When one of the nation's biggest banks invades the Internet person-to-person payment industry, what is the leading provider, PayPal Inc., to do?

Befriending the enemy is one option, and PayPal chairman and chief executive Peter Thiel hinted that his company may collaborate with Citibank, whose c2it payment service he sees as PayPal's biggest threat.

The two sides have had discussions, though neither side will say what they were about. But in a recent interview, Mr. Thiel said, "I think there's a decent chance that something might happen at some point."

The synergy is there: Citigroup Inc. has connections to millions of consumers around the world and PayPal has developed a sophisticated back-end processing system. "Sure," Mr. Thiel said, clearly relishing the idea, "Citigroup would be great."

Antony Jenkins, c2it's chief operating officer, would only say, "We don't comment on those sorts of discussions."

But a union of PayPal and Citi would support Mr. Jenkins' contention that a shakeout in the P-to-P space is in the cards and will eventually leave the industry with just one or two providers. The big question is who will be left standing.

In the meantime, PayPal, c2it, and other online payment providers are grappling to differentiate themselves in a business TowerGroup says will increase from 100 million transactions this year to more than four billion by 2005.

PayPal officials said their patent-pending fraud prevention system sets the Palo Alto, Calif., company apart. It developed the system in-house after deciding that "we will kill fraud or fraud will kill us," said Max Levchin, PayPal's chief technology officer.

Igor, named after the company's first identified fraud perpetrator, has enabled PayPal push fraud rates down to 0.85% last year and 0.45% currently, compared with an industry average of 2.64% , according to PayPal.

PayPal guarantees its merchants that all transactions will be fraud-free as long as they take simple steps such as verifying their shipping addresses. "Only at a 0.45% fraud rate can something like this become viable," Mr. Levchin said.

Because PayPal money moves in a closed-loop system, the company can track every dollar that goes through the network, every transaction those dollars are involved in, and every individual who makes contact with them.

When PayPal recently conducted an audit of all transactions it had executed since its inception, Mr. Levchin warned staff to expect a small amount of loss. To his surprise, he said, there was none - "not one penny."

He described an incident involving a Los Angeles company that used the PayPal system to process fraudulent orders of Sony PlayStation consoles last holiday season. The company took orders in October and told customers they would receive their PlayStations in mid-December. PayPal's team of investigators noticed suspicious patterns in the 800,000 transactions that were being processed, Mr. Levchin said, and the "red flags" went up. PayPal was able to freeze the funds before they left the system. The con artists were arrested, and PayPal refunded money to all consumers who placed orders.

James Van Dyke, a senior analyst with Jupiter Media Metrix, said PayPal's patent-pending method for authenticating users is brilliant in its simplicity. When a new PayPal user sets up an account, he said, PayPal deposits two random amounts between 1 cent and 99 cents into the customer bank account that will be linked to the PayPal account. The customer must ascertain the amounts by contacting the bank, and then provide the information to PayPal to link the bank account to the PayPal account.

"It's really innovative," Mr. Van Dyke said. "When you think about banks investing millions or billions in security systems, what PayPal is doing is piggybacking on that investment."

PayPal's system is also used by Citi, Mr. Van Dyke said. "It'll be interesting if their patent gets approved, because Citi will have to stop using it," he said.

Mr. Van Dyke said PayPal's fraud rates are acceptably low and will likely continue to drop, despite what its detractors might say. "Because PayPal is an innovator and they've been the only alternative payments company to ever succeed, they've been subject to a lot of scrutiny. Problems are inevitable. It's a question of, What do you do about it?"

Mr. Jenkins said banks have an inherent advantage over companies such as PayPal in combating fraud.

"In the credit card business, a lot of activity is real time, so I think in Citigroup we feel as though we have a lot of experience and infrastructure we can leverage to make sure we manage fraud appropriately," he said. "I think it's hard to replicate that outside of a banking environment."

Citi's brand, distribution network, and quality of service also differentiate c2it, Mr. Jenkins said. But the company is not taking any chances, and it is widening its focus to enroll new c2it customers.

The service went live on America Online in November and on Microsoft's MSN network in March. Last month c2it began offering international money transfers in 30 countries and went live on Auction Watch in an effort to snare some of the online auction business that TowerGroup estimates will continue to make up more than 95% of P-to-P payments through 2005.

"What we're trying to build is a collection of situations in which the consumers will use the product and then over time, we think these products will become mass-market," Mr. Jenkins said. "It's a marathon, not a sprint. It requires a degree of commitment from institutions who want to play."

c2it has signed up 70,000 users since its launch last October, against 8.25 million for PayPal since its launch in October 1999. PayPal, which adds more than 20,000 new customers daily, is beginning to extend its reach beyond eBay, which generates slightly more than half of PayPal's $3 billion a year in transactions. PayPal says it is the preferred payment vehicle for more than 65% of all eBay sellers.

High on PayPal's agenda is to find bank partners that will private-label PayPal's service and offer it to their customers. The company said it is in discussions with a number of U.S. institutions and already has arrangements with international banks including ING Group in the Netherlands and Bankinter in Spain.

On Monday, PayPal and Providian Financial Corp. of San Francisco rolled out a co-branded credit card targeted at customers who make frequent payments. It also offers debit cards that let customers who receive frequent payments withdraw funds from their PayPal accounts.

New products will continue to be introduced every four to six weeks, Mr. Thiel said, including an electronic wallet, available in about two months, that will pre-fill checkout forms for consumers shopping online. In March the company's Web site began featuring online merchants that accept PayPal, and about 10,000 online stores are now linked to the site.

About $250 million in transactions flow monthly through the PayPal system. The company is projecting revenues this year of $80 million to $100 million, and expects to be profitable by yearend.

Naseem Tuffaha, chief executive officer and co-founder of CheckSpace Inc., a Bellevue, Wash., payments provider for small businesses and their customers, said PayPal's plan to private-label its products is not realistic unless it restructures its service. Currently, either the sender or the receiver must have a PayPal account, and PayPal has not yet determined whether it will change that requirement to market its product to banks.

Mr. Tuffaha, whose company focuses on selling its product to banks to offer to small-business customers, said that if PayPal retains its current structure it will be directly competing with the financial institutions it hopes to attract as clients.

"If the money is staying in PayPal's accounts and not the banks', the banks just aren't going to buy that," he said. "You can't sell a bank a bullet with one hand and try to shoot them with the other."

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