Embedded Finance: From Fintech to Techfin

A small peek through all the questions that the article tries to answer:

1. What is Embedded Finance? Where are the technology giants expanding in fintech and how do they do so?
2. What trends allowed fintech to emerge and offer Finance-as-a-service?
3. Why do technology companies add financial services to their product portfolio?
4. What’s next? Who will win and what innovations might we see?

What is Embedded Finance?

Embedded Finance: When technology companies offer financial services to customers for a better experience but do not depend on the margins from those financial services, they are said to embed finance.

Now, this is definitely not new. Companies have, for decades, offered from payment processing services to co-brand cards (think Amazon credit cards or Reliance gift cards) on their platforms. The innovations in cards and payments have actually been wide and consistent for decades. But something has changed over the last few years. Particularly, the variety of financial services that technology firms offer today has broadened multiple degrees.

Some examples to back the claim: Google — primarily an advertising company and a search engine — is planning to offer bank accounts from next year, apart from expanding its hugely successful Google Pay. Similarly, Facebook has done everything to push the Libra project into existence and is trying to do the same — perhaps more successfully — with WhatsApp Pay. And Reliance is fiddling with JioMoney — a digital payments platform. Payments, in hindsight, seem to be capturing a lot of interest. But the impact is across financial services.

Even Apple launched Apple Card — a credit card — late last year and can be expected to build more such solutions. But Amazon, as it usually does, has gone a step further. The image below highlights how it has entered almost all arms of financial services.

Image: How Amazon has unbundled the bank; Credits: CB Insights

You might point out that these companies, either way, spread their claws in multiple industries. What is the big deal if they get into financial services?

True. But this trend is common across bigger but less branched-out businesses as well. A small list of such companies and their products:

• Shopify — an e-commerce company — launched Shopify Capital (for business loans) in 2016 and reported ~$166 Mn in revenues from the subsidiary in Q2 2020.
• Uber — a ride-hailing company — launched a separate financial services division called Uber Money late last year and is expected to work on building a suite of financial products, including a digital bank, a digital wallet, as well as debit and credit cards
• Udaan — a B2B trade platform — even acquired an NBFC license in 2019 and had launched Udaan Credit for retailers on the platform a year before that
• Tesla — an electric vehicle and clean energy company — has its own insurance services arm

Payments, checking accounts, lending, or insurance — there is hardly a part of financial services that companies are not playing around with today. As we go down the hierarchy, we see the smaller technology companies rely on existing infrastructure from Fintech companies, and presently the focus for them seems largely on bringing payment interfaces to their products. Despite this, the trend is obvious.

We are yet to capture the extent of its impact, however. Angela Strange of Andreessen Horowitz put it bluntly when she said that every company will in spirit be a Fintech company in the future. She even expects these added services to get companies a sizeable revenue proportion, and not merely coexist with other products. The last few months seem to have accelerated that trend and made that statement more believable.

The big companies — resting on their deep pockets — are building end-to-end financial products (Amazon Pay, Whatsapp Pay, Tesla Insurance, etc.) as well as leveraging the existing and more sophisticated financial infrastructures (Lyft, Shopify, Slack use Stripe). For smaller non-fintech companies, the focus is more on the latter — deploying APIs to their products. And it makes sense, why spend millions and years to build partnerships when you can simply get such services and focus on your core.

What this has done is open up a whole cupboard of Fintech firms that provide finance-as-a-service to businesses. Think Square, Venmo, Stripe, and the list of finance based SaaS is only getting bigger. Many of these companies have seen their revenues and valuations increase in multiples of 2X-10X every year for the last four, and there is hardly a better indicator of a strong shift towards embedded finance.

So, what has changed?

There are, I believe, three major shifts that have today allowed companies to add financial services to their products:

1. Unbundling of Banking Services: the breaking down of financial services began in the second half of the 20th century. And for a large part was still restricted to national banks controlling their separate banking functions. But over the last three decades, access to programming and computers has allowed people to take one part of financial services and build a superior solution around it. Think of Paypal for payment services way back in 1998. The incumbents are hardly ever as innovative and brilliant in one particular function as a focused start-up can be. And as a result, today we see big players across payment platforms, alternative lending, wealth management, trading, and essentially every part of financial services. The superior technology and specialised financial solution are what non-fintech firms leverage from fintech players, instead of building all of it on their own.
2. Infrastructure over Cloud Services: the next major shift came in the form of AWS revolutionising the software services. At the start of the century, building and distributing software required more than will and brains. It required physical servers and plenty of capital. But with AWS, the costs and complexity of software have reduced enormously — all because you can leverage infrastructure-as-a-service. This in-effect has allowed a community of creators to start fintech companies with few laptops and lines of code. No wonder investments in fintech were 28X last year versus 2010.
3. Mobile and the Move to Digital: Finally, the wave of smartphones in the last ten years and the thinning line between mobile web and desktop web has taken these applications and technology services to nooks and corners of the planet. For a function as critical as banking, ubiquity is extremely crucial and with smartphones — financial technology can reach more than half the world today without the need to fill tens of documents for insurances or loans.

The pattern is obvious. First, regulations and smaller traditional banks forced banking services to be separated. This allowed such services to be reimagined by the first-age fintech players. Next, the software infrastructure was subsidised with AWS, which bought down the software building and distribution costs significantly. Fintech companies proliferate. Finally, smartphones are today allowing banking to be done bereft of paper and all on the mobile-web. This mobile-web has made accessibility to banking almost ubiquitous — giving fintech players a larger ground to play in.

Combined, the three waves of changes have made fintech-as-a-service feasible for software companies to build and deploy, and profitable for buyers to adopt.

Why do technology companies embed financial services?

With the above sections, we explored what embedded finance is and how it came into being. But now to answer the most important prompt: Why are technology companies running after it?

There are two reasons: Data and Money. Both are key to almost all business decisions today. But how does financial technology help with either?

Technology companies are already building products to acquire customers. So, they are already solving for acquisition — which makes the CAC for financial services they add fairly lower. But the winners among these technology companies are still those that can predict customer behaviour well, improve retention, and build great relationships. This is where financial services come in. And all innovations in fintech usually start with payments. A payments infrastructure arm such as Google Pay can give Google a great picture of your finances — the products you buy, how often do you buy them, and where do you buy them from. This information can then be used to cross-sell goods or make strategic business decisions. As it stands, where you spend your rupees or dollars on is probably the most crucial data point for companies.

An Ola Money, similar to Google Pay, can drive more engagement by offering credits on your accumulated account savings. Even for small businesses — especially in the B2B domain, it makes sense to take complete stock of the payment processing. The process for transactions is still messy and complicated. Especially, bookkeeping, invoicing, payroll management, and spend forecasting — all with high 15–20% net margins- are merchant problems that each technology company can solve for in B2B. And from commerce to subscriptions, there are plenty of customized financial solutions that businesses can offer to their merchants.

On the other side, loans and insurances allow companies to sell high-margin products and build long-term relationships with their merchants and customers. Businesses usually use revenues from their core products or tie-up with banks or NBFCs to provide such services — essentially earning commissions on distribution. A win-win situation. A good example of this in practice is Udaan, which made almost ~80% of its revenue last year from the credit business — enough to call it a financial services company. It is no coincidence then that plenty of businesses offer loans and insurances to SMEs and small merchants today. And it also highlights why loans and insurances are the most logical steps post solving for payments.

What’s next?

The opportunities for Embedded Finance are immense, especially with digital banking and payments witnessing the push that they are. Soon enough, almost all our banking services — loans, insurances, payments, bank accounts, wealth management, etc. — will become sophisticated enough for the majority of us to rely on digital banking. Also, the customer experience would be almost seamless if the UX of neobanks is anything to go by. Not only banking services, but any payment we make — on restaurants, rent, electricity, maintenance, education — can become part of payment value propositions for businesses. If fintech interests you in the slightest, these would surely be trends to watch out for.

Before I end the article, a few predictions on what might happen in the space in the next few years:

1. SaaS companies that build fintech APIs will grab an increasing share of Fintech investments. Indian players to watch out: Razorpay, Setu
2. Co-brand cards from technology companies would become quite common. These would make more sense for platforms that have a substantial merchant or supplier base. Uber, Ola, Paytm are among many to already release co-brand credit cards. Expect Swiggy, Zomato, Udaan, Jumbotail, and the like to follow.
3. Finally, the complete circle. For a good portion of companies, their incorporated financial services would end up making a majority revenue share of their business — essentially making them fintech companies. The big plays would be in account management, invoicing/billing, cost or revenue forecasting, and other such merchant based solutions.

Hope you found the article informative. Feel free to add a response below or to send me your thoughts over Linkedin. Thank you for reading!