PayPal's Partnership with Discover Extends Its Mobile Wallet Reach

PayPal (EBAY) will soon extend its reach through Discover's (DFS) network — enabling direct acceptance of its mobile wallet at more than seven million American merchants.

Up until now, the ecommerce unit of eBay has been inking individual deals with big box retailers, such as Home Depot, as well as terminal makers and middleware providers. This latest deal places PayPal in the same league as the issuing banks in terms of its ability to issue a card that's accepted over an open-loop network.

The partnership, which was due to be announced Wednesday morning, will change the way PayPal handles those transactions as well. Once the system is live (in spring 2013, the companies say), Discover will be the network over which those payments ride, and PayPal will continue to process the transactions. Previously, PayPal did both jobs.

"This is a really fast-changing world and this event accelerates that change," says Don Kingsborough, PayPal's vice president of retail and prepaid products, adding that merchants will not have to upgrade their terminals or point of sale software to accept PayPal at the point of sale.

PayPal already uses its network to fund a prepaid MasterCard managed by card marketer NetSpend Holdings (NTSP) and issued by the Bancorp Bank, a unit of Bancorp (TBBK).

But this latest move creates an unprecedented method for merchants to accept PayPal payments no matter whether a customer is online, offline or on a mobile device.

Discover is creating a "virtual private network" for PayPal that will keep the technology company's virtual wallet in a closed-loop system. This will de facto create a new transaction type separate from credit and debit with unique pricing, branding and operating rules. PayPal will determine the pricing, which will differ by type of retailer.

In the second half of next year, months after the initial launch, merchants will also get access to special marketing tools from PayPal.

"They needed us to get into the physical world, we loved the things that they were doing in the online space and we both have a mindset that we don't have to do it all ourselves," says Diane Offereins, Discover's president of payment services. "That's the philosophy that we are going to build on."

In the future, this latest deal — which is currently only domestic — could equally benefit the card company's acceptance worldwide, says Brian Riley, a senior research director in the retail banking and cards practice at CEB TowerGroup.

"One of Discover's stated goals [is] to expand the number of countries they are in for processing," he says. "Suffice to say it opens up a lot of space there."

Discover already has a relationship with PayPal.

The Riverwoods, Ill. company already bases its Money Messenger tool, which allows cardholders to send cash to anyone, including non-cardholders, on PayPal's technology.

What's currently unclear in this current partnership is how these transactions will be handled at the point of sale.

At Home Depot, people can pay the retailer with PayPal's special card that routes transactions through PayPal's network, or with a phone number and PIN.

That will differ, Kingsborough says, based on the types of terminals each merchant has.

Transaction fees, however, will be lower than the 2.7% interchange merchants pay on debit and credit cards when they use PayPal Here. And those rates will be negotiated by industry segment. The way both PayPal and Discover will divvy up that revenue was not disclosed.

Indeed, PayPal is aggressively expanding its point of sale strategy, partnering with more than a dozen merchants directly.

Most recently, according to Reuters, the ecommerce company has been in early trials with McDonald's in France. The pilot has the fast-food giant testing the waters around allowing its customers to pay with PayPal at the counter.

Previously, in March, PayPal launched PayPal Here as a new way to allow payments to be made electronically as well as by card swipe and by using the phone's camera to accept card or check payments.

Last month, PayPal bought Card.io, which drives PayPal Here's mobile payment option by using cell phone cameras to scan cards, in order to bolster its technology.

"From day one — around 1999, when I first began to actively follow PayPal — only two things have mattered with PayPal: number one, how do they build adoption, on the correct assumption that they can collect some modicum of revenue from users," says James Van Dyke, president and founder of Javelin Strategy and Research, in an email. "[And] number two, how do they lower the cost of processing below the per-transaction level of revenue they collect."

He added that often, industry watchers lose sight of that second objective. But without lowering processing costs, they can't make money.

"Enter Discover, the low-cost leader in retail card payments, to work with PayPal in order to improve the profits of both," says Van Dyke. "This is a direct threat to Visa, MasterCard and American Express, with Discover's demographics that are opposite PayPal's youth-oriented users."

He says that for him, that makes the marriage a good match.