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Introduction

The word Fintech (Financial Technology) is the buzzword for the covid era. Almost every single company wants to become a fintech because companies understand that the way to monetize the relationships that they have with their customers is through payments. But come Q2 of 2022, times have changed. The gains that fintech startups had during covid are gone, in fact, the slump is even bigger.

In today’s essay, I want to talk about what this changing landscape means to the BNPL business and what the future looks like. A key highlight for my Product Management friends is the network effect that BNPL brings and I will explain in detail about how this network effect is built. Most of the essay will be centered around Buy Now Pay Later (BNPL) and focus on companies that support the BNPL model as their bread and butter income. This essay will not touch upon other facets (outside of BNPL) of the fintech industry.

In recent days, especially since Apple launched Buy Now, Pay Later (BNPL) feature you must have surely heard about names like Klarna, Affirm, Afterpay, PayPal’s BNPL launch, etc. With this much said, let me start by explaining what is BNPL and how these companies make money.

What is BNPL

Buy Now Pay Later (BNPL) firms have created one of the fastest-growing segments in consumer finance, with transaction volumes hitting $120 billion in 2021 up from just $33 billion in 2019, according to GlobalData. BNPL is an innovative and fast-growing segment of the fintech market. Globally BNPL is projected to account for $680 billion in transactions by 2025 (representing 12% of all eCommerce sales on goods, where BNPL is currently concentrated).

Buy now, pay later arrangements are point-of-sale installment loans that allow consumers to make purchases and pay for them at a future date. Consumers typically make an upfront payment toward the purchase, then pay the remainder off in a predetermined number of installments. Buy now, pay later plans often don’t charge interest and are often easier to get approved for than traditional credit cards or lines of credit are. Normally BNPL does not affect your credit score.

BNPL has set itself apart from credit card companies by offering short loans with no interest or fees, unlike credit cards. They don’t run hard credit checks before issuing a loan. And in many cases, BNPL companies aren’t the lenders themselves—they offer technology services but rely on bank partners for the loans.

How BNPL Makes Money

The BNPL business model emerged out of a very low-interest-rate environment which enabled BNPL firms to raise funds at a relatively low cost and offer point-of-sale loans to customers on online shopping websites. Consumers pay for their purchases in installments over a period of weeks or months, usually interest-free, and BNPL firms charge online retailers a fee for each transaction.

The model proved popular among young consumers during the COVID-19 pandemic as e-commerce volumes soared, with Buy Now Pay Later transactions accounting for 2% of transactions in e-commerce last year, according to GlobalData.

The value proposition for buyers is to increase the affordability of expensive products and provide a loan at zero percent or a low single-digit percentage. If a buyer misses the payment they have to pay back interest on the loan depending on the creditworthiness of the buyer. Similar to what happens in the credit card world if you miss a payment.

Sellers are the main source of income for all BNPL companies. The value proposition for sellers is an increase in sales revenue by enabling the buyer to purchase products that they would otherwise have left due to a higher price tag. To enable this value prop for the sellers, BNPL companies usually charge between 4 to 9.5% of the product selling price or total sales. Credit card companies usually charge between 2 to 4%. Despite high fees and APRs it is the network effect that convinces merchants and customers join the platform and continue to use it. Let’s see how.

Network Effect and BNPL

Visa and Mastercard thrive on the network effect. They sit in the middle of banks, consumers and merchants. Everyone in this loop benefits from each other. Visa and Mastercard collect a network fee from the merchants and pay an interchange fee to the bank.

BNPL companies sit between consumers and merchants and do not have quite a strong network effect as they do not have a direct relationship with the banks. BNPL creates a two-sided network effect.

This is where the concept of super apps becomes very interesting. Let me explain this with PayPal. PayPal originally start with a product for merchants to enable easy payments for merchants from anywhere. PayPal then bought Venmo enabling consumers to pay each other. It is a great product and easy to use. Venmo also has its own network effect. Where PayPal needs to do a better job is enabling money transfers between Venmo and PayPal. I am pretty sure that is going to happen soon. Like Square has done with CashApp

PayPal also has a BNPL offering which they started in the first half of this year. BNPL will enhance the already existing relationship PayPal has with merchants which it built over the years (since its inception). Once customers are able to share the balance between Venmo and PayPal accounts, this provides customers with an option to use money in (PayPal + Venmo Bank) to be used for monthly Payments with BNPL.

Problems with Startup BNPL Companies

I want to make sure that readers understand that the problems illustrated below are applicable to startups in the BNPL space. There are legacy banks that are and in the future may operate as BNPL. Most of these problems will not affect them. I will explain why that will happen with each scenario and problem.

The model is simple to implement and understand but there is a lot of economic and financial risk associated with the BNPL model.

Problem 1: Delinquencies

BNPL company is lending to one of the riskiest and most poor credit quality groups of people. In the first quarter of 2022, Affirm had 12.7M customers and provided $3.9B in loans. 2/3rd of the population buying with BNPL are considered subprime. According to Lending Tree, 42% of consumers who’ve taken out a buy now, pay later loan have made a late payment on one of those loans. How is that a problem for BNPL companies you will ask, ANSWER: SECURITIZATION of these subprime loans.

Securitization of Tranches

Let me explain this with an example using Affirm. Affirm issue the loans, package the loans, and sell them to a group of investors (i.e., securitization). This allows them to (1) not hold the risk on their balance sheet, and (2) increase the volume of loans issued as they re-use the liquidity derived from the sale to issue more loans, and repeat. The majority of the risk is thus transferred to the buyers of these deals, but AFRM still retains an “equity tranche”.

Basically, securitization is a form of financing for the company, which also means that the higher the interest they have to pay on the securitization tranches, the lower their net interest margin and thus the higher pressure on their overall profitability. As the number of loans, fees, and interest increases, the quality of such deals steadily decline. This is evident from loans with an average interest of 18% and with an average FICO of 690. In 2021, the average interest passed 20% and FICO went below 686. In 2022 deterioration has accelerated: the average interest rate in the latest securitization is 22% and the average FICO is 668.

This credit quality deterioration leaves a much riskier balance sheet and loan pool, which is one of the many reasons the BNPL business model appears unsustainable.

Problem 2: Accidental explosion is over

BNPL companies started out in places like Australia and Scandinavia, and they’ve been kind of growing momentum over the years. They came to the U.S. largely around 2015. But the critical mass moment just as the pandemic started. They were starting to be taken up by larger and larger companies, eventually places like Amazon and Walmart, and Target, which exposed them to a lot more people. And this happened just as a lot of lockdowns were happening, and a lot of people were turning to the internet and online shopping as a form of retail therapy or just a place to find basic essentials as they scrambled to figure out how to work from home.

BNPL rode this huge explosion in online shopping that’s happened over the years since the pandemic started. It just became a new, ever-more-convenient way for people to do their online shopping. Retail sales held up pretty well in the first half of the year, even accounting for inflation’s impact on the numbers. But with consumers spending more on food, gas, and experiences instead of discretionary goods, it’s not clear how retail will do in the second half. Lower spending means lower income for already revenue-stressed companies

Problem 3: Regulations – Bane for startups but a boon to banks

The intention behind the regulation is to enforce responsible lending practices, benefiting and protecting the economy as a whole from untrackable debt accumulation. Right now the sector is unregulated, and half of the British adults who have a BNPL loan said they found it difficult to keep up with household bills and credit repayments, according to a survey by debt charity StepChange. UK government’s plan, announced on June 21, requires lenders to carry out affordability checks on people using BNPL, to make sure they can afford the loans they take out.

BNPL is sending the TikTok generation into the debt spiral. This unsettling report shows how 43% of BNPL users are missing their payments. Here are a few regulations that BNPL vendors will have to adhere to:

1. BNPL providers will need to report to the credit bureaus
2. Contractual terms will be more transparent and fair
3. Mandatory credit checks in the loan journey

Regulation will raise the barriers to entry, closing the doors to smaller BNPL providers. While the big fintech won’t be shut out of the market, the industry will definitely have greater barriers to entry. Consumers tend to gravitate toward brands that they are familiar with and trust. When choosing to use a BNPL option, they are more likely to opt for a solution that is backed by a reputable financial institution.

Entry of Apple and Super Apps

Apple

Coming to Apple, the network effect this company enjoys is unbeatable. The Apple ecosystem is such a great experience for users that it enables Apple to sell multiple devices to the same person just to live and enjoy this ecosystem.

Apple’s entry into the banking world was in 2019 with the introduction of a credit card. Apple not only wanted to be the recipient of your money, it wanted to have a hand in how you manage that money. So it was not a surprise for Apple to jump on the latest payment trend. In WWDC, this year along with other critical launches, Apple introduced BNPL for its apple pay users. This will tap into its existing Apple Pay service for in-app and online purchases, and let iPhone users in the US pay for things in installments—with no fees and zero interest—over six weeks.

Apple has integrated the app store, social, entertainment, and payments into a super app service for its users. With iMessage and FaceTime, it already has a strong position in social networking. Apple Pay Integration not just makes regular payments but also manages subscriptions for apps that you bought via App Store.

Super Apps

Apple’s model provides a very interesting opportunity for companies that offer super apps. The image below shows the super apps available in North America.

With increased product offerings and access to both merchants and consumers, many of these players are laying the groundwork required to be a “super app.” Asian markets have trailblazed this category: Alipay and WeChat Pay are prime examples of successful “super apps.” 

In order to succeed, “super app” competitors must meet a handful of conditions to successfully scale and consistently engage consumers:

1. Scale: Dominant scale across consumers both AND merchants
2. Behavior: Highly habitual and interactive behavior within the app
3. Functionality: Platform must natively incorporate commerce and payments

Players that have historically operated in financial services (e.g., PayPal, Square) with high consumer engagement are expanding and bundling additional commerce functionality into their offerings. Similarly, players that have operated as leading commerce platforms (e.g., Amazon, Shopify, Walmart) are looking to more tightly integrate financial services as part of a broader experience.

Conclusion

SEBASTIAN SIEMIATKOWSKI, CEO, and co-founder of Klarna describes Apple’s decision to offer its own BNPL product as validation of Klarna’s concept. What this says to me is that the competition is coming from existing companies. Legacy banks with trust from the consumers will have an easy entry into the market. Apple’s entry into the BNPL market has shown, that integrating BNPL features in the technology is not difficult.

The slump within startups in the BNPL market is concerning. Especially Klarna which has gone down from $46B in valuation to $6.5B. The same goes for Affirm which has lost 80% since the beginning of 2022. Delinquency and securitization of loans is a real concern and will impact if regulations are not strengthened in this direction.

Having said this I feel, the BNPL concept is here to stay and will continue to grow towards 12% market capture for all e-commerce transactions by 2025. I also believe legacy and big tech companies have an advantage in this space, even though they started late. The super app model is all about tech integration which companies like Apple and Google can perform easily.

Cheers