Fraud is a constant problem in the payments space. PayPal (PYPL) has acknowledged as much in prior disclosures and has implemented anti-fraud measures and protection programs designed to protect both merchants and consumers from loss primarily due to fraud and counterparty performance.

Specifically, PayPal’s generous buyer-seller protection program protects consumers if they do not receive an item they ordered or if the item received is significantly different from its description. In its 2019 10-K, PayPal warned the program could result in losses:

“Increases in our loss rate, including as a result of changes to our buyer and seller protection programs, could negatively impact our business.”

In its 2020 10-K, PayPal confirms its prediction has come to fruition:

“We incur substantial losses from our buyer and seller protection programs as a result of claims from consumers.”

PayPal tries to recover losses from its buyer and seller protection programs from the merchant, but does not always fully recover them if the merchant is unwilling or unable to pay or the transaction involves a fraudulent merchant.

Though PayPal would argue its year-over-year transaction loss rate as a percentage of Total Payment Volume (TPV) has fallen to 0.12% from 0.15%, the change in language in this year’s 10-K signals the loss is a growing concern to management. TPV spiked due to the pandemic, which pulled years of digital transformation forward. Instead of looking only at the loss rate as a percentage of TPV, we believe it’s important to look at the growth rate.

In 2019, PayPal realized more than $1 billion in losses from its protection programs. In 2020, the company’s loss increased 10% to $1.2 billion. PayPal did recover a portion of the loss, but we believe the protection program loss rate is a key metric to which investors should pay particular attention.

In its 2020 10-K, PayPal includes this warning:

“Historical loss rates may not be indicative of future results. The duration and severity of the impacts of the COVID-19 pandemic remain unknown. Its negative impact on macroeconomic conditions could increase the risk of merchant bankruptcy, insolvency, business failure, or other business interruption, which may result in an adverse impact on our transaction losses, particularly for merchants that sell goods or services in advance of the date of their delivery or use.”