May 2, 2017 Reading Time: 2 minutes

In years past, almost all retail trade was conducted at brick-and-mortar stores. Merchants depended on their reputations to drive customer traffic. But reputation mostly spread by word of mouth. Merchants risked their good reputation if they sold bad products. This gave consumers a layer of protection. As retail sales moved outside of brick-and-mortar shops to the internet in the early 2000s, consumers did not have such protections.

Prior to the early 2000s, some retail trade occurred outside of brick-and-mortar shops. The Sears catalog, for example, was first published in the late 19th century. Growth in non-store retail sales accelerated with the advent of online shopping. Outside of the Great Recession, online retail sales have grown over 10 percent per year since 2000. In comparison, brick-and-mortar sales have seen year-over-year growth in the low single digits.

The internet brought together millions of buyers and sellers from around the globe. Early on, it was much harder to verify an online market participant’s reputation. How could anyone know whether [email protected] would send the goods as advertised? Harry Smith, if that was his real name, could not be excluded from local markets for fraud. Mr. Smith could live anywhere in the world. His reputation in the local community would not necessarily be ruined if he committed fraud.

Customers were unhappy transacting in an online marketplace full of fraud. A strong demand for a system of private governance emerged. A firm named PayPal stepped in and responded to that demand. In 1999, PayPal began as a small Silicon Valley start-up. After less than a year in operation, PayPal had over a million users. Within two years, fraud was costing PayPal $10 million per month.

PayPal reached out to the FBI to combat fraud but soon realized that the FBI was a good decade behind in its technology. The founder of PayPal, Peter Theil, found that the FBI barely had a functioning email system in the late 1990s. FBI agents did not know what a banner ad was. The Silicon Valley start-up took matters into its own hands and created a private system of governance to police the online marketplace.

PayPal’s dominance as the premium online payment system was not a done deal in the early 2000s. PayPal’s competitors included names such as eMoneyMail, PayMe, and PayPlace. A big reason why PayPal beat the competition was that they created the best private-governance system in the market. For example, PayPal created the Gausebeck-Levchin test, which asks users to retype an alphanumeric message to confirm that they are not robots. PayPal also wrote algorithms to trace fraudsters and freeze their accounts. Security measures reduced fraud and brought more market participants to the table.

The importance of PayPal cannot be overstated. Before PayPal, most eBay transactions were settled by nothing more secure or convenient than personal check. Established financial companies such as Visa, MasterCard, and American Express followed PayPal’s lead in online security. Amazon Prime quickly and securely verifies and delivers goods. Secure online markets have saved us countless stressful hours of driving to unpleasant big box stores. We all put that saved time to better uses.

Theodore Cangero

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