First Bank of US (credit: wikimedia)

Your PayPal balance isn’t FDIC insured: the case for a new model for financial startups

TLDR: PayPal isn’t FDIC insured, neither are Venmo balances, nor was the Amex Bluebird debit card (pre-2013). ‘Deposits’ don’t have to be insured, which if coupled with operational insurance, could allow startups to engage in deposit-taking, bankish behavior (excl. investing deposits) without being / renting banks.


Yes, shock and horror, if you’ve got an active balance with PayPal, contrary to popular wisdom, it isn’t insured by the US government. It doesn’t even sit in a bank. Welcome to the world of unsecured creditors, banky non-banks, and what may very well be a promising business model.

So, first to back up my claim regarding PayPal.

At one point, PayPal balances were held at other banks, and therefore benefited from FDIC insurance. Those banks included Bank of America, Citi, HSBC, RBS Citizens, and Wells Fargo (sorry, JPM). And if you have a balance on your PayPal debit card, your balances are actually maintained at the Bancorp Bank, one of the largest issuers of white-label debit cards in the US, also FDIC insured.

But today, if you have a balance at PayPal, it’s an unsecured claim against PayPal. That’s right, you’re lending PayPal money. And you’re doing it for free — you aren’t earning interest on the deposits, although PayPal is (very minimally), because they’ve invested those deposits in “liquid investments.”

Turning to their 10-K, you’ll see that your deposits are categorized as “Funds receivable and customer accounts”, of which there were $10bn last quarter. $3.6bn were (p.11) marked as level 2 assets, invested in “short-term investments”. Now that could be worrisome as level 2 assets are less liquid, but I think it’s more likely that PayPal has the $3.6bn invested in money market funds, which are very liquid / stable but IIRC still get categorized as level 2 for some arcane, FAS-related reason. Only PayPal knows.

So, what happened to the FDIC insurance? Well, in 2010 California passed AB 2789, which extended certain money transmitter regulations to “anyone receiving money for transmission” which, well, PayPal. Previously, PayPal had done the sensible thing and said “we’re just in the business of sending people’s money, we don’t want to take ownership of it” and stuffed everyone’s balances into banks, which meant the funds were FDIC insured and off PayPal’s balance sheets. By 2012, though, California’s Dept. of Business Oversight told PayPal that because these funds were off balance sheet, they wouldn’t qualify towards PayPal’s liquidity reserves, newly required under AB 2789.

Which is why there are a few million new (probably unwitting) creditors of PayPal out there today. Thank you, California.


But it’s not just PayPal

This entire practice of non-banks holding ‘deposits’ isn’t exactly new, though. A quick example would be with Venmo, a distant relative (and authorized agent) of PayPal. Like PayPal, Venmo lets you send money to people. Plug in a debit or credit card (credit and lesser-known debit cards get charged 3%, otherwise the service is free) and send funds to your friends in seconds. Once your friend creates an account, they can “cash out” their balance… which then takes a day. Where does the cash sit between it being sent and being cashed out? With Venmo. Does Venmo have FDIC insurance (either itself or pass-through)? Nope.

A more interesting example, though, is the old version of the Amex Bluebird card. Interesting, because Amex has a bank license and controls Amex Centurion Bank and Amex Bank FSB. Getting a license is expensive, comes with a regulatory burden which exceeds that for a Money Transmiter License (even from CA), and takes time. It’s no surprise, then, that PayPal and many other non-bank institutions contract with banks to benefit from FDIC insurance, or, like Venmo, avoid the issue altogether. But in 2012 when Amex and Wal-Mart launched their Bluebird prepaid debit card, Amex chose to leave its balances without FDIC insurance— they sat entirely outside of Amex’s bank holding structure. Subsequently, Amex realized that this didn’t work because this setup prevented cardholders from receiving government pay checks. Bluebird is now insured through Amex Bank and, strangely, Wells Fargo.


A new model for bankish non-bank startups(?)

I think that common wisdom would state that if you’re taking deposits you must be a bank, but that’s clearly not the case (and it’s not as if PayPal and an Amex-WalMart product are edge cases). If you can get away with taking money without being a bank, why wouldn’t you? You avoid a lot of regulatory hassle (…and if you’re in California, it makes it easier to be a money transmitter). More importantly, it means that you avoid some of the more onerous anti-money laundering / Know Your Customer (AML-KYC) regulations that banks have to implement where money transmitters don’t (this is why Western Union, which sends money for many unbanked clients, can still do its job). Not being / affiliating with a bank means that you aren’t inadvertently refusing service to the ~20 million americans who are un[der]banked (p. 15).

Now, I don’t think that the PayPal model of investing balances without FDIC insurance is a good thing, even if they’re putting all the customer balances into US Treasuries or Money Market Funds. At some level, they are engaging in maturity transformation (e.g. they have lent the US gov’t money to be repaid at a later date using customer deposits which could all be withdrawn immediately), and conventional thinking is that to do that they should either be FDIC insured (as a bank) or classified as a shadow bank, which, well, good luck PayPal.

The Venmo / Bluebird model has something, though. Assuming (based on a lack of disclosure; probably not a great idea) that the ‘deposits’ are not being invested but are instead held as “cash” on a spreadsheet somewhere, then there is no maturity risk which would require FDIC insurance. Instead, the risk is operational — against employee fraud, hacking, negligence, etc. This risk should be insured, and can be if we look at companies like Coinbase and Xapo (putting aside that they hold bitcoin instead of dollars, and Xapo’s questionable captive insurance model). Perhaps, this insurance would be even cheaper than FDIC insurance (which is charged on all assets, not just deposit liabilities, and is passed on to customers) because it’s operational insurance, not operational and investment insurance.

This combination (non-bank deposits insured by private, highly-rated insurer) would allow start-ups more flexibility to engage in bankish (scientific term) activities without going through the regulatory hurdles of becoming a bank holding company, or paying to ‘rent a bank’ like Metabank, Bancorp Bank (inventive name) or Greendot. It would mean that capital could be consumed to finance growth as opposed to conserved for regulatory ratios.

And I think that would be interesting.

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