We have seen rapid growth in the ‘Buy Now, Pay Later’ (BNPL) space in recent years, with reports citing that the global market size is expected to reach USD 39 bln by 2030. More and more companies now provide consumers with access to short-term interest-free credit that can help spread the cost of comparatively smaller-ticket purchases over a number of weeks or months.
The explosion in BNPL shows that consumers view it as a fundamentally valuable product. It meets their longstanding demand for access to credit without the interest charges and barriers to entry associated with traditional lines of credit, such as credit cards.
In the UK alone, millions of people currently rely on expensive overdrafts and credit card products for both discretionary spending and essential household costs. The US is no different - in this market specifically, over USD 140 bln in fees and interest are paid to credit card companies every year. Many other people are unable to even access these traditional forms of credit due to a lack of credit history. In the UK and US combined there are over 50 million people who fall into this category, named ‘credit invisibles’.
In that context, the appeal of BNPL to consumers should be no mystery. When appropriately regulated and responsibly provided, zero-cost credit that’s equally accessible to those with poor or no credit histories can promote financial inclusion and choice and save billions of pounds in unnecessary costs.
However, concerns arise when unregulated BNPL providers are seen to act without the proper customer safeguards and affordability checks in place. Meanwhile, the biggest and best-known providers in the BNPL space have seen intense downward pressure on their valuations this year.
BNPL companies’ ability to navigate both of these two challenges – to do right by their customers and by their investors – depends in large part on whether they adopt the traditional ‘direct-to-merchant’ model, which is referred to as BNPL 1.0, or the more innovative ‘direct-to-consumer’ approach - BNPL 2.0.
In the ‘DTM’ model, the BNPL 1.0 providers offer POS finance via checkout buttons on a merchant’s online storefront. In this business model, the customer is the merchant, not the consumer, and the service is promoted as a payment option on the merchant’s checkout page by both the BNPL provider and the merchant. Today, this has become a highly commoditised, low-margin choice of business model and a highly competitive space to operate in.
From a consumer safeguarding perspective, this means that they meet their borrowers for the first time at the checkout. The provider is therefore significantly less able to build an informed picture of a borrower’s affordability limits, nor any insight into their behaviour. Merchant demands and their ever-present pressure on conversion ratios place more lending pressure on such providers with no regard for the consumer’s true affordability.
In the ‘DTC’ model, known as BNPL 2.0, the provider owns the relationship with the consumer. It’s one that’s formed before any individual purchasing decision is made. Crucially, a defining difference is they do not provide finance at the POS. Instead, customers of DTC companies arrive at any merchant with a spending limit that is bespoke to them and their affordability profile. Naturally, this leads to a customer only being able to spend what they can afford to repay.
Tellingly, it is this DTC approach that Apple, widely regarded as the world’s most innovative and successful consumer-focused tech company, has chosen to follow with its own recently announced entry into the BNPL consumer credit market.
The advantages of the newer DTC model over the traditional DTM approach can also be seen from a commercial perspective. The sharp fall in the valuations of companies like Affirm, Block (AfterPay) and Klarna is fundamentally a symptom of the challenging economics of ultimately having a model that processes payment, particularly in a recessionary environment.
If your product is a POS finance option that a merchant integrates into their checkout page, then you are being paid as a payment processor. You are providing a highly commoditised service, competing with other providers to finance the purchases made by the merchant’s own customers.
These are unattractive supply-demand dynamics – an ever-proliferating number of BNPL providers launching the same service, competing for a finite number of merchants. That means downward pressure on your margins. And that’s before the cost-of-living crisis and reduced discretionary consumer spending begins to bite.
In addition to this, recent news from the Financial Conduct Authority (FCA) will see the regulator clamp down on merchants who work with these checkout button providers by preventing them from talking about the button in promotional material. Anyone who doesn’t abide by this will be handed a hefty penalty (or even jail time).
In line with this, Meta and Google pledged to the FCA that they would not allow promotions from financial services companies unless they are regulated by the FCA. They have since made good on this pledge and recently halted any such promotions across all platforms. That combination of factors has been a major driver in investors’ loss of confidence in and reduced appetite for these DTM business models.
In the long term, we see the winners in the B2C payments industry as those companies that can offer complete ubiquity, a direct-to-consumer model that offers access to every merchant, not just some. This also allows you to offer a range of payment options on your own proprietary app or website – not just credit, but also debit, and savings in the form of rewards a customer can’t otherwise obtain.
The holy grail is being able to combine payments and commerce on one platform. In that model, the payments provider is getting paid by merchants as a marketing channel to both put their products in front of consumers and convert a buyer’s intent when they then visit the online or offline store.
That creates a bigger and more sustainable pool of revenue on which to base your business model. Retailers’ marketing budgets are projected to climb to c.USD 1 trillion p.a. within the next two years. Moreover, they are likely to remain robust through a recession, as retailers compete to increase sales.
There are some parallels here with Amazon marketplace and Amex’s business model. Investors are attracted to the unit economics, customers to the way in which retailers are covering the cost of both interest-free credit and cashback rewards on debit payments.
The traditional BNPL model has demonstrated the huge consumer appetite that exists for new ways to pay and, specifically, for zero-cost credit. But it is the direct-to-consumer approach, pioneered by newer entrants into the payments space, which has the most potential to create value for investors and merchants and, most of all, to change the lives of millions of consumers looking for the most rewarding ways to pay.
About Philip Belamant
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