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“Buy Now, Pay Later” and the Coming “Closed Loop”

This is part of an on-going series exploring the “buy now, pay later” (BNPL) space.

Part 1 “Buy Now Pay Later” and What Might Be Coming Next discusses why BNPL adoption is likely to surprise to the upside…and why BNPL must ultimately merge with commerce to survive.

This is Part 2.

Part 2 “Buy Now, Pay Later” and the Coming “Closed Loop” discusses Square’s acquisition of Afterpay…and why BNPL is a credible threat to the current payment network landscape.

Part 3 How Shifting Consumer Preferences Could Threaten “Buy Now, Pay Later” explores how shifting consumer preferences could lead to a showdown between BNPL and subscription services…and why subscriptions might win out.

In 6 months, Capital Flywheels will turn 5.

While I’m not really sure what I expected when I began this journey / project, I’m happy that it hasn’t turned out to be a complete failure…

Perhaps, the most surprising thing so far is that Capital Flywheels’ most popular post by far (and I really mean, by far) has been “Buy Now, Pay Later” and What Might be Coming Next published almost a year ago in late 2020.

When I sat down to write that post, I thought I had something interesting to say, but I didn’t think it would be by far the most interesting thing I’ve ever written.

I always thought any of the following were just as worthy of the crown, too:

  • Emerging E-Commerce Franchises / Sea Limited – A piece where I discuss the hidden potential of Sea (with a worthy mention of Mercadolibre) and why it deserves as much attention as Amazon and Alibaba…before the stock’s massive ~10x run.

The reason I found the popularity of “Buy Now, Pay Later” and What Might be Coming Next surprising is because the post specifically argues that (standalone) BNPL has no future!

For a blog focused optimistically on the future, I found it surprising that my most pessimistic post about an emerging area of technology / finance / commerce would also become the most popular of all.

The post argued that BNPL has no future as a standalone business because it will be consumed by the players that control the platforms / verticals such as Square and Shopify:

What I think is worth speaking more about is how the BNPL space may potentially evolve in the future, and why I believe BNPL players will need to evolve in order to remain relevant.

As Capital Flywheels wrote recently in Square, Fintechs, and Our Changing Economy, banks and traditional credit channels are being dis-intermediated. While all fintechs are currently benefiting from this dis-intermediation, the long-term changing structure of our economy will not lead all fintechs to success. Capital Flywheels firmly believes that the realm and domain of credit will solidly belong to the digital players that control the verticals. 

For example, Square’s control over restaurants and SMEs mean they will be better positioned to offer credit to these merchants than any standalone fintech player. For example, Shopify’s control over e-commerce SMEs mean they will be better positioned to offer credit to their merchants as well.

…

Currently, in western markets, you have to partner with a BNPL player to offer consumers BNPL payment options. However, it’s not inconceivable that BNPL will also eventually be offered as an option by western merchant acquirers since they ultimately control the point of checkout.

Source: “Buy Now, Pay Later” and What Might be Coming Next

In addition, the post further argued that a merchant-centric strategy will eventually give way to a consumer-centric strategy with digital wallets like Cash App in the driver seat:

This is important because while BNPL players are mostly fighting to lock-up merchants, the most important battle is actually to lock up the consumer. While merchants can choose to offer installments or not, the choice is ultimately up to the consumer. Hence controlling the consumer decision is monumentally more important than controlling the merchant.

…

Mercadolibre has effectively allowed their consumers to do installment payments regardless of what options the merchant offers.

And this is doubly more problematic for merchant acquirers that only control the merchant side of the equation because Mercadolibre also controls the most dominant e-wallet in the region, MercadoPago. 

This means that Mercadolibre not only influences consumer decisions on its e-commerce platform in a way that merchant acquirers may struggle to match, MercadoPago e-wallet extends that influence and control to effectively every merchant in the region, online and offline. 

Sea is already quickly executing on a similar strategy in Southeast Asia. And platforms like Shopify already have similar power as well even if their positioning in the value chain is slightly different, but still more powerful than the credit / BNPL player all the same. This is a power that Square’s Cash App will eventually have as well.

Source: “Buy Now, Pay Later” and What Might be Coming Next

Square’s recent high-profile acquisition of Afterpay seems to validate a lot of those arguments.

But what’s most interesting about how this has all gone down is that out of all the potential suitors for Afterpay, Square is one of the only players that can bring together both sides of the equation – both the merchant / POS side as well as the consumer / digital wallet side.

The only other players that could have been similarly situated are PayPal and Shopify (given the increasing momentum of the Shop app…essentially a digital wallet). Outside of this select group, almost all other potential suitors only have one side of the equation (e.g. merchant acquiring / POS but not digital wallet).

And, not surprisingly, this is a key strategic rationale highlighted by Square when announcing the transaction.

On the Seller side, being able to offer BNPL is good for Square’s merchants because BNPL has proven to be high ROI for merchants as well as an excellent way to expose merchants to new, incremental customers (in a way, BNPL works kind of like advertising).

And for Afterpay, this is an excellent outcome because it removes one of the most vexing bottlenecks for the business. Afterpay’s business model requires them directly going to merchants and signing them up…but Square already has a lot of merchant relationships and can turn on BNPL with the flip of a switch!

One aspect of Afterpay that I find under discussed is the general similarities of the selling process vs other merchant acquirers but the greater (historical) challenge of convincing merchants to accept BNPL in addition to card payments. Afterpay basically has to go through a similar process as every other merchant acquirer, but merchant receptivity historically has been very different.

Merchants understand why they should accept debit / credit cards. But BNPL is not a product that merchants historically have had much experience with. Being able to sell BNPL to merchants alongside what Square already offers in terms of card payment / payment scheme acceptance should dramatically increase the efficiency of the selling process.

And then on the Cash App side, this is great for Square because it not only creates another high-value, high-frequency use case (alongside P2P payments, banking, and investing), it also meshes very well with the demographics where they are strong in (younger + underbanked consumers).

For Afterpay, this is also a huge win because Cash App integration brings a lot of consumers that will be more likely to use BNPL. Part of what Afterpay does isn’t just getting merchants to accept BNPL, they also have to find consumers that want to use that over all the other available payment methods out there. If the consumer doesn’t choose the BNPL payment option over cards at the point of checkout, wide merchant adoption alone doesn’t amount to anything.

Source: Square

If that was all there was to it, that would be interesting enough!

But what I find most fascinating is this specific slide:

Square not only says that Afterpay has a role to play in the Seller ecosystem and the Cash App ecosystem. Square says Afterpay has an important role to play in connecting these two ecosystems.

The Quest for the Holy Grail – A Closed Loop Ecosystem

While I’ve seen many posts highlight this specific point about connecting the Seller and Cash App ecosystems, most people seem to think of it akin to a traditional marketplace two-sided network effect.

For example, Amazon is a two-sided network that connects consumers and merchants. The more consumers there are, the more merchants sign on. The more merchants there are, the more products are listed, which brings even more consumers.

Similarly, most people seem to view the connection between Seller and Cash App the same way: The more sellers that accept BNPL, the more people will sign up for Cash App and pay with BNPL. The more people paying with BNPL via Cash App, the more merchants will sign up.

Looks something like this:

Source: CGAP

This is indeed a beautiful flywheel for Square.

But I think it can potentially go further than that.

Having analyzed fintech and payment businesses around the world for many years, this deal marks one of the few times I’ve gotten goosebumps from seeing a credible pathway for the creation of a closed loop payment network.

What is a closed loop payment network?

It’s the Holy Grail.

It’s what made American Express valuable for a long time. And it’s what makes Alipay and WeChat Pay so powerful. And it’s what makes PayPal potentially very powerful as well.

The idea of the closed loop payment network is that if you control the payment source (e.g. bank card or digital wallet), the merchant acquiring solution / POS, and the payment network that connects them, you can effectively create an internal loop where all the economics, data, and long-term strategic value of the payment ecosystem accrues to the platform.

Not only does the closed loop network not have to share any of the economics with external parties (e.g. Visa / Mastercard in the payment network side or a 3rd party merchant acquirer / processor on the merchant side), the platform fully controls and unifies all of the data that is created across the ecosystem.

In the traditional card payment set-up, the networks have the highest margins, but the banks keep most of the economics and have all the data. The merchant acquirers are stiffed with the heavy lifting but ultimately has the direct relationship with merchants. Not only are the economics not evenly divided (with potentially some conflicts of interest), each part of the system controls only some portion of the data and strategic value of the system. And none of it is unified.

If all Square cared about was the marketplace-like two-sided network effect connecting Seller and Cash App ecosystems, this could have been easily achieved via the Cash Card and Boost efforts already underway. Cash Card allows consumers to spend what they have in the Cash App at merchants. And merchants, by virtue of being able to accept debit and credit cards, are happy to accept the Cash Card. The availability of the Cash Card makes Cash App more attractive to consumers. And the availability of Boost (which gives you discounts when using Cash Card with specific merchants) encourages consumers to use the Cash Card with merchants more.

The main difference between that set-up and the new dynamics with BNPL is, of course, BNPL has the potential to completely cut the network out.

Pocket Rockets

The value and potential of closed loop networks is not really a secret. American Express has been running a closed loop network for decades. And the dramatic rise of Alipay and WeChat Pay in China have brought renewed attention to how disruptive and powerful closed loop networks can be.

In fact, PayPal once upon a time pursued such a vision as well. Similar to Square, PayPal theoretically has all the working pieces for creating a closed loop. It processes payments for merchants, and it has a digital wallet used by hundreds of millions of consumers. All it needed to do is convince consumers not to use cards as a funding source (which run on Visa / Mastercard networks) when using the digital wallet.

For many years, PayPal would try to steer consumers into using ACH / stored digital wallet funds for payments, while demoting the options for card payments. By doing so, PayPal could steer consumers into effectively their own closed loop payment system where the economics were dramatically better for PayPal.

However, ultimately PayPal ended up hindering their own progress because cards just work really darn well. Consumers love their cards. And actively demoting the usage of cards likely slowed the spinning potential of the flywheel.

PayPal and Visa eventually settled their differences and agreed to a partnership…the final result is that most PayPal transactions today are paid for with cards.

So why does Square stand a better chance today compared to PayPal?

The problem with PayPal’s effort is that their approach ultimately was inferior to a card payment. While using ACH as a funding source is not that different from using a card as a funding source, consumers ultimately love their credit cards because you don’t have to pay right away and you get rewards. Even though PayPal had a closed loop network set up, consumers preferred to use the open loop setup via their credit cards. What PayPal failed at wasn’t a lack of effort…PayPal failed at providing a reason why a consumer should prefer it.

American Express’ setup is also interesting in its own right. While American Express was successful in creating their own closed loop network with dramatically better economics for itself, it did so by forcing the closed loop on its consumers. Consumers could only use their American Express cards at merchants that American Express has signed up (which is very similar to how Afterpay’s BNPL network has been set up so far). This worked well for American Express, but it also meant consumers couldn’t use their American Express card at a lot of places. Ultimately, this caused American Express to lose momentum vs Visa and Mastercard as networks because it couldn’t scale either the merchant or consumer side fast enough. Merchants that already accepted Visa / Mastercard cards didn’t understand why they need American Express, and many consumers didn’t see the point of getting a card that looks like a Visa / Mastercard but works at fewer places.

But Square has pocket rockets that PayPal (and American Express) simply did not have.

This is a common argument – BNPL is only for people that don’t have credit cards because if you have a credit card, you would want to use it for the rewards.

While this may be true for now, I’m not sure this will be true forever, and it’s already starting to change.

What makes Square’s attack on the networks different this time is that BNPL truly has the potential to be superior to credit cards. From a credit perspective, BNPL is already vastly superior to credit cards. Credit cards require you to repay within 30 days or get charged usurious rates. BNPL gives you a lot longer to repay. Some BNPL players still charge you an interest rate (that is much lower than credit cards), but when it comes to Afterpay’s version of the product, there is no interest at all.

I’m sure you’ll agree that getting more than 30 days to repay something is strictly superior to having to repay something within 30 days (or suffer the consequences and ruinous path to bankruptcy as your debt compounds at 20% CAGR!).

The key difference is, of course, rewards. Credit cards have rewards! BNPL does not! Therefore BNPL will lose (?)!

While it is true BNPL does not have rewards, I think everyone that employs this argument fails to understand the micro and minutiae of average human decision making. With a credit card, in a good scenario you might get 2% cash back or perhaps 3% if you have a premium card (used in specific categories).

But make no mistake, that 2% or 3% cash back (or points or whatever) is a perk. It is NOT the point of the transaction.

The POINT of the transaction is the ITEM the consumer is buying…whether it is a sweet pair of Jordans or Kylie Cosmetic lipstick.

2% or 3% off is a perk.

Whether it is 1% or 3% or 5% doesn’t change the fact that what truly makes the transaction happen is the desirability of the product that is being bought.

So with that frame of mind…it should be obvious why BNPL has an advantage that credit cards do not.

You can buy a pair of Jordans with a credit card and get 2% off.

Or you can buy a pair of Jordans and split it into multiple BNPL payments (possibly with no interest)…and potentially buy more of what you actually want today because the payments are lower!

An extra pair of Jordans (or whatever you are buying) or 2% off?

Seems like an easy choice to me.

Credit is credit is credit.

Make no mistake – what people want is what they are buying. No one buys things just to earn the perk.

People that assume that perks alone are enough to keep people on credit cards, might not fully recognize what consumers actually want when they are buying something. What they want is very likely not the perk. The perk is just nice to have.

(As an aside, I do think ultra-premium travel credit cards will maintain their place in the world because these are viewed differently from cash back perks. Many aspiring consumers view 100k points which have cash value of $1000 as much more than that because you can potentially turn that into multiple thousands of dollars worth of flights / hotel bookings…so effectively the consumer views travel cards as offering dramatically better discounts, sometimes as much as 50-70% off the cost of travel. But please keep in mind the number of people that have premium travel cards is nowhere near a majority of people. And formulating views on whether BNPL succeeds or not based on cards that only the top 20% of the population will use seems wild to me.).

Okay, but doesn’t this potentially mean you are going to end up with risky behavior? Wouldn’t people end up spending more than they actually should because the payments have been spread out?

Yes and no!

If the consumer was going to make these purchases anyway with a credit card (e.g. buy two pairs of Jordans over multiple months), the advantage of the BNPL payment method is that you get all of the shoes right away because you can split the payment.

In such a scenario, the consumer hasn’t spent more money…the consumer has simply accelerated future purchases into the present. The consumer is happier this way because s/he gets more of what they want upfront without having actually spent more money compared to the credit card over the same repayment period.

But there’s more.

The magic of this whole setup is that it’s not only better for the consumer, it’s also a LOT better for the merchant as well.

The merchant loves this because booking the sale sooner rather than later is always a plus.

IF the consumer does overspend, the merchant also prefers it to happen through BNPL rather than through credit cards. Some people, unfortunately, do overspend. If a consumer uses a credit card and overspends, this is a slippery slope towards financial enslavement. Credit cards generally carry very high interest rates that are very difficult to get out of once balances spiral out of control. An important insight to recognize is that any interest paid on credit card revolving balances goes ONLY to the bank / card issuer. If a consumer overspends on a credit card, the consumer ends up paying a lot of interest and money over the long-term ONLY to the bank / card issuer.

When it comes to BNPL, on the other hand, if a consumer overspends, at least the merchant is the one that gets the money (since you simply just bought more upfront)! And since loans are interest free (or low), there is a much easier pathway for consumers to eventually work down their debt and eventually have the ability to buy from the merchant, again.

With credit cards, sometimes this is not a possible reality. Many consumers end up paying thousands of dollars of interest to banks forever…and merchants would much prefer consumers to be able to pay down that debt in a reasonable manner so that money that would have gone towards interest ends up going towards new purchases in the future.

It’s also important to recognize that when merchants accept a card payment, a portion of the MDR paid by the merchant usually goes towards funding credit card rewards. This is why premium credit cards that have very rich reward schemes often cost merchants more when they accept them. The idea is that if they fund these rich rewards, consumers are more likely to use their card. And if they use the card more, they might buy more from the merchant.

But this argument is a bit loose…

From the merchant’s perspective, they are funding perks that have almost nothing to do with their own business with nothing more than hope that consumers will end up spending more. I don’t know about you, but the fact that I get 3% on travel from Chase Sapphire Reserve card doesn’t change how much I spend with Nike. And I’m sure Nike would prefer to spend less towards my travel rewards.

When it comes to BNPL, however, merchants don’t have to do that! BNPL naturally encourages the consumer to spend more with the merchant itself.

If you’re a merchant, BNPL is a vastly superior solution. And if you’re a consumer, BNPL is also a superior solution as well.

Where We’re Heading

Here’s one version of the world that we’re heading towards:

Young / average consumers (especially ones that don’t have credit cards or don’t have premium credit cards…which is the vast majority of people) will increasingly recognize that BNPL gets them more of what they want with less financial downside risk.

Merchants also increasingly recognize that BNPL gets them more of what they want while keeping the consumer healthy over the long-term.

Young / average consumers shift more and more of their purchases to BNPL until it eventually becomes the dominant method of payment. As BNPL becomes the dominant method of payment, it makes sense to keep cash and liquidity where most of the spending occurs. This gradually leads to a shift in payroll deposits and bank balances over to the BNPL-enabled wallet (e.g. Cash App).

Right now the networks and banks are still consoling themselves by saying that BNPL payments are still mostly paid for using bank debit cards (the money is still held in a bank, and consumers use a Visa / Mastercard branded debit to pay for the BNPL installment, which earns the networks a fee even if consumers no longer use the card directly for the purchase). But…good luck?

And in the long-run, as more and more of the payments and financial gravity shifts towards BNPL, not only will it nudge consumers to move more and more of their funds towards the BNPL-enabled wallet, it also centralizes data there.

In China, Alipay ended up threatening the whole financial system by making consumer data evermore opaque. As most purchases and payments data flowed into and through the Alipay ecosystem, the rest of the financial system gradually lost sight of data necessary for them to make any lending decision at all. The financial system was reduced to paying Alipay a fee for access to the data and consumer lending opportunities. In China, the government couldn’t tolerate this and did something about it.

But in the west, when all of this happens, I’m not so sure much can or will be done to stop it. And when this all happens, Square will have a closed loop payment system before anyone knows it (ditto potentially for PayPal and Shopify).

Lastly…I’m a big fan of listening to what people are whispering even if they are trying to hide it. Jack Dorsey is a big fan of bitcoin because he believes the internet needs a native open currency. And Cash App was one of the first consumer-centric payment apps to integrate bitcoin trading as well as allowing Sellers to accept bitcoin.

Square has even filed patents for a bitcoin payment network before:

square bitcoin

Public documents published on Aug. 21 show that the U.S. Patent & Trademark Office (USPTO) has approved Square’s application to patent a system that allows merchants to accept cryptocurrencies alongside conventional payment methods and cash out in their currency of choice. The San Francisco-based firm first filed for the patent in Sept. 2017.

Source: Yahoo / CCN

The point of all of this definitely isn’t to attack his own merchant-facing Seller business or his own consumer-facing Cash App business…the whole point is to remove the network in between. The network that currently controls the flow of money.

We may all be playing a game of Telephone with the future, but I’m pretty sure I know what I hear!