Embedded finance: What’s all the fuss about?

by Lucy Frost

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Embedded finance is changing the face of the fintech and payments industries, with transactions projected to exceed US$7 trillion by 2026, but the real winners will be small businesses.

Financial services embedded into e-commerce accounted for $2.6 trillion in the US in 2021 (nearly 5% of total US financial transactions), according to consultancy firm Bain.

Such products could include payments, lending, insurance, or accounting, and together are referred to as embedded finance – an umbrella term for a financial service brought into an unrelated customer journey where they are expected to need it.

“Looking at both embedded finance services for consumers and small businesses, there’s been a huge shift in what’s offered and the level of adoption over the last decade and there’s much more to come,” says Amelia Cox, senior director of enterprise strategy at FIS Global, a fintech firm.

Some of these offerings have been around for years. For example, for an airline’s customers booking a flight, it’s not unusual to be offered insurance products at the same time as booking the flight itself. The insurance offering is embedded into the flight ticket customer journey and means they do not have to separately look for insurance.

More recently, buy-now-pay-later (BNPL) – a form of embedded lending – has grown its presence in key markets like the UK with providers like Swedish Klarna becoming a household name and offered to customers as easily as payment through PayPal or entering card details.

Even though we’ve seen a variety of offerings in the space already, there’s still a lot of growth projected. According to Bain, embedded finance transactions in the US are set to exceed $7 trillion – more than 10% of the country’s total transaction value.

Unlike the previous bank-centric or insurance broker-centric landscapes of payments and lending, embedded finance comes with a whole new set of interested parties: the merchant who provides the distribution channels; the technology enabler; the financial services firm funding the product, as well as the customers and regulators. This long list of transaction participants means there are a lot of people to benefit from developments in the space.

Creating convenience

The benefits are clear, by providing a service to a consumer at the moment they need it, they’re most likely to use it and make the payment purely because of the convenience.

“Customers benefit from contextual, seamless experiences,” says Adam Davies, associate partner at Bain. “Platforms can unlock new use cases and often use proprietary customer data to improve financial access, while reducing costs for their end customers.”

For Davies, the ease for merchants is a huge benefit, especially in embedded payments. “Historically, merchants signed up for payment services via independent sales organisations to be approved by an acquiring bank — this is an arduous process that could take months.”

Now fintechs can underwrite merchants on the acquiring bank’s behalf, which streamlines the delivery of payment acceptance capabilities.

As well as the ease for merchants, this seamless experience comes through to the end consumer, and this can be beneficial for merchants too.

“Embedded finance products increase the lifetime value of a customer for a merchant,” says Cox. “The customers become more sticky, because you’re offering them all these valuable services in one convenient place and this loyalty, for firms that get embedded finance right, will be really important.”

For Cox, this turns into a virtuous cycle. “The more data a merchant can get on its customer, the more products you can make customised for their journey and the more likely they are to take them on.

“Then you’re giving them an additional service so they’re more likely to come back to your platform,” she adds.

Small business, big opportunity

All sorts of firms are expected to leverage embedded finance for growth, particularly those involved in e-commerce. According to FIS Global, 30% of financial services are investing in embedded finance to boost revenue, while 40% of non-financial services firms are developing embedded finance services for their customers.

But according to market participants, the real benefits are expected to come for small and medium enterprises (SMEs), as embedded finance can be used to streamline the finances for entrepreneurs and smaller business owners.

“Embedded finance can offer much faster loan turnaround for SMEs than conventional finance,” explains Fiona Henderson, senior associate at law firm CMS. “That’s a huge selling point, especially with the SME funding gap we’re currently facing.”

There’s an estimated £22 billion funding gap for SMEs in the UK, according to the Bank of England. Meanwhile, 25% of small businesses that apply to banks have their loan applications rejected.

As embedded finance is heavily linked with automation, this approach to lending could reduce the number of loans rejected, because the automatic process would remove any potential bias in assessing applications.

Embedded loans aren’t the only type of embedded funding that could benefit the small business sector.

An example use case is for a small business using an accounting platform. Through embedded finance, that accounting platform could offer the organisation it serves a debit card to use for business expenses, which is then automatically fed back to the accounting platform. Added to that, it could then use the data insights from the card to provide other services to that small business.

Trust and data concerns

Within the wealth of opportunity and large growth projections, there will also be some challenges to the industry, specifically around gaining consumer trust and balancing innovation with regulation.

“The biggest challenge for the industry will be customers trusting the psychological safety around brands as it’s not how we’re used to accessing financial services just yet,” says Cox.

For Cox, this is likely to come with time and can be compared to customer hesitation to input card details online around a decade ago. Now, people are very used to this as a way to pay and a similar progression could be mapped to embedded financial products.

What may not be so well adjusted to is the data tracking that comes with embedded finance.

“The more data a company has on a small business, the more it can help them and embed something at the point of need,” adds Cox.

Leveraging data will be a huge marker of success in the embedded finance space. But at the same time, the general public is becoming more data privacy conscious, which could lead to a clash of interests down the line.

Regulation is coming

While embedded finance is not currently regulated, developments in the space could pose a challenge for the market.

“Consumer-facing products are definitely under increased scrutiny at the moment,” explains Henderson.

A BNPL regulatory package is expected later this year in the UK, which the Financial Conduct Authority (FCA) has a consultation out on at the moment.

Similarly, the UK’s new Consumer Duty, described as being an overhaul to how banks and financial services institutions treat consumers, is also likely to pose a question for embedded finance providers that will need to ensure products are marketed and managed in line with the goals of the duty.

As many of the players in the space, such as BNPL provider Klarna, are unregulated, adapting to this new environment as the FCA expands the regulatory scope will come with its challenges.

And it won’t just be UK regulations that businesses should be aware of. If a fintech is looking to expand its embedded finance offering overseas, parties involved will need to review regulations there, even though there may not be as many rules in place.

In the EU, some European countries have already taken a firmer approach to these types of financial products. As overseas expansion is much easier for tech-first approach firms than traditional financial services, this could be an issue many firms face.

Going forward

How the industry develops could be led by the embedded finance ventures of industry giants. Apple is trialling an embedded banking service, quite different to the conventional shape of the market. How it develops could shape the industry going forward.

“The development of Apple Pay will be very interesting to watch,” says Henderson. “Apple controls its own distribution channels so there’s fewer parties involved than in other embedded finance offerings.”

Embedded finance often requires a number of participants: the merchant which provides distribution channels; the tech provider; the loan provider; and the regulated financial institutions funding the providers. In Apple’s service, this number is greatly reduced because Apple provides both the technology to consumers and the banking platform.

The question is whether this will take off compared to the more staggered approach currently taken. If it does, it could lead to consolidation in the industry.

Another exciting area of development highlighted by market participants is how embedded finance can be used to further ESG objectives, according to Henderson. There have been a number of examples of this already, including Revolut’s credit card for under 16s, which includes financial education on budgeting and handling credit.

For other commentators, the key for the future will be how embedded finance impacts the traditional banking and financial services.

“Traditional financial services have reached an inflection point,” says Davies. “They face the threat of shifting economies and adverse selection. Yet they can still also tap tremendous growth potential, especially if they identify where to play across specific vertical segments.”

No matter what, the sector is not expected to look the same as it does now in 10 years time due to the highly innovative nature of technology companies leading the way by creating new products to meet different customer needs.

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