Navigating the BaaS maze
Banking-as-a-Service might be en vogue, but that doesn’t mean it’s well understood
I came across this impressive twitter thread a while back from Nicolas Benady, who runs a new Banking-as-a-Service (BaaS) platform called Swan. It explains why BaaS, Core Banking and Open Banking solutions are totally different.
But, to our mind, some of the confusion is justified. While today there is a big difference between Open Banking, BaaS and B2B SaaS systems, like core banking solutions, a lot of the differences are dissolving. Further, not all BaaS platforms are created equal and, as the example of Sequoia walking away from its investment in Finix demonstrates, the BaaS space is also quite complex.
What follows is our schematic for understanding the differences between BaaS models, as well as a discussion about the battle to dominate the BaaS space over time, which we think is likely to involve both open banking and B2B SaaS platforms.
PaaS vs BaaS
Platform-as-a-service (PaaS) is about providing a platform on which others can simply and cheaply build a new proposition. Banking-as-a-Service (BaaS) is about providing a platform that allows (normally non-financial) businesses to embed banking into their existing proposition, like point-of-sale credit.
However, this is a somewhat false dichotomy in that many of the platforms actually do both. They can enable companies to build a new proposition on top of the platform and offer an already-assembled service to be embedded directly into an existing proposition; the distinctions can be quite nuanced.
The differences in BaaS
Instead, we perceive the main points of differentiation in BaaS to be the extent to which services are vertically integrated vs modular and the extent to which they are out-of-the-box vs customizable.
Let’s start in the top left quadrant.
Out-of-the-box BaaS models are fully-formed, end-to-end services that a brand can embed into their propositions, typically with little customization. They tend to work on the basis of a variable, revenue-sharing model. And they are generally best suited to smaller businesses that have few internal developers (or don’t want the hassle of development) and do not want to be regulated in any way: that is, those business willing to forgo customization (and higher margins) for ease of use.
An example in the payments space would be Stripe, which allows any digital business to accept payments through a simple API integration. Stripe integrations are largely the same — the same layouts, with the same fields. And Stripe charges a variable fee for this service, 2.9% and $0.30 “per successful card charge”.
An example from the wealth management space would be DriveWealth, which we profile in our recent report, which provides an end-to-end brokerage service that brands can embed into their proposition on a revenue-sharing basis.
Finix is a kind of hybrid model
In the matrix above, we have positioned Finix between the regulated and the unregulated spaces. This is deliberate since, although Finix is regulated under the Payment Card Industry Data Security Standard, it is not regulated as a payments company. The quirk here is that Finix basically provides all of the capabilities for its customers to become payments facilitators, for which they need to be regulated, and in doing so it changes the economics for those customers. Instead of paying a per-transaction fee, customers pay a subscription to Finix meaning that a much greater proportion of the income from payments accrues to customers over time. In a strict sense, then, Finix is not a direct competitor to Stripe. But, it is an alternative to Stripe, which is why Sequoia felt the need to walk away from its investment.
Vertically-integrated, customizable BaaS platforms
In contrast to the out-of-the-box BaaS services are those that are still vertically integrated (in that a single platform provides the end-to-end service) but they allow for much higher levels of customization. This is where the line gets slightly blurred between PaaS and BaaS in that with many of these platforms it would be possible to build both a standalone fintech proposition as well as highly customized user journey with distinctive look and feel within an existing proposition.
There are broadly two models for vertically-integrated, customizable BaaS.
1. Vertically-integrated, customizable BaaS offerings from incumbent banks
The first are from incumbent universal banks, such as Goldman Sachs (Marcus), BBVA (Open Platform) and Standard Chartered (Nexus). This is a logical play for these banks, since it allows them to spread costs and grow volume. Much of a bank’s cost base — software, infrastructure costs, compliance — is relatively fixed and, therefore, generating a higher volume of business through indirect channels helps to spread these costs and improve cost/income ratios. Furthermore, new customers coming via indirect channels should be acquired at much lower cost since they are existing customers of the acquiring platform. However, what is less clear is the extent to which the better unit economics will be shared between the brands distributing banking services and banks manufacturing them (especially over the medium to long term).
2. Newer entrants offering a narrower range of services
The other players operating in this area — more numerous for now — are relative new entrants, regulated digital platforms or banks which offer generally a much smaller range of services than could be offered by a universal bank. These players, by dint of being platforms and having little or no consumer-facing activities, are not particularly well known, such as Solarisbank in Germany or Cross River bank in the US. There are also examples solely focused on specific segments. One example, profiled in our wealth management report, is WealthKernel, which provides a full-end-to-end stack for businesses to start wealth management businesses, a kind of Shopify for wealth managers.
Modular and customizable BaaS platform
The other main type of BaaS systems are those that are both customizable and modular. By that, we mean that they afford their users a lot of flexibility in the implementation of the services, which can be easily extended, but also that it is not a single provider providing the service.
These types of BaaS platforms are a partnership between a service provider, which typically provides the service configuration and orchestration as well as customer and risk management, and a regulated institution, normally a bank, which provides compliance, balance sheet, settlement, custody and other regulated services.
An example in the wealth management industry is Bambu (profiled and evaluated in our wealth management report) with its Bambu GO platform for the US market, which allows new entrants to launch a robo advisory service or to embed one into an existing offering, using Apex Clearing to provide the custody and brokerage.
The business rationale for these partnerships is around specialization and flexibility. The partner banks can focus on banking manufacturing while the partner can focus on the distribution of these services, which requires these services to be served up in context-aware user journeys. Moreover, the BaaS provider can work with different partner banks in different countries to overcome the geographical constraints of these partner banks, which tend to be limited to operating in single countries or jurisdictions.
Lucrative for the licence holders?
This kind of partnership with BaaS providers can be very lucrative for the banks involved, but it is harder to see how this can be a viable model for incumbents. Owing to the scale economies and lower CAC, small credit unions and community banks in the US that have developed these partnerships are earning elevated returns on equity. Celtic Bank, for instance, a small commercial bank based in Salt Lake City, earned an RoE of 37% in the quarter to end of September 2020 (source: US Bank Locations).
The problem with the incumbent banks is that they have very different cost bases compared to these small credit unions or digital banks. The idea of distributing services wholesale through these intermediaries is difficult to imagine given the sunk distribution costs, such as a branch network, that most banks have as well as the high costs from legacy technology. Distributing a subset of services through these intermediaries might be more viable to grow subscale or non-strategic business lines through an indirect channel, such as Goldman partnering with Stripe Treasury. But, in the main, we expect incumbents to move slowly on BaaS and when they do to elect, at least initially, a vertically integrated model — because they are not yet ready to decide which services are core and non-core.
BaaS operating platforms: the value of linking many to many
A change that we foresee is for the BaaS systems to become less static and more networked over time. In short, we expect the modular BaaS providers to evolve into providing a many-to-many gateway. By that we mean that rather than partnering with a single or a very small number of banks on the supply side, which is generally the case at the moment, we anticipate that these players will work with both many suppliers and many brands on the demand side, in a model more analogous to a software operating system.
We already see the early signs of this. HUBUC, based in Barcelona, offers a single integration point into both multiple banks and multiple other BaaS providers; a one-to-many aggregation service massively simplifying access to a range of banking services, even across borders. Stripe Treasury is also doing something similar. It is a single integration into mutiple banking services, but it’s go-to-market is to partner with other platforms like Shopify, making it the platform of platforms. Interesting also is that we have placed both HUBUC and Stripe Treasury on the line between regulated and unregulated since both carry out some compliance activities. In fact, we think that some (partial) regulatory responsibilities will be a competitive differentiator over time, both to attract banking partners and to reduce friction for brands.
The emerging competitive landscape for BaaS operating systems
This model of the BaaS operating system is, in our view, the most exciting area in the whole of the fintech landscape — the pinch point where the most value is likely to accumulate.
However, it is a not a foregone conclusion that the most successful BaaS operating systems will stem from the BaaS field. B2B and B2B2C are becoming increasingly blurred and this opens up the possibility for B2B systems of intelligence to also emerge as BaaS operating systems contenders.
Consider the graphic above, which relates to the wealth management market. On the left-hand side, we illustrate a B2B SaaS system of intelligence, in this case additiv for wealth management. additiv provides wealth managers with software that enables them to manage the customer relationship independently of the core banking system and independently of distribution channels, but the software is mostly used by single institutions in a vertically integrated business. Elinvar has the same proposition as additiv, except it also offers some business processing outsourcing. Next is WealthKernel, mentioned earlier, an end-to-end vertically integrated BaaS platform. Then, we have an example of a modular, BaaS platform: Bambu GO. The interesting point to note here is that Bambu’s main business is being a SaaS provider to regulated firms, such as Standard Chartered, providing its solution in the service of an integrated business model, just as additiv does. The offering provided by Bambu doesn’t change, just the end customer (now not a regulated entity, but fintech or consumer brand) and the provider of regulated services (a partner, rather than the end customer).
Therefore, it follows that any B2B system of intelligence can easily pivot through partnerships to become a modular BaaS provider and, from there, to become a BaaS operating system. In fact, the move to a BaaS operating system is, in many ways, easier since these systems of intelligence are being used by many banks in a SaaS setup, meaning there are already several supply-side options for the brands on the demand side. Bambu has already started down this route with Bambu GO, but others in the wealth management field, such as Elinvar and additiv, are moving in this direction, too.
The other players that are potentially in the running for the BaaS operating system are the Open Banking platforms, like Plaid, Bud, Yolt, and Tink. These platforms provide the capabilities for connecting customer data with other services, where the customer provides the permission for this to happen. For example, if you want to connect your accounting system to your bank account, an open banking platform will provide the connectivity to make that happen. However, most platforms have realized the potential to go further, moving beyond just connecting banks and services and towards fulfilling user journeys, such as switching a utility provider. By connecting banks and brands, they are also in a position to pivot and become BaaS operating systems.
So, rather than being completely different, the worlds of open banking, SaaS and BaaS may actually be converging — with several highly lucrative winner-take-most platforms likely to emerge.
This blog was based on an excerpt from our recent “Digital Age Wealth Management” report, which you can access and purchase through this link.