Embedded Finance | From a handshake to an API: banking now and anywhere

Today your accounting software can offer you a loan, and your electric scooter app can sign you up for an insurance product. How is that possible? What are the implications of that for incumbents, non-financial institutions, and fintech players? Quo vadis, banking?

Since its inception, banking has been a relationships business. From understanding what the customer needs, to figuring out who will be likely to repay a loan, to just making sure a certain customer is who he claims to be. Banking has always been about people and was offered and serviced by specialized financial professionals.

Things have changed during the last decade. First, we lost the relationship aspect, to an extent, especially physically, and second, traditional financial institutions started facing new competitors like neobanks and Bigtech.

We believe that we are entering a new phase, where that relationship between financial providers and their customers becomes further removed. Non-financial institutions (or just brands) are taking center stage.

How did we get here?

Interoperability and the everything-as-a-service model are transforming financial services, as a result new business models have arisen. At Cardumen Capital we call them financial utilities and financially-enhanced products.

Many market forces have created this change. In our eyes, the two most important ones are interoperability and the everything-as-a-service business model (XaaS).

1. Interoperability arrived first as a regulatory push (with regulation of the likes of PSD2, or Open Banking) and then got streamlined and connected (APIfied) by the first wave of infrastructure fintech providers (such as TrueLayer, Tink, CurrencyCloud, Plaid or Dwolla). These platforms are the essential levers for the revolution as they provide the plugs for universal connections in a similar way to what schemes did for card payments back in the day.
2. The other pillar is the everything-as-a-service (XaaS) trend, which reminds us of the typical industry splits that are usually put in place after a privatization plan. One company becomes the utility asset operator, and all other companies use that asset in a fair and equal manner with the objective of serving the final consumers (think electricity transport operators and electricity commercialization companies). This is a very efficient model in which CAPEX is separated into a new entity and shared and paid by everyone instead of everyone having to commit extensive resources that are collectively redundant. In our digital economy, far from the hands of the regulators, some companies have been able to become the utility asset operators that provide the rest of the players with (arguably) fair and transparent capabilities so others can innovate without requiring vast CAPEX investments. AWS is a clear example of this, it owns the hard assets (servers) that companies used to need to invest heavily as a sunk cost just to start operating. A less clear example may be Apple’s App Store, where instead of holding and sharing hard assets, it holds equally critical distribution rails and payment rails used by hundreds of thousands of companies that, for a fee, get to start their business from the shoulders of giants.

Together, these two forces are playing a decisive role in fintech today and are heavily impacting the traditional commercialization model of financial services. As a result of these forces, some companies are poised to become the new “financial infrastructure providers” or “financial utilities” and many non-financial companies are realising that they can delight their customers by cleverly integrating financial services without needing to become financial experts themselves.

This new environment changes things for several actors:

The most impacted players here are:

1. Brands as new financial providers
2. Financial utilities
3. End-customers

Brands as new financial providers: Incentives for the creation of financially-enhanced products

Embedded finance has proven to be a lever that can improve real business metrics like CAC, retention and stickiness.

Embedded finance may sound like a fancy euphemistic name for cross selling of financial products, but it is very far from the image of your supermarket cashier offering you to sign up for your tenth credit card.

Done well, it can have a real impact on customer acquisition and retention, improve the frequency of use and enlarge customer journeys whilst increasing the revenue per customer.

Some examples of these benefits in the market include:

• Shopify, who has unprecedented data on the performance of all the e-commerce shops that work with them. It can score their credit worthiness invisibly and automatically, and it can learn when and how to offer a loan.
• Uber needs to keep gig workers from switching to other platforms, and it also needs to pay them, which is not so easy in developing markets. Can Uber become their banking provider? Would an underbanked gig worker leave to another platform now?
• ERP systems already channel all business processes including accounting and purchasing. Can they include payment initiation, FX hedging or account aggregation?

The problem with offering financial services is that in order to do so, it is necessary to work with the regulator and submit an application that can take a long time to be assessed and approved. From a business perspective, this equals a long time-to-market. Additionally, regulatory licenses usually come along with the implementation of overreaching governance models that can directly affect the company’s ability to operate nimbly.

With all these hurdles to face, many companies prefer to stick to their bread and butter and to implement financial services into their product offerings through a Banking as a Service model. In other words, to create financially-enhanced products with API integrations that provide white-label financial services. These integrations can be implemented into the product offering without losing control over the customer experience.

Financial utilities

Financial service providers will benefit from new business models with an ever-wide reach.

Non-financial companies are likely to outsource financial services to specialist companies, whose defensive mote is precisely the ability to help the brand jump over those hurdles and still provide the financial service within their product offering.

For financial providers this new market has three main advantages: (I) it increases the number of customers they can reach, (II) it increases the depth of the information retrieved from those customers, and (III) it dramatically reduces the marketing cost to acquire them.

This is a very tantalizing set of benefits for new bread fintech companies without the brand recognition nor the capital to sign up large numbers of end-customers. Marqeta, SolarisBank, Railsbank, Stripe and many others seem to be following this strategy.

For incumbent banking players, commercializing products via APIs has a radical impact on the customer relationship model that they have traditionally had with their customers, given that they currently have the brand recognition and already enjoy a direct relationship with the customer.

The case for the end-customers

Customers will benefit with products with a significantly improved UX

However, some traditional financial institutions have realized this paradigm change and have started to compete in this new field too. This is the case of BBVA with the API Market, which has been particularly fast at identifying the new trend and jumping on the opportunities.

Customers of financial services have historically struggled with having access seamlessly to financial services at the moment of need. Banking has been this kind of service that requires unending forms and signatures and long waiting times. The embedded finance model allows to incorporate the service into the brands’ customer journey.

Some of the processes financial services require to be acquired such as KYC, AML screening or credit evaluation can be greatly improved by API-based identification linked to the customer bank accounts.

The end game for customers is service convenience and seamlessness. Most successful companies in the internet era are such because they managed to offer their service just 1 click away.

Imagine an e-commerce retailer that sells unicorn-shaped stuffed toys. Who do you think will give it a faster and more convenient loan to purchase its inventory: the bank branch down the street or the payment provider that is already handling the store’s sales?

Additionally, the end-customer has new needs and wants such as the control over their data. In this regard embedded finance also greatly enhances customer experience, as it is now easy to pay safely thanks to a single-use card or a token integrated into the payment experience to ensure the non-leakage of payment-related information.

Cardumen Capital Angle

We believe that there will be three clear types of winners from this revolution:

• Enhanced value propositions: Companies that effectively integrate financial services into their product offering will gain a competitive advantage. We believe that in order for these companies to be successful, they need to be product centric and not necessarily incorporate a myriad of financial services into their value proposition. Instead, only incorporate those that will improve the customer experience.
• Data-intensive financial services: Interoperability will give the opportunity for financial and non-financial institutions alike to have access to a huge pool of customer data, if the client is willing to share it. This means that financial services providers will be able to anticipate the customer needs and tailor-made their product offering instantly. It will also mean that credit scoring could be vastly improved by having full access to revenues, savings and expenses across the board, which could greatly impact customer experience.
• Efficient resource-allocators: the move into an as-a-service model will not only imply that financial institutions will be able to reach distribution channels with depth, recurrence and data; as mentioned above. It will also radically impact the Go-To-Market strategy and reshape the salesforce as the focus will no longer be reaching individual clients (long-tail) but businesses with a high customer base (short-tail). Additionally, the adaptation of traditionally human-intensive (and expensive) servicing models will be outdated thanks to new players (AI-powered chatbots, automated collections services etc.). All of these will greatly impact the cost base of financial services providers and will make it more sensitive to changes in demand. To take full advantage of this opportunity, financial service providers will need to focus on creating developer friendly products.

Cardumen Capital is a VC fund focused on B2B early-stage deep-tech investments in Israel. Get in touch with us here.

Analysis by Aitor Almendros, Head of Value Creation at our Tel Aviv office and Alberto Criado, Associate at our Madrid office.

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