Online payment systems: Easy money?

Making online payments flexible and secure is the key to the digital economy. But, asks Wendy Grossman, is PayPal the solution?

In July, the internet's largest auction service, eBay, announced that it was acquiring the net's largest payment service, PayPal, for $1.5bn (£1bn). Why? Because it saw payments as complementary to its service, following a fine tradition of internet pioneers who have tended to believe that e-commerce needs a new, more flexible financial system.

Probably more companies have gone to the wall searching for this Holy Grail than any other. But PayPal is the first New Economy payment service to have achieved mainstream acceptability, and our first glimpse of what the digital economy will look like.

PayPal solves a widespread e-commerce problem. Online sellers are often individuals and small businesses who don't have "merchant authorisation" to accept credit cards. Online buyers want a quicker, easier way to pay than sending cheques – which is prohibitively expensive for international transactions. PayPal accept the credit or debit card payment on behalf of sellers, and allocate it to their accounts. Buyers enter the usual numbers. It's free to buyers; sellers pay just over 2 per cent in transaction fees. PayPal say you can send electronic payments to anyone with an e-mail address.

Founded in December 1998 with the idea of allowing Palm Pilot users to beam each other payments by infrared, PayPal had, by its November 1999 launch, switched to payments by e-mail. By April 2000, it had a million users, and had been acquired by the now-subsumed online bank X.com.

Unlike other online "money" schemes, using PayPal is simple: enter the payment and off it goes. The good points, as Neil Leacy, a UK user says, "are how quick and easy it is, and how well they keep you informed of all the transactions you make." For international users, the bad side is that PayPal denominates its accounts in dollars, and charges fees for international bank transfers (domestic US transfers are free).

Dave Winder, who uses it to pay US-based web subscriptions and charity donations, says that, "The exchange rate PayPal implements makes it pointless to use it for UK-based ones." From the latter standpoint, the eBay purchase is being welcomed: eBay has many international subsidiary sites, and users hope it will change PayPal into a truly multi-currency service.

Where trouble has been reported, it's generally been by users who have fallen foul of its anti-fraud profiles. In these cases, PayPal freezes the user's account, and won't allow withdrawals. Complaints that the company is trigger-happy have led to four class-action suits in California, filed earlier this year, around the time the company launched on Nasdaq. (PayPal believes it can defend these cases.)

Yet for all its success, this is not what net pioneers hoped for from online commerce. They wanted wholly new money for their virgin world, which hasn't happened. The belief was that cryptography would enable a new kind of digital currency with strong privacy and authentication built in, plus the ability to handle micropayments.

Credit cards – even as implemented by PayPal – are too expensive for transactions much under £5. What everyone thinks they want is a system for charging 10p to listen to a song, or 5p to read an article. Payment aggregators, such as Qpass, attempt to cover this market, but are too expensive.

The first such initiative, DigiCash, was based on newly available cryptographic techniques. Its 1995 founder, mathematician David Chaum, wanted DigiCash to be as anonymous as real-life coins. A competing service, CyberCash, required users to deposit dollars into an online purse, out of which they could spend as needed.

But few people were willing to turn government-backed currency into cryptographic strings that could be lost in the next disk crash. Recently, the British company Beenz has attempted to promulgate loyalty points as a currency. But as a paper on payment cultures from the Electronic Payment Systems Observatory points out, loyalty points are intended to lock customers in to a particular business; the more they become a currency, the less retailers will want to accept them. These ideas all failed, while the services that build incrementally on the system we have are becoming successful.

But where does PayPal fit in the existing financial regulatory structure? It holds millions of dollars on behalf of international consumers, as a bank might. But it isn't a bank, and is not regulated as one.

Karen Loudon, a spokesman for the Financial Services Authority, explains that the FSA regulates businesses that do two kinds of activities. One is accepting deposits from the public, who expect to get the money back at a future date, and lend it out or use it to finance other activities. The other is issuing e-money, which was the subject of rules published last April. A company engaged in either activity needs to be authorised by one of the other countries in the European Economic Area, or by the FSA, in order to offer services in the UK.

Arguably, PayPal falls outside of both. It holds deposits for consumers, but the money comes from third parties. And, PayPal doesn't lend the money out. It sweeps those deposits into a federally insured bank account at Wells Fargo Bank in the US, or into a money market fund that is not managed by PayPal and is overseen by the Securities and Exchange Commission.

The company has said, however, that it expects to apply for a licence to issue e-money. Within the US, where banks are regulated at the state level, a number of states began asking in 2000 if PayPal was engaged in banking. So far, only New York has issued a final opinion: it came down on PayPal's side. New York encouraged PayPal to apply for a money transmitter licence. The upshot is that PayPal is considered as an agent and a payment service.

One outcome of PayPal's having to prove that it is an agent for federal insurance purposes was that it had to move the money it holds on behalf of customers into non-interest-bearing accounts. That cost PayPal roughly 6 per cent of its annual revenues derived from its use of that money – $2m in the half-year ending June 2001.

Another 8 per cent of PayPal's revenues seem likely to go in the transfer to eBay, representing the money it makes from enabling online gambling. When gamblers deposit a stake at an online casino, they want to know how they will get the winnings out. PayPal and its competitors are important to the casinos because credit card companies have no facilities for accepting inward payments to consumers other than refunds. Visa International says it's looking at the problem, but don't expect a change soon.

Little seems to have changed since 1991, when the online activist (and Grateful Dead lyricist) John Perry Barlow noted that "Cyberspace is where your money is". What he didn't mention is the trouble getting it there – and back again.