Embedded Lending Part-1 — How it will lead to the Next Disruption in Fintech
Introduction to Embedded Lending, its Benefits and Scalability
Financial Services has seen multiple rounds of disruption in the past two decades — there has been emergence of some of the largest players around the world across Payments, Insurance, Banking and Lending — with business models ranging from Enterprise, SMB to Direct Consumer. A dozen Unicorns have emerged on the Lending side in the past two decades, namely LendingClub, Prosper, C2FO, Kabbage, Klarna, CreditKarma, SoFi, Greensill, Affirm, Oaknorth, Tundaiwang and Brex, with an equal split across Consumer and SMB Lending as their specialization or customer segment
While there has been an emergence of newer models around Lending and how customers consume different Financial Products, there has been a shift in purchasing patterns of customers in recent times. As per the report published by Cornerstone, consumers are increasingly tilting towards consuming Financial Products from non-traditional Financial Providers, some being companies which have been never related to Financial Products, like Starbucks or Snapchat
Companies such as Monzo, Revolut, Nubank and N26 have already proven beyond doubt that there is a case for adoption among the current generation when it comes to opening a bank account and operating it, without interacting with a core Financial Provider (a Bank), which has always been the case. This adoption is also driven by the openness of customers in sharing their personal data over the Internet with Web/Mobile apps, for something as sensitive as a Bank Account, Insurance or even a Loan. This openness results in them being adaptive to a Product which solves for Pricing and Convenience, and in doing so, the customer tends to place more trust and comfort with a name that they resonate with, whether for a Financial Product or not — which has led to Google, Amazon and Shopify launching Financial Products and Services at a much faster scale than most incumbents
While some of the largest companies (FAANG — Facebook Amazon Apple Netflix Google) may go about launching their own Fintech verticals and start building their own Financial Products, there are thousands of brands worldwide who are also increasingly thinking of offering Financial Products to their customers. For any company to offer Financial Products to its customers, there are multiple options available:
a. Build their own Fintech Verticals and launch their own Financial Products
b. Partner with existing Fintech Majors and resell their Financial Products
c. Partner with an Embedded Finance company and offer Financial Products
Of the three options above, Embedding Finance is the flavor for the next decade and especially in Lending, we would see Embedded Lending drive the next wave of disruption in the Fintech space. Embedded Lending is the integration (rather deep integration) of Lending Products into the systems of a non-financial service provider application — website, mobile application or any other software/process, so that the Service Provider’s customers can access/be offered Lending without any redirection to a third-party player
Current Market and Relevance of Embedded Lending
Embedded Lending, while otherwise relevant, has gained momentum in the past few months for various reasons:
a. Increasing digitization — As businesses and customers become more and more digitized, access to Financial Services, and Lending in particular, has also moved to digital channels. Going to a traditional lender is becoming a thing of the past and popularity of digital lenders is at an all-time high. Marketplaces and Aggregators have emerged across sectors and more and more customers and businesses are buying or selling different products and services through these in some form or the other
b. Alternate channels of Revenue — With increasing competition and higher acquisition costs, more and more brands (especially SaaS companies) are looking for increasing monetization and alternate channels of Revenue. Offering Financial Services is an obvious move for most of them and Embedded Lending opens up that avenue for them with limited investment and infrastructure costs
c. Post Covid-World — With Covid impacting physical contact, touch and interactions, most transactions are now moving online, and this makes the future of Financial Services ripe for disruption. Trust and Data Security are more critical in these times, and customers would prefer to transact with their otherwise non-financial service providers, to also offer them a Lending Product
Embedded Lending makes even more sense for Vertical SaaS companies as they can significantly multiply the lifetime value (LTV) of their existing customer base by offering them Financial Products which are more relevant for the vertical use case (which they are able to understand and tailor around better than others)
Embedded Lending — Channel-Agnostic Implementations
Embedded Lending, being a deep integration, can be assumed and implemented in online, offline and blended channels of operations. Let me try and list down certain examples to drive the point below:
a. Completely Online Models — Embedded Lending solutions can be integrated in online aggregators or marketplaces and the customers can be shown offers on the respective Mobile Apps or Websites of these service providers
b. Completely Offline Models — Large Brands (example FMCG Companies), who use ERP systems which also connect to their Vendors or Suppliers, can offer Lending Products to these Vendors or Suppliers by Embedding Lending into their life cycle and processes
c. Blended Models — Discovery Platforms (like Yellow Pages), which aggregate various services or provide Directory of Services to their customers, can also increase monetization by Embedding Lending for certain specific services which would require some sort of support/capital for completing the transaction
Depending on the implementation, the exact revenue model and monetization of Embedded Lending solutions could be different. It must be noted, though, that the decision regarding the extent of deep integration of an Embedded Lending solution will rest with the Brand or the Company pursuing the same
Typical Architecture of Embedded Lending Solutions
It is important to understand how Embedded Lending Solutions can be integrated in the existing processes of non-Financial Service Providers to appreciate their scalable plug-and-play nature. Typically, Embedded Lending can be offered by Brands, SaaS companies or digital marketplaces/aggregators at various stages of their customer life cycle:
a. Transaction Embedded Lending — Example of this being a purchase transaction where the customer is given an option to “Buy Now Pay Later” or “Pay in EMIs” using an Embedded Lending product
b. Feature Embedded Lending — Example of this being an option for the customer to obtain funds in the form of Working Capital on their Dashboard (like an Early Settlement in case of a Payment Gateway or a Working Capital Financing against future Cash Flows)
c. Product Embedded Lending — Example of this being an option for the customer to opt for Lending Product from their Service Provider, against past history and trust being built over time between the two — like, Shopify providing Working Capital Lending Products to their customers/businesses or Amazon offering Growth Capital/Business Loans to the Sellers on their platform
In all the above models, the Embedded Lending Solution interacts with the existing Transaction Data systems of the Service Provider/Brand and consumes the same for better decisioning. The application and fulfilment of the Lending Product could, though, be completed in a mix of digital and physical processes, depending on the ticket size and use case. It is interesting that the Embedded Lending use case must be clearly differentiated from a simple “Strategic Lending Partnership”
The Powerful Economics of Embedded Lending
There are various reasons why the Economics of Lending work far better for an Embedded Lender compared to the Brand or Service Provider doing it on their own. These are best understood once we try to break the Lending Process into the key tasks of Acquisition, Underwriting, Operations, Debt Capital, Collections and Compliance:
a. Acquisition — This is the piece which is taken care of by the Brand or the Service Provider and is the core reason why an Embedded Lender exists in the first place — to ride on the low (near ZERO) cost of capital of the Brand and build Lending Portfolio focusing on the other pieces like Digital Onboarding, KYC, Documentation and Processing of Application for Fulfilment. This framework makes the whole Embedded Lending concept profitable for both the Brand and the Embedded Lender as it reduces costs for both
b. Underwriting — This is where the Brand adds critical value for the Embedded Lender by providing them access to Cash Flow and Transaction data about its customers and enabling better decision making compared to traditional Lenders who find it difficult to underwrite customers using Transaction information and still rely on traditional sources of data
c. Operations — There are a lot of moving pieces when it comes to origination of Lending Products — customer support, managing customers during various stages of applications and improving conversions across drop-offs, streamlining documentation requirements for the lender and others. For a brand to build systems around all of these is very costly and thus, an Embedded Lender, with scale across different Brand partners, can manage this in a more economical way
d. Debt Capital — It must be noted that the Embedded Lender, in most cases, will be working with a Balance Sheet provider (Bank or Non-Banking Entity) at the backend and will act as an intermediary for all other processes related to the Lending life cycle. With multiple partnerships, lending expertise, proven risk models using transaction data from different brands and scale over time, an Embedded Lender will be able to secure Debt Capital at much lower rates compared to the Brands themselves and thus, will be able to pass on that cost advantage to the end customer
e. Collections — Through a mix of Collections-At-Source (in case of the Brand being able to help deduct the outstanding dues from recurring payouts of the customer) and multi-Channel Collections expertise, the Embedded Lending solution will have far better Collections compared to the Brand directly collecting the dues from their customers, who would have spent a fortune building these capabilities
f. Compliance — This is often the most ignored part in any Lending discussion with regards to the expected costs and investment, but Compliance and Regulatory costs could sky-rocket for any Brand venturing into Lending Solutions. An Embedded Lending solution brings down the entire Compliance and Regulatory investment for a Brand down to a minimum, whether it is with respect to KYC, Legal Documentation, or Fair Pricing and Disclosures
Case Study — India’ OCEN Model and LSPs
India has recently taken a major initiative to democratize Lending by launching OCEN (Open Credit Enablement Network), a protocol which aims to standardize the Lending Processes by acting as a Common Language (a collection of simple APIs) between various Service Providers and Lenders. The various Brands or Service Providers, who provide the customers in the OCEN Model are called LSPs (Lending Service Providers). This model would also see emergence of Middleware (or Embedded Lenders), which would connect these LSPs and Lenders and provide Technology Interfaces, Underwriting Solutions, Modeling Insights and Advanced Analytics to bring various Innovative Lending Products to life. This initiative is still at a nascent stage but has the right vision to help scale Lending Products for the masses, especially the SMBs who have been underserved by the existing Financial Institutions
