What PayPal does with your money

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(FORTUNE Small Business) -- Next month, eBay (EBAY, Fortune 500) intends to implement a controversial new policy that will entail holding payments sent through PayPal for up to 21 days for certain "high-risk transactions."

Furious at the prospect of waiting to receive funds, sellers have been publicly speculating about how much money PayPal (and its parent company, eBay) makes off the accruing interest on funds under PayPal's control - and whether a desire to retain those funds for longer spurred eBay's holding plan.

However, company executives and industry analysts say the money PayPal makes off such payments has a negligible impact on its bottom line.

Any funds PayPal holds for dispersal are automatically deposited in a corporate bank account, which earns interest, according to Paypal representative Amanda Pires. The money is kept there until it's ready for distribution. PayPal, which processes payments for eBay auctions as well as e-commerce transactions from elsewhere on the Internet, counts interest payments on those funds as one of its revenue streams.

That's a perfectly legal practice, as PayPal is classified as a deposit broker, according to Federal Deposit Insurance Corporation (FDIC) spokesman David Barr.

"Deposit brokers make money being deposit brokers," Barr said. "That's the reason they're in business. As long as fees are disclosed, that's fine from our standpoint."

Indeed, Paypal's user agreement - which all accountholders must read and accept - states: "Paypal may combine your funds with the funds of other Users and place those Pooled Accounts in one or more bank accounts in PayPal's name."

This applies to any user funds that are in the company's "custody." The agreement further states that accountholders "irrevocably transfer and assign to PayPal any ownership right that you may have in any interest" that accrues in these accounts.

But the revenue generated from this practice is miniscule given PayPal's total revenue picture, said Thomas Weisel Partners managing director Christa Quarles.

"Money's definitely being made on the float, but is that the purpose at the end of the day?" said Quarles, who covers eBay. "Our sense is it's not necessarily material in its contribution."

Citigroup (C, Fortune 500) Director of Internet Research Mark Mahaney arrived at similar estimates by examining PayPal's public quotes of average "stored value." Mahaney approximates the interest earned on the float at "single-digit millions per quarter, and at most $10 million a quarter."

All that's a drop in the bucket, said Quarles. In 2007, PayPal generated $1.8 billion in revenue. EBay's total 2007 revenue was $7.7 billion. EBay does not break out PayPal's earnings in its financial statements, meaning analysts must rely on their own estimates of the division's profits.

"I understand sellers are angry about [the 21-day policy], but the fee changes are really what's going to drive broader revenues at eBay," Quarles said.

PayPal's Pires said accountholders should be aware that they have the power to collect interest for their own use on delayed funds. It's as simple as enrolling in the company's PayPal Money Market Fund, Pires said.

For enrolled accountholders, any funds earmarked for a hold are diverted into the Money Market Fund rather than PayPal's corporate bank account, Pires said. The dividends earned are credited to user accounts on a monthly basis.

"Every U.S. accountholder has the ability to invest in the Money Market Fund," Pires said.

PayPal's Money Market Fund is run by Barclay (BCS)'s Global Investments. No minimum balance is required, and the fund's current interest rate is 3.46%.

The company would not disclose what percentage of PayPal's 57 million active accountholders have enrolled in the fund. But Pires said the fund is a "well-utilized service by our customers."

Barr of the FDIC notes that PayPal does not ultimately fall under the jurisdiction of the FDIC, which regulates banks and banking institutions. Regulation of deposit brokers or money-transfer operations falls to individual states, he said.

Alana Golden, spokeswoman for California's Department of Financial Institutions, said PayPal's plans for a 21-day holding period do not run afoul of any DFI regulations. The DFI regulates only PayPal transactions that involve transmitting money to foreign countries, and has no jurisdiction over PayPal's domestic operations.

Therein lies PayPal's competitive advantage, said Quarles of Thomas Weisel Partners.

"They've figured out how not to be regulated, and they've done that globally," Quarles said. "[PayPal] has gone to great pains to be not considered a bank."