In our modern world businesses are becoming more consumer oriented and user friendly – consumers have a variety of options to get the best experience and product/services with minimum effort online and offline. If you get your Uber in the morning and use your Apple Pay to buy a cappuccino on your way to the office you’re already taking advantage of ‘Embedded Finance’. If you’re looking to buy a nice bag for your mom, Affirm or Klarna can finance your purchase via their buy-now-pay-later model. So, what is Embedded Finance and why this has become yet another buzz word?
Embedded Finance comes from the general concept of Banking as a Service, or BaaS. BaaS allows non-financial companies to offer access to standard banking products and features at point of sale. This is enabled through webhooks and open APIs (Application Programming Interfaces) – Embedded Finance is more defined by the front-end access to financial services, whereas BaaS is more defined by its back-end banking functionality. This integration via open banking systems and API architecture allows e-commerce platforms, websites, apps and other non-bank businesses to deliver financial services, often white-labeled, to their customers. Now, without the burden of regulatory and compliance oversight of being a traditional bank, embedded finance enables you to offer to your customer additional features to accelerate your sales and engagement, simplify user transaction experience and generate new revenue streams.
According to recent studies, the Embedded Finance market globally is expected to reach $7 trillion in the next 10 years. This is a huge opportunity for banks, fintech companies and other non-bank lenders. VC investors have been fast to recognize the potential value in the niche – the chart below depicts global VC investments in Embedded Finance companies from 2016 through September 2021, and we’re just in the beginning of the cycle.
Source: Statista 2022
This is a global phenomenon – young population and technology advancements drive embedded finance in China, India, Indonesia, several Latin American countries and, of course, the US, Europe and the UK, the latter being one of the earliest adopters of BaaS models. This trend created a lot of opportunities for virtual banks, also known as neobanks, fintech companies, BaaS and, of course, embedded finance. These models are taking a growing share of overall transaction volume compared to traditional banks. Quoting J.P. Morgan CEO Jamie Dimon, “The role of banks in the global financial system is diminishing”, and millions of newly added accounts by neobanks prove it. Embedded finance future lies in several major applications:
Payment processing involves an automatic pay feature with your saved credit card or digital wallet. PayPal and Stripe have been at the forefront of embedded payments for several years now, while other players are coming to the market to address other areas such as international transaction complexities, user onboarding processes, KYC compliance, virtual credit cards and others. These solutions make the process more secure and streamlined, help protect from fraud, card management and fulfillment, reduce transactional fees and provides liquidity faster for various jurisdictions.
Renting a car, booking a trip, obtaining Airbnb host protection and other goods and/or services purchases come bundled with an insurance protection coverage in the same offering. An embedded insurance solution is usually integrated into an existing system through an API, which helps insurers analyze policy and price data and suggest the right policy at the point of sale.
Embedded lending is split into two significant components: Retail lending and Business lending. Affirm and Klarna are great examples of B2C lending, where capital provider would face consumer credit risk based on FICO score or other proprietary alternative scoring system. Business lenders are B2B capital providers and include such companies like Kabbage, Fundbox and others targeting SME’s (small to mid-sized enterprises). Sometimes these providers are standalone offerings integrated into customer’s ERP systems, and sometimes they target specialized software products to give a supplier or vendor an option to get paid early on the product sold or job completed. The structures could vary from lending to revenue-based model, advances against receivables, purchase orders and inventory. These working capital solutions help consumers purchase discretionary products and help small business sustain their working capital requirements and overhead as well as create stronger trade networks with customers and suppliers.
Another extension of Embedded Finance is Embedded Investing, or providing robo-advisory, brokerage and wealth management services to consumers. Acorns, for example, delivers micro investing, full automation and adjustments according to your goals and wishes via automatically investing your spare change. PayPal now offers crypto purchases through their platform, which also changes the way brokerage services are offered and consumed.
Our everyday life includes a wide variety of transactions, and they are increasingly being digitized. Embedded Finance will continue to grow as tools to offer a digital product and deliver a more convenient and flexible customer experience. It can help streamline the payment process, allow customers to earn points and rebates, improve savings, protect data security, and make businesses more efficient and resilient. Embedded Finance will bring additional structural changes to the finance world and revolutionize capital flows over time – this creates great opportunities for VC and Private Equity on the technology side and debt providers on the B2C and B2B side. The first players who embrace the changes are the most likely to win.
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By Alisa Rusanoff, Portfolio Manager, Senior Vice President at Crescendo Asset Management