A not so stablecoin? A deeper dive into PayPal USD

By Jeff Huther

PayPal recently added its own stablecoin, PayPal USD, to its offerings of bank-like products and services, making the coin the first offered by an institution with a large presence in payment services. PayPal sees its stablecoin as a way to streamline transfers into and out of Venmo (a PayPal subsidiary) and PayPal accounts instantly and, ultimately, undercut pricing for banking services. The company is taking a long view: establish a presence, argue for a particular kind of regulated environment (notably without the consumer protections provided by banks), and quietly pursue the goal of being in a position to be the preferred alternative to the bank-centric payments systems. It’s an ambitious plan, and one that poses real risks to the traditional banking business as well as to overall financial stability.

The putative allure of stablecoins is obvious: low transaction costs at fast speeds without a bank account and, conceivably, with lower risk of devaluation. Hurdles include challenges in scaling up and, relatedly, acceptance by merchants in real-world transactions. The hope for stablecoin issuers is that use in crypto will spill over into transactions for real goods and services (after issuers figure out how to process the large number of transactions that are currently handled in traditional markets). Acceptance of a stablecoin in everyday financial transactions would have a huge payoff to the issuer; mediums of exchange are naturally monopolistic, since multiple currencies just increase transaction costs. If successful, a stablecoin issuer would establish itself as the preferred coin for transactions and, possibly, as a permanent alternative to the dollar. Again, it’s an ambitious goal with big implications for more than just the payments system.

New not-a-bank business

PayPal already offers a “wallet” to hold some cryptocurrencies, and PayPal USD does not differ significantly from other USD stablecoins. It is backed by reserves comprising vaguely disclosed assets (it asserts that it holds U.S. Treasury bills, repo and bank deposits), it promises to be redeemable 1:1 with U.S. dollars and it is issued by a U.S.-incorporated firm that has approval to operate in the U.S. by the New York State Department of Financial Services.

At issuance, PayPal USD is competitive with existing stablecoins. In less than two months from introduction, its market cap has grown to over $130 million (see Chart 1). While still tiny compared to market leaders (Tether, with a market cap of over $80 billion, and Circle, with a market cap of almost $25 billion), PayPal USD has the potential to grow given PayPal’s presence in traditional markets.

PayPal USD outstanding (Source: Coingecko). Click to enlarge and share.

The initial growth in PayPal USD has been driven by crypto market participants, but the longer-term growth driver may be the ease of access to the crypto world for PayPal’s large customer base (430 million active users who conducted $400 billion in total payments in Q3). If customers – merchants and buyers – come to see transactions in stablecoins as easier or less expensive than transactions in dollars, PayPal USD has a good chance of being the coin that facilitates those transactions.

New risks

In theory, there is no reason why PayPal’s existing model cannot be expanded to cover stablecoins. PayPal has succeeded by providing instantaneous payments while taking on short-term credit risk with transactions that provide a high degree of anonymity, often to people or entities without traditional credit records. Its financial success stems from earning interest on floating balances and charging fees to merchants that are roughly half of credit card costs, but without providing the same kind of consumer protections, broad payments acceptance or payment credential ubiquity that cards do. The limiting factor to PayPal’s growth has been its choice to create a closed-loop core business that lacks robust network effects. PayPal USD may provide a link between traditional finance lines with crypto transactions. (PayPal has been providing crypto services since 2021, so it has familiarity with the underlying tools and risks.)

Stablecoins have the potential to disrupt traditional banking. PayPal cites international transfers, card transactions and correspondent banking as targets. The company has already made significant inroads in international transfers (it operates in most countries) and other business lines in which the costs of traditional payments are widely recognized as high.

While core banking businesses have faced competitive challenges for the last two decades, PayPal competes with banks from a unique perspective. PayPal’s international success, so far, is concentrated in small-value transactions. That combination of market familiarity and existing relationships creates the potential for broad displacement of many traditional international banking transactions. PayPal USD could disrupt traditional correspondent relationships among U.S. banks by replacing banks with nonbank financial institutions that selectively extend or receive credit.

Like other stablecoins, PayPal USD also poses risks to users that, in the banking world, would be mitigated by regulation. Stablecoin issuers have attractive incentives to add leverage to their supporting assets, to invest unregulated funds into risky instruments and, in the absence of deposit insurance, ultimately face run risk similar to that of money market mutual funds. These risks to overall financial stability could lead to forced selling, a negative feedback loop and contagion.

The PayPal USD-specific risks are difficult to quantify: the investment strategy is vague, and PayPal could mix investments across its savings accounts, float and coin-supporting assets without necessarily running afoul of existing regulations or PayPal’s investment statements. Discipline for maintaining account integrity will fall almost entirely on PayPal management, given its current lack of federal regulatory oversight (CFPB Director Rohit Chopra has made comments suggesting that he is scrutinizing PayPal).

It is still an open question of how consumers will view the PayPal stablecoin. From the PayPal press release, it would be easy for many to believe that PayPal USD is regulated (“Fully-backed, regulated stablecoins have the potential to transform payments in web3 and digitally native environments.”) PayPal USD, like other stablecoins, has the potential to be very profitable for PayPal, since it will keep the interest earned on whatever securities are backing the coin. PayPal, like other stablecoin issuers, is incentivized to invest in longer-maturity and lower-credit securities to maximize returns. Investment discipline comes from internal controls and voluntary disclosures (which have typically been vague).

Conclusion

PayPal, as a stablecoin issuer, has an advantage over other issuers given its well-known brand. Banks should be concerned that the integration of an unregulated stablecoin with a competitor in traditional markets will have unfair advantages. Regulators should be concerned that a stablecoin integrated with traditional financial services would introduce a new risk to deposit safety and, more broadly, financial stability.

The ultimate success of PayPal USD, as with other stablecoins, is uncertain. One potential outcome is that it follows the trajectory of previous stablecoins, generating initial interest but appealing to a small market. A more ominous outcome would be a period of slow growth that builds into exponential growth as users, attracted by lower transaction costs, become more comfortable with new technology and counterparties, all while operating outside the regulatory perimeter.

Jeff Huther is VP for banking and economic policy research at ABA.

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