The fintech fever is breaking.
Shares of payments company Square—which has more than doubled this year—are down 13% so far this month through Monday’s close, capped by an 8.6% one-day drop. Rival PayPal had declined 8.3% so far in October, and Funding Circle, a UK-based peer-to-peer lender, was down 21.6% since its initial public offering at the end of September.
The declines are partly just a natural correction in some highflying names, but they also reflect rising market awareness of some basic risks to these companies’ business models.
The trigger for Square’s drop on Monday appeared to be a note from BTIG analyst Mark Palmer pointing out its dependence on fickle funding sources for its lending business.
Square has been extending credit to merchants through its Square Capital program and recently announced plans to finance purchase installment plans for shoppers. It retains little credit risk as the loans are typically sold on to investors but, as Mr. Palmer points out, the market for these loans is prone to disruption during times of market stress.
Such disruptions, which are bound to happen from time to time, clearly aren’t baked into the bullish case for Square. Investors who bid the shares up are focused on the thesis that it will continue to rapidly take market share from other payment processors.
Offering credit has become a key way for Square to win and retain customers, says Mr. Palmer. Anything that interrupts the company’s growth story would make its aggressive valuation of 109 times 2019 earnings look even more questionable.
Square took some steps to address this potential weakness last year by applying to form a wholly owned bank based in Utah. If successful, this would give Square access to stable deposit funding, but it also would likely mean retaining more risk on the loans it originates. “It’s a double-edged sword,” says Mr. Palmer.
In other words, the basic principles of financial risk—in this case liquidity and credit risks—apply to fintech lenders just as they do to traditional banks. That realization should keep pushing fintech shares down to more realistic valuations.