December 2001

Digital Cash Payoff

PayPal's fraud-busting technology makes it easy for people to pay one another over the Internet--and may give credit card companies a run for their money.

By Evan I. Schwartz

Around the time he immigrated to Chicago from Ukraine as a teenager in 1991, Max Levchin became obsessed with cryptography. Living under the old Soviet regime convinced him of the need to carry out communications undetectable by authorities. As a computer science student at the University of Illinois, he immersed himself in the mathematics of creating and breaking codes, not only making it the focus of his studies but also, he says, turning his pursuit into a "huge hobby" that consumed countless days and nights at the supercomputer center on the Urbana-Champaign campus. Dreaming that he would one day profit from his passion, Levchin aimed to start a company that would process financial transactions over the Internet, devising codes so secure that hackers wouldn't be able to read the data even if they intercepted them. He moved to Silicon Valley after graduation in 1998 to make good on his goal.

It didn't quite go as planned-but close. Now a worldly 26 years old, Levchin is the cofounder and chief technology officer of PayPal, the Palo Alto, CA, company that has suddenly become the leading processor of person-to-person, or P2P, payments over the Internet. Just as Napster allowed people to directly share music online, PayPal enables people to exchange money instantly without having to open expensive merchant accounts to accept credit cards. Yet to Levchin's surprise, advanced cryptography has had little to do with PayPal's success. Rather, the company's rapid adoption by millions of small businesses and individuals operating chiefly on Internet auction site eBay is largely credited to Levchin's more recent obsession: developing financial surveillance software that closely monitors PayPal's customers and almost instantly alerts both the company and law enforcement officials to any suspicious account activity. "We mine millions and millions of transactions in real time," Levchin says.

Limiting illegal transactions is crucial to the long-term survival of Internet commerce. Since consumers aren't typically liable for fraudulent use of their credit card numbers, they usually don't worry much about these numbers, or even their very identities, being stolen. Merchants, however, are keenly interested in stopping such swindles, because they are the ones who have to eat what is estimated to be $2 billion in annual credit card fraud losses, with a disproportionate share of those losses occurring online. Whereas Visa reports an overall fraud rate of .07 percent, a Gartner study of Web merchants indicates the figure soars to 1.13 percent for online transactions. In other words, buyers and sellers online face a 16 times greater risk of not being able to recover the money or merchandise due to them.

PayPal claims it has found a way to bring the online fraud rate down to less than .5 percent, thus eliminating 60 percent of the risk of taking credit cards online. It is this ability to combat criminal behavior that has enabled the privately held company to raise a whopping $211 million in equity financing, with more than 40 percent of that coming after the great Internet implosion that abruptly ended so many getrichquick.com schemes. And in September, PayPal announced plans to complete an IPO worth up to $80.5 million.

At a time when few startups can exhibit a clear competitive edge, Levchin's fraud-monitoring software-dubbed Igor, after a Russian hacker it helped detect-may very well be a technological silver bullet that largely eliminates one of the chief obstacles to conducting commerce with strangers around the planet. But PayPal's potential for widespread growth has been a cause for alarm in the $2.7 trillion credit card industry, which seems fearful that the company could displace Visa and MasterCard, first on the Internet and then offline. PayPal could "cut the legs off of banks and credit card companies," says Kjell Hegstad, senior vice president of business development at ING Direct, a U.S. arm of Dutch banking giant ING Group, which has taken a "know-thy-enemy" approach to matters by investing in the upstart.