This article first appeared in The Edge Malaysia Weekly on August 9, 2021 - August 15, 2021

FOR the past week or so, the spotlight has squarely been on two large consumer-focused financial technology or fintech firms. Robinhood Markets Inc, which pioneered commission-free trading of stocks, options, cryptocurrencies and fractional shares, listed on Nasdaq, raising US$2 billion (RM8.4 billion). The listing was a disaster as investment banks failed to keep the stock from falling well below the initial public offering (IPO) price. In the four trading days since, however, Robinhood stock has more than doubled.

Days after Robinhood’s IPO, US payments giant Square Inc, which operates the ubiquitous Cash App, made its biggest acquisition ever, buying Australian-listed buy now, pay later (BNPL) firm AfterPay Ltd for a whopping US$29 billion in an all-stock transaction. Even for the overhyped fintech space, that is a hefty price tag. Square is paying 25 times AfterPay’s estimated sales for the current fiscal year ending next June — a multiple until recently reserved for a handful for ­ultra-high-growth software firms.

Listed firms overpaying for large transformational acquisitions often see their stocks clobbered on news of the deals. Yet, for Square’s investors, somehow it all made sense. The Cash App operator, which itself trades at stratospheric multiples, was using its own overvalued shares as currency to buy a company with strong revenue growth. Although Square’s revenues grew 102% last year compared with AfterPay 78% sales growth in its last fiscal year, and Square is projected to post 100% revenue growth this year, it is mostly on the back of the Bitcoin boom. Excluding crypto trading, Square’s revenues only grew 17% in 2020, and analysts expect its total revenue (excluding cryptos) to grow just 13% in 2022. AfterPay’s sales are expected to grow 60% this year and over 50% next year. By leveraging on each other’s growing client base, the combined firm expects to supercharge its growth.

BNPL firms facilitated US$20 billion in transactions in America last year. In the first two months of this year, BNPL transactions in the US grew 215% year on year. Kaleido Intelligence, a market research firm, estimates that consumers could spend US$680 billion globally using point-of-sales instalment payments over e-commerce channels by 2025. If that pans out, it could mean a huge market share loss by traditional banks, credit card issuers and consumer finance firms.

To be sure, the instalment credit business, called layaway or point-of-sale credit in the US, is older than credit cards. Long before plastic issued by the likes of Visa Inc, Mastercard Inc and American Express Co became popular, an array of consumer goods — refrigerators, washing machines — were being sold on instalment with interest rates as high or higher than the 20% to 28% charged by credit card firms.

BNPL is the credit card for millennials (those born between 1981 and 1996) and Gen Z (born in or after 1997). You can pay the entire US$1,099 for a 12.9in 128GB iPad Pro, US$199 for the popular Nike Air Zoom Tempo sneakers or US$1,895 for a Peloton bike using cash or your credit card. Or you could split it into four monthly payments with BNPL instalments. And if you pay all the instalments on time, there is no interest or fee that credit card or instalment credit firms normally add on. Moreover, some fintechs will not charge you interest if one instalment is a few days late, as opposed to the hefty late payment fees and metered interest rate charges of as high as 28% that begin as soon as you miss the payment deadline on bank-issued credit cards or ­layaway instalments.

BNPL fintechs like Afterpay and Affirm Holdings Inc of the US, Sweden’s Klarna as well as emerging US player Sezzle Inc and Australian-listed SplitIt Payments Ltd, which offer the option of financing in smaller monthly payments, make most of their revenue from merchants willing to lay out money upfront to acquire customers who might not want to pay the full price of goods or services. The merchants are effectively discounting the goods 4% to 6% by paying BNPL firms to make the sale. The credit risk is borne by these software firms disguised as BNPL entities that understand how to deal with charge-offs, or debt that can no longer be collected because the borrower has not made payments for a period of time, as well as how to give customers enough time to pay the balance they owe without having the clock of interest payments running. In many ways, credit cards and instalment loans are a category that has long been ripe for disruption.

BNPL firms collect a tonne of data on you to assess risk and monetise, and don’t have huge legacy costs like banks.

Is Square overpaying for Afterpay? “It’s certainly not expensive when you look at what they are getting for the price,” Dan Dolev, fintech analyst at Mizuho Securities in New York, told The Edge in a phone interview. “Square has a network of 70 million users on their platform and what they get is 16 million buy now, pay later users, instantly giving them another US$32 in ­average revenue per user, or ARPU.”

Once the deal is consummated, he estimates Square will go from an ARPU of US$50 currently to around US$82 on its Cash App for the combined firm. Dolev notes that Square has been a US-centric company and the deal gives them massive international exposure. More than that, the enlarged Square, he says, “will have a strong credit card alternative that millennials and the younger demographics want”.

Think of consumer-focused fintechs like Square and PayPal as a financial social network for payments. Square bought a controlling stake in music streaming service Tidal from singer and actress Beyoncé and her rapper husband Jay-Z last year. It also has a commission-free online stock trading platform in the US, which it plans to eventually take global.

There are two keys to consumer financial services: convenience or ease of use, and trust. And one of the biggest costs is customer acquisition. Fintechs like Square and PayPal already have a big and growing customer base to whom they can cross-sell an array of financial services at a fraction of the cost of the incumbents.

Paypal, for example, has a network of over 400 million users and 30 million merchants. “They already have a great two-sided network and all they need to do is to execute on it,” says Dolev. He believes PayPal’s new financial super app strategy is a winner. Paypal was the first mover in the BNPL space with its own “Pay in 4” instalments service last year. It has grown its own BNPL operations organically 49% quarter-on-quarter this year.

The way Dolev tells it, Square is far better positioned to be the premier financial service provider for a new generation of savers, investors and spenders. Eventually, the Mizuho analyst sees Square applying for digital banking licences in key jurisdictions or partnering with digital banks around the world who want to piggyback on its financial social network and allow Square to piggyback on their own local connections, user base and local digital banking licences.

“It’s going to take some time to build out but we are already starting to see it take shape,” he says. “Square wants to be a full-fledged global digital bank with social and peer-to-peer (or P2P) elements.” And while the likes of JPMorgan Chase &  Co and Citigroup Inc took over 200 years to take shape, fintechs like Square will probably do it in a fraction of that time, he adds.

Competition is coming, particularly in the BNPL space. iPhone maker Apple Inc is teaming up with Goldman Sachs’ consumer finance app Marcus to launch its own BNPL service later this year. Initially, in many countries, the venture is likely to just finance Apple products. If you want to buy the new iPhone 14 that will be released next month or MacBook Pro, you will not need a credit card or have your credit history checked. Apple will sell you the item as long as you are willing to pay for it over four instalments. No silly charges or usurious credit card interest rates.

In other geographies, the BNPL service will allow you to buy Nike sneakers or even yoga pants in Lululemon stores. Incumbents like JPMorgan and Citigroup are launching their own BNPL services. Dolev says he does not think Apple-Goldman Sachs or ­JPMorgan’s new strategy to leverage fintech will slow either Square or PayPal. “The consumer credit market is huge and still growing, and there is plenty of room for both fintechs and the incumbents to grow,” he says.

Shares of Visa and Mastercard plunged 5.5% and 7.5% respectively in the two days after the Square-Afterpay deal was announced while American Express stock was down 3%. Stocks of the biggest card issuing banks in the world — JPMorgan, Citigroup and Bank of America Corp — also fell 1% to 2% on the news. Over the long run, credit card industry analysts say the real damage is likely to be inflicted on smaller and medium-sized banks rather than the big banks like JPMorgan for whom cards are a small portion of the total business and whose core investment banking and basic balance sheet lending business is hard to replicate.

In the lead up to its IPO last week, Robinhood was a much-derided retail brokerage criticised for its reliance on “payment for order flows” as well as on crypto trading revenues. Now with US$2 billion in the bank from the IPO, another US$300 million being raised from the greenshoe overallotment option next week, and a stratospheric stock price, Robinhood is seen to be doing a series of quick secondary offerings or selling additional shares in the market at a high valuation. It is expected to unveil its own crypto wallet within the next few months and a slew of other financial services, including a BNPL service.

Its immigrant co-founders Vlad Tenev and Baiju Bhatt, who are now worth over US$4 billion each, are keen to slash reliance on payment for order flows as well as crypto trading. They already have a ton of data and nearly 20 million satisfied young customers who do not trust incumbent banks. Their goal is to build a consumer-focused global financial behemoth, not just expand their commission-free brokerage.

It has been done before. In 1971, Charles Schwab, the writer of an investment newsletter, took over a small brokerage firm to serve retail investors. When the New York Stock Exchange abolished fixed commissions in 1975, he rolled out his eponymous discount brokerage. Today, Charles Schwab is the 12th largest bank in the US with over US$6.6 trillion in client assets and the third largest investment management firm in the US behind BlackRock and Vanguard. Charles Schwab transformed from a discount brokerage to an asset manager to one of biggest banks in America because it had access to customers. People buying stocks also want credit cards and mortgages, as well as deposit and checking accounts.

The road ahead for Robinhood and Square is going to be bumpy but challenger fintechs like them, with a loyal and fast-growing customer base, are the strong disruptors that incumbent banking giants will have to contend with.

Assif Shameen is a technology writer based in North America

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