The most recent online shopping research released by Adobe shows that, globally, online spending is expected to hit $910 billion this season, scoring an 11% growth year-on-year.
Buyers are embracing new payment methods, such as the prodigy child Buy Now, Pay Later (BNPL). Online revenue from BNPL this year has been 10% higher than 2020 and 45% higher than 2019.
In this article I will offer a detailed look at the key functionalities of Buy Now, Pay Later products, reviewing the opportunities this new technology offers to customers and merchants as well as some of the threats and risks to look out for.
How to buy now and pay later
With more payment options available for people than ever before, what are really BNPL providers bringing to the table?
For consumers, the advantages of using BNPL products are clear: convenience, more flexibility, “just in time” customizable financing at point of need.
For merchants, the benefits of offering BNPL as a payment option are also many – from intercepting new customers through to increasing conversion rates and Average Order Value (AOV). People can now buy more by spending less – that is, without needing to have one large cash-out event at the moment of purchase. Of course, this extra revenue doesn’t come completely for free, since BNPL providers charge merchants fees that are 10-20% higher than what typical credit card providers would charge.
Australia, the UK and, of course, the USA are some of the countries where the BNPL model really took off, where players like Affirm, AfterPay (now part of Square), Zip enjoyed tremendous growth in the last few years.
BNPL products can be set up and offered in a few different ways for consumers and merchants:
- Split Pay: the most common configuration. The payment is split in equal installments and then repaid by the customer typically over 4-6 weeks, generally at no cost to the buyer;
- 0% Financing: these deals are effectively underwritten as loans at 0% interest. The customer doesn’t pay any additional amount but the merchant contributes to the economic of this via their Merchant Discount Rates (MDRs);
- Longer-Term Financing: for certain merchants and borrowers, some BNPL providers offer proper long-term, interest-bearing loans.
In essence, the Buy Now Pay Later model gives the opportunity to consumers to pay for an item in installments, often benefiting from a 0%-interest agreement.
The most popular BNPL provider in the USA, Affirm, has published in their latest annual report a convenient pictorial representation of how the BNPL model works.
It is a simplified view, nevertheless one that is important to analyze and understand.
As we can see, when the consumer buys an item, instead of paying for it straight away, does so via a BNPL agreement.
If the item costs $1000, the customer doesn’t pay for it immediately but starts (what basically is) a “personal loan” with the BNPL provider (for example, he might repay the $1000 in 4 installments of $250 each). If the customer is regular in his payment, he will never pay for interests.
In the meanwhile, the originating bank pays $950 to the merchant ($1000 – $50 in merchant fees). The BNPL provider pays $1000 + fees to the originating bank to “purchase” the loan (BNPL providers enters a loan relationship with the originating bank). The originating bank pays the $50 to the BNPL provider as merchant fees.
We will review a bit later in in this article more details around this process and how different this is from a standard credit card transaction.
From the merchant’s perspective, the timeline for receiving a deposit from a BNPL provider in their bank account after capturing a charge is similar to a credit card payment timeline. Since BNPL providers work with multiple lending partners to originate their loans, the lending partners are the entities that effectively disburse payments to the merchant’s bank account.
We can already come up with a few important success factors that could make or break a BNPL business model: trust of the BNPL product brand, speed of capital, relationship with merchants, modern checkout solutions with good conversion rates.
As the number of BNPL providers increased over-time, also the types of distribution models have flourished.
Fincog‘s research has identified four key distribution models:
- Direct Merchant: the BNPL provider is integrated directly at a merchant’s check out (eg, Klarna as a payment method on Adidas’ site) or as part of a platform the merchant uses (Affirm as a payment method on a Shopify seller’s site).
- Multi-lender network: a merchant integrates with a network like Mastercard/Vyze or Visa/Chargeafter, which, in turn, has a network of lenders; financing type and fee structure will vary based on the type of lender for a given transaction.
- Direct card issuer: existing credit card companies like Chase and American Express introduced the ability to ‘convert’ credit card charges over a certain amount into an installment-type loan.
- White-labelling: a set of customizable features offered directly to merchants by BNPL providers.
A new model is enabled by BNPL
As we mentioned before, the BNPL model creates advantages for both merchant and customers: it gives merchants the ability to attract a diverse set of customers, and gives customers the ability to purchase more than they would probably do without the availability of this payment option.
Max Levchin, the inventor of PayPal and founder of Affirm, is very clear on how he sees this industry moving:
“The best way to think about Affirm or at least the way I think about Affirm is as a software-defined, data-preserving, vertically integrated network. So it’s kind of a mouthful, but each one of these components is really important. If you compare and contrast us to existing payment networks out there, one of the greatest missed opportunities, if you will, is the fact that they do not preserve the majority of the transactional data as transactions move through the system.”
Increasingly, BNPL products are helping drive up lead generation, conversion & brand marketing for merchants.
Due to the data and parallel network that these BNPL platforms own, they’ve become good at driving traffic for businesses: an extra value-add to justify high Merchant Discount Rates (or MDRs, the percentage charged to merchants as processing fee for payment services opted by them).
We can imagine the “BNPL flywheel” as something like this:
It is useful at this stage to draw a comparison with how credit card transactions work and how the economics of typical credit card networks are very different from the one of BNPL products.
In the picture below, you can follow the flow of funds of a credit card transaction, where the actors involved are many:
- the cardholder,
- the merchant,
- the Acquirer Bank,
- the credit card payments processor (in this example, VISA),
- the Issuer Bank.
As it is evident by this diagram, the bulk of the fees go to Issuer Bank in the so-called interchange fee.
Effectively, BNPL as a model equates to building an orthogonal set of payment rails that skip issuing bank, payment card processor and merchant acquirer bank.
It’s a win-win-win situation for merchant, consumer and product manufacturers.
As Alex Rampell, General Partner at American venture vapital firm Andreessen Horowitz, puts it, right now this is a “customized financing carrot” put in front of a buyer, but with time these extra rails can be used for “discount carrot”, “warranty carrot”, “rewards carrot”, in direct partnerships with the manufacturers.
The classic Visa and MasterCard system based on open-loop payments proved to be one of the greatest network effects of all time. At this stage, the raise of BNPL providers and mobile wallets is challenging that model and creating the first market-based (not regulation-based) cracks in the fortress.
Why? Because of data.
A massive advantage of BNPL providers is that they retain the data across all the steps of a payment transaction.
While credit card providers and the middlemen listed above don’t know anything about a consumer’s transaction, BNPL providers have all the details, right down to the product that was purchased, its color, its size, its brand. Just think that credit card systems are so obsolete that typically do not even cater for an adequate number of characters to properly describe a transaction.
Usage of data helps BNPL companies in at least 3 key ways:
- improving their risk models leveraging ML-based techniques,
- giving a full understanding of the customer purchases,
- providing them with an opportunity for revenue increase through lead generation.
BNPL is creating the real possibility for product manufacturers to avoid entirely the established payment rails (ie typical credit cards) and new MDRs are getting set by BNPL providers.
Of course, growth potential for BNPL is massive which is why FinTech giants like Square and PayPal, as well as traditional banking players, have jumped on the bandwagon.
Risks and threats of BNPL
So far, we have discussed the reasons why BNPL has rapidly increased in popularity and why this new industry has seen a large amount of FinTechs entering the space.
However, a serious discussion on the BNPL model calls for a review of the risks that this industry attracts.
Let’s start.
1. Understanding of financial commitment by the buyer
Because of the frictionless nature of the BNPL experience, users might forget that this is, in all practicalities, a loan that they are requesting.
55% of users admit to spending more than they usually would when they can use BNPL, and this is often on non-essential items. BNPL services are debts on top of credit cards, home mortgages, car loans etc.
The more BNPL services consumers sign up to, the more debts they are adding to their portfolio. This increases the likelihood they will lose control of their debt management.
The latest report by Credit Karma shows that younger consumers are more likely to miss payments. More than half of Gen Z or millennial respondents – those born between the early 1980s and mid-to-late 1990s – said they had missed at least one payment.
2. Late payment fees add up
A non-so-transparent aspect of BNPL providers, which is already under scrutiny of regulators in a few countries, is the lack of clarity with which late payment fees are advertised – or perhaps we should say, not advertised.
For some BNPL providers, such fees are significantly higher than late payments fees on credit cards. The more BNPL services individuals use, the harder it is for them to keep track of spending and repayments. Individuals may even forget that they have a payment due when they sign up to too many providers.
In this article, Janek Ratnatunga, Australian CEO of the Institute of Certified Management Accountants, provides a quantitative view of why those who struggle to pay off their debts within the repayment schedule could be better off making purchases on a credit card than with BNPL. He uses AfterPay as a case study, but the principles are applicable to all major BNPL providers across the globe.
It is reasonable to assume that most of the users of BNPL services are to be found amongst youngest buyers who are not experienced at managing their finances very tight – as Prof Ratnatunga explain we might be well sitting on a time bomb (“Unfortunately, being digital-savvy does not often equate to being financially savvy”).
3. Regulation is insufficient
In Australia, because BNPL providers don’t charge interest, they aren’t regulated under the National Credit Code as credit cards and payday loans are. Nor do they have to comply with the responsible-lending and financial-hardship regulations that come with the Code.
The industry is subject to ASIC’s (Australian Securities and Investments Commission) intervention powers, and the Australian Competition and Consumer Commission (ACCC) has previously written to merchants expressing its concerns about surcharges on BNPL transactions.
According to an ASIC report, 21% of BNPL consumers missed repayments in the preceding 12 months and incurred late fees. Eight BNPL providers, representing 95% of the market, have signed to a voluntary code of conduct, which came into effect in March 2021.
Most suspect this might not be enough to protect the weakest consumers.
In the UK, at the beginning of 2021, the Financial Conduct Authority (FCA) stated that ‘billions of pounds were being lent in unregulated transactions’ and that more than 10% of consumers who had used a BNPL option were already overdue. The British government has communicated that a legislation will be tabled as soon as parliamentary time allows, and it’s been said that it may take two or more years for the law to change.
In the USA, as we can read in the Credit Karma studied mentioned earlier, 40% of US consumers who used BNPL have missed more than one payment, and 72% of those saw their credit score decline.
Fitting BNPL into the US regulations is relatively challenging since laws vary by state. Overall, BNPL schemes are regulated by federal and state laws under consumer credit regimes, depending on the different definitions of credit covered by those laws.
4. There is an impact on Credit Scoring system
“Just like any debt, if you don’t pay, it is likely to affect your credit score and that’s because if you don’t pay it and the company decides to record that with a credit reporting bureau as a default, then that will affect your credit score” says Fiona Guthrie, the CEO of Financial Counselling Australia.
While not all BNPL providers use the credit reporting system, people can be refused a home loan or a car loan if their capacity to repay is limited due to existing multiple Buy Now Pay Later commitments or other loans. As we just saw, in the USA over two thirds of BNPL users have already seen their credit score getting negatively affected.
In a recent report, Fitch Ratings said the sector’s debt performance reporting is “opaque.” Many BNPL providers do not report the use of such services to credit bureaus, the ratings provider said.
“Consequently, BNPL debt is often not visible on the credit file and borrowers could try to get BNPL credit from multiple providers” Fitch analysts wrote.
“Lenders (including non-BNPL) could underestimate a borrower’s debt level when underwriting new debt.”
Findings by the Australian Securities and Investment Commission in November 2020 showed that 15% of Australian consumers using such pay-later schemes had to take out an additional loan in the previous year to pay off their BNPL plan on time.
5. Merchants also face risks
But there are not just risks for the consumers.
In a report from last year, Equifax identifies at least two major risks for merchants:
- merchant default risk: merchants that work with BNPL providers can close their business without notice. If the trader owes funds to his partners then problems arise;
- merchant fraud risk: illegitimate merchants can send false orders using real or fictitious consumer Personally Identifiable Information (PII) and collect payment for ‘sold’ but not shipped products. The BNPL provider ends up holding the bag without anyone to go to for a refund.
Most of the major BNPL providers have been quite active in addressing some of the key risks we mentioned above.
When lending becomes too easy, in fact, we can often see troubles at the horizon.
The answer is, once again, Artificial Intelligence and Machine Learning techniques.
Thanks to the massive datasets these new players have access to, they have the ability to build extremely sophisticated risk modelling tools and only issue credit to actors that are worthy of it. This data is not normally accessible to credit scoring companies, hence BNPL products can potentially give a more accurate picture.
Credit decisioning based on data collected from both merchants and consumers becomes then of paramount importance.
Max Levchin has, once again, expressed his views clearly, highlighting how Affirm’s business model is tightly interconnected with the financial health of their customers:
“If you don’t charge late fees, don’t do deferred interest, don’t sort of “gotcha” into paying you a little extra, you are fundamentally aligned with the consumer. If they can’t pay you, are late, are delinquent, go into default state, we [Affirm] are going to make no money”.
Other BNPL providers follow a similar approach.
Conclusive Thoughts
I have no doubt that BNPL products are here to stay. They represent the next form of credit issuing for retail purchases, they are designed for a digital native audience and they generally offer a customer experience which is light years superior to plastic credit cards and obsolete credit technology.
BNPL products represent a decisive shift from the more traditional credit card networks. Those platforms originated in the 70s, have seen massive adoption over the decades but displayed a very low rate of innovation overtime. If anything, BNPL is putting some pressure on the well established oligopolies of the Visas and MasterCards of the world.
Skeptics raise a valid point though. BNPL products are to money what social media networks are to attention: they want to make it easy for you to waste it.
These products are designed to let consumers make impulse decisions in a frictionless fashion. They are an insidious threat for people that are already struggling to keep their debt commitments manageable.
In an economic downturn scenario, assuming rising inflation and rising interest rates, a widespread usage of BNPL services might also contribute to a systemic risk whose consequences are not easily understood at this stage.
Will they ultimately turn out to be a positive outcome for the buyers and what impact will they eventually have on the overall economic system?
References
- The global phenomenon of Buy Now Pay Later – Fincog
- Buy Now Pay Later, Regulations and Risks
- Australia takes the lead in Buy Now Pay Later regulation
- Does Buy Now Pay Later need tighter regulation?