Venmo is one of the fastest-growing parts of PayPal (NASDAQ:PYPL). Last year, the peer-to-peer mobile payments app processed $35 billion in payment volume, nearly 8% of the company's total payment volume for the year.

While Venmo is primarily used for peer-to-peer payments, it's starting to move into merchant services. PayPal expects to follow a path in monetizing Venmo similar to the one it took for its flagship service but with a greater focus on mobile and a younger demographic. To that end, management says PayPal's monetized business services like "pay with Venmo" are already seeing faster adoption than its peer-to-peer service.

But as Venmo moves into more merchant services, the company risks cannibalizing more of its main business. That means Venmo might not be as big a growth driver for PayPal as some investors are hoping, as each incremental dollar of transactions could be coming right out of PayPal's pocket. CFO John Rainey says he's fine with that -- here's why.

A phone with the Venmo app open, sitting on a table surrounded by clothing

Image source: Venmo.

All about transaction expense

Over the last couple of years, PayPal's transaction expense as a percentage of total payment volume has increased. It started at 0.93% in 2015, climbed to 0.95% in 2016, and reached 0.98% last year.

A big part of that increase stems from the additional options PayPal is offering to its users. Users no longer have to draw from their PayPal balance before other payment methods, and the company is no longer pushing users to link their bank accounts instead of using credit cards.

PayPal signed deals with several credit card companies and payments networks in 2016 and 2017 to reduce processing fees on its network, in exchange for opening more options to consumers. Those deals have paid off in strong user and engagement growth, but PayPal is still seeing an increase in transaction costs.

So how does Venmo fit into this?

Venmo users are significantly more likely to pay from their balance or use a bank ACH (automated clearing house) than to pay with a card. Using the balance costs PayPal absolutely nothing, and ACH fees are significantly lower than card payments.

That's due to the way Venmo users behave with the app. They're much more engaged than PayPal users, sending or receiving payments four to five times per week, on average, and the vast majority of those are relatively small payments to friends. By comparison, PayPal users average one payment every 10 or 11 days, and they're often paying a merchant.

Because users are sending payments with Venmo more often, they're more apt to leave a balance in the app since their next use is imminent. That's great for PayPal: It helps reduce the losses taken on Venmo's free peer-to-peer service. As Venmo's merchant services scale, they should start to have a positive impact on transaction expenses as a percentage of total payment volume.

Venmo has been a drag on profits

Venmo is currently undermonetized. It has a few services that generate revenue, but for the most part, PayPal is subsidizing peer-to-peer transaction expenses. That shows up in PayPal's take rate -- the percentage of total payment volume that it takes as revenue. Take rate has fallen from 2.88% in 2015 to 2.68% in 2016 and down further to 2.53% in 2017. Rainey expects that trend to continue in 2018.

At some point the take rate will stabilize, and as Venmo's monetized services begin to grow, it should start recovering. At the same time, the growth of Venmo's services ought to help transaction margin, as more payments come from balances and ACH instead of the more expensive credit cards. If that's the case, the company will be happy to sacrifice some growth at PayPal for more profitable growth from Venmo.

Adam Levy has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends PayPal Holdings. The Motley Fool has a disclosure policy.