How bankruptcy applies to fintech giants PayPal and Block — and how it doesn’t

US authorities have stepped in to try to stabilize the chaos started by the sudden collapse of Silicon Valley Bank. A confluence of events (poor asset management, rising interest rates and fear among SVB’s tech start-up customers) led to a bank run, and shares in other small and regional banks have sold off.

Fintech giants PayPal (PYPL -1.30%) and Block (SQ -1.00%) are not exactly banks themselves, but investors may wonder if similar risks may apply. Let’s dig into some details.

Are PayPal and Block actually banks?

PayPal and Block are financial technology (fintech) companies that use software and computer technology to do business differently than traditional banks. Still, as they’ve grown, PayPal and Block have started to look a little more like typical banks.

PayPal and its digital wallet subsidiary Venmo are quite different from a bank. The typical user has small amounts of cash in their PayPal and Venmo account and instead chooses to link their existing bank and credit accounts to PayPal and Venmo to make digital payments. PayPal primarily makes money by earning a small percentage fee taken on each transaction, much like Visa (W -1.29%) or MasterCard (MA -1.62%) make on transactions that cross their electronic payment network.

But like a traditional bank, certain PayPal and Venmo deposits do qualify for the Federal Deposit Insurance Corp. (FDIC) protection known as pass-through insurance. This happens when PayPal or Venmo deposits money on users’ behalf at three FDIC-insured banks — The Bancorp (TBBK 15.96%), Goldman Sachs (GS -4.47%)or Wells Fargo (WFC -3.64%). PayPal Debit Mastercard holders, users who have signed up for direct deposit with PayPal or Venmo, and buyers of cryptocurrency using PayPal or Venmo qualify for this FDIC pass-through insurance. Holdings of cryptocurrencies and non-US dollar balances do not qualify for FDIC pass-through insurance. However, this insurance does not provide protection against failure of PayPal or Venmo.

Block also makes most of its money from transaction fees. Block is slightly different from PayPal, however, because it actually received a banking charter in 2021 when it bought a bank, now part of Square Financial Services. On the Square merchant side of the business, Square Checking accounts are offered through Sutton Bank, a regional bank based in Ohio. Accounts are insured by the FDIC up to $250,000 per depositor.

At the Cash App consumer business, deposits are also eligible for FDIC pass-through insurance through Sutton Bank for customers using the Cash App Cash Card (a Visa debit card). Again, any crypto or deposit made in anything other than US dollars does not qualify for FDIC insurance.

Financial system risks for PayPal and Block

Technically, any financial company that accepts and holds money on your behalf can run into a liquidity crisis – including PayPal and Block. Why?

According to PayPal’s 2022 annual report, the company holds users’ balances as “direct claims against us that are reflected on our consolidated balance sheets as a liability classified as amounts due to customers.” At the end of 2022, these liabilities totaled $36.4 billion, which was more than offset by $40.1 billion earmarked as “funds and amounts payable to customers,” which PayPal maintains in short-term liquid assets.

However, even short-term assets such as bonds and other interest-bearing assets must be sold before money is sent to a customer requesting a withdrawal. Although these are highly liquid, it still takes time to sell these assets on the market. Thus, too many withdrawal requests at once can cause problems. PayPal revealed that over $17 billion of receivables and customer funds were invested in short-term debt securities available for sale by the end of 2022.

Block’s customer balance was significantly smaller than PayPal’s at the end of 2022. It reported $3.18 billion in customer funds, and $1.75 billion of that was designated as cash, with the rest invested in the money market and other short-term cash equivalents.

In addition, both PayPal and Block have loans to consumers and businesses that involve other types of risk. These include credit risk if a borrower stops paying, and interest rate risk when market interest rates rise as they have in the past year.

Because it is not a bank in itself, PayPal uses partner banks for customer loans. As of 2021, Block can lend directly to its merchant customers through Square Financial Services. However, customer loans listed on PayPal and Block’s balance sheets were much smaller than available liquid assets – so these two companies still don’t pretty looks like traditional banks.

PayPal listed $7.4 billion in loans and interest as assets (which are only assets as long as customers keep paying), but it had $10.8 billion in cash and short-term equivalents on hand, plus another $5 billion in long-term investments. Block listed only $474 million in customer loans held for sale, since most of the loans it originates are sold to investors on the market. It reported $5.6 billion in cash and short-term investments on its balance sheet, and another $573 million in long-term investments.

In other words, both PayPal and Block have plenty of cash available if customers start defaulting on their loans.

Are PayPal and blockchain at risk?

Although PayPal and Block have begun to look more like banking, the bulk of their businesses still rely on fees earned by processing digital payment transactions. A cash crunch does not seem likely for either company.

Still, as time goes on and PayPal and Block acquire more customer funds and dive deeper into the lending business, traditional banking risks may emerge. I think PayPal and Block will come out on top when the current bear market ends, but it’s important to think about the risks in both of these businesses.