How does PayPal work?

Why making payments easier for the consumer means layers of complexity behind the scenes

In the era of bots who manage your finances by text message and instant bank account authentication — it’s easy to take earlier fintech innovations, such as PayPal, for granted. But let’s take a moment to remember how PayPal — now an undeniable giant in the payments space — moves money between various parties.

How PayPal moves money

Like many companies with staying power, PayPal looked quite different when it launched than it does today. Confinity, founded in 1998, was initially a security software for handheld devices. When it merged with online bank X.com, and with its powers combined, the combined business became known as PayPal, so named for its service that allowed users to “beam” money between handheld devices and via email.

eBay acquired PayPal in 2002, needing a solution to the checks and money orders being used to exchange money on its platform — and it was at this point that PayPal transitioned from exclusively peer-to-peer (P2P) to buyer-to-merchant payments. Today, PayPal offers the option to do both — users can send money to their friends, just as they did in the early days of PayPal, as well as pay for goods from eBay and many other online merchants.

At its most basic, PayPal uses a digital (and sometimes physical) layer to allow more seamless Automated Clearing House (ACH) transfers between bank accounts, greatly decreasing the friction of online and P2P payments. PayPal’s technology enables an online merchant to collect payments from users whether or not they have a PayPal account.

For example, say Emily is making a $20 online purchase from a merchant who uses PayPal to process online payments. If Emily has a PayPal account, she can log in directly to her account, which will eventually charge her card and transfer funds to the merchant. If she does not have an account, she can enter her card details and subsequently choose whether or not to create one. Either way, PayPal — not the merchant — receives (and is responsible for protecting) Emily’s card details.

At this point in the transaction, no funds (in any of the 26 currencies PayPal accepts) have moved yet, and a number of steps must be completed before this actually happens. Note that if $20 were being transferred directly from Emily’s account to the merchant’s via ACH (as occurs in, for example, automatic bill pay), the merchant’s bank would act as the Originating Depository Financial Institution, or ODFI. In a PayPal transfer, however, PayPal acts as an intermediary and its bank as the ODFI: rather than one ACH transaction, PayPal initiates two — one to get the money from the customer’s account, and another to deliver it to the merchant.

Assuming Emily has no funds in her PayPal account, the merchant’s website collects her payment details and sends them securely to PayPal using a service called Payflow. PayPal then begins an ACH transaction by delivering an ACH file (containing information about how much money is owed and from which account) to its bank, the ODFI. The rest of the process looks just like a traditional ACH transaction: The ACH files go from the ODFI to the Federal Reserve, which debits Emily’s bank account (at the Receiving Depository Financial Institution, or RDFI) for $20 and credits PayPal’s bank, the ODFI, for the same amount. It is only now that settlement — the actual movement of funds — happens. In this example, once settlement occurs, Emily has $20 less in her account, and PayPal’s bank account has $20 more.

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During this process, PayPal notes funds pending on the merchant’s PayPal account. Once the funds are received through the above process, the account indicates a balance greater by $20 minus PayPal fees — in the U.S., 2.9% of the sale plus $0.30 per sale — so $19.12 in this case. The balance remains in the merchant’s PayPal account until the merchant requests a transfer to its bank account. This process is similar to that detailed above, with PayPal’s bank again acting as the ODFI and the merchant’s bank acting as the RDFI. But this time PayPal initiates an ACH transaction for a credit to the merchant’s bank account.

In the event that Emily has a PayPal account with funds in it sufficient to cover a $20 transaction, the process is much simpler, with the only necessary ACH transaction occurring when the merchant requests a transfer to its bank account. PayPal can also be used in this way to send money between friends, as long as both parties have PayPal accounts; for merchants to issue refunds; or for sellers to use a PayPal point of sale system to collect payments in person. Ultimately, funds can be sent between virtually any two parties via PayPal, whose bank acts as the ODFI to debit and credit the appropriate senders and recipients of funds.

Paying more than pals

More than 700 words later, it’s apparent that even early fintech innovations like PayPal are much more complicated than handing cash to a friend or merchant—but these complications are necessary to streamline payments in the digital era. Given that technology companies are constantly threatened by upstarts with new and improved offerings, PayPal has acquired a number of companies over the years, expanding its core technology to offer even better payment experiences to consumers and backend systems to merchants. Despite these acquisitions, however, the core of money transfer via PayPal and its subsidiaries relies on the above processes — and fundamental banking infrastructure like ACH — to get money from one party to another.

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