Is it a bank, a money transmitter, or a Silicon Valley shadow financier? No, it’s just Paypal!
In the US, what determines whether a payments company qualifies for
money transmitter status (rather than bank or investment manager status)
is how it treats customer funds.
Generally speaking, to qualify for money transmitter status, customer funds must be transmitted to a specified person/place or to licensed depository institutions to be held “for the benefit” of customers (FBO).* The creditor relationship is not supposed to be between the customer and the money transmitter — because they’re not supposed to be deposit takers — but between the customer and the entity which banks the money transmitter. That’s the transmission.
But this arrangement, quite obviously, isn’t as profitable as being able to do what you want with the money put in your care. While money transmitters are still able to benefit from the interest earned on these FBO accounts, this is a paltry sum compared to what could be achieved if they were managing the money on a discretionary basis.
Indeed, a long time ago, money transmitters like PayPal did invest the funds directly themselves.
Some history…
Back then, the interest-spread which could be juiced from the customer float was as critical to the business model of PayPal as the revenues which could be generated from transaction fees. See PayPal’s original 2001 prospectus for how it recognised interest on funds held for others (it gobbled the revenues for itself). For those customers that didn’t want to forgo interest, PayPal offered something known as a PayPal Money Market Reserve Fund, to which it acted as a fee charging investment adviser, but to which it also waived liability over principal loss.
But as the original Paypal prospectus noted, the company said it would forgo interest earned on customer funds that sat outside of its money market offering to prove it was in fact a Money Transmitting custodian rather than a depository institution:
By 2002, in time for its IPO, the FDIC had offered PayPal an opinion on its depository status. This noted:
Indeed, one might speculate, the only reason the business model adopted an FBO system in the US was to qualify for FDIC guarantee status and US money transmitter licensing ahead of its public float.
So it was that by March 31, 2002 PayPal’s interest-rate arbitrage play was largely dead in the water, with the company having transferred most customer money to banks on FBO terms, an off-balance sheet custodial sum which amounted to $188.5m.
Why drag all this ancient history up today?
Because, well, you may have heard the news that PayPal was recently spun out of Ebay and re-listed on Nasdaq for the second time.
Here’s the newly independent company’s performance since the July 20 float:
Lovely.
More exciting, however, is the Form 10 issued as a result of the float, which provides extensive details about how PayPal’s business model has adapted since the 2002 eBay acquisition.
Notably, also, how PayPal’s FDIC treatment has changed in that time (our emphasis):
As an aside, the document also reveals that PayPal now operates a Luxembourg-based bank subsidiary through which it originates PayPal Credit services internationally. It also participates on a revenue share basis with a US chartered bank for credit product provision over in the US.
So the question which needs to be asked is: what exactly is PayPal these days? Is it a money transmitter as per what its license says? Or is it something else entirely? A deposit taking bank? An investment manager? A credit institution?
If it’s the latter, why is it licensed as a money transmitter?
Two other things worth noting. It was shortly after eBay acquired Paypal that its money market fund, whilst still operating, stopped being marketed aggressively on its website. By 2009 a prospective customer really had to know where to look if he wanted to receive interest on his funds. By 2011 the fund had entirely shut up shop. Today, there is no such interest-accumulating option for customers.
Furthermore, it was sometime during the latter part of eBay’s ownership (approximately the beginning of 2013, just after the unlimited insurance on non-interest bearing accounts set up by the FDIC in October 2008 expired) that user terms & conditions abandoned FDIC pass-through cover notices and changed the policy to note:
(FYI — PayPal also has a lot of autonomy over how and when it chooses to distribute your funds back to you as well.)
Update 2245: *Adds detail on money transmission qualification.
Related links:
Your PayPal balance isn’t FDIC insured: the case for a new model for financial startups – Medium
Mpesa: the costs of evolving an independent central bank – FT Alphaville
‘PayPal locked up my money for 207 days’: What happens when an online company decides you’ve broken its rules - Mirror
Generally speaking, to qualify for money transmitter status, customer funds must be transmitted to a specified person/place or to licensed depository institutions to be held “for the benefit” of customers (FBO).* The creditor relationship is not supposed to be between the customer and the money transmitter — because they’re not supposed to be deposit takers — but between the customer and the entity which banks the money transmitter. That’s the transmission.
But this arrangement, quite obviously, isn’t as profitable as being able to do what you want with the money put in your care. While money transmitters are still able to benefit from the interest earned on these FBO accounts, this is a paltry sum compared to what could be achieved if they were managing the money on a discretionary basis.
Indeed, a long time ago, money transmitters like PayPal did invest the funds directly themselves.
Some history…
Back then, the interest-spread which could be juiced from the customer float was as critical to the business model of PayPal as the revenues which could be generated from transaction fees. See PayPal’s original 2001 prospectus for how it recognised interest on funds held for others (it gobbled the revenues for itself). For those customers that didn’t want to forgo interest, PayPal offered something known as a PayPal Money Market Reserve Fund, to which it acted as a fee charging investment adviser, but to which it also waived liability over principal loss.
But as the original Paypal prospectus noted, the company said it would forgo interest earned on customer funds that sat outside of its money market offering to prove it was in fact a Money Transmitting custodian rather than a depository institution:
We pool these customer funds and, as agent for our customers, we deposit the funds in bank accounts or invest the funds in short-term investment grade securities. Beginning in October 2001, we plan to deposit all customer funds not transferred to the PayPal Money Market Reserve Fund into bank accounts. We believe that, in handling customer funds, we act solely as an agent and custodian and not as a depositary.The prospectus also shows that until that point non MMF funds were never considered eligible for FDIC cover and insured instead by Travelers Insurance. Also, that PayPal was seeking advice from the FDIC about whether it counted as a depository institution or not, following regulatory concerns that it might.
By 2002, in time for its IPO, the FDIC had offered PayPal an opinion on its depository status. This noted:
On February 15, 2002, we received an advisory opinion from the FDIC in response to our request for an opinion on the availability of pass-through FDIC insurance. This opinion concluded that pass-through FDIC insurance would be available to our customers if we (1) place pooled customer funds in bank accounts denominated “PayPal as Agent for the Benefit of its Customers” or similar caption, (2) maintain records sufficient to identify the claim of each customer in the FDIC-insured account, (3) comply with applicable record keeping requirements, and (4) truly operate as an agent of our customers. In connection with our implementation of steps to establish that we are truly operating as an agent, in February 2002 we transferred customer funds previously held in bank money market accounts into non interest-bearing bank accounts as discussed in more detail in “Business—Regulation—Bank Regulation.”The key thing to note, though, is that the FBO set-up wasn’t actually how things started out at PayPal. The 2002 filing confirms that prior to the first quarter of 2002 PayPal invested customer funds at its own discretion in bank money market accounts, short-term money market securities and money market equivalent securities and happily recognised the interest income for themselves.
————
We seek to place customer funds in well-capitalized banks, and we have obtained an opinion from the Federal Deposit Insurance Corporation that funds placed in bank accounts will be eligible for federal deposit insurance on a per-customer basis as long as we maintain accurate records and continue to act as agent for the customer. However, customer funds could be lost in the event of the insolvency of one or more of these banks. Customers who opt to invest their money in the Fund may lose the original principal value of their initial investment. If these losses occur, perceptions regarding PayPal’s safety and handling of customer funds may result in decreased customer balances and payment volume, which would increase our costs and reduce our revenue.
Indeed, one might speculate, the only reason the business model adopted an FBO system in the US was to qualify for FDIC guarantee status and US money transmitter licensing ahead of its public float.
So it was that by March 31, 2002 PayPal’s interest-rate arbitrage play was largely dead in the water, with the company having transferred most customer money to banks on FBO terms, an off-balance sheet custodial sum which amounted to $188.5m.
Why drag all this ancient history up today?
Because, well, you may have heard the news that PayPal was recently spun out of Ebay and re-listed on Nasdaq for the second time.
Here’s the newly independent company’s performance since the July 20 float:
Lovely.
More exciting, however, is the Form 10 issued as a result of the float, which provides extensive details about how PayPal’s business model has adapted since the 2002 eBay acquisition.
Notably, also, how PayPal’s FDIC treatment has changed in that time (our emphasis):
Our cash, cash equivalents, accounts receivable, loans and interest receivable, and funds receivable and customer accounts are potentially subject to concentration of credit risk. Cash, cash equivalents and customer accounts are placed with financial institutions that management believes are of high credit quality. In addition, funds receivable are generated primarily with financial institutions or credit card companies which management believes are of high credit quality. We invest our cash and cash equivalents and customer accounts in highly liquid, highly rated instruments which are uninsured.You see that? PayPal is back to managing customer funds at its own discretion rather than passing them through to a licensed institution. Most importantly, PayPal accounts are no longer FDIC guaranteed because they don’t sit in the regulated banking system, but exist instead as unsecured claims against PayPal, a money transmitter.
From time to time, we may also have corporate deposit balances with financial services institutions which exceed the Federal Deposit Insurance Corporation (“FDIC”) insurance limit of $250,000. As part of our cash management process, we perform periodic evaluations of the relative credit standing of these financial institutions.
As an aside, the document also reveals that PayPal now operates a Luxembourg-based bank subsidiary through which it originates PayPal Credit services internationally. It also participates on a revenue share basis with a US chartered bank for credit product provision over in the US.
So the question which needs to be asked is: what exactly is PayPal these days? Is it a money transmitter as per what its license says? Or is it something else entirely? A deposit taking bank? An investment manager? A credit institution?
If it’s the latter, why is it licensed as a money transmitter?
Two other things worth noting. It was shortly after eBay acquired Paypal that its money market fund, whilst still operating, stopped being marketed aggressively on its website. By 2009 a prospective customer really had to know where to look if he wanted to receive interest on his funds. By 2011 the fund had entirely shut up shop. Today, there is no such interest-accumulating option for customers.
Furthermore, it was sometime during the latter part of eBay’s ownership (approximately the beginning of 2013, just after the unlimited insurance on non-interest bearing accounts set up by the FDIC in October 2008 expired) that user terms & conditions abandoned FDIC pass-through cover notices and changed the policy to note:
If you do hold a Balance, that Balance represents an unsecured claim against PayPal and is not insured by the FDIC. PayPal will combine your Balance with the Balances of other Users and will invest those funds in liquid investments in accordance with State money transmitter laws. PayPal will own the interest or other earnings on pooled Balances. PayPal will hold pooled Balances separate from its corporate funds and will not use Balances for its operating expenses or for any other corporate purposes. PayPal will not voluntarily make Balances available to its creditors in the event of bankruptcy. In addition, the issuer of the PayPal Debit Card, which is The Bancorp Bank, holds debit card customer balances in a pooled account held in the debit card issuer’s name for the benefit of PayPal debit card users.
If you’re a UK PayPal customer, meanwhile, your user agreement, dated July 1, 2015, states:
If you hold a Balance you will not receive interest or any other earnings on this Balance because the Balance represents E-Money and not a deposit.
Which according to the policy means:
Welcome to the new Silicon Valley “fintech” sponsored, uninsured shadow banking system.“E-money” means monetary value, as represented as a claim on PayPal, which is stored on an electronic device, issued on receipt of funds, and accepted as a means of payment by persons other than PayPal.
(FYI — PayPal also has a lot of autonomy over how and when it chooses to distribute your funds back to you as well.)
Update 2245: *Adds detail on money transmission qualification.
Related links:
Your PayPal balance isn’t FDIC insured: the case for a new model for financial startups – Medium
Mpesa: the costs of evolving an independent central bank – FT Alphaville
‘PayPal locked up my money for 207 days’: What happens when an online company decides you’ve broken its rules - Mirror
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