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+++ S P E C I A L R E P O R T +++
"PayPal's Model Is Fundamentally Flawed"
Loryn E. Jenkins, Chief Operating Officer
Standard Reserve Corporation
March 2, 2001

Robert X. Cringely recently exalted X.com's PayPal service. Exuding all the confidence of an overpaid televangelist mingled with Silicon Valley tech-oriented bravura, he declared that PayPal will be to the Internet what "Citibank" is to off-line financial institutions. Pontificating on the customer acquisition growth rates, he leveraged his "high-school calculus" and "rough business knowledge," to declare: "According to the numbers, this game is already over, and X.com's PayPal is the winner."

Robert X. Cringely speculates that PayPal will dominate online transactions because of its overwhelming customer base. This is exactly the same reasoning as that used by all the failed dotcoms. Each failed dotcom speculated that at some massively huge revenue rate they would gain enough scale to make a profit. To achieve this, they spent massive sums of money on customer acquisition. Now that the bubble has burst, many of them have and will fail. Robert X. Cringely's juvenile analysis positively makes me cringe.

Don't get me wrong, PayPal offers an excellent service. PayPal's great contribution to the world is that they proved that an 'online' payment service could gain a sufficient mass of customers. No online payment service had proven it until they did it. Their concept of breaking into the market through person-to-person payments was incredibly insightful: it was a stroke of marketing genius. Unfortunately, their business model does not contain that same stroke of genius. In fact, their business model is just plain bad. So bad that I fear for X.com's future as an independent financial service provider.

Let us explore some of the statistics of their business model. X.com / PayPal have raised somewhere in the order of USD$200 million. They have probably spent somewhere in the order of USD$30 million acquiring customers. Their asset base under management (that is, customer funds) resulting from this expenditure is USD$40 million. Performing some quick calculations, we can determine that an average deposit at PayPal is USD$12.12. Once you subtract the customer acquisition bonuses that have been paid (USD$9.09 per customer), there is a net deposit per customer of USD$3.03. Essentially, their investors have poured $200 million into a company in order to acquire an asset base of $40 million. Not smart business. Not smart when you need 400 employees to support the 3.3 million "customers" PayPal have obtained.

Exactly why has PayPal achieved such a small deposit base? Not only because their business model is fundamentally flawed, but because the economic architecture of the business is fundamentally flawed. By economic architecture, I mean the fundamental economic structures that govern people's decisions.

PayPal's economic architecture

Currency management
Although X.com does not yet realize it, they are in the 'currency' business. Their customers provide them USD in exchange for PayPal liabilities. Despite the 3.3 million customers, PayPal liabilities are far less liquid than the general USD distribution. Not only are these liabilities far less liquid, but they are also far riskier. They are risky because X.com's asset base backing the company liabilities could be claimed by creditors in case of bankruptcy. So the risk of holding PayPal liability is greatly influenced by the financial stability of the company. Due to this fundamental economic architecture, people exit their PayPal liabilities as soon as possible. This explains the abysmal $12.12 deposit per customer.

PayPal is obviously a great transaction service. It provides an excellent means of moving money between people, and is therefore easy to enter and exit. And there is the problem: people inherently understand that their money is much better off being held in a stable bank, backed by FDIC insurance, and earning interest, than being held in a PayPal liability. The possibility of offering interest that causes Robert X. Cringely to gloat is a necessity. For without it, PayPal's asset base will be limited to the volume of funds in transit between locations. Offering interest is in reality an admission that they must bid for their deposit base, and should herefore be compared to any other financial institution that does so.

PayPal has built their system on top of the ACH and credit card world. They are exposed to the rules and regulations, the chargebacks and reversals and fraud that have grown around these institutions. Unfortunately, PayPal has encouraged the scamsters and fraudsters to invade the online world, relying on archaic provisions for reversing fraudulent transactions. So what is PayPal's policy position?

PayPal has decided that losses from fraud must be borne by the merchant. The bottom line is that a transaction across PayPal is inherently unsafe: every transaction could be reversed. This ensures that few major merchants will use PayPal, and small ones will evacuate their money out of the system as quickly as possible.

A superior economic architecture: The Gold Economy

Douglas Jackson, the founder of e-gold, recently outlined an economic architecture that has proven far more powerful than PayPal's. In fact, statistics tell me that it is exactly 25 times more powerful! (Statistics are near the end of the article.)

Currency management
The gold economy is built on the fundamental tenet that every gram of gold in circulation is backed by a physical gram of gold held in escrow, and owned by a special purpose trust for the benefit of holders of e-gold liability. In short, this means that if all the companies issuing gold-denominated liability are bankrupted, customers still own their gold. There is no way creditors can obtain the gold assets belonging to the customer's of gold issuers. Therefore, the circulation of gold liabilities are inherently less risky than the circulation of PayPal liability.

The circulation of gold currency is currently a minuscule value compared to the entire economy. This fact would place pressure on the volume of gold liabilities in circulation if it were not for the fact that there is a serious opportunity cost for exiting the gold economy. That opportunity cost exists because it costs money to enter the gold economy. Because it costs between 4% and 15% to purchase new gold, there is a strong economic incentive to maintain the gold in circulation. That doesn't mean people can't remove their value from the gold economy. It just means that there are always going to be others who contribute the capital to maintaining the gold in circulation.

Who would inject their capital in order to maintain gold in circulation? Market Makers. Market Makers are people who buy gold in order to sell it for a profit. These individuals and businesses ensure that there is a stable circulation of gold in the system by purchasing gold from those wishing to exit the system.

Then there is the trust issue. The gold economy is predicated on the idea that every transaction is a cash transaction. The operator of the transaction system will not reverse transactions. Additionally, every transaction is settled immediately. This means that merchants can be sure that when they receive gold, they have been paid. People in the gold economy know that when they have gold, it is theirs.

A strictly non-reversible transaction systems is at odds with the world's legacy transaction systems, which have a large latency in settlement, and a great ability to be reversed. So when the gold economy meets other economic systems, how does it protect itself? Again, through Market Makers. Market Makers not only buy and sell gold, but they also absorb risk. A Market Maker can only sell gold to people when they are sure that they have received the person's money. If they are not sure they have received money, the Market Maker will lose money, because they cannot get their gold back from the fraudster.

Although it is counter-intuitive, increasing the economic and transactional hurdles for entering and exiting the gold economy have created the right economic architecture for a dynamic economy. This economic architecture stands completely at odds with the rationale behind the economic architecture adopted by PayPal. Yet it is the gold economy that is winning.

Winning? Yes. A quick look at the performance of the two 'economies' reveals that the gold economy is beating PayPal's performance on every measure excepting speed of customer acquisition.

The Results: PayPal versus The Gold Economy

The following table tells the story.

PayPal The Gold Economy

1. Capital Investment USD$200 million USD$3 million

2. Customer Accounts 3.3 million 120,000

3. Customer Acquisition
Costs USD$30 million USD$100,000
(10 months) (4 years)

4. Current Asset Base USD$40 million USD$15 million 
worth of gold

5. Avg Customer Bal. USD$12.12 USD$125.00 
worth of gold

6. Avg Customer Bal
less Cust. Acquisition
Costs USD$3.03 USD$124.17 
worth of gold

7. Annual Value of 
Transactions USD$1.8 billion USD$2.5 billion

8. Ratio of Invested 
Capital to Asset Base USD $0.20 USD $5.00

9. Power Ratio 
(PayPal = 1) 1 25

So what does this table tell us? It tells us that the economic architecture of the gold economy is currently performing 25 times more powerfully than PayPal's economic architecture. PayPal have raised $200 million dollars to create an asset base of $40 million, while the gold economy has raised $3 million and created an asset base of $14 million.

It tells us that people are willing to pay to be part of the gold economy: people pay to acquire their gold, they pay to store their gold and they pay to transact their gold. People perceive a great deal of value in owning gold currency, unlike holders of PayPal currency, who flee the currency. So, unlike PayPal, the gold economy does not have to bid interest to acquire an asset base. Any experienced business person will tell you that customers who pay are far more valuable than customers attracted by 'free.'

The table tells us that PayPal are currently destroying value, while the gold economy is creating value. The logical result is that PayPal will one day cease to exist in its present form. It will either change its business model, be bought by an established financial institution, or will become bankrupt. Four hundred staff members cannot be supported on a $40 million dollar asset base: even your local community bank is likely to have a greater and more valuable asset base.

Finally, logic tells us that PayPal are going to have great difficulty in extracting value from customers. They have bought 3.3 million 'customers,' (if you can call a non-fee paying database entry a 'customer') through a clever marketing campaign. They need to convert these convenience-seeking cheapskates into high value customers. Can they do it? History says this is quite difficult.

On the other hand, the gold economy have acquired 120,000 accounts of people who perceive the real economic value of participating in the economic exchanges occurring within the gold-based economic system.

The gold economy has the right economic architecture for success. The gold economy have acquired and are acquiring the high value participants. The gold economy is beginning to attract a range of competing financial institutions to issue gold-based currency (Standard Reserve, Metal Savings, Digi-gold and e-gold). The gold economy is growing at 30% per month with extremely low customer acquisition costs.

The gold economy is set for success. My money (and stock options!) is on the gold. Where will your money be?

Loryn E. Jenkins, 
Chief Operating Officer 
Standard Reserve Corporation

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