Its regulated as an "electronic money institution" in the UK—i.e. its regulated but it does not have the rock solid guarantees that make banks a safe place to keep your savings.

but could paypal legally use the money you deposited inside your paypal account for some other purpose (of their choosing), provided they can front the money back if you ask for it?

In the UK no. This is reserved for Banks only. They can make money on the interest which I presume is why EBay UK has moved to a no-fees model but they now keep your money in a balance rather than paying out immediately.

Under most US money transmitter laws, they can’t do that either, not even off the interest. (Hence why they charge fees to move money)