On Thursday, the Consumer Financial Protection Bureau (CFPB) released its hotly anticipated report on the buy now, pay later (BNPL) industry. It has been in the works since late 2021, and it highlights a laundry list of concerns about the new installment-based lending product, which has operated almost entirely unregulated for the last few years.

Technology is evolving at such a rapid pace that legal frameworks are struggling to keep up, and the BNPL industry is a prime example. Large tech companies are meeting young consumers where they shop online, and they're delivering credit products that would typically be expected from banks and credit card companies -- without the onerous compliance burdens.

Block (SQ -0.28%) is one of the largest providers of BNPL loans thanks to its $29 billion acquisition of industry-leader Afterpay in 2021. That buyout left Affirm (AFRM 1.31%) as the single biggest standalone operator. Both companies have had a difficult year in 2022 amid the broader sell-off in technology stocks, but will a regulatory overhaul make things better or worse?

Two friends taking a break from shopping to sit at a table, smiling while checking one of their smartphones.

Image source: Getty Images.

Buy now, pay later -- or never

Overextension was among the largest concerns highlighted in the CFPB report. It simply means that BNPL platforms are potentially leading consumers to borrow more than they can afford, and they're doing so in a way that is entirely new to regulators. 

Since the BNPL concept was designed by tech companies rather than the financial sector, it relies on practices that have been borrowed from areas like social media. Afterpay, for example, runs a "discovery" feed on its website and mobile application that shows users brands or products they might be interested in. Similarly, it builds artificial-intelligence-based data models for its merchant partners, allowing them to push highly targeted advertising to consumers who are most likely to engage with their goods. 

The CFPB refers to this as data harvesting, and it goes far beyond simply collecting personal information from consumers like their name or email address. BNPL providers have a very unique, granular insight into the purchasing behavior of their customers, which they're leveraging to drive more sales.

The result: A consumer who's more likely to spend -- even if it means borrowing money to do so. That brings us back to overextension. The CFPB report found that 3.8% of borrowers had a loan that was charged off in 2021, which means they never repaid it. That was up from 2.9% in 2020, and it could be exacerbated in 2022 by rising inflation and interest rates.  

What this could mean for BNPL lenders like Block and Affirm

Credit cards are the main form of consumer finance that BNPL providers are disrupting. Therefore, regulators want to align the BNPL industry with the credit card industry. This would have multiple impacts.

A lack of dispute resolution processes is the top complaint among BNPL borrowers. Most providers aren't following any sort of dispute resolution requirements that are mandatory for credit card lenders, and this could drive up costs if it were imposed. 

Additionally, BNPL loans aren't recorded on a consumer's credit report, which means other lenders don't have visibility over all of their liabilities. If this were changed, consumers might be more careful about how often they use BNPL products so as not to adversely impact their credit. 

Thirdly, regulators are looking to prevent the use of autopay, which allows BNPL lenders to automatically draw funds from a customer's bank account or card for repayment. This makes the likelihood of repayment significantly higher, so BNPL providers could be subjected to more credit losses in its absence. 

Block and Affirm could still be long-term buys

To be clear, none of the above changes or CFPB findings paint the BNPL industry in a positive light as a whole. But regulation in this case is good news, especially if it improves the customer experience and forces lenders to be more cautious about who they lend to, and on what terms.

The fact is, BNPL is winning because it's convenient. It saves the consumer from having to interact with their bank to make an application for a credit card. Instead, platforms like Afterpay and Affirm simply integrate directly with the online stores of their merchant partners allowing the consumer to finance their purchases with a few clicks. 

Between 2020 and 2021, the volume of transactions processed using the concept rocketed tenfold to $24 billion, and it's powering higher because Affirm expects to fund up to $22 billion in volume in the upcoming fiscal 2023 year all on its own. And since BNPL users are typically young -- those aged 33 and under are heavily overrepresented -- it's going to be hard to reverse the movement. 

Block is a much larger business than Affirm, with several other segments and revenue streams beyond Afterpay and BNPL. But I think an overhaul of the regulatory framework will be great for both companies in the long term. Even if the end result is a higher cost of doing business and a more expensive credit product for the consumer, the key is to maintain (and improve) the convenience factor using technology.

But to be clear, Block and Affirm are higher-quality companies than many others in the space, so the above may not be true for the rest of the industry. Affirm, for example, has gigantic partnerships with e-commerce powerhouses Shopify and Amazon, driving screaming growth for the company.

Convenience appears to be the secret sauce powering the BNPL revolution, because with an industrywide average loan size of just $135, according to the CFPB, the interest rate is likely less of a factor. BNPL providers should beat credit card issuers by meeting them on a level playing field -- I still think they'll win, because the product is just better suited to the modern shopper.