Understanding the Buy Now, Pay Later (BNPL) phenomenon: The Pledge

2021 has been a crazy year in many ways. For the broader tech industry specifically, it started with a crash course on Stonks (remember GME?) and Mars landing. Soon enough, we went into the rabbit hole of NFTs, Metaverse, DeFi, and of course, Dogecoin. And now with 10-min deliveries, BNPL, and dozens of D2C brands serving artisanal coffee (and also sending good vibes with sunflower emojis on Instagram). Amidst this, I was struggling to remember the full form of NFT and understand the meaning of fungible. As it turns out, being fungible has nothing to do with fungi.

Now the attempt at mildly amusing humor aside, let's start with the topic of the post - about BNPL, one of the many acronyms in a barrage of tech activity happening across the globe.

Introduction and structure of the explainer

The business of lending goes thousands of years back, as far as 10,000 BC - to the era of barter systems with loans provided in the form of food grains and cattle. With the advent of coins thereafter and paper money a few hundred years before today, the business of lending has gone through different mediums of transactions. Over the last two decades, however, a lot of businesses have seen tectonic shifts with the internet and smartphones becoming a part and parcel of our lives.

BNPL is one such version of consumer financing (read short-term loans) that's been making waves, especially over the last two years - with the claims around no interests and late fees. The mega acquisition of AfterPay by Square for $29B recently is a testimony to the fact that BNPLs have come of age now. So to understand and contextualize the BNPL movement, here's a simple explainer.

[As an aside, I will break down the BNPL topic in a series of three articles. BNPL is a huge topic with tons of facets. To even cover a reasonable primer within one post (~ 2K words) would induce a lot of anxiety for the information hoarder in me. So I chose the easy route of dividing the topic into a series of articles. As for the title of the post, I wanted to use a filmy reference and hence, the quote from The Prestige.]

Now in this article, we'd be covering the below prompts:

a) What is BNPL?

b) Positioning of BNPLs with Traditional Credit providers

c) The marathon and the sprint to BNPL

d) Economics of BNPLs

With that out of the way, let's dive into understanding BNPL.

What is BNPL?

Donning the Mr. Obvious hat, BNPL (or Buy Now, Pay Later) services are largely what the full-form suggests - that we buy and avail the service or product now - and pay later. Hence, BNPL services let the customers pay for a service or a product in installments over time. There are of course nuances to it to which we will come later. But first, an example.

Say we want to buy that fancy shoe worth $400 at an online store. So we add that shoe to the cart and click on the Payment or Checkout screen. On the screen or the webpage where the payment options are present (Debit Card, Credit Card, Cash on Delivery, Mobile Wallets, etc) - there's another option called Pay Later (or some version of the phrase). The user clicks on the Pay Later option and within seconds, gets approved for that payment option. The user also has the option to either pay the complete $400 in say 4-6 weeks or divide the payment in four installments of $100 each. The purported USP for this service is that it enables high ticket purchases for the users who can pay it over weeks (generally without interest). On the merchant's end, it increases sales conversions.

Here's a general process of how the BNPLs are integrated into the online buying journey (Canva is ???):

At this point, some of you may wonder - Wait, isn't this similar to what the traditional installment plans (EMIs) or even the Credit Cards also offer? So how is BNPL any different?

And I'd respond with the popular catchphrase within the black-coffee drinking, Game of Thrones watching population - It's a little complicated ya.

While the new-age BNPL service providers have a few elements taken from the traditional credit card industry and the traditional pay in X months constructs, it also has many elements as differentiation. Those nuances to the BNPL phenomenon will become clearer when we benchmark BNPL providers with Traditional Credit card companies below.

Benchmarking: BNPL <> Credit Cards

Not to end up writing a wall of text, here's a high-level overview to create a general benchmark of BNPLs and the traditional credit card players. I'm again emphasizing the word - general - because just like hundreds of varieties of mangoes, there are possibly dozens of BNPL variations. So hardly a point in boiling the whole ocean for a benchmarking study.

A few hot takes have boxed the BNPL platforms to the purview that they don't charge interests or late fees to the consumer. Now only if life was so easy. The actual reality is more like - It depends. Let's below how the BNPLs also have their interests or late fee constructs but they are more transparent and easy to follow.

Affirm, one of the largest BNPL players based out of the US doesn't charge any fees but may charge interests or APRs [screenshot below from their website].

However, AfterPay (the one Square bought recently for $29B!!) charges late fees if the scheduled payments are missed. [you'd need to expand the image - note the fine print mentioning the late fees]

Coming to Klarna, the OG of the new-age BNPL movement, these are their offerings. Essentially you don't get charged if you pay the loan in 4-6 weeks but for longer-term financing, there are the usual APRs and interests. Quite similar to how credit cards work.

Bear in mind that these offerings are customized to serving customers in the US. For a different market, maybe the terms and conditions are different.

So the larger story is that while the new-age BNPLs have a few distinct differentiators to them from the traditional banks - they are also similar to credit cards in the broader construct.

The marathon and the sprint to BNPL:

In the previous sections, we covered the what, the who, and the how of BNPL. As you, the ever-attentive Product manager would be wondering, we have to cover the why of BNPL. This section does that.

a) Opaque traditional Credit Card industry: With a few hidden charges, high APRs, and a relatively opaque process of credit approval - traditional credit card companies aren't generally viewed favorably especially within millennials and Gen Z. Over the last few years, the narrative has been shifted to view credit card companies as having played their hand too much. Like by adding more fees just for shits and giggles - late fees, prepayment fees, annual fees, account opening, closing fees, you name it. It doesn't bode well with the already financially crunched millennials and Gen Z and hence, there's a general wariness for traditional credit cards.

b) Rapid growth in E-commerce and digitization: E-commerce has seen a rapid uptick in the last decade and has seen growth on steroids especially since the pandemic hit. This has directly increased the market for new forms of point-of-sales financing. More e-commerce shopping means more online payments and more innovation on consumer financing. The new age BNPLs have found this to be the perfect storm to capture consumer behavior and shift some of the spendings from credit cards.

c) Mountains of data and sophisticated analytics: As an extension to the above point, with rapid digitization, online purchases, the companies have a treasure trove of customer data to analyze and build sophisticated credit models. This is in contrast with the credit card companies that typically rely on credit bureaus to figure out how bankable someone is. The new age BNPLs have focussed on alternative data (consumer behavior on online portals, analyzing their social media activity, your SMS folder and other apps installed) to create a credit risk profile. The thesis is that for the huge bulk of users that don't have much credit history digitized otherwise, analyzing this alternative data can help build reliable credit risk models.

To this end, when we look at the google search trends for the term - Buy now pay later - we may notice a healthy interest that's been growing over the last 15 years (chart below).

However, there is a discernible increase in interest in Buy Now Pay Later phenomenon around 2017 and of course, it's red hot right now. Interestingly, there are a few local peaks that seem cyclical yearly. These peaks happen around Nov-Dec of each year and my assumption is that it happens because of the holiday season with Christmas, numerous sale events, and New Year celebrations. Happy to know if there are other hypotheses to this.

At the same time, the google search trends for the term - BNPL (the shorthand used in tech and business circles to discuss the phenomenon) has seen an uptick only in the last 3 years or so. And how so! The trend (chart below) is the classic representation of exponential growth and interest.

The interest in the topic was pretty much at similar levels till 2018 and saw a consistent increase in interest till 2019. However, post-April '20, it has seen a resurgence and adoption that's going off the charts. So the sprint has really taken place in the last 18 months or so. That's largely been attributed to the impact of Covid which led to people tightening their wallets and hence, spreading out the payments over the course of a few months.

So old wine in a new bottle? Yes and No.

As has been argued, there are clear overlaps between the BNPL industry and the traditional credit card players - on the tools of charging late fees and interest rates to the consumers. Some of the credit card companies are coming out with their BNPL products as well with spunky messaging. At the same time, a few BNPLs are getting their hands on the banking licenses. This is still Day 1 for BNPLs so we will see how it evolves.

Another lens to look at this phenomenon is by establishing analogies. A lot of the modern-day online services have derived significant value not necessarily by inventing the use cases but by simplifying them. Just like Robinhood is not the first discount brokerage firm but rather the one that gamified the user experience of buying and selling stocks - Klarna is not the first Point of Sale financing company.

Robinhood didn't invent online stock investing in the US and nor did Zerodha or Groww in India. There have been online discount brokerage providers all along - from Charles Schwab in the US to Kotak in India. What has rapidly changed in the last 5-6 years is the mass adoption of smartphones and a leap in improved user experience. Similarly, firms like Klarna, Affirm and hundreds of others have re-imagined the process of loan approvals, with minimum friction and a spunky platform with millennial/Gen-Z friendly UI/UX/copywriting.

So there's huge value in building products that do better than the incumbents even if the premise is largely the same.

Economics of BNPL* (*subject to change, just like T&Cs)

The larger narrative on the revenue generation for BNPLs is to focus on MDRs. Typically, the commission charged by the BNPL service provider to the merchants lies in the range of 4-7% which is higher than the one charged by the Credit Card industry.

So, a broader thesis the BNPL providers are betting on is having the commission generated from the merchants to be significantly larger than defaulted loans. The industry parlance is MDR (Merchant Discount Rate) and it indicates the charge which BNPLs levy to the merchants for enabling the payments. Bad loans are dubbed as NPAs (Non-Performing Assets).

So if the NPAs go beyond 4-5%, it should be a warning sign for a BNPL provider since the MDRs don't generally go beyond 6-7% of the transaction value. The revenue from the MDRs has been purported as the primary revenue source for BNPLs. As an example, have a look at the ratio of Afterpay's revenue to the transaction volume (taken from the investor presentation of Square's acquisition of Afterpay). You'd notice that the ratio of Revenue to GMV (Revenue / Gross Merchant Volume) hovers around 4-5%. Add to the interchange fees the BNPL providers have to shell out, their Gross profits are ~ 70% of the revenue numbers.

Hence, the quest to keep the NPAs below 5%.

More importantly, though, keeping a low NPA percentage is crucial to validate the larger narrative that new-age lenders can lend effectively using alternate data and make money.

That being said, the BNPLs have a few cards up their sleeve to generate revenues apart from MDRs - from DSA (Direct Selling Agent) fees to Lead Generation to becoming a shopping destination by themselves!

For example, users can log inside their Klarna app and shop for deals from partner merchants in the Klarna app itself. Here's an article that explains the phenomenon of BNPLs going 'D2C' (had to use the term D2C without which 2021 would feel incomplete). This article - and the SubStack - is highly recommended and it's amazing how the writer has kept the newsletter for free.

As they say, change is the only constant and the evolution of the various business models for BNPLs is a testimony to that. Hope the article was useful. Ideas, suggestions, feedback - your turn :)

References & Further reading

https://growthbug.com/bnpl-vs-credit-cards-f968ec2ce6fc

https://alexandre.substack.com/p/-buy-now-pay-later-solutions-are

https://www.rba.gov.au/publications/bulletin/2021/mar/developments-in-the-buy-now-pay-later-market.html

https://www.bloomberg.com/opinion/articles/2021-08-20/square-and-afterpay-rediscovered-grandma-and-grandpa-s-installment-plan

https://www.mckinsey.com/industries/financial-services/our-insights/buy-now-pay-later-five-business-models-to-compete

https://www.forbes.com/sites/ronshevlin/2021/09/07/buy-now-pay-later-the-new-payments-trend-generating-100-billion-in-sales

https://www.washingtonpost.com/business/how-old-style-buy-now-pay-later-became-trendy-bnpl/2021/09/15/dcd6e2f2-15e1-11ec-a019-cb193b28aa73_story.html

https://www.techinasia.com/explains-kredivos-akulakus-fast-rise-500m-club

https://www.techinasia.com/time-ripe-buy-pay-asia

https://www.techinasia.com/dark-side-buy-pay

https://www.ft.com/content/8c751ac6-bb63-11e8-94b2-17176fbf93f5