Over the last few years, the growth of ‘buy now, pay later’ (BNPL) services has been exceptional. This niche product, finding itself conveniently at the intersection of the burgeoning digital payments and e-commerce spheres, and appealing to a new generation of spenders more comfortable with technology and less concerned about privacy than their predecessors, has gathered a momentum akin to an unstoppable wave.
Indeed, one of the largest BNPL providers, Sweden-based Klarna Bank AB, a subsidiary of Klarna Holdings AB, which has been described as ‘Europe’s largest start-up’, raised an additional US$1 billion in financing at the end of February 2021. It boasts 90 million customers worldwide, and its operations in the United States recently exceeded those in Germany, its second-largest market. Two other major BNPL providers, US-based Affirm Holdings, and Australia-based Afterpay Limited, have also shown phenomenal growth. (Klarna is still privately-held, while Affirm and Afterpay are publicly-traded.) All are active outside their home countries, either under their own name or other names. Established payment providers, such as large commercial banks and PayPal, are also entering this space.
In Southeast Asia, several BNPL providers have sprung up just in the last few years, such as Bill Ease, Jungle, and Tendo Pay in the Philippines and Razer, hoolah, Atome, Rely, Split and OctiFi in Singapore. Pine Labs, an Indian company, has recently partnered with Mastercard on a scheme called ‘Pay Later’, envisioned eventually to cover all of ASEAN. Malaysian provider Pace Now Enterprise plans to serve customers in Thailand and Singapore as well as in its home market. The Southeast Asian ‘super-apps’, such as Grab and Shopee, also offer BNPL options in a limited way to their customers.
What is it about BNPL that is so appealing to consumers, investors, and merchants alike? Is it truly a ‘disruptor’, which over time will displace credit and debit cards as means of retail payment, not only online but also in ‘brick and mortar’ stores? And what are the concerns, if any, for financial stability and consumer protection? Is there room for prudential as well as consumer protection regulations? This blog post attempts to answer these questions, as well as describe some interesting features of this booming market that may not be readily apparent from newspaper and magazine articles.
BNPL: A Primer
‘Buy now, pay later’ schemes allow consumers to obtain goods and services now while stretching out payments in installments over a pre-arranged period of time. The period of time can vary considerably, from 30 days to 4 years. Generally, the option to pay in installments is provided ‘free’ to the consumer; that is, without the payment of interest, although interest is charged to the customer in some arrangements.
When a customer makes a purchase, either in-store or online, the BNPL provider makes an immediate payment for the full amount to the merchant. Subsequently, the customer makes the installment payment to the BNPL provider. These installment payments may be automatically drawn from a customer’s bank account, or the amounts could be charged to a customer’s credit or debit card. (It’s not immediately clear why any customer would want to set up this arrangement, if the typical motivation of a BNPL customer is to avoid using credit or debit cards. Moreover, at least one credit card provider, CapitalOne in the United States, prohibits its cardholders from linking to BNPL providers.) These actions create something resembling a loan agreement between the BNPL provider (the creditor) and the customer (the obligor). This loan agreement may be retained by the BNPL provider, or it may be securitised and sold to third-party investors.
For its part, the merchant pays the BNPL provider a fee, generally ranging between 2 and 8 per cent of the purchase amount. These merchant fees typically provide the bulk of BNPL providers’ revenue: 69 per cent in the most recent period for Klarna and 51 per cent in the most recent period for Affirm. (Afterpay’s published data do not permit a similar calculation.)
BNPL programs had already achieved popularity before the COVID-19 pandemic struck, with a steadily rising trend of e-commerce and smartphone payments. The pandemic has accelerated this trend, along with even stronger demand for e-commerce and other forms of cashless and remote payment. Uptake of this payment mechanism has been most pronounced among people aged 40 and younger, especially among those without established credit histories.
As a part of their risk management activities, BNPL providers say they conduct credit checks on both customers and merchants before onboarding them. On consumers, credit checks are conducted using proprietary algorithms and alternative data, rather than accessing public credit registries or private credit bureaus, which are unlikely to possess information on the (mostly young) targeted customers. On merchants, BNPL providers use both external credit registry or credit bureau data, supplemented by internal data.
It may not be immediately obvious why BNPL providers conduct credit checks on their merchants. There is, of course, a reputation risk to the BNPL provider if dishonest merchants selling shoddy or overpriced merchandise are on the platform, alienating customers. More important than that, however, is the underlying mechanism involving customer returns. BNPL providers typically guarantee that the customer’s already-paid installment(s) will be refunded, and the unpaid installment obligations canceled, if a product is returned. If a BNPL provider has a continuous relationship with a merchant, the monies refunded to customers in a particular reconciliation period are simply subtracted in the calculation of the net amount owed by the BNPL provider to the merchant. But this process does not work if the merchant has gone out of business. There is no company to which the customer can return the merchandise, and no company from which the BNPL provider can subtract the monies refunded in the process of reconciliation.
The range of products for which BNPL purchases are popular is vast, but the payment mechanism is most common for consumer electronics and health and beauty products. The product range is widening all the time, however: some BNPL providers cover health care expenses, and experiments are underway for using BNPL to settle utility bills, which can be quite large for certain customers, especially in jurisdictions where utility consumption is heavily taxed.
Keeping the above analysis in mind, we may characterise the essence of a BNPL program as the following:
- Allowing a customer to pay for a good or service over time is another way for a merchant to give some customers a discount on that good or service without actually lowering the price for all customers. The cost of the discount to the merchant, and the value of this discount to the consumer, goes up with increases in the level of market interest rates. At times when interest rates are near zero or negative, merchants may benefit substantially.
- It is administratively costly, and perhaps detrimental to cash flow, for a merchant to operate a BNPL scheme on its own. Therefore, ‘outsourcing’ this task to the BNPL provider is a convenient solution. The merchant receives its money up front, and the BNPL provider handles all of the administration and debt collection tasks, as well as the credit risk of customer nonrepayment.
Risks of BNPL schemes to the consumer
At first glance, customer obligations to BNPL providers do not seem to pose any greater risk than other kinds of household debt, such as credit cards or unsecured personal loans obtained from banks for miscellaneous expenses. On the national level, in jurisdictions where aggregate household debt as a percentage of GDP is still within reasonable levels, the addition of a sliver of additional household debt is probably no cause for concern. On the individual level, however, there are concerns of possible overindebtedness, especially among young and inexperienced users, as well as missed payments resulting in late charges and declining credit scores.
Indeed, as reported in a recent survey, 40 per cent of US customers have missed at least two payments, and 72 per cent of these customers have seen their credit scores decline. (Not all BNPL providers report late payments to credit registries or credit bureaus.) Similar results have been reported in other countries. Another problem for the less financially-literate consumers is overdraft fees charged by banks when BNPL payments are automatically drawn from a consumer’s account without sufficient funds. These overdraft fees have caused significant hardship for some customers. Some consumers even sign up with multiple BNPL providers, evading spending caps, caps on accumulated late fees, and blocks on additional purchases when payments are missed, in order to keep on spending.
What’s more, customers have even reported falling behind in servicing other debt, such as car loans or mortgage loans, in order to keep BNPL obligations current. Customers with spotless BNPL records can obtain benefits, such as discounts on certain products, which sometimes leads to perverse outcomes when these minor benefits can’t completely offset the major drawbacks of going into delinquency on loans that are actually reported to credit registries and bureaus.
Consumers appear to be at least somewhat aware of these risks, and some of them even enjoy features on BNPL apps that track their total spending against budgets, promoting financial responsibility. Avoiding actual or perceived high credit card fees or interest charges is also a motivation to use BNPL services for some customers, evincing another dimension of thriftiness.
It should be apparent from the preceding paragraphs that financial literacy is key, and financial education promoting literacy, whether provided by the BNPL firms themselves or by other entities such as non-profits or regulatory authorities, will be an important component of responsible BNPL usage for young and old for years to come.
On a more esoteric level, some customers (and regulators) may be concerned about how the BNPL providers are using personal data. It’s no secret that BNPL providers accumulate a large amount of data on individual shoppers –- amounts spent, goods purchased, timing of purchases –- that are valuable to merchants in targeting specific customers with advertisements and discounts appealing to them. When the data directly obtained from purchases are combined with data that the BNPL providers are accessing to perform their own credit scoring, a complete profile of a consumer can be developed and sold. To what extent are customers aware that this is happening, and have they provided informed consent?
Risks of BNPL schemes to the providers
Enumerating the risks to BNPL providers is relatively straightforward –- in fact, the three main global providers, all publicly-traded, do this themselves in their required securities filings. Similar to banks, BNPL providers are subject to credit risks, liquidity risks, and operational risks. Their proprietary scoring models may be subject to model risk, and even the risk that they may not now, or no longer in the future, be authorised to use the data that run the models. They may also be subject to reputation risks if the general public perceives them as preying on young or less financially-literate consumers.
Of the three main global providers, Affirm operates with a strikingly different business model and is subject to different risks. Affirm has some characteristics of an investment bank. It has two partner banks, both FDIC-insured deposit-taking institutions in the United States, who actually fund the loans made by Affirm to consumers after Affirm approves the loans. Affirm often on-sells the loans to investment banks for securitisation, retaining the servicing, and sometimes even buys loans to add to their loan packages for sale. All of these activities subject Affirm to liquidity risk, if they are unable to sell the loans they have acquired from their partner banks or purchased in the open market.
All three main providers report risks of intensified competition, as the activity of providing BPNL faces few barriers to entry and is easily scalable. One risk mentioned specifically by Affirm is the risk that not enough bespoke sales personnel, data scientists, and engineers will be available at affordable salaries to accommodate its ambitions for growth. Affirm also reports concentration risk in a large percentage of their transactions taking place with a single merchant (a supplier of home fitness equipment, demand for which has soared during the pandemic). Afterpay, for its part, worries about its technology not interoperating with third-party platforms and point-of-sale systems that merchants may prefer in the future.
It is clear that these risks are company-specific and not systemic. No one thinks that BPNL services are a vital component of the payment system in any jurisdiction or that the failure of any one of these firms would cause irreparable harm to customers or merchants.
Regulatory approaches to BNPL
Regulators in different countries are taking notice of the rapid growth in BNPL activity. Over the past year, the Financial Conduct Authority in the United Kingdom, the Australian Securities and Investments Commission (ASIC), and the Monetary Authority of Singapore have all announced their intent to develop what they view as the most appropriate form of regulation for this activity. Regulators have cited concerns over transparency, customer suitability, customer overindebtedness, and treating customers fairly. ASIC is investigating the possibility that merchants are marking up the prices for customers selecting the BNPL option for payment, although BNPL providers prohibit that practice. In the United States, the Consumer Financial Protection Bureau regulates all types of lending from a disclosure and transparency standpoint, but it has not specifically focused on BNPL providers. Finally, no regulatory authority seems to be concerned, at least not yet, about financial stability or money laundering risks.
An intriguing experiment in self-regulation has recently commenced in Australia. In March 2021, the Australian Finance Industry Association. (AFIA) released a ‘Code of Practice for Buy Now Pay Later Providers‘. Compliance with the Code is enforced by means of a detailed Terms of Reference and By-Laws, and only providers in compliance will be allowed to advertise themselves as Code Compliant Members. Adherence is legally enforceable, in the sense that violators who still portray themselves as compliant can be subject to civil action.
The Code is principles-based, and focuses on customer outcomes, which is the emerging philosophy of customer protection in the financial services industry of the 2020s. It is organised around nine pledges to the consumer to:
- Focus on customers, especially the most vulnerable
- Be fair, honest, and ethical
- Keep you properly informed about our product and service
- Make sure our BNPL product or service is suitable for you
- Undertake an ongoing review of suitability of our products or services
- Deal fairly with complaints
- Offer financial hardship assistance
- Comply with our legal and industry obligations
- Support and promote this Code.
Central banks and regulatory authorities in other jurisdictions may elect to work with the industry to develop self-regulatory mechanisms in the same manner as ASIC has worked with AFIA in Australia.
‘Buy now, pay later’ schemes represent a new twist on a very old practice of ‘merchant credit’. They blend technology and payments to satisfy the urges of instant gratification among (mostly) young consumers. But do they represent a ‘disruption’ of the credit and debit card industry, which is already being viewed as a dinosaur and ‘last century’ by the younger generations? The evidence is not in. So far, BNPL is being used mainly for small purchases, paid over short periods of time, and as a means by which merchants can offer ‘discounts’ to some consumers without offering them to all. BNPL carries the stigma of ‘impulse purchases’ and rampant consumerism, at a time when a cultural shift may be occurring as the world emerges from the pandemic’s grip: households may be adjusting to a slower way of life and an emphasis on experiences rather than the accumulation of things. Nevertheless, regulators, the industry, and consumers themselves should be cautious, and should promote responsible use, transparency, and guardrails.