Embedded Finance: we need to stay the course

medium.com/aperture-hub/embedded-finance-we-need-to-stay-the-course-cd6054c8b209

Ben Robinson July 11, 2023

Banks like Starling, Westpac and BBVA have slowed down or stopped their BaaS sales.
BaaS providers like Solaris, Varengold and Cross River have got into hot water with
regulators. Railsr went into administration. And valuations of former embedded finance
darlings like Stripe and Klarna have been hit massively.

What happened? We were told that embedded finance was a panacea, capable of
turbocharging bank margins at the same time as boosting revenues and customer loyalty
for their brand partners.

The truth is that sentiment overshot. The near universal view of the last couple of years
that embedded finance would imminently transform banking has given way to a lot of
doubt and scepticism. Part of this is broader market sentiment — fintech has been the
eye of the storm of the recent market crash — but part is a realisation that embedded
finance is harder and more complicated than people thought.

But, embedded finance will transform banking. It will just take a while as the missing
infrastructure and expertise is built out. We need to stay the course.

A recap on why embedded finance is changing the business

model of finance
Embedded finance refers to the integration of financial services into (typically) non-
financial platforms, applications, or processes. It aims to create a seamless experience
for the end-user by eliminating the need to use separate platforms for financial services,
and to address financial inclusion, using contextual data to better understand customer
needs and provide them with the right financial services.
 Embedded finance value chain (taken from additiv.com)

For the brands which act as distributors of financial products, it enables them to leverage
their captive customer base to generate new revenue streams. In addition, by either
solving unmet needs or just improving customer convenience, it also increases customer
loyalty and gives the brand more comprehensive data about customers to facilitate further
product innovation.
For the financial services company offering their products over new distribution channels,
there are also strong benefits. The cost of acquiring customers is reduced, while
spreading infrastructure costs over higher volumes leads to lower average costs and
better margins.

Easy to understand, harder to execute well in practice

The concepts explained above are intuitive and easy to understand. Furthermore, the
perquisites to be an effective “embedder” brand are also reasonably easy to fathom. A
brand needs a large customer base. They need online distribution. And strong customer
engagement is a big plus, since it means customers spend longer using the service,
creating a larger surface area (as well as more data) to cross-sell relevant financial
products.

The challenge comes from the fact that brands are not financial institutions. They know
their customers and they’re experts in service delivery. But financial services are
something new. There is a knowledge gap around how to define propositions, how to
price, bundle and take them to market. And their Banking-as-a-Service (BaaS) and
embedded finance partners often can’t fill this gap because they either provide
technology or they provide banking services — critically, they do not guide the brand step
by step through what is required to launch financial services.

As a result, many embedded finance projects don’t go live. Many fail to deliver value. And
many run into challenges, around regulatory compliance or division of responsibilities.

Consumer payments show us the potential for embedded finance

Embedding consumer payments has worked well. It’s easy to understand how embedding
payments into a check-out process can improve customer convenience, increase
conversions and grow net take. In the case of marketplaces, it’s easy to see how
introducing a seamless payments experience can grow revenues. Examples of platforms
that have benefited strongly from embedding payments are Lightspeed, Toast and
Shopify, the last of which generates more than 50% of its revenues today from payments.

Furthermore, the provider landscape around embedded payments is also relatively

mature. Put (very) simply, for brands there are three principal payment service providers
to choose from in an ecosystem.
 1. Modular payments-as-a-service providers, who orchestrate between the companies
and platforms embedding payments and the underlying payment infrastructure and,
increasingly, the (international) payment methods. An example here would be Stripe
Connect, which is the full-service product of Stripe. This space is also populated by
smaller operations-focused orchestrators like TrustAp. They are all connected by
the same value proposition: merchants and platforms can connect to get an end-to-
end payment service including the necessary operations like customer service and
KYC;
2. There are the digital payment service providers (PSPs), which might move to
adjacent verticals like Adyen (accounts) or Stripe (treasury); and,
3. Payment technology providers, such as Finix and IXOPAY, which are providing
technology, enabling brands to become payment facilitators.

These software providers play in an ecosystem with payment methods (bank networks,
credit card networks, wallets) and leverage different gateways either online, hosted or
POS. Additionally, the ecosystem is complemented through services like credit checks,
invoicing or KYC, to finalize the entire journey with external providers.

But moving beyond consumer payments is harder

The first issue is that outside of consumer payments, the embedded finance ecosystem is
less mature.

Take business-to-business payments. The maturity of infrastructure is substantially lower

than in B2C payments. Many of the necessary technical infrastructure components to
launch B2B payments as a corporate are offered on a customized basis, which slows
development and adoption. Even basic processes like invoice reconciliation (a standard
process for businesses of all sizes) are still being individually connected to the payment
gateway providers systems and not always offered as part of the platforms.

The same is also true to an extent in embedded lending. Buy Now Pay Later (BNPL) is a
relatively straightforward use case to execute, which is part of the reason why it was
rolled out too quickly, without adequate focus on consumer protection or unit economics.
But the infrastructure and use cases in B2B embedded lending, conversely, are barely
existent. This is counterintuitive as corporate banking is estimated 3x the size of
consumer finance.

Business customers tend to have more complex requirements. As a result, it may not
always be possible to meet client needs through a single financial services partner,
especially when corporate clients are also operating internationally. Further, it is harder to
offer a standardized service since business requirements are likely to be more
heterogeneous, translating into a need to vary conditions and, by extension, a greater risk
and compliance overhead.

But there is not just the dichotomy between consumer and business use cases.
Consumer use cases also vary in complexity. Payments and product insurance are much
more straightforward than, say, life insurance or private wealth management to embed
into non-financial distribution channels.

And, moreover, it is not just infrastructure that is missing for these use cases but other
factors too.
There has been a limited pressure to act…
As already noted, the power and competitive right-to-win in financial services distribution
is shifting significantly from global banks to global brands. But, the fact that brands can
realise massive benefits from distributing financial services does not necessarily mean
that they will become “embedder brands”.

In any successful organization, there is always inertia and a bias to the status quo which,
as Clayton Christensen explains in the “Innovator’s Dilemma”, is often paradoxically
higher the more successful the company. In general, psychological frameworks show that
the urgency to act in case of pain is 3x higher than in case of potential gain. As a result,
when times are good, it’s rare that a decision maker ever wakes up one morning ready to
start an embedded finance project.

…along with a general risk aversion…

Embedded finance projects are estimated to have high ROIs, are close enough to the
core business to be in familiar territory (same customer, same channels, same user
journeys), and are innovative enough to bring our Digitization and Innovation budgets.
This should make adoption a breeze in corporate processes, but it’s not.

One factor is a lack of success stories. Outside of consumer payments, insurance and
lending, there are not so many case studies that provide the robust evidence to prove the
technology, to build the business case, and to establish operational frameworks using
compliance-approved norms. On the contrary, the many stalled embedded finance
projects likely give ammunition to management to turn down internal requests to launch
proofs-of-concept and other small-scale experimentation projects in this area.

…and a lack of expertise

But, the bigger factor is a lack of internal expertise at wannabe embedder brands.

Embedded finance is not a line of business, it brings together multiple lines of business.
Project managers need to be comfortable to move through three territories, which makes
these projects highly difficult to execute well:

the core business and its customers;

the process of launching new solutions and innovation in corporates;
and, Fintech-specific knowledge about solutions, partners and regulation.

But, the situation is changing.

Successful cases are emerging
While, for now, embedded finance has not lived up the hype, successful case studies are
emerging. In our Embedded Insurance 2.0 report, for example, we included 12 case
studies, across both B2C and B2B use cases, and many more have emerged since.

These case studies will help overcome risk-averse decision-making, by providing

concrete proof points to justify proof-of-concept projects, which will in generate more
evidence and success, creating a flywheel effect.

In addition, the need to act will grow. Embedded finance doesn’t just create new revenue
streams, it creates a better business. That is to say, embedded finance strengthens the
value proposition of the core business. A brand with trade financing will sell more than
one without, a brand with alternative payment methods will have higher conversion than
one without, and a brand with supplementary insurance revenue will be able to outspend
competition on marketing. As such, corporates will soon face competitors who have
successfully implemented Fintech products in their core business and gained a
competitive advantage as a result. This will create the pain that will see them scramble to
catch up.

Technology providers are stepping up

In addition, the technology landscape is evolving. Effectively, we are seeing the same
kind of ecosystem emerge in other verticals of financial services that has been
established in payments. That is, we’re seeing the emergence of scaled regulated
infrastructure providers (or carriers in the case of insurance); scaled vertically integrated
providers; and modular technology providers that sit in between regulated financial
institutions and brands.

This may not sound new, but there are two important trends to highlight.

The first is the growing importance of incumbent banks and (re)insurers in providing
regulated infrastructure and capital. This is important not just because it brings balance
sheet scale. It also helps to make embedded finance more global since these providers
have international footprints. For example, Goldman Sachs, whose BaaS business we
wrote about here, provides treasury services in 36 countries. Lastly, it brings regulatory
muscle. In an embedded finance set up, the customer’s legal contractis with the regulated
financial institution, irrespective of whether there is an embedded finance (technology)
layer that controls the customer experience. In the first wave of embedded finance, some
of these lines got blurred and, as a result, some of the decisions about which clients to
onboard, how much scrutiny to place on KYC and so on were not well enforced by the
underlying “sponsor” bank. This is changing and will change faster with larger incumbents
propping up the ecosystem.
The second change is in the nature of the embedded finance providers. Their job was
always to abstract away complexity: to make it easy for the embedder brand to introduce
financial services seamlessly into their existing user journeys, and to make it easy for an
underlying bank to distribute through multiple additional channels. Now, they have to do
more. First, they have to up their game in terms of compliance, fraud and risk —
abstracting away complexity for the brand without ignoring or arbitrating away the risk for
the sponsor bank or carrier. Second, they have to orchestrate across more underlying
providers, to extend the range of services a brand can offer without them handling
complexity across multiple embedded finance providers, as well as bring the best
combinations of providers for a given use case. Thirdly, they are beginning to operate
more internationally, allowing embedder brands to offer the same use cases across
international borders. Lastly, they are moving to contextualize services, at scale, to the
needs of customers or groups of customers, allowing for more personalized services and
more complex use cases. Examples of the new breed of embedded finance providers
include additiv and Toqio for banking, and Alicia, for insurance.

From embedded to orchestrated finance

And there is a proven methodology to follow to deliver successful

projects
To overcome the lack of internal know-how or expertise, consultants like aperture have
developed proven methodologies for implementing (complex) embedded finance projects.

In our case, our methodology, which we have tested in 12+ embedded finance projects,
covers:

Analysing user needs and designing a proposition

Evaluating feasibility of embedded finance solutions and necessary partners
 Screening and cooperating with partners from longlist to contract signing
Building the proposition and testing it
Taking it to market and continually growing adoption

On top of a systematic approach, close collaboration with innovative enablers is required.

Through our work with FinTechs, we are in touch with the market and bring in an
accelerated connection to preferred partners on top of our project and process know-how.

A repeatvle process for launching embeded finance solutions

Renovate in winter
Embedded finance has fallen out of favour. But it won’t last long. The opportunity and
advantages of providing financial services to consumers through channels they use
already and in which their buying intentions and context can be easily understood, is too
irresistible to ignore. Brands will improve their core product and grow their revenues.
Consumers will enjoy a better experience and get solutions to unmet needs. And
underlying financial institutions will be able to spread their costs over higher volumes of
business, lowering average costs.

The factors that have held back wider implementation of embedded finance projects are
being addressed. More successful case studies are emerging, which will provide
confidence to decision makers at the same time as increasing urgency to act. The
provider landscape is maturing, growing its value add beyond just providing technology
and financial services to proving compliant, contextualized, composite services at global
scale. And the pool of project expertise is also expanding, creating a bedrock of proven
processes, vendor knowledge and implementation best-practices that brands can rely on
to accelerate and de-risk their projects.
We just need to sit tight and stay the course.