Embedded Finance – Financial Services in every sector

Financial needs must be met at any time and any place, without technical hurdles and difficulties in handling. But how can this be established by financial service providers and which business models are profitable here?

Setting the scene

The times, they are a-changin’

Bob Dylan famously sings “The times, they are a-changing.” This is probably a song that can be sung daily by anyone working in financial services. Traditional banks and insurers are facing continued challenge from a range of dynamic forces – from changing customer expectations, increased digitisation and technology innovations that opens completely new business models, increased regulatory complexities, a host of new competitors eating their lunch, and most recently also the COVID pandemic, which has accelerated the move to a new “digital-first” normal.

All this change is driving an emerging new reality that is shaping the future of finance – one where the boundaries between financial services and other industries are permanently blurred. Consumers increasingly expect their finance needs to be met on their terms and at the point of need, with financial services and products available to them everywhere and anytime. This means that finance is increasingly embedding itself in a host of other industries and value chains outside of traditional banks and insurers.

This is the new world of Embedded Finance, which democratises the provision of financial services – taking it out the hands of few and putting it in the hands of many.

De-mystifying Embedded Finance

Embedded Finance is all about selling financial products or services in a non-financial customer value chain. It is about non-financial firms like retailers, car companies, airlines, manufacturers, telco’s etc. directly offering financial products & services to customers while retaining complete control over the customer experience. Where you previously had to engage directly with your bank or insurer to manage your finances, take out a loan, make a payment, get insurance coverage etc. you can now do this seamlessly while shopping online, visiting a car dealer, visiting the doctor, buying a new cell phone. A lot of these use-cases are reducing the need to interact directly with your bank, or even to have a traditional bank account.

So it is all about enabling finance on the customer’s terms at the point of need, rather than as a standalone product, for example – if a customer is at an e-commerce checkout and is offered one-click interest free financing of the purchase, it is much more likely to result in sales conversion than asking the customer to exit the process and apply for financing from their bank.

And it is pervasive – Embedded Finance impacts all three components of Financial Services:

  • The transfer/store of value in space – payments/banking (e.g. card-less payments – Uber, WeChat)
  • The transfer/store of value in time – financing/investments (e.g. buy now, pay later options (BNPL) – Amazon, Klarna, Afterpay)
  • The value of complexity reduction – insurance (e.g. embedded insurance – Tesla)

A couple of related concepts really all talk about the same thing, but from a different perspective, for example:

  • Embedded Banking, Embedded Insurance, Embedded payments (aka)
  • Banking-as-a-Service (one of the main response options for incumbents – more details further below)
  • Open Banking (Starting point of development)
  • Open Finance (the next evolution)
  • Fintech/Insurtechs (the first wave of providers)
  • Digital Ecosystems (the playground)

Embedded finance is not exactly new. Retailers have provided their own closed-loop credit cards for decades, and even old-school store credit looked a lot like the embedded finance we see today, because it kept money out of banks.

The difference now is that the internet enables a fully integrated banking experience on a massive scale and across industries and value chains.

This is what all the new fintech’s and challenger finance players have been exploiting for years now – applying the increasing power of new tech innovations like AI, machine learning, IoT, biometrics etc. to solving customers’ financial needs in more effective ways.

The changing of the old Guard

Banks and insurers have been experiencing a decline in profitability for a number of years and as mentioned at the start, this is due to having to deal with several parallel challenges:

  • Legacy tech stacks struggling to adapt to digital
  • Increased regulation & lost customer trust since the 2008 credit crisis
  • Net interest margins, a key source of revenue, are being squeezed by increased competition and low interest rates
  • Increased internet-driven transparency reduced margins for commoditised products
  • New competitors focus on profitable parts of the value chain, which are eating away at banks’ share of wallet
  • Changes in distribution patterns to digital-first has left banks with costly and obsolete infrastructure e.g. branches that deliver diminishing returns
  • Regulatory, compliance & IT maintenance costs remaining substantial

Pre-COVID industry trends towards a new digital normal have accelerated because of it, compounding this new reality. It is also causing banks other economic challenges with loan loss provisions skyrocketing while deposits are surging which banks are struggling to lend in many cases.

By contrast – fintechs are skyrocketing (at least from a market cap/market value perspective – with long term profitability still to be proven by many…and future funding will increasingly demand a need to unlock profits and scale).

And why are consumer fintechs finding success? They start with the customer problem, not the product, which leads to brand new business models. In contrast, bank’s historically start with existing business models and products, which they try to digitise via tech transformations, with the result that customer problems may or may not be solved.

Many banks’ existing business & operating models are hence still not geared for a future where customers expect finance experiences on their terms. Many incumbents have been trying to address this misalignment for years via multiple digital transformation efforts, but the questions remain – how effective has this been, and what if there was a better way to fix the model?

The time is now

A quick temperature check in the news reveals that the Embedded Finance train is moving at full-steam – incumbent players and a host of new challengers (both within FS and non-FS value chains) are continually pushing the envelope, with many already offering compelling new embedded finance propositions and experience to clients, and the marketplace is evolving almost daily. The time to act is clearly now (or yesterday).

Some industries are especially well-positioned to expand on their existing ecosystem through embedding finance in their value chains. Here are just some examples.

The business case

Embedded Finance offers one of the most exciting new digital growth opportunities to incumbent financial institutions: an addressable market potentially worth over $7 trillion (Bain Capital Ventures projection for the US market extrapolated to a global addressable market size), or roughly double the market value of the world’s top thirty banks today.

Driven by this dynamic growth, VCs, big tech and fintech entrepreneurs are investing large sums in this market. The market valuations speak for themselves: after the prohibited acquisition of Plaid, the valuation of the startup jumped from 5 billion to over 15 billion US-dollar within a year. The enormous valuations of the upstarts in the private markets (Stripe: 70-100 billion US-dollar; Klarna: 11 billion US-dollar 31 billion US-dollar; Checkout.com: 15 billion US-dollar) and on the stock exchange (PayPal: 280 billion US-dollar; Square: 100 billion US-dollar; Adyen: 65 billion US-dollar) speak a clear language about the markets’ assessment.

And what is driving this value potential for Embedded Finance?

  • It solves real problems – For example, Uber offering its drivers prepaid cards, allowing drivers without access to a traditional bank account to get instant payments from the company without any high fees.
  • it strengthens customer loyalty – lots of non-bank players have much deeper data points on their customers’ financial needs and behaviour, even more so with the increased access to data through open banking and PSD2, and with the right insights, are in many cases able to provide better recommendations around financial products than their banks and therefore much more likely to be successful in up-sell/cross-sell at the point of need.
  • It opens new revenue streams – it allows companies to expand their value proposition into new profitable areas quite quickly, for example Square started as a payments processor but soon evolved into a point-of-sale company, customer relationship manager, and inventory management services provider. Introducing multiple revenue streams allowed the company to grow and thrive.
  • It improves customer experiences – by also offering financial services it gives companies increased ownership of the total customer experience, with more holistic insights on customer behaviours and patterns that in turn help them identify and serve new customer needs not currently catered for by existing products and services.

Banking-as-a-Service and the rise of APIs

Technology innovations is the driving force here, but a lot of the is also being enabled by Open Banking regulations which has democratised access to customer data, and has allowed various non-financial players to embed banking services in their offerings through API’s.

This modular capability approach is known as “Banking as a Service” (BaaS). By abstracting banking and insurance functionality into technology, Embedded Finance enables any brand or merchant to rapidly and at low cost integrate innovative financial services into new propositions and customer experiences, by “cherry-picking” from a range of modular BaaS capabilities.

As we have shown, a host of non-FS brands like Amazon, Apple, Grab, Shopify, Uber, Google have now successfully “embedded” payments, loans and insurance directly into their own customer experiences.

This in turn also creates new distribution opportunities for banks, insurers, lenders, and helps them win new customers and grow their balance sheet, with banks that have embraced BaaS shown to experience up to 2-3x above-market return on equity (RoE)

The BaaS race has started and big banks are already running, with BBVA, Railsbank and Goldman Sachs providing some of the more prominent recent BaaS examples, with the list growing by the day.

Another cool recent example is Stripe Treasury, with Stripe partnering up with Goldman Sachs, Citibank, Evolve and Barclays to provide Stripe’s platform users powerful APIs to embed financial services – enabling their customers to easily send, receive and store funds. Stripe clients also get access to interest-bearing bank accounts and faster access to payments. Shopify is also partnering with Stripe Treasury to build out Shopify Balance – which allows merchants to directly open bank accounts within Shopify. Shopify merchants will have seamless access to revenue which can be easily spent or transferred.

The danger for banks and insurers is that they could become marginalised and commoditised in this market, becoming “dumb pipes” purely providing banking infrastructure to others.

A clear understanding how they fit into this new interconnected ecosystem, platforms and changing customer needs is therefore key for incumbents, so that they can pro-actively lead this change and stake their claim in this new future.

Looking ahead

The future of finance is digital, ubiquitous and invisible. We are fast moving to a world where financial services will be so embedded into other technologies—and therefore our lives—that the term bank, insurer or fintech becomes essentially meaningless.

Remember, by 2030 providers will be serving 3 generations of digital savvy consumers that expect the same from financial services and products as they do from any other product – available anytime, anywhere and on their terms.

For incumbents to find success, they will need to effectively deal with some new realities:

  • Responding to the embedded finance opportunity requires leadership courage and a willingness to innovate at the risk of “cannibalising” existing business models in the short term. The definition of success (KPIs, metrics etc.) also need to allow and encourage this type of innovation.
  • It also requires a quick and agile response to test and refine new propositions, if they want to compete with challengers that are unencumbered by legacy tech and processes. This requires a new way of working and collaboration across the organisation and could also likely require partnering with other players and providers to ensure you have the skills and capabilities required for success.
  • Costly physical bank branches will continue to disappear, but there is also opportunity to re-imagine and re-purpose physical distribution channels to be more effective enablers of embedded finance (Read our paper on the shift to Phygital distribution models for more perspective on this)
  • Cards and cash will finally become a thing of the past as the person becomes the payment, and banks will need to redefine their role in facilitating payments.
    • There are loads of examples in the payment space of cardless and cashless payments via mobile wallets, QR codes etc. And in some retail stores, the payment terminal is already a thing of the past (e.g. Amazon Go). This is and will increasingly be driven by biotechnology (thumbprints, iris scans and voice recognition). We are already seeing car companies partnering with payment networks to create connected mobility experiences. In the next decade, connected cars are expected to communicate with other connected devices and Point of Sale systems using biometric voice technology to facilitate payments for goods such as fuel, toll roads, vehicle maintenance, and parking—effectively embedding payments into the car so that transactions can be automated for speed and convenience. What is consistent here is that there is no act of payment. Whether in a car or ordering a taxi or walking out of a store, the transaction happens in the background.

For fintech and other non-FS players some of the main challenges will be around capability, profitability and scale:

  • Complexities remain – embedded finance does not take away the complexities of FS, it merely hides its, and bringing new finance propositions to market in a way that is secure, scalable and profitable will require the right investments in FS skills, capabilities and partnerships.
  • Funding will reduce – Fintech-led growth and innovation will keep on increasing, but there will be less VC funding as the search for profit and scale becomes key investment priorities. In a survey of fintech executives, the majority agree with the statement that investors will prefer profitability over “moonshots” in the future.
  • There has been a trend towards unbundling with fintech’s focusing on differentiating in relatively narrow product offerings. Going forward there will likely be a shift to re-bundling and broadening the focus vertically and horizontally across the value chain in search of the required profit and scale. Partnerships with incumbent banks, insurers and other Big Tech providers will therefore become more important.
  • Tech innovations like blockchain will be used alongside other previously “buzzword” technologies such as IoT, AI, VR, and big data analytics to start solving real business problems, particularly in the embedded finance space.
  • Big tech firms will play an increased role in accelerating this trend, partly driven by their size and customer base. One example is Google’s recent partnership with 11 banks to launch a new kind of bank account in 2021. Called Plex, these mobile-first bank accounts will have no monthly fees, overdraft charges or minimum balances. The banks will own the accounts but the Google Pay app will be the main conduit for managing these accounts.

Regulations will also need to move with increased agility to both enable and control this shift:

  • with payment values (minimal cardless payments without prohibitive transaction costs) becoming smaller, volumes skyrocketing and increasingly moving across borders, it will require cross-industry and cross-country interoperability and standardisation. In Open Banking we have seen the promise of creating new industry payment infrastructure. But we have also seen much of this promise still remaining unfulfilled.
  • The role and responsibility of fintechs and new non-bank players also need to be defined here – who takes ultimate responsibility in a new digital world where end-users trust their social media or mobile providers for financial services?

And one final perspective – it can be said that the real promise of embedded finance is one of improved levels of financial health and financial inclusion.

  • Consumers do not naturally love their banks, just as most consumers find it hard to love utilities, be it energy, telecommunications, and others. We love other brands and user experiences which helps us manage our busy daily lives, whether it be buying groceries, planning a vacation, renting a car, shopping online etc. If we could also meet more of our financial needs directly in these non-financial interactions, then we are likely better off. New non-financial services and challenger companies tend to know more about us and can therefore help us make better financial decisions to manage our overall financial well-being, which banks are not naturally positioned for, given their underlying profit-motive. (Be sure to check out our paper of Financial Health for a broader perspective on this)
  • Embedded Finance also allows for financial inclusion in the absence of having a traditional bank account and credit rating.
    • Asia provides a good example here – with many businesses lacking card payment systems, and with large numbers of people remaining un-banked until recently, internet companies in Asia circumvented the banking system entirely, jumping straight from cash to launching their own digital finance solutions. China’s Alipay is a notable example:
      • Alipay is Amazon competitor Alibaba’s ubiquitous mobile and online payment platform. Today, people across China use it to pay for everything from train fare to retail products, online or offline. The platform saw $15 trillion in transactions last year, and its parent company, Ant, was eyeing IPO of over $200 billion before it got halted by regulators last year.

The opportunity is therefore quite clear for both incumbents, fintechs and non-FS brands. It requires a shift in attitude and approach, but is without doubt worth the effort, and unavoidable – if you do not seize it as an opportunity, it will haunt you as a threat.

More Trends

Let’s get phygital – The blurring of online and offline

Has the branch network become obsolete in the near future due to pandemic restrictions? What innovative ideas exist to enable a competent and customer-focused fusion of offline and online experiences? What does an optimal phygital customer experience actually look like?

Enabling Financial Health

How does the financial well-being of customers affect the relationship with the financial service provider? How can trust be built up, what tools are needed and where are financial health offers already being used?

New interfaces in banking

With increasing technological progress, the perception of the brand is also changing: Where once branch design and public image stood, one now finds a digital interface of an app and innovative technology. What interface trends are there, how are they applied in practical terms and what problems can arise?