PayPal (NASDAQ:PYPL) introduced Pay with Venmo about two years ago. Pay with Venmo takes all the functionality of PayPal, but allows consumers to pay merchants using their Venmo account instead of a PayPal account. It's another way for PayPal to take share of the market and leverage the growing user base of its free peer-to-peer payments app.

But until recently, Venmo's monetization efforts hadn't really caught on. In May, just 13% of Venmo users had tried a monetized product. That may be because Pay with Venmo required merchants to opt into the program, and add yet another button to their payment options screen.

As of the company's third-quarter earnings, the percentage of users that tried a monetized Venmo product grew to 24%. PayPal introduced a Venmo-linked debit card in the interim, but it also provided merchants with a smart way to offer the best payment options for their customers. It's called "Smart Payment Buttons," and it could enable PayPal to grow Pay with Venmo.

Checkout on desktop and mobile using PayPal's Smart Payment Buttons.

Image source: PayPal.

What's a Smart Payment Button?

Smart Payment Buttons is a tool merchants can use to dynamically populate a list of checkout methods for customers based on data PayPal has on each customer and his or her geography. If a user has a Venmo account, they'll see a Pay with Venmo button; if they don't, they won't see that option. In other countries, PayPal will populate checkout options with local digital wallets where the consumer has an account.

Smart Buttons provides a better checkout experience for consumers because they're only presented with relevant payment options. That reduces the amount of friction in the checkout process, leading to greater conversions for merchants.

Merchants may also see a benefit from more consumers using Pay with Venmo. PayPal points out that Venmo transactions are often posted to users' feeds, so their friends can see what they bought from a store. That's free exposure for small merchants in an app that users check relatively frequently.

Smart Buttons provides a compromise for merchants that don't want to inundate every customer with a Pay with Venmo option when only a relatively small portion of consumers have an account. But the product allows them to take advantage of the additional benefits of Pay with Venmo when it makes sense.

Cannibalizing its core product

More often than not, Pay with Venmo is going to cannibalize PayPal. PayPal's management is just fine with that idea. That's because PayPal believes Venmo merchant transactions will ultimately be more profitable for the company.

There are two reasons for that belief.

First, Venmo users are more likely to hold a balance in their accounts compared to PayPal users. PayPal doesn't have to pay payment card processing fees to card issuers and payment networks in order to move a balance to a merchant's account. Additionally, the payment cards Venmo users have in the app are more likely debit cards, since Venmo charges a fee to send money to a friend using a credit card. Debit cards are less expensive to process than credit cards.

Second, PayPal doesn't have the same limiting partnerships with payment networks on Venmo as it does on its flagship product. A couple of years ago, PayPal moved away from requiring users to spend down their balance first before paying with a credit card in exchange for favorable terms from payment networks and credit card issuers. It hasn't done that in Venmo, so it could theoretically require users to pay with their balance first.

The use case for Venmo (splitting payments with friends) is more conducive to using a Venmo balance to pay for things online. Still, the success PayPal has had by giving consumers more choice in their payment options in its flagship product may encourage them to pre-empt any demands from credit card companies.

Smart Payment Buttons presents an excellent solution to one of the biggest problems merchants face when considering Pay with Venmo or any other new payment option, for that matter. If PayPal effectively gets the message out about the benefits of offering Pay with Venmo when relevant, it should help the percentage of Venmo users taking a monetized product continue to expand rapidly.

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 the following options: short January 2019 $82 calls on PayPal Holdings. The Motley Fool has a disclosure policy.