayPal, are and will continue to be, a disruptive force in the payments industry.

"Less encumbered by legacy technologies and especially by regulation, nonbanks have deconstructed the payments value chain, cherry-picking opportunities in high-return areas and experimenting with new business models," said Elizabeth Robertson, a TowerGroup Senior Analyst.

"They are increasingly challenging the position that banks have typically held in providing these services," Robertson said. "Nonbank payment mega-vendors help expand the market and provide banks with payment services and solutions, but they can also pose a competitive threat to banks' payments markets and revenues because they are less comprehensively regulated than are banks."

Success Brings Competition

Interestingly, PayPal's appearance of success could lead to its eventual demise. Other nonbank payment vendors are and will continue to enter the space (see "Back to the Future With Cash Payment Options," The Green Sheet, July 25, 2005, issue 05:07:02). Competitors cutting into PayPal's profits could hurt eBay's high-volume but low margin division, and could erode the market enough to give traditional credit card issuers the entry they need.

Consumers are looking for ease of use, security, payment options to use in most or all Web commerce sites, and name recognition. These are the factors that give Google and PayPal an edge over other nonbank vendors. But, if the market proliferates to the point of confusion, consumers may abandon them for a branded online credit card alternative that seems more ubiquitous.

"Credit card companies could enter the micropayments market simply by lowering merchant transaction fees," Litan said. "But these companies don't have PayPal's advantage of funding payments from PayPal stored accounts. PayPal can beat credit card pricing because it blends credit card, bank account transfer and stored PayPal account value funding on the payer side, lowering PayPal's overall cost of funding any payment.

"PayPal encourages repeat payer customers to keep money in their PayPal accounts (the company's lowest-cost funding method), and to use credit cards (the most expensive funding option) as a last-option funding method," she said. "A change in regulatory climate toward nonbanks could also alter some of these dynamics," Robertson said.

Relationships Over Price

In order to compete with PayPal, Litan said vendors should offer value beyond payment processing. She also suggested that vendors consider reselling PayPal rather than attempting to compete in the online payments market with outdated payment methods. But ISOs and merchant level salespeople (MLSs) are not sanguine about that strategy.

Analysts speculate that Google Wallet will bypass the resellers completely, only offering accounts direct to merchants. PayPal, too, offers little in the way of incentives for ISOs. "We typically don't have what you'd call an ISO channel," Bettencourt said.

"There are some shopping cart companies that package PayPal merchant accounts into their shopping carts, but we don't have an ISO agreement per se."

Lightbridge Inc.'s Authorize.Net Corp., a provider of Internet protocol-based payment gateway services, said 63% of its resellers are concerned about PayPal adversely affecting business and cutting into their merchant banking revenue stream.

"Authorize.Net is actively encouraging all ISOs to educate their merchants on the benefits of retaining a full merchant account," said Roy Banks, Authorize.Net President.

"While those unfamiliar with PayPal's recent moves may still consider it to be a niche payment method for eBay auctions, the reality is that PayPal is now a considerable threat to the ISO's channel, as any merchant with a business or a premier PayPal account also has the ability to accept credit card payments, which are then routed through PayPal.

"Based upon this new model, we believe that PayPal's ultimate strategy is to displace the traditional merchant account," he said. "It is for this reason that we believe it is critical for ISOs to proactively reach out to their merchants so as to avoid having them poached by PayPal."

How will PayPal, and its nonbank competitors, affect the financial services industry? If traditional credit card issuers head off PayPal in this volatile terrain by offering merchants both affordable micropayments and robust, and secure, online initiatives, ISOs and MLSs may not have much to worry about.

But for now, the magic eight ball says: "Reply hazy, try again."