Industry buzzwords: breaking down “Embedded Finance”
I clicked on one too many “Embedded Finance” ads, and now I see (yes, recency bias) even more payment provider marketing materials on “Embedded Finance”. However, I’m perplexed as to whether everyone means the same thing when they write “Embedded Finance”, though the term has some value.
As part of the investigation, I asked someone who advises companies“what does “Embedded Finance” mean? Their response was: “accepting card payments and paying out sub-merchants”.
Ok 🤔 —I have so many thoughts!
How is that embedded finance? Is that all there is to it? What is so impressive about that? What does “embedded finance” even mean?
In this post I’ll discuss:
- What “Embedded Finance” means
- Observations and questions to ask
1/ What “Embedded Finance” means
Going down the rabbit hole of PSP marketing material and consulting thought leadership [1], here are some definitions:
Bain defined it as —
“ nonfinancial software platform providing an adjacent financial service, for which it takes some degree of economic ownership”
which helps, though “economic ownership” is a weighty word that deserves it’s own deep dive.
McKinsey defined it as —
“nonbank companies are offering financial services, such as bank accounts or wallets, payments, and lending. The companies’ embrace of embedded finance — banking-like services offered by nonbanks — aims to retain customers and increase their so-called lifetime value.
which is a more complete definition of “Embedded Finance”. I think in buckets. Based on what I’ve researched, I define “Embedded Finance” as non bank/non-financial companies offering financial services, which are in the following three categories:
(A) Platforms/marketplaces monetizing payments by charging their SMBs/sellers a spread for payin/payout services.
(B) Platform/marketplaces white labelling payment services.
(C) Platforms/marketplaces taking on small business banking services.
I’ll dive into each, with some examples.
(A) Platforms/marketplaces monetizing payments
A marketplace like Ebay, Amazon, Alibaba has buyers and sellers. A marketplace that processes payments collections from buyers, and then payouts to sellers all across the world is (1) making shopping an integrated experience for buyers (2) allowing sellers to sell to anywhere in the world. Charging sellers for those payment services, on top of other services like logistics, customer service, marketing, reporting, is the cost of doing business on via that channel. Seller fees on marketplaces might be ~30–50% all in.
Opinion: I think this is the most basic level of “embedded finance” and arguably too basic, but fits the consultants’ definition that embedded finance is “accepting card payments and paying out sub-merchants”. If that’s all embedded finance is, global marketplaces have been doing this for a while already with their internal payments and treasury flows.
(B) Platforms/marketplace white labelling payment services
Shopify Payments is a well-known example here. Normally, small merchants have to set up a relationship with their own payment provider and then integrate the APIs (or use pre built plugins) into their web store. However, with Shopify, merchants can “Skip lengthy third-party activations and go from setup to selling in one click. Shopify Payments comes with your account, all you need to do is turn it on.” (source). SMBs get to enjoy the advantage of economics of scale of the mega platforms, and obtain competitive pricing via a seamless easy set up.
Opinion: This is the foundational piece and entry into offering banking services to SMBs/individual sellers on platforms and marketplaces. By offering payments first, platforms see business health, which helps with risk assessment and potentially business banking.
(C) Platforms/marketplace taking on small business banking services
The summary here is — platforms and marketplaces offering bank-type services to their SMBs/sellers. This where I believe “embedded finance” is truly embedded in platforms and marketplaces.
Platforms and marketplace might offer bank-type services in a few ways
- Becoming a bank themselves (note: tough in markets with heavy regulation)
- Partnering with a fintech that partners a banking provider
- Partnering with a bank directly
Theoretically, a platform/marketplaces could handle payments for its SMBs, and also offer the bank accounts, cash advances, supplier payouts, issue cards, payroll solutions for their employees etc, offering a broad range of services that otherwise might have been handled by banks. [2]
Opinion: This is the exciting part about “Embedded Finance”. Moving beyond payment acceptance to providing holistic financial solutions for SMBs.
2/ Observations and questions to ask
Yes, the movement of non banks into financial services might make sense for large platforms/marketplaces.
Large platforms who want to go into financial services will find themselves with more potential partners than ever before, given the rise of “embedded finance”. It is easier now to find a partner that could enable a platform to accept payments, and extend that into offering bank accounts, lending, issuing and other services to SMBs. Platforms can differentiate themselves by offering these additional services, and potentially increasing loyalty to their platform.
However, should every platform offer banking services? No.
How many business bank accounts does a SMB need? SMBs might struggle to get bank accounts with banks, and so it makes sense to be getting it from the major platforms they work with. But hypothetically, if a SMB selling on 4 platforms — thinking Amazon, Ebay, Alibaba, Shopify, would that merchant need banking services from all of them? Would that be worth the extra operational lift?
My guess is that amongst the marketplaces, there will be a winner takes all scenario e.g. only the biggest platforms will deliver to SMBs financial services needs, and these platforms must cover all parts of the SMB’s daily operations. A mid size platform, even if moderately successful, does not cover ALL parts of a SMB’s daily operations, which means it would be less attractive to an SMB’s needs.
McKinsey articulates it well “Does adding banking make sense within the user experience or journey we offer? Or is this just an innovation project without a strong brand or experience hook.” Adding banking does not make sense for every platform.
Moreover, market nuances matter for the success of “Embedded Finance”
- Cash advances have to be done carefully — lending has its flip side of losses and regulatory requirements. How will platforms, or the partners powering their “Embedded Finance” manage risk and losses (that have taken down banks as well?). SMB banking is hard for a reason and why the segment has traditionally been underserved.
- Is issuing as profitable in lower interchange markets? It sounds exciting to have branded payment cards, but after issuing, program management and revenue share, how big is the pie for the issuer?
- A localized approach is key. I love the example of Uber in Brazil here — and its intersection with local payment rails like Pix, to drive value add for drivers and delivery partners.
Questions to ask
I expect my thoughts on Embedded Finance to evolve, and am excited for new developments to shape it. For now, I would ask a platform/marketplace considering “embedded finance” to:
- Understand deeply the SMBs using your platform/marketplace and their specific financial needs.
- Assess if the SMBs needs are already addressed by existing solutions (eg another bank already does it better), and if not why, and what does your platform uniquely offer that is differentiated?
- Evaluate if your platform/marketplace should partner (eg send SMBs directly to a bank), vs build a deeply integrated finance offering , given the resources needed to build and maintain a regulatory compliant and robust banking solution.
[1] 2021 reports. Bain and McKinsey. Plaid has a solid report here too.
[2] BCG: There are three key financial services categories — cash advances, bank accounts, and card issuing — that offer platforms the quickest path to market and a potential revenue uplift of up to 70%.
