The new banks: How Square, PayPal and other fintechs are taking over finance

Published Fri, Sep 25 202010:14 AM EDT

A remarkable thing happened at PayPal during the pandemic. Even while physical stores around the world were shuttered, crippling sales at retailers and restaurants, the payments processor saw transactions jump 26% to 3.7 billion in the second quarter. Driven by the need for merchants and consumers to move online, the company consistently saw volumes more typical of peak holiday shopping periods. In other words, at a surging and suddenly crucial PayPal, every day is now Black Friday. That digital shift — which analysts say will be a lasting legacy of the coronavirus pandemic, as those who adopt these new platforms tend to stay on them — has bolstered 21-year old PayPal and its younger rival Square , making them more valuable than most U.S. banks. Thanks to the upheaval caused by Covid-19, which accelerated the uptake of digital payments across entire industries, PayPal and Square both reported double-digit revenue growth in the second quarter. Their rise solidifies their rank as leaders of the new guard in finance: Firms that began as niche players in areas overlooked by traditional banks and that are growing rapidly along with e-commerce. Now, their heft in market capitalization and their ambitions make it clear that they are making a play for the future of banking. They started out as payment processors like Visa or Mastercard : PayPal first gained traction as the payment rails for users of eBay , which spun out the company in 2015, and Square's initial product was a smartphone credit-card reader for micro-merchants. PayPal now has 346 million active accounts globally, and Square has garnered attention for its Cash App platform, a consumer finance app that has tripled users to 30 million in the past two years. "When it comes to Square and PayPal, they have a huge number of relationships in their respective ecosystems," said Kenneth Hill, a managing director at Loop Capital Markets. "As they start to match up the needs of their customers, it can go in a number of directions. Over time, you will begin to see them blur the line with traditional banking." Cash App The Cash App exemplifies the threat that fintech firms pose to traditional banks. What began as a peer-to-peer money transfer tool (much like PayPal's Venmo app) has morphed into a consumer finance super app that is routinely the most-downloaded finance app for Apple users. Users can direct-deposit paychecks into the digital accounts, use a linked debit card to make purchases, pull cash out of ATMs, and buy stock and cryptocurrency. Square is constantly experimenting with new features that obviate the need for users to rely on other tools, recently adding the ability to make cross-border payments and testing small personal loans. That viral success has gained the attention of other would-be disruptors, even those at established banks. Adam Dell, the Goldman Sachs partner charged with helping its Marcus brand expand into new consumer finance products, has cited Square and PayPal as inspirations. "I think that the success of things like Square and Venmo are harbingers of things to come, and also evidence of the appetite that exists in the market among consumers for innovation," Dell said this month in a phone interview. "It is not a new idea to be able to send money to someone. But it is a new idea to be able to send it instantly, simply and done on a mobile device." New adopters One of the biggest drivers of adoption during the pandemic has been from what Hill refers to as the "silver tech" demographic – retail and business users in their 50s who have resisted digital payments and e-commerce until their hand was forced. Once people make the shift to digital payments, however, they tend to rely on them. Hill rates Square and PayPal as "buys" and says investors should own both companies for years to come. The growth at these two companies has resulted in eye-watering, technology-like valuations. Square has surged 145% this year, and at a $68 billion market capitalization, it is worth slightly more than Goldman Sachs , a threshold it crossed for the first time last month. PayPal has climbed 68% this year, and at $213 billion is worth more than every U.S. bank except for the biggest, JPMorgan Chase . Meanwhile, the KBW Bank Index has lost 38% this year on concerns over pandemic-related loan losses as JPMorgan and others set aside tens of billions of dollars for expected defaults. After the financial crisis of 2008, in which big banks played a key role in risk-taking, it was assumed that technology-centric players would soon arrive to begin challenging them. And yet the biggest banks, especially JPMorgan, Bank of America and Wells Fargo , have only grown more dominant in that time, and last year the industry threw off record profits. But the core aspect of their businesses – taking in deposits and lending out money at a higher interest rate — is under pressure from the Federal Reserve, which has stated its intent to keep its benchmark rate at zero through 2023 to help the economic recovery. And for the most part, they are leaders in mature businesses that aren't experiencing the growth of PayPal and Square, which mostly rely on charging fees within a closed ecosystem rather than making money through loans. In fact, Bank of America CEO Brian Moynihan has made slow growth a cornerstone of his tenure at the second biggest U.S. lender, branding it "responsible growth." Competitors or friends? Representatives at Square and PayPal are quick to downplay the competition with established finance, saying that they partner with banks and that the real rival is still old-school paper payments. But as they continue to grow and find new ways to service their customers, a clash may be inevitable. The investment case for both firms relies on the continuation of strong growth and on these firms using their data and technology edge to find new ways to service businesses and consumers. Although they began with small merchants and underbanked consumers, their ambitions are higher. "With Square, that merchant ecosystem is relatively sticky, and they can launch new products around that data and do cash-flow underwriting in a way that Wells Fargo can't," said Conor Witt, a research analyst at CB Insights. "On the consumer side, with Cash App, they have insanely loyal users, and they can develop products around the customer data they have, like consumer lending and credit." In March, Square got conditional approval to start its own bank, Square Financial Services. The firm plans on launching it next year, and will offer small business loans and deposit products. Newer digital players that aren't encumbered with maintaining existing businesses with older technology systems are now setting the agenda for innovation, said Devin Ryan, a bank analyst at JMP Securities. Some big existing finance firms will struggle to adapt, he said. "In ten years, the way people deal with their financial institutions will be very different from today," Ryan said. As for today's fintech players, "they all might not succeed to the level that the market is giving them credit for right now, but the ones that do will probably exceed even those expectations." More than a decade after the financial crisis, it may have taken another calamity — the current pandemic— for banks' true rivals to emerge. (This story is only for CNBC Pro subscribers )

Jack Dorsey, CEO of Square

Louis Ascui | Fairfax Media | Getty Images

A remarkable thing happened at PayPal during the pandemic.

Even while physical stores around the world were shuttered, crippling sales at retailers and restaurants, the payments processor saw transactions jump 26% to 3.7 billion in the second quarter. Driven by the need for merchants and consumers to move online, the company consistently saw volumes more typical of peak holiday shopping periods.

In other words, at a surging and suddenly crucial PayPal, every day is now Black Friday.