Stoney Brody wishes he had never discovered PayPal. At first, he was enthusiastic about the e-mail payment system: PayPal made it easier to collect money from his online clients, who pay Brody to invest in gold on their behalf. The drawling Texan once even considered himself quite a fan, convincing more than 200 other people to join the network.
But Brody's devotion turned to disgust last November when PayPal started freezing access to deposits to his account. PayPal, unlike credit card companies, "didn't even bother calling" to discuss the questionable charges, Brody says. Instead, all he received was a form letter stating that PayPal had handcuffed the cash in order to investigate "possibly fraudulent funds."
Then, in February, came the real deal breaker. PayPal refused to release deposits totaling over $20,000 even after Brody sent verification information proving that his customers used their own credit cards (rather than stolen ones) to secure PayPal acounts. At that point, Brody contacted the FBI and decided to sue, not just to recover the cash in his account, but also for $400,000 worth of lost business.
"It's a poorly run company with low-grade standards," he says. "Let's face it: Banks don't make these kinds of mistakes."
PayPal representatives declined to comment specifically on Brody's case, citing privacy concerns. But Brody's outrage is anything but unique. PayPal may be a phenomenon -- the preferred payment method on eBay, a darling of the financial press and the inspiration for copycat services like Citibank's C2it -- but among a growing number of the service's 6.5 million users, backlash is brewing. AuctionWatch message boards buzz with tales of locked accounts, unjustified chargebacks, wrecked reputations and financial ruin. Many of the people who helped put PayPal on the map -- the small-time buyers and sellers of everything from Beanie Babies to Victorian greeting cards -- now spend their time trying to form class-action lawsuits or advising others to stay away.
PayPal representatives admit that its anti-fraud techniques are aggressive, and acknowledge that mistakes have been made. But they argue that aggressive tactics are warranted. Credit card fraud is at least three to four times more common online, say industry analysts, who point to problems with identity verification as the cause. The Palo Alto, Calif., company has already suffered attacks from Russian, Nigerian and Indonesian gangsters, and executives say that more attacks are never far away. Unless users bear more of the burden -- whether in the form of charge-backs or closed accounts, says Peter Thiel, a PayPal founder -- the "tsunami of fraud" will overwhelm the entire company.
But how many mistakes and how much risk should consumers expect to endure? When David Chaum, a U.C.-Berkeley cryptographer, first came up with the concept of e-cash in the early '80s, he expected banks to grab the idea and make digital cash legitimate and irreversible, just like tangible bills and coins. Digital cash would be the new cash. PayPal's approach -- mimicking credit card payment systems by limiting transactions to those people who have joined the PayPal network -- only arose after it became clear that the big banks didn't want to get involved. And while PayPal's usership numbers seem to prove that there's a demand for such a service, the lack of bank-backed support could threaten to injure the very consumers who have made it popular.
PayPal thrives in what many consider a dangerous form of legal limbo. Though it looks more and more like a bank with each passing week -- offering money market accounts and as of this month, credit cards -- PayPal remains outside the strictures of banking laws. Consumer accounts have neither the protection of federal insurance systems like FDIC nor the assurance of regulatory oversight. Even agencies such as the Federal Trade Commission and Better Business Bureau, which have recently started familiarizing themselves with several e-payment providers, appear to have limited power. Since PayPal is privately held, they don't even have the outright authority to scrutinize the company's finances. As one FTC lawyer put it, "if they filed for bankruptcy tomorrow, no one knows what would happen to their accounts."
Ultimately, no company that processes $7 million in transactions every day, as PayPal claims to do, deserves a free ride, says Ken Thomas, a finance professor at the Wharton School of Business. Because PayPal essentially works like a bank -- thriving in an industry where "any type of activity involving payments is heavily regulated simply because issues of public confidence are involved," he says -- they should be treated as a bank. Changing the laws, or persuading PayPal to buy a bank charter may be difficult, slow and expensive but until then, Thiel and his 575 employees aren't just asking that users endure a few technical difficulties. They're asking for nothing less than blind, pre-Depression trust.
"This is banking circa 1928," says Tom McGrath, managing partner of Bank Earnings International (BEI), a banking consulting company. "It's backwards. They could take all these customers' dollars and misapply them, so the money isn't available when the person wants it. They could be insolvent and no one would ever know."
Peter Thiel, a former hedge fund manager, conceived of the idea that became PayPal in the fall of 1998, after giving a speech at Stanford University. After the speech, he met up with Max Levchin, a 23-year-old programmer with experience at three start-ups. After throwing around a few ideas for how to mix their talents, they decided to focus on digital payments.
The field was littered with casualties: Close to a dozen companies had tried and failed to make digital currency happen. But Thiel did some research and speculated that the strategies of his precursors were too broad, too technologically and socially idealistic. "No one ever used their products because they were too inconvenient," he says. "And even if they were useful, they had these utopian business models. It was like they were trying to get everyone to speak Esperanto."
PayPal would be different, Thiel and Levchin decided. Person-to-person payments would be the target, dollars would be the only currency, drawn from checking accounts or credit cards, and accounts could be settled in two ways, through e-mail and infrared rays passed between Palm Pilots. They launched both services in the fall of 1999.
To further set themselves apart from the competition, they added a bonus program. Since the key to every financial service's success lies in attaining high levels of liquidity -- lots of money moving between lots of users -- PayPal decided to literally give its currency away. Users could earn $10 for opening a new account and for getting friends to sign up.
The viral marketing technique brought mixed results. Almost immediately, the Palm Pilot application "fell into the gee-whiz bucket of applications that didn't catch on," says James Van Dyke, a senior analyst at Jupiter Communications. But the e-mail service showed promise. More than 10,000 people signed up before Jan. 1, 2000. The winter and spring brought further growth as the eBay faithful started recommending the service as superior to BillPoint, the auction giant's own payment system. Users raved that it was easier to sign up, and even though PayPal shrunk the bonuses to $5 per new account, the expansion kept going. New accounts poured in: 100,000 by Feb. 1; 1 million by Easter. No one -- not Thiel, not Chaum, not the analysts who covered electronic finance -- saw it coming. But instead of cheering, Thiel and Levchin found themselves trying to deal with a crisis. How on earth could a company that started with only two customer service representatives handle what had become a backlog of 100,000 e-mails seeking technical support?
"We wildly underestimated the degree to which this would scale," Thiel explains. "Things ramped up like crazy. It just snowballed."
Meanwhile, as Thiel was in the process of hiring hundreds of new employees for a service center that now sits in Omaha, Neb., another problem arrived -- criminals. Throughout the spring, scammers operating from computers with Indonesian, Russian and Nigerian Internet addresses started bombarding PayPal's servers, launching small computer programs that automatically set up accounts with stolen credit cards and fake names. The Secret Service and FBI helped staunch much of the financial damage from "the mafias," as Thiel put it, but at the time, PayPal's technology was unable to differentiate questionable charges from legitimate ones. So anyone who accepted PayPal funds from one of the dubious accounts -- even if they didn't realize it was fraudulent -- ended up without access to their money. Customers fumed. Even today, many people say they'll never return to the company after their experiences last summer. Watching PayPal treat "suspected fraud like actual fraud and blame the receiver [and] not the sender," says Donna Locke, who used PayPal for her computer-training business, turned her away.
Thiel says he regretted having to freeze the accounts, and wishes he didn't have to put in place other anti-fraud measures that incited further complaints, such as a more complicated sign-up and verification system. But he says PayPal had no choice: "PayMe, PayPlace, PayPro, ExchangePath -- they all went out of business because of the fraud issue. The fact of the matter is that people use our service because it's easier to use than anything else. As a result, there are more responsibilities that people have to assume," says Thiel.
Specifically, he argues, both buyers and sellers need to grasp that PayPal's very nature dictates that it must be more aggressive than both credit-card companies and banks. It's all a matter of convenience. PayPal's genius lies in large part in its low barriers to entry; a few clicks and you're through. Instead of fighting fraud at the front end with the credit checks and the paperwork that's common for anything bank-related, PayPal employs a gather and sift model -- grab as many people as possible, then weed out the good from the bad. "The flipside" of open access, Thiel explains, "is more aggressive anti-fraud measures further down the road. We're trying to balance two things: convenience and security. It's an ongoing struggle."
Indeed, some analysts stress that PayPal should be treated with a greater degree of understanding. "They're defining a new way of doing something," says Jupiter's Van Dyke. "They're doing a lot of positive things for online payments. You can't remove the factor of trial and error; there's no way that any company could move online payments ahead without angering customers."
Even the occasional digital currency veteran agrees, and sympathizes with PayPal's plight. Take Jim McCoy. A former DigiCash enthusiast and the founder of Mojo Nation -- a peer-to-peer service that uses digital currency as payment for downloads -- McCoy has been evaluating and working with digital payment for almost a decade. He argues that PayPal must use aggressive anti-fraud tactics. "From a business perspective, it's the only way they could have gone," he says. "They're trying to become the standard for open market, person-to-person transactions but now that they're bigger, they're going to run into the same problems as larger institutions. The larger you get, the more people you're going to have who are trying to cheat the system."
Plus, McCoy adds, PayPal actually has a financial incentive to ignore its customers, to act swiftly and without discussion. "Customer support costs will eat you alive," he says. They pose the greatest threat to any bottom line so "the less you have to get involved in customer disputes, the better off you are," he says.
Still, what if what's good for business also damages PayPal's chances for survival? Thiel believes that the vast majority of the people whose accounts have been closed or back-charged deserve some of the blame for taking money from "sketchy" customers. Thiel noted that one of the companies that Stoney Brody purchased gold from was e-Gold, an offshore company based in the Caribbean that had been a favorite target of the previous summer's gangsters, many of whom attempted to launder funds by buying e-Gold gold certificates.
"While I doubt this person [Brody] is engaged with the Russian mafia, I don't think [he and other e-Gold merchants] are totally innocent either," Thiel says. "They certainly know that much of the money they're receiving is from suspicious sources."
Brody denies any such knowledge. He still believes PayPal is in the wrong. More to the point, he's spreading his criticisms as vigorously as he can, raising the question of whether the same viral marketing that made PayPal a success could eventually be its undoing. Could he and other critics topple PayPal? Could perceived injustices -- which PayPal defends as necessary -- become the cause célèbre for public abandonment of the service?
The clamor against PayPal is rising. AuctionWatch is flooded with critics arguing that PayPal must be "punished and terminated." Entire discussion lists are dominated by debate over the company, including one at E-Tailers Digest. Even former fans who have had no personal trouble with PayPal now help critics fight back against the company. In fact, one former PayPal evangelist, Izzy Goodman, set up a Web site that aims in part, he says, "to undo the damage I did in convincing folks to join PayPal." After seeing "complaints numbering in the hundreds," Goodman says, "I can't recommend it."
PayPal also faces a serious threat from more established financial players. When it comes to financial transactions credit-card companies and banks still have the upper hand, says David Chaum, the digital currency inventor. "I originally went to banks and asked them to be the custodians of the cash because that's what they did," he says. "It was safer and it made the most sense." At some point, Chaum predicts, the banks will recognize that they belong in PayPal's market. By directly tying already existing financial accounts to digital currency, they'll eventually create a more convenient service that renders PayPal obsolete, says Chaum.
Banks have the advantage of consolidation, says Tom McGrath at BEI. "Credit cards took off because you could use one piece of plastic to do what a whole wallet of store cards used to do," he says. Similarly, consumers will embrace bank-based e-currency systems because "we simply don't need more payment methods. Too many already exist."
PayPal could attempt to trump the banks by becoming a bank itself, but PayPal appears to want to avoid getting under an official institutional umbrella. Its terms of use emphasize that PayPal is "not a bank ... not subject to banking regulations," and while the company considered buying a bank charter last year, executives ruled against it. "The cost and regulatory burden was too high," Thiel says. The paperwork and all the restrictions of law were just too much. "Consumers didn't want another bank account, they want to move money," he says.
That may be the case, but at some point, banking experts argue, both users and PayPal might need to think beyond their next purchase of an antique lamp. E-payment providers aren't the only unregulated financial institutions -- Western Union and American Express, for example, also run outside banking laws -- but "there isn't much of a chance that they'll go out of business," says Jeff Baker, an analyst at W.R. Hambrecht, an investment bank.
PayPal and its ilk, on the other hand, are far more fragile. Banking experts argue that the very novelty factor that they're using to ask for special treatment puts the company at greater risk. Fraud, consumer backlash, new competitors and an industry wracked by failure all highlight the shaky state of PayPal's prominence and the potential need for more consumer protection. "Considering the public policy issues involved," says Thomas at Wharton, "it appears that this is an area where some type of regulation would be appropriate."
The FTC, the catch-all regulator of Western Union and other businesses that fall outside specific corporate laws, has yet to call for tighter new legislation. The agency is trying to balance the potential for deception against the benefits of letting a new economy business grow unstifled, says Tracy Thorleifson, a staff attorney who has studied e-payment providers. "It's still up in the air about whether more laws are needed," she says.
But while the drama plays out among PayPal users, in the courts and perhaps in Congress, Thorleifson is offering some somber advice. "I suggest that people keep their PayPal balances low," she says.
This article has been clarified.
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