While the ancient Babylonian laws on credit capped interest on loans of silver at 20%, the latest incarnation achieves the apparently impossible by making a business model out of lending with no interest.

Investor enthusiasm is remarkable. In September 2020, a funding round valued Sweden’s Klarna at $10.6bn, making it the most valuable fintech in Europe. Afterpay of Australia, parent of the UK’s Clearpay, is listed and, just seven years after founding, has a market value of around £18bn as of January 2021. That’s higher than the market cap of Deutsche Bank. US provider Affirm’s most recent filing proposes a Nasdaq market cap of around $10bn. All this with a spotty record of operating profits.

Consumers may think there’s a catch, that if they miss payment they’ll be mugged for substantial late fees. In fact, some, including Klarna, do not levy late fees. As a mini-test, in late 2020 I defaulted on a Klarna payment and ignored all communications from the company. After three months, no interest or additional fees were being levied, although a couple of letters were sent saying, in polite and slightly regretful tones, that they wouldn’t offer me credit again until I paid up.

This creates an important dynamic. While credit card companies can make money out of those who struggle to keep up with payments (as long as the borrowers don’t outright default), the buy now, pay later providers have different incentives. As they don’t charge interest, they need to get their cash back quickly to fund the next purchase transaction. It makes little sense for them to fund the purchases of those who, like your humble scribe, go absent after happily taking delivery of the goods. That said, some also offer conventional credit for higher-value items. That is a traditional, fully licensed credit business.

The refusal to charge interest on their main, short-term lending product is not, however, the result of generosity on the part of the buy now, pay later providers. It is how they operate, in the UK at least. They can offer their service – without being troubled by the regulator – thanks to a long-standing provision that no licence is needed to offer short-duration, interest-free loans repaid with a limited number of instalments. Without this provision, informal credit arrangements – such as a newsagent allowing customers to pay for their deliveries at the end of each week – would need some form of Financial Conduct Authority authorisation.

A later extension to those rules in 2015 was passed without debate by a Commons committee to help solicitors create instalment plans for clients who couldn’t immediately pay legal bills. “I think when the legislation was drafted, legislators didn’t anticipate the kind of corporate provision of credit on the scale that we now see with dedicated lenders like Klarna and Clearpay and others,” says Mardi MacGregor, financial services regulatory specialist at City law firm Fox Williams.

MPs may still not grasp how big buy now, pay later is. An amendment to the UK Financial Services Bill, which would have regulated it, was rejected by MPs in mid-January. However, The Financial Conduct Authority is carrying out a review into unsecured credit, the Woolard Review, which is due to report soon. It will be looking at ‘potential changes’, rather than rule setting, but it seems likely that it will have a view on a stricter approach. Certainly, regulators worldwide are starting to act. Sweden has already moved to prevent online retailers making buy now, pay later the default payment method; non-debt systems such as the local Swish bank payment system must be first on the list. Regulation is also moving closer in Australia and New Zealand.

What causes some concern is the psychology of the buy now, pay later checkout. A credit card requires a formal application. Getting buy now, pay later credit is a single click at checkout when the consumer is focused on acquiring something they want, not on making a measured assessment of their finances.

Unlike credit card providers, the buy now, pay later providers in the UK do not exchange information about bad payers or share data with credit agencies, although this may change. This means a consumer could potentially run up credit with multiple providers on top of other debts.

That is not the only looming problem. The high valuations given to buy now, pay later providers are causing a rush into the market, helped by the fact that barriers to entry are low. Current buy now, pay later providers – such as Klarna and Clearpay – are teaching consumers that it is safe and convenient. New providers could create lookalike services with a more exploitative business model.

Alex Marsh, Country Lead, Klarna UK, said in a blog post in early December 2020 that “regulation has not kept up with innovation and the changes in consumer behaviour” and that the time had come for “appropriate regulation”.

Clearpay and Laybuy said they would be happy to work under appropriate regulation and that a code of conduct, already in place in New Zealand, was an additional vital tool to promote transparency and good customer outcomes.

Worthington says it’s inevitable that regulators will apply the Duck Test: if it looks like a duck, swims like a duck and quacks like a duck, then it probably is a duck. “I think the regulators will say this is a credit product and needs to be regulated as a credit product,” he says.