$SQ - Hip to Be Square - Net Interest

Welcome to another issue of Net Interest, the final one of the year. I’ll be back in January with more weekly insights on financial sector themes. Feel free to share this or prior issues of Net Interest widely over the holiday season with friends and family. And if you could spare a few minutes I’d also appreciate it if you could fill in my short reader survey. Wishing you a safe and happy few weeks. — Marc

Hip to Be Square

The term unicorn is used to describe a privately held startup company valued at over $1 billion. In the summer of 2014, there were around fifty of them in North America and Europe. Many of the big ones have now gone public, the most recent being AirBnB which debuted on the stock market last week. Among them sit two financial technology companies—Square and Lending Club. Together they bookend the returns these unicorns have shown in public markets. While Lending Club has bombed, down 80% since its summer 2014 valuation, Square has ballooned. This week its valuation surpassed $100 billion, thirty times its valuation back then.

In addition, because Square came to the market earlier than many of the others, most of that value has accrued to public market investors rather than its venture capital backers. And being public, its successes and failures have been a lot more visible.

Source: Wall Street Journal, Net Interest calculations


My own relationship with Square is mixed. My fund participated in its IPO in late 2015 but we sold our position a few months later. In 2017, I went to visit the company at its headquarters in San Francisco, but I came away sceptical. This year alone the stock is up 260%, a beneficiary of the changes in the technological and financial landscape that Covid has accelerated.

So what makes Square so hip?

The Opening

The funny thing about that 2014 valuation is that it could have marked the top. In the summer of 2014 Amazon embarked an all-out attack on Square.

Square had been founded five years earlier. Jim McKelvey, an entrepreneur in St Louis Missouri, knew Jack Dorsey from when Jack had done some work for him as a 16-year-old. They’d kept in touch and in 2008 decided to start a business together.

As well as maintaining an interest in business, McKelvey was a keen glass artist; the story goes that one day a customer came to buy something from him but he didn’t have the capacity to accept her credit card. McKelvey did some research and realised that he was not alone: there were millions of small businesses out there who weren’t plugged in to the non-cash payments system. He and Jack devised a business to serve them.

At one level, their innovation was simple: a small square block which contained a magnetic stripe reader that could plug into the headphone jack of an Android or Apple mobile phone. Using the device, merchants could swipe a card and process the transaction on software installed on their mobile phone. Rather than recreate a new payments system, they would ride on the rails already in place.

At another level, though, the innovation was the business model they constructed around the device. McKelvey points out in his book, The Innovation Stack, that the square dongle was never successfully patented, so was available to everyone. (The actual story is a bit more messy: in echoes of The Social Network, an early collaborator laid claim to the invention in a case that was settled years later for $50 million.) But the business model was uncontested. Square offered merchants simple, low cost pricing, free sign-up and a bunch of other features. According to McKelvey, “combining simple and free caused our growth to explode.” Following launch, Square grew 10% every week for two years without advertising.

Underpinning the growth, Square had tapped into a new market. It is interesting how many of the unicorns on the list were doing the same. Rather than go head to head with incumbent competitors in a market, they explore virgin terrain. In Square’s case, the opportunity was the 80% of the 30 million US businesses with sales less than $100,000 that didn’t accept cards. It’s a market they were either priced out of (transaction fees ranged up to 4% on top of sign-up fees) or were rejected from because of creditworthiness. Square gave away its reader for free and charged 2.75% for transactions. By aggregating a huge volume of small transactions, it had the scale to extract price concessions from the card associations who operated the rails, and a sufficient breadth of data to overcome fraud.

None of this was lost on Amazon. In the summer of 2014, “Jeff Bezos delivered a severed horse head via free two-day shipping,” writes McKelvey. Amazon rolled out a black rectangle which did very much the same thing as Square’s white square, undercut pricing by 30% and offered live customer support which Square was not yet doing.

The attack lasted just over a year. McKelvey’s book is an exploration of how a small company (“a kid dressed as a soldier”) can go up against a giant (“an actual soldier”) and win. His argument is that although one or two features of the business model can be copied, it’s difficult to replicate the whole stack.

Over the next few years, Square would make itself invaluable to its customers. Because it operated as a single integrated system encompassing hardware, software and payment processing, it was able to add new services that entrenched its position with customers. It added services like working capital, invoicing and payroll, all to help merchants run and grow their businesses.


In addition, by tackling specific industry verticals, Square was able to shift upmarket, away from an exclusive focus on small merchants and win share from incumbents. In the years following its IPO most of the earnings upside came from these share wins. Today the company serves 3.5 million merchant sellers and estimates its addressable market is $100 billion, of which it has a 3% share.

In payments there’s a trade-off between being part of an open network or being a closed network. The open network, operating on the rails of card associations like Visa and Mastercard, allows a cardholder flexibility to use their card almost anywhere. But participants have to share the economics. In Square’s case, merchants pay a rate of ~3% on transactions, but Square has to distribute ~2% out to others in the network, leaving only ~1% for itself. In a closed network, the operator maintains a proprietary ledger and can move money from the cardholder side to the merchant side freely, retaining all the economics for itself.

The investment required to build a closed network is vast, but the economics in the endgame make it alluring. Early on, Square gave it a go with Square Wallet. The wallet gave consumers payment functionality which they could use at participating merchants. In order to get it started, they did a deal with Starbucks. Square would take over processing for all Starbucks’ US credit and debit card transactions, and customers would be able to buy coffee using Square Wallet.

The deal wasn’t a success. When it went public in 2015, Square revealed that it had lost $71 million on the deal over the past three years. It chalked it up as a “marketing expense” and unwound the agreement. Square Wallet was replaced with Square Order which allowed customers to order ahead from restaurants via an app, but that too was retired with little uptake.

Years later, Square’s CFO would say: “I think what we learned there and why we shut it down is if you tried to contain what a consumer wants to do, you effectively are removing utility from them.

Not that they’ve given up hope. Rather than mesh a consumer network onto a merchant network before it is ready, Square has been cultivating an independently viable consumer network called Cash App. The two networks are steadily converging.

The Middlegame

Square Cash was introduced in 2013 and is now known as Cash App. It was devised during a hackathon as a way for consumers to make electronic peer-to-peer payments. Its developers were looking for a solution for people to split the bill at a restaurant or share the costs of an AirBnB rental without using cash.

Today the app has over 30 million monthly average users, up from 15 million at the end of 2018 and 7 million at the end of 2017. Its growth has been driven by many of the same strategies that fuelled growth in the merchant seller business: it was made free and simple to use; adjacent services were quickly layered in, in this case payment cards, bitcoin trading, merchant discounts; and the company identified an untapped market among the underbanked population, who could use Cash App as a proxy bank account. With all of the additional services overlaid, Cash App has much of the functionality of a bank account without the friction and expense of getting one.


Early adopters of Cash App came for the network – the ability to pay their friends – and stayed for the utility. More recent adopters have come for the utility and stayed for the network. Utility was an enormous customer acquisition engine during the early part of the pandemic, with the addition of a feature making it easy for people to claim their $1,200 stimulus funds. The company markets the network side through its own money giveaways allied to viral campaigns. The formula has allowed Square to pick up customers at a cost of ~$5 per net new transacting active customer.

Cheap customer acquisition is perhaps the holy grail of fintech. It’s what separates successful consumer fintechs like Square and Affirm from duds like Lending Club. Brian Grassadonia, the Cash App lead, knows it:

“Probably the biggest contribution that I had early on at Square was kind of an obsession around building…a distribution-centric culture. And what that means is putting a major, major emphasis on coming up with proprietary, innovative ways of acquiring customers at massive scale for an incredibly low cost… I think nobody had really come up with a way of acquiring customers at a massive scale for an incredibly low cost, and that just puts them at a disadvantage relative to a lot of incumbents.”

The company reckons there’s a $60 billion opportunity in Cash App from 100 million potential customers, consisting of 65 million underbanked and 35 million in the 15-39 age bracket. Right now, it makes money principally off card issuance – where it earns fees from merchants where its customers spend their money – and instant deposits, where it charges 1.5% for instant withdrawal. In total it earns around $45 of revenue per average user.

If the combination of network and utility makes Cash App sound like a social network, then that’s because it reflects one. Lana Swartz, a professor of Media Studies at the University of Virginia, argues that the technology of money has always tracked the technology of communications and media. Some of the largest payment companies—notably American Express and Wells Fargo—began not in the financial services industry but in the communication industry.

In her book New Money: How Payment Became Social Media, she charts two trends which Square is tapping into.

The first is that while the internet creates more commercial opportunities for individuals, existing payment infrastructure is built around paying companies. Peer-to-peer money has not kept pace with peer-to-peer communications. The convergence of individuals and companies is a theme Jack Dorsey seems to appreciate:

“Yes, I guess some of the magic that we’ve seen in our business is because we've blurred the line between those two dimensions, and I guess, I’d want to resist a lot of the labels on the categories because it resists the potential of what we could do ultimately… So we've had a seller dimension for quite some time. We’re building a growing consumer dimension… But then you have products like Payroll that mix those two. You have sellers certainly, but their employees are individuals and their employees are now getting paid via Square Cash… So the more we resist some of the labels of B2C and B2B, that the more optionality we have to build something that is used in unexpected ways…”

The second is that money has always had a social element to it. Paper money is decorated with stories about a shared national past. Credit cards allow more niche affiliations—a favourite store, an airline, a social tier. People have multiple cards which they may use to reflect different identities. American Express has long referred to its cardholders not as customers but as ‘members’. The internet allows affiliations to splinter more broadly. Just as we have moved from mass broadcast media to social participatory media, payments mechanisms are following. Crypto is the sharp edge of this trend, but networks such as Cash App are an alternative representation.

The number of payment mechanisms in the market is proliferating, as my Christmas shopping experience at JD Sports attests. Some may argue it’s a land grab ahead of inevitable consolidation. But there’s no reason the number of payment networks should be any fewer than the number of social networks, and we know what the Federal Trade Commission thinks about that number.


The Endgame

A few weeks ago, Square announced the acquisition of Credit Karma’s tax preparation business. The acquisition adds another service to the Cash App palette but it also provides a gateway to get more funds into the Cash App ecosystem. Around 2 million taxpayers use Credit Karma to file their returns and in 2020 the average tax refund for self-filers was $2,000. The deal is pretty well timed to capture the fund flow this coming February.

It reflects an underlying goal of Square which is to get more money into its ecosystem, and keep it there. The playbook is pretty similar to Ant Group’s in China. Brian Grassadonia, again: “All of these new offerings are ways of bringing money into the ecosystem. When money comes into the ecosystem, customers transact more. When customers transact more, we make more revenue, and there's a very direct correlation between those two things.”

Eventually, Square’s two networks – its merchant seller network and its consumer Cash App – can converge into one, just like Ant Group’s. When that happens the company can lay claim to one of the strongest payment-cum-social networks in the country.

The convergence has already begun. Last week, the company launched a trial ‘Pay with Cash App’ button on its own clothing site. When it comes out of beta, it will sit alongside all those other buttons on the JD Sports checkout page. A few months ago Square launched On-Demand Pay for employees, and Instant Payments for employers. On-Demand Pay allows workers to transfer up to $200 of earned wages for free to Cash App, if their employer is a Square corporate customer; Instant Payments allows Square corporate customers to pay employees instantly using their Square balance, if their employee is a Cash App customer.

At a recent investor presentation, Jamie Dimon, CEO of JP Morgan, said:

“Square has done an unbelievable job of Square Cash. So you’ve had a huge amount of value in what you and I would have called the financial system, which has moved out of the banking system… I look at some of those things very often to say, ‘We could have done that, too,’ and we didn’t.”

Square is not quite as big as JP Morgan but at $100 billion it would rank the fifth largest bank in the United States. And it isn’t finished yet.

More Net Interest


They say, “If you’re not paying for it, you’re not the customer—you’re the product.” This week Robinhood was fined $65 million by the US Securities and Exchange Commission for “repeated misstatements that failed to disclose the firm’s receipt of payments from trading firms for routing customer orders to them, and with failing to satisfy its duty to seek the best reasonably available terms to execute customer orders.”

Now the first of these complaints Robinhood customers arguably should have known. There’s no such thing as free and in Robinhood’s case zero commission trading was always subsidised by payment for order flow, although it seems the company didn’t always make that clear.

The second complaint is interesting because it suggests that not only were they the product, but they were paying for it as well. It seems that Robinhood provided inferior trade prices that deprived customers of $34 million even after taking into account the savings from not paying a commission. So they’d have been better off just paying for it. But by removing visible commissions, Robinhood removes some of the friction around trading, with consequences that have led to a separate complaint, filed by the State of Massachusetts.

Bank Dividends

This week, the European Central Bank gave the banks under their tutelage the go-ahead to restart dividends with their full year results. With some conditions, naturellement. A ceiling will be applied linked to asset size and profit; no catch-up dividend from the skipped 2019 financial year will be allowed; and nothing can be distributed out of 2021 earnings until at least September. The conditions are a bit more restrictive than those imposed on UK banks a few days earlier. In the US, the Federal Reserve will give banks guidance on their regulatory capital positions after the close of the market tonight.

Yet having seen them cancelled once, it’s difficult for investors to discount that it won’t happen again. The regulators will protest that they were responding to unusual circumstances, but they also seem a bit dismissive of the lasting impact the precedent has set. In October, Alex Brazier, the Bank of England’s Executive Director for Financial Stability Strategy and Risk said, “I wouldn’t overstate the impact of that dividend restraint on banks’ equity performance and that’s because we’re not asking here for banks to run with a higher level of capital in the long run. So this is a dividend delayed rather than a dividend destroyed forever; it doesn’t change the amount of distributions banks will make over the long run.”

Responding to him, my friend Simon Samuels makes a number of counterpoints. He argues that forcing a cancellation of dividends is not consistent with higher capital requirements in place to absorb unexpected shocks. And given the complexity of bank earnings, dividends are an important signal to investors; the investability of bank stocks is undermined if that signal is extinguished.

Bank dividends may be back on, but the prospect of future regulatory intervention persists.

Seasons Greetings

When I started Net Interest in May 2020 I had no idea that it would reach so many people. You read about the power of internet leverage, but until you experience it, you have no idea. This edition goes out to 10,698 people and I am grateful to each of you for entertaining me in your inbox each Friday.

Net Interest will return in the New Year, but in the meantime I’d appreciate it if you could fill out this short reader survey. I am open to any and all feedback, so if you want to message me directly, either by replying to this email or via Twitter, that’s fine too.

Wherever you are spending the holiday season, I wish you a restful time and look forward to engaging with you in 2021.