Former PayPal Leaders Debate: Can Facebook Credits Replace PayPal?

[Editor’s Note: Facebook has been experimenting with Credits, its in-house virtual currency, for years. But now the company is looking at ways to get all developers on its platform using Credits (while it takes a 30% fee for the service). And given Facebook’s ambitions for the currency already, many people in the industry are wondering what Credits might become in the future. A “PayPal killer?” In other words, a payment wallet that can be used for any transaction across the web, if not in physical locations?  That description makes for easy headlines, and there are reasons it could happen, as panelists at our Inside Social Apps looked at in April.

The debate has emerged on question-and-answer service Quora, after a user posed the question: Can Facebook Credits replace PayPal one day, why or why not? Former PayPal (and Facebook) leaders have weighed in on both sides. We’re republishing David Sacks’ response, but you should read what Lee Hower, Yishan Wong, Eric Jackson and other Quora users have to say, as well.]

I don’t think so. Here’s why:

PayPal is the low-cost provider in the industry. The main reason is that roughly half of its payments are funded from a PayPal balance or bank account instead of a credit card, virtually eliminating funding costs for those transactions. Funding costs (because of credit card interchange fees) are by far the biggest portion of the expense of processing a payment.

This funding mix was extremely difficult to achieve. It required us to drive a huge percentage of users to (1) add and verify their bank account so it could be used as a funding source, and (2) keep money in their PayPal account so it could be recycled within the system. A bank account was only verified by transferring to it two small payments (less than $1) that together constituted a 4-digit PIN. Waiting for the PIN took several days so this was a multi-step/multi-day process. It still amazes me that so many users completed it; however, we systematically created benefits for becoming “PayPal Verified”.

PayPal also incentivized balances through money-market interest rates and a PayPal debit card that made the PayPal account liquid at any ATM. Finally, anyone could receive payments through PayPal, which meant that ordinary buyers could accumulate a balance; although P2P payments seem easy, they are actually extremely risky and require special fraud detection systems. All of these features would be extremely difficult for Facebook to replicate; even if they did, it’s not clear users would have the same incentive to verify their accounts.

As a result, Facebook will have higher funding costs than PayPal, which will prevent it from challenging PayPal on the basis of price. For many companies, like social gaming sites and apps on Facebook’s platform, this won’t matter. They will gladly pay more for the additional conversion that Facebook payments will generate. This is because their margin on each incremental transaction is 100%. On the other hand, price-sensitive e-commerce sites with thin margins will want to use the cheapest payment provider. If your margin is only 10%, for example, then saving a couple of points on payment processing increases your profits by 20%.

Here’s how I see the market breaking down: Facebook will charge a premium fee for delivering additional convenience, distribution, and conversion to merchants. This will win over the virtual goods market. But merchants with thin margins (e.g. sellers of physical goods) will prefer to stick with the low-cost leader for the majority of their payments.

David Sacks was the original Chief Operating Officer and product leader of PayPal. He is now the founder/CEO of Yammer, a leader in enterprise microblogging.