By Leon Gauhman – chief strategy officer at Elsewhen

If the financial services industry is spinning on its axis right now, the ‘Buy Now Pay Later’ (BNPL) model is fast emerging as a major disruptive force. This lucrative concept has gained traction in line with rapid digitalisation, as behavioural shifts among young consumers drive one of the hottest trends in new-gen cardless payments.

Reluctant to rack up debt on credit cards, large swathes of Gen Z and millennial customers have been seduced by the prospect of using BNPL as their preferred form of point-of-sale (POS) credit. Latest estimates suggest that market demand is burgeoning and online fashion outlets are among the biggest beneficiaries, with growth of around 15% per annum. To put this in perspective, BNPL pioneer Klarna was recently crowned as Europe’s biggest fintech unicorn, with a valuation north of $10 billion.

Clearly, BNPL is the popular kid of the sector; and online payments giant PayPal wants to be right at the centre of the party. Over summer, it launched its own BNPL scheme, Pay in 4, in the US and France, followed by a similar solution – Pay in 3 – in the UK in recent weeks. A sharp increase in online shopping caused by Covid-19 gives an extra edge of great timing to these consumer-savvy launches.

The big question now is whether Klarna can withstand PayPal’s ambition to be the heavyweight champion in the win-all arena of BNPL. In a world where many digital sectors have coalesced around one category killer, a number of scenarios seem possible. Will we see an eBay/QXL-style mismatch, a Spotify-style giant-killing or a split decision – more analogous to the Visa/Mastercard duopoly? The market is all to play for.

Head to head:  Klarna and PayPal

Merchant relationships: BNPL is, in the first instance, a B2B play – with PayPal and Klarna having to convince merchants to sign up to their programmes. In this respect, Klarna has a first-mover advantage, with established partners such as Macy’s, Asos and Ikea in its corner. For the first half of the year, it was adding an impressive 200 new retailers a day – despite the uncertainties caused by Covid-19. The message here is that Klarna has established itself as a credible and trusted partner, capable of generating significant new volumes of business for retailers. The company’s own data is convincing on this point, suggesting that retailers typically see a 68% increase in average order value with Klarna instalments.

PayPal, by contrast, is playing catch-up – though this term is slightly misleading when you consider how deeply embedded the brand already is in the global merchant network. When it unveiled Pay in 4 in the US, it was launching into a market where 79% of the top 100 online merchants already accept PayPal as a payments option. In total, the company can boast a network of 25 million merchants.

True, merchants still need to sign up to Pay in 4 – but it’s free for them to do so and raises the prospect of increased sales. Should merchant take-up be slower than expected, PayPal has deep enough pockets to incentivise them – perhaps with a discount on the fees it charges. Vendors that have already committed themselves to PayPal’s BNPL solution include Crew Clothing, French Connection, Robert Dyas and Ryman.

We also shouldn’t forget that PayPal actually has more than a decade of experience enabling people to pay for everything from cars to event tickets by installment. In 2019, it estimated that US consumers had spent $50 billion since 2008 using its PayPal Credit platform. So in one sense, Pay in 3 or 4 is not so much a new contender but a rebrand designed to position PayPal more prominently in the battle for BNPL revenues.

B2C brand affinity: Getting merchants to sign up to BNPL is just phase one: after that you need consumers to use the service. True, some customers will sign up to any financial services brand that offers them delayed payments (remember the payday lender boom) – but real traction comes when brand affinity underpins ongoing engagement.

Klarna, for example, made much of the fact that it was recently ranked as the 7th most-loved financial services brand by UK consumers in a survey from research firm Savanta. Explaining why “love” matters, Savanta says: “Data shows us that if a consumer loves a brand, they are more likely to consider and prefer it than if they just trust a brand.”

One obvious downside for Klarna is that PayPal was top of the same Savanta poll. But brand extensions have had a mixed success rate over the years, so it’s not a given that consumers will warm to PayPal’s BNPL solution now that they are comfortable with Klarna’s pink and fluffy approach to lending. For young consumers, Snoop Dogg surrounded by Afghan Hounds may be all the enticement that’s needed.

Still in the brand affinity stakes, PayPal has over 340 million active users worldwide, which puts it in a league of its own when it comes to direct contact with end users. That said, Klarna’s global user base powered past the 85 million mark this year. The company is also working hard to keep those punters on-board via its new rewards programme Vibe. At launch, CEO Sebastian Siemiatkowski said Vibe members would enjoy “unique, tailored benefits from hand-picked partners in addition to exclusive offers, deals and other rewards.”

User experience: In 2019, Klarna proclaimed that “experience is the new loyalty”. Notwithstanding the launch of Vibe (see above), the point the firm is making is that users will stick with a brand only as long as the solution on offer stacks up. While the core pillar of Klarna’s offer is that it allows consumers to pay 30 days later or split the cost of an item into three equal instalments, another real strength of the platform is its emphasis on a friction-free customer journey from beginning to end (“smoooth” as they like to say in their ads). This means offering great deals, a seamless checkout process and a post-purchase experience where shoppers can keep track of orders and manage payments easily.

An inside glimpse at how Klarna is looking to stand out here comes with its acquisition last month of the fintech startup Woilà, created to enhance the post-purchase shopping experience. By identifying price drops, price guarantees and vouchers, Woilà helps consumers claim money back if a product bought online drops in price after they bought it. Klarna’s UX track record is also supported by the fact that the company has pretty robust risk algorithms, which means clients are defaulting at a rate of less than 1%. That should head off the risk of Klarna attracting the kind of negative PR that undermined payday lender Wonga.

PayPal is no slouch on this score, with CEO Dan Schulman able to call on bleeding edge tech innovation in support of his vision of the company as a “customer champion”. That said, Pay in 3 and 4 will not be as friction-free as Klarna. While Klarna’s model sees the purchase amount directly transferred from the customer’s online banking account to the merchant’s account, PayPal is an e-wallet. This means that the customer receives a virtual account that they have to maintain and load with credit in order to be able to make a purchase. Of course, any problems this might create are mitigated by PayPal’s brand recognition, deep pockets and trust in the digital space.

Challenges for both brands

Other rivals: Klarna and PayPal are two of the biggest names in the BNPL space, but other brands like Clearpay, Laybuy and Affirm are also vying for market share. Australia has been a hotbed of BNPL startups, with Afterpay in a strong position to keep momentum on a global basis. By mid-2020, the firm was just shy of 10 million active customers, with the US, Canada and UK all targets for expansion. Key product innovations at Afterpay have focused on increased flexibility, such as the ability for consumers to make overdue payments at checkout (which improves the recovery of late payments and enables them to continue purchasing with Afterpay). Also new is the ability for customers to request a change to payment schedules to align with pay days, or help in managing finances. Even if Afterpay is not a global threat to Klarna and Paypal, it is a potent reminder that the big two will encounter well-backed rivals in most markets they enter. There is, for example, also a surge of BNPL activity in India and Latin America .

Afterpay is also instructive in terms of the response it has drawn from traditional banks. While banks haven’t yet got to grips with BNPL, there is a strong likelihood that incumbent financial services brands will seek to muscle in on the POS credit space with their own products. JP Morgan Chase, for example, launched My Chase Plan in 2019 to allow card customers to finance certain purchases with monthly fees rather than interest payments. It’s also interesting to note that credit card giant Visa is piloting instalment options in the US.

 Regulation: Because BNPL firms generate money from fees as opposed to interest, they have had a pretty clear run so far, but it seems increasingly likely that regulators are going to start scrutinising this sector more carefully. Such is the speed of growth in POS credit that we are certain to see new players rush to enter the market, often without banking licences. As BNPL default stories start to rack up in the media, national regulators will have little choice but to intervene.

If regulators do decide to target BNPL more aggressively, then this may involve tightening the rules around fees or ordering providers to perform more extensive credit checks before approving users. A stricter application process and tighter spending limits may reduce some of the brand love and feted “smoothness” discussed above.

A battle too tight to call

It’s too early to say how the Klarna vs PayPal contest will pan out – but Klarna’s agility suggests that PayPal will find it difficult to land a knockout blow on the Swedish contender, despite its superior punching power. As long as Klarna continues to focus on flawless user experience and keeping defaults to a minimum, it should be able to hold its own against its well-endowed opponent.