Square's (SQ -0.34%) recently announced $29 billion acquisition of Afterpay has gotten investors excited about the fintech ecosystem Square is building. Square's merchant offerings continue to grow, the consumer-focused Cash App is expanding both its user base and capabilities, and the newly acquired Afterpay will bring a buy now, pay later (BNPL) offering to the mix. Initially, the new service can fold into Square's merchant offerings, but I think that's just the start of Square's vision.

The ultimate goal is to replace the entire banking system within Square products. Banking, lending, investments, cryptocurrency, and merchant solutions are all part of Square's package already. Afterpay bolsters that position and could help complete the lending side of the ecosystem.

Square Cash App Card being used on a Square reader.

Image source: Square.

Better than a regular bank

Square's digital products have slowly started to replace traditional banking services. Cash App can take direct deposits of paychecks, and the Cash App Card is a debit card to access deposits. This is the start of a relationship with customers that I think will increasingly include lending options from BNPL to traditional loans. And Square can make the lending process much easier than a traditional bank.

Consider how lending works at traditional banks: 

  • With a traditional loan for a home, vehicle, or personal loan, consumers apply through the bank, supplying income verification and the asset they want to purchase. 
  • An underwriter reviews the statements and approves or denies the application, tying an interest rate to the loan based on loan risks. 
  • Terms are typically standard with upfront fees and multi-year payback. 

Credit cards from banks come with fewer checks on income or credit, but much higher fees. The money made from the transaction usually falls on the merchant. 

  • For credit cards, the customer applies for the card and a bank offers credit based on credit score and other factors like income. 
  • Customers have the option to use $0-fee cards and are often offered perks, but if balances are held, the interest rate charged can be 20% or more.
  • The fee to use a credit card normally falls on the merchant selling goods. Credit card fees vary, but a fee of 2.4% of a transaction's cost plus around $0.30 per transaction is fairly standard. This fee goes to the payment processor, like Visa or Mastercard, and the bank offering the card.

To look at what Square is doing with its merchants service, Cash App for consumers, and Afterpay in the middle of the two, we need to take a holistic view of how it could change the traditional credit and transaction and lending structure I outlined above. 

Square is already offering payment services and other tools to merchants, charging the 2.4% + $0.30 cents that I outlined above. It also has Cash App, which is effectively a bank account for users who can use it for direct deposit of paychecks and to pay for goods and services with the Cash App Card. Square would like to grow both the merchant and customer sides of the business. But what's tying them together? 

The answer may be Afterpay and its BNPL business model. Cash App can integrate into Afterpay and be used as the payment method. And Square could help businesses determine who is worthy of lending money to and who isn't. This is effectively a new form of credit card, all within the Square ecosystem. Think about this: 

  • Square may already know your income through your direct deposit and can assess your ability to pay for goods. 
  • Square understands your spending habits and even your assets with Cash App and the Cash Card. 
  • Square can instantly determine how much it will loan you at any time with the funds available almost immediately. 
  • Since it is the merchant payment solution, Square could change lower fees for highly qualified customers or merchants, or even for using more of the Square ecosystem. 

Afterpay could be the third leg of the stool in Square's business. It has merchants in the Square app, customers in Cash App, and now it has a credit service between them. BNPL may be where Afterpay starts, but given the loans Square is already offering businesses with Square Capital, we could see this be a new credit/loan product as the ecosystem grows. Eventually, Square could be the ecosystem we use to buy everything from dinner at a food truck to a used car on credit. 

Disruption is already here

Not all of these projections are theoretical, even if they aren't built yet. Square Capital will offer capital to businesses for any number of business needs and base the loan size and terms on how much the company processes through Square. The offer is effectively always outstanding to a business using Square. 

Customers could get similar terms from Square based on income, brokerage balances in Cash App, or even bitcoin held in Cash App. Owning the entire ecosystem will allow Square to see a customer's digital financial picture and offer them loans or BNPL at a moment's notice. If done effectively, this could lead to lower fees than traditional banks or credit cards and lower interest rates on outstanding credit for customers. And Square could make more money on its fees from transactions than it is making by processing credit cards today. 

On the credit side of the market, Square could offer the instant feedback of a credit card with the underwriting ability of a traditional loan. Square is simply replacing the traditional banking model with its own integrated set of digital products. 

Square's vision of banking is taking shape

As Square continues to add features, it gets closer and closer to disrupting banking as we know it. The company could integrate services that have traditionally been held in powerful financial institutions that charge high fees for transactions (credit cards), overdraft fees (banks), and short-term loans (BNPL, credit cards, and payday loans). If it's successful, this could be a transformative fintech stock and a great investment long-term.