PayPal next year will extend its reach through Discover Financial Services' network, enabling direct acceptance of the PayPal digital wallet at more than seven million U.S. merchants.

Up until now, the eBay unit inked individual deals with major retailers such as Home Depot, as well as terminal makers and middleware providers. Its new agreement with Discover changes PayPal's approach and places it in the same league as the issuing banks in terms of its ability to offer a product that's accepted over a widespread open-loop network.

The partnership, which is due to be announced Wednesday morning, will change the way PayPal handles those transactions as well. Once the system goes live next spring, PayPal transactions will ride on the Discover network. PayPal will continue to process the transactions. Currently, PayPal does both jobs.

"This is a really fast-changing world and this event accelerates that change," says Don Kingsborough, PayPal's vice president of retail and prepaid products. Merchants will not have to upgrade their terminals or point of sale software to accept PayPal payments, he added.

Discover is creating a "virtual private network" specifically for PayPal payments. This will create a new transaction type separate from credit and debit with unique pricing, branding and operating rules. PayPal will determine the pricing, which will differ by type of retailer.

In the second half of next year, months after the initial launch, PayPal will offer merchants special marketing tools.

"They needed us to get into the physical world, we loved the things that they were doing in the online space and we both have a mindset that we don't have to do it all ourselves," says Diane Offereins, Discover's president of payment services. "That's the philosophy that we are going to build on."

Discover has some experience with digital wallet initiatives. It was an early partner for Isis, the mobile-wallet venture of AT&T Inc., T-Mobile USA and Verizon Wireless. Last week, Discover announced it would become Google's second issuer partner for its mobile wallet.

PayPal's deal with Discover currently covers only domestic transactions, but in the future it could boost Discover's acceptance worldwide, says Brian Riley, a senior research director in the retail banking and cards practice at CEB TowerGroup.

"One of Discover's stated goals [is] to expand the number of countries they are in for processing," he says. "Suffice to say [working with PayPal] opens up a lot of space there."

Discover, of Riverwoods, Ill., earlier worked with PayPal on the card company's Money Messenger tool, which allows cardholders to send cash to anyone, including non-cardholders, using PayPal's technology.

At Home Depot and over 15 other retailers, consumers can pay with PayPal's special card that routes transactions through PayPal's network, or with a phone number and PIN.

That will change, Kingsborough says, based on the types of terminals each merchant has.

Transaction fees, however, will be lower than the 2.7% interchange PayPal charges for card acceptance with PayPal Here, its mobile card reader and app. PayPal and Discover did not disclose how they would share revenue.

PayPal launched Here in March to allow its customers to accept card payments using a smartphone's camera or a triangle-shaped add-on reader. Last month, PayPal bought, which drives the camera option in PayPal Here.

"From day one—around 1999, when I first began to actively follow PayPal—only two things have mattered with PayPal: number one, how do they build adoption, on the correct assumption that they can collect some modicum of revenue from users," says James Van Dyke, president and founder of Javelin Strategy and Research, in an email. "[And] number two, how do they lower the cost of processing below the per-transaction level of revenue they collect?"

Often, industry watchers lose sight of that second objective, he says. But without lowering processing costs, PayPal can't make money.

"Enter Discover, the low-cost leader in retail card payments, to work with PayPal in order to improve the profits of both," says Van Dyke. "This is a direct threat to Visa, MasterCard and American Express, with Discover's demographics that are opposite PayPal's youth-oriented users."

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