PayPal ( PYPL) may have opened some eyes with the 54% first-day gain its IPO posted earlier this month, but it's been all downhill since then. Shares of the online-payment clearinghouse have steadily dropped from their first day's highs, and on Monday they briefly fell below the IPO price of $13.


Avivah Litan
Research Director,
Gartner
Recent Meet the Streets
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The worry? That online auction giant eBay's ( EBAY) own payment system could take business from market leader PayPal. Last week eBay said it was taking control of its subsidiary Billpoint, also known as eBay Payments, by buying out partner Wells Fargo ( WFC).

PayPal was able to overcome some initial skepticism after a patent lawsuit from a rival and threats of state regulation delayed its IPO. But the prospect of heightened competition from eBay seems to have dampened much of the excitement over PayPal.

Still, PayPal is the dominant player in the industry: In a recent survey of 1,000 online users by research firm Gartner, 27% said they use PayPal, or 2.5 times the number that use Billpoint, the No. 2 company. Avivah Litan, the research director at Gartner and the author of the study, explains why she expects government regulation of the industry, and why eBay's efforts should make PayPal nervous.

TSC: Regarding PayPal, one of the things that delayed its IPO was the fact that some states said they were going to start looking into regulating PayPal. What makes PayPal different than a bank, other than the fact that it's strictly online?

Litan: My understanding is that the definition of a bank is that they accept deposits and they make loans, and PayPal is accepting deposits, but they're not making loans. What they are doing is taking those deposits and investing them or putting them into safe money market accounts, which makes them less risky on the surface. That's why they don't fall immediately under bank regulation rules. When you make a loan, you take your deposits and make loans with them, and that's a much riskier business than putting them into money market stable accounts. So that's the definition of a bank.

Now there are entities called narrow banks, like American Express ( AXP) used to have when they issued traveler's checks, before they started making loans. When they opened up the American Express bank, they were considered a narrow bank, and you can be regulated also as a narrow bank.

TSC: What type of oversight do you think there needs to be for companies like PayPal?

Litan: Well, given how much money they're starting to move -- the equivalent of $3 billion a year -- my own personal view is that they should be regulated, because consumers and merchants need some protection that PayPal is not going to run off with their money. Now that they're a public company, there are more checks and balances, but we all know how financial reporting works, after Enron. You can't always count on the auditors or the public statement.

With regulation, you get more protection obviously, and you also get FDIC insurance. PayPal offers its own insurance, but there's no certainty like there is when you're regulated that they can stand behind their policies. So consumers need that protection, and I think so do the merchants, because people are starting to look as these businesses like alternative banks.

TSC: PayPal is clearly the leader right now, but as regulation occurs, don't the online-payment arms of established banks such as Citibank (C) have the advantage?

Litan: No, I frankly don't think they do. The only advantage they have is they know how to deal with regulators and they already have the staff to do that. But in terms of market share, we've had C2It Citibank's online payment service for a long time now, going on two years, and before eBay bought the Wells Fargo portion of Billpoint, Wells was running that service, and those companies do not have anywhere near the market share that PayPal has.

I think the lesson that you can draw from this is that brand awareness, early mover advantage and some of the features that PayPal has built in for merchants are much more important than being a regulated bank.

TSC: Last week, as you know, eBay took control of Billpoint by buying out the remaining stake from Wells Fargo. Should that make PayPal nervous? What are the ramifications there for PayPal?

Litan: I think it should make PayPal nervous. The main reason is now I think eBay can move more quickly. My speculation is that they were saddled by Wells Fargo staff on their decision-making board, and that they couldn't move as quickly as they could if it was all internal, so now they'll be able to compete much more aggressively, still having a strong partnership with Wells.

I think PayPal uses Wells, too, for processing. It's one thing to have a back-end relationship, but it's another thing to be on the decision-making committee. I do think eBay's a very aggressive company; they have more experience than PayPal does in sales, and eventually over time I do think they'll be able to catch up with PayPal in terms of features of the system, and start putting Billpoint much more prominently in front of their users and moving PayPal over to the side. I don't think that's going to happen immediately. I think that will take a few years.

I think another thing that Billpoint, which is now called eBay Payments, is going for is large value payments. I think they're going to try to expand the service to manage all the payments for all the transactions, because eBay eventually wants to sell everything to everyone. They're already the biggest automobile dealer on the Internet. They're not confined to low-value transactions like PayPal. Anyway, I would be very nervous about eBay if I was PayPal.

TSC: Do you expect eBay to do something incredibly aggressive like try to forbid users from using PayPal?

Litan: No, because they couldn't. They'd have a revolution. They tried that at one point. They had a checkout service, and as you know, the users didn't like it very much, and one thing that eBay excels at is listening to what their users want. And users love PayPal; they certainly like PayPal more than Billpoint, according to our survey. They're more trusted than Billpoint is, which is a measure of how much you like the service.

So eBay's not going to push eBay Payments in people's face at the risk of alienating the business. They have to do it very gradually.

TSC: Do you think PayPal has been overly aggressive in combating fraud, as some have alleged? Some folks say that they've frozen accounts of innocent users in their efforts to combat fraud.

Litan: I'm sure they've made some mistakes, but they also have reason to be paranoid. They've had tremendous fraud -- you've probably heard about some of those crime rings. In order to combat that kind of fraud, they have to be overly paranoid. Only the paranoid survive, it's true. And they do that at the risk of alienating some customers. They freeze accounts if they look suspicious.

So yes, those complaints are very valid, but on the other hand, they're not the norm. If they were the norm, PayPal wouldn't have grown its business so quickly. Over time, they're getting more sophisticated in how to handle those suspicious transactions. They've already stopped freezing accounts -- they now freeze transactions, but a lot of times those transactions are the only thing in the accounts, so it looks like they're freezing the entire account.

If a seller had 10 transactions and only one of them looked suspicious, they're not going to freeze the other nine. So anyway, they do have a right to be paranoid, and that's the cost of doing business with them. If it becomes frivolous, people aren't going to do business with them. There are other options.

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