Embedded Fintech: Which financial services should be embedded? (Part II)
In the first part of this series, we outlined why we think non-fintech platforms should care about embedded fintech. We believe true embedded fintech refers to non-fintech companies leveraging contextual data to build financial products natively into the UX/UI. When done right, embedded financial services can cost effectively (i.e. minimal CAC) improve retention and loyalty while driving higher LTVs by opening up additional revenue streams.
Building financial products from scratch is no small feat. Between navigating regulatory requirements, connecting into legacy systems, and building rules engines / ledgers, it can take a large team years to get a basic product off the ground. To address this, a category of infrastructure companies have emerged that are abstracting away the complexities on the back end to power financial experiences.
In this post, we will cover the types of financial services that are most commonly embedded as well as the corresponding types of enabling infrastructure providers that have emerged to help platforms make this shift.
For platforms where transactions are happening at high frequency with a relatively low ticket size, natively embedded payments capabilities are a great way to gain insight into a user’s preferences and behavior through their transactions. It’s not surprising to see that of the global super-apps and ecommerce platforms that have evolved to layer in financial services, all have a native payments offering.
When it comes to embedded payments, it’s important to clarify that this does not refer to working with a payment gateway (e.g. Stripe, Adyen, Braintree) to accept funds. A key characteristic is that an embedded payments offering typically allows a business to turn payments from a cost center to a revenue generator.
There are a few forms this can take:
- New, proprietary payment methods: Offering a new payment method that has the ability to bypass traditional credit / debit rails and allows end users to make purchases that are outside of the offering platform. The pioneers of this were the Chinese super-apps launching mobile-first capabilities in Alipay, TencentPay, and WeChat Pay respectively. Today, consumer adoption of AliPay and WeChat Pay have far outpaced that of the local card network, UnionPay (95%, 88% vs. 43%).
- Closed loop payments ecosystems: Companies can also create a tight, closed-loop ecosystem to drive loyalty and repeat purchases. Starbucks has done a great job of this — their mobile payments platform boasts a whopping 31m users and is second only to Apple Pay. By incentivizing customers to pre-load balances with additional rewards, Starbucks has managed to strengthen their balance sheet with over $1.4B in deposits. Companies with a robust ecosystem where users are transacting frequently (either with each other or the host) can use payments functionality as a way to have customers essentially “pre-buy” goods and services (makes this in some ways pay-now-buy-later!) while locking them in.
- In-house payments acceptance: Even today, it is difficult for merchants with small volumes to pass acquiring bank underwriting standards and manage the complex legacy process to get set up to accept payments. Companies that have large ecosystems of small merchants can become payment facilitators (payfacs) to monetize the payments flow between users and their customers. Toast is a good case study for why this can be really successful. Although the company started as a point-of-sale platform (so does not quite meet our definition of an embedded finance opportunity), they quickly expanded into a vertical SaaS platform for restaurants. By becoming a payfac, they were able to monetize payments from diners to their restaurants. Today, Toast derives ~78% of revenues from payments processed. Companies like Finix, Payrix, and Tilled provide the infrastructure that helps companies become payfacs.
The calculus changes slightly when it comes to large transactions between businesses. Consumers are accustomed to the convenience and rewards of using our cards and as a result, consumer-facing merchants accept paying 2–3% of top-line as a cost of doing business. In the B2B and wholesale world, thinner margins and larger ticket sizes make this cost hard to swallow. Spend travels on 1) low cost but slower rails like check and ACH and 2) managing working capital needs and payment terms. 81% of US businesses still report paying other firms via paper checks in 2021. As a result B2B payment options often come hand-in-hand with financing solutions as firms look for ways to manage the cadence between cash inflows and outflows (see lending section below).
The thesis for offering access to capital to one’s customers is relatively straightforward: leverage a direct relationship, proprietary data, and (oftentimes) access to cash flows to proactively underwrite customers. Not only does this engender loyalty, the access to capital enables customers to spend more and transact more often.
Embedded lending can manifest in different ways depending on the type of relationship and interactions the end user has with the platform. Here we cover three types that we’ve seen.
Growth capital refers to offering end users access to unsecured credit. Shopify Capital exemplifies this opportunity well. Given Shopify’s position as the operating platform for their merchants, they have 1) proprietary transaction data allowing for pre-qualification of merchants 1) high visibility into cash flows for underwriting, 2) direct access to payments flow to both disburse loans and deduct payments from future sales. The speed, simplicity and convenience simply can’t be matched by a bank or third party lender. Merchants invest this capital directly into their business (e.g. buying new equipment, investing in digital marketing) to create more revenue for themselves, and in-turn for Shopify. It’s the ultimate win-win. Startups like Parafin, Kanmon and Lendflow are helping companies launch similar products on their own platforms.
Many small businesses operate on thin margins and need to carefully manage the timing of inflows and outflows of cash. While larger businesses oftentimes have AR and AP teams to help manage this, for small businesses and independent operators, mismatches in timing and transaction sizes can be crippling. For example, ecommerce merchants who need to bulk buy inventory up front but then make this back bit by bit through individual sales may have to choose to buy smaller quantities for a higher per unit cost. Similarly, a freelance designer might invoice a corporation for a completed job and need to wait 30–60 days to get paid. For these situations, long duration growth capital isn’t the right solution. These users need shorter term solutions to help bridge a timing gap.
Factoring capabilities help bridge this gap by underwriting specific invoices or transactions where a purchase has been made. This can work on either side of the balance sheet: a user can either offer an invoice they are owed payment on and get paid instantly OR submit an invoice they need to pay and extend out the payment timeline. These are the B2B equivalents of earned wage access and by-now-pay-later (BNPL) respectively. Companies like Resolve, Balance, and Wisetack are a couple examples of enablers that are providing access to embedded factoring capabilities.
White-label Credit Cards
White-label credit cards are another flavor of embedded lending offering. A credit card program has long been a great way to encourage loyalty/recurring purchases, give retailers a fuller picture of their customers’ spend (helpful for personalization) and drive up customer LTV. Today, most credit card programs are offered as a co-brand between a merchant and an issuer (i.e. bank). Most major retailers from Macys to Delta offer a rewards card powered by the likes of Citi, Chase, or Synchrony Financial. In these arrangements, the brand manages customer acquisition and offerings for rewards while the bank handles financial components like underwriting, processing, and servicing. This separation means that in most cases, the brand has little input into and no control over the financial side of the experience and the bank doesn’t access any unique data that the retailers may have to improve underwriting. This prevents co-branded cards from being a truly embedded experience.
However, a new crop of startups such as Imprint and Cardless are now empowering brands and platforms with loyal customer bases to create tightly integrated credit offerings. The customer experience can be highly customized and live natively within a platform or an app.
Banking is a natural extension of payments — in order for money to be spent (e.g. through a debit card), it needs to be stored somewhere. This concept is not new: Walmart has been offering pre-paid debit in partnership with GreenDot since 2006.
Bank accounts are highly sticky; the average American has stayed with their primary checking account provider for a staggering 14 years. Strategically, offering embedded banking capabilities can deepen the relationship with end-users (i.e. more frequent and varied touchpoints) while also getting a deeper inside look into their finances. Checking accounts are typically paired with a debit card which opens up a new revenue stream that can be earned off of interchange. Examples of embedded banking today include Uber offering bank accounts and debit cards to drivers as well as T-Mobile Money accounts that offer T-Mobile wireless customers up to 4% APY.
While the regulatory hurdles to becoming a bank are high, many banking-as-a-service (BaaS) companies have emerged that help customers build FDIC-insured banking products. These providers build technology platforms on top of chartered banks to provide the white-label infrastructure necessary for opening and managing accounts without the complexity of inking banking partnerships directly.
The key distinction to make is between wallets and full-fledged bank accounts. The delta hinges on FDIC insurance. Many services including Venmo, Cash App, and even Starbucks have introduced mechanisms that allow a user to maintain a balance. Because these are not backed by an underlying bank charter, these are not subject to the same regulatory requirements as a fully regulated bank account. The FDIC and this legislation was introduced after the Great Depression when the collapse of banks across the country led to depositors losing their entire balances. In practice, FDIC insurance protects account holders from losing their funds in the event the bank fails. Wallet providers typically operate under money transmitter licenses and can’t offer the same protection.
This may matter less for users who are primarily using these accounts for transactional or transitory purposes (and therefore hold smaller balances for shorter durations) and can be sufficient for many use cases (e.g. a loyalty program). However, when it comes to where to store their entire livelihoods and savings, the distinction of FDIC insurance becomes more important. BaaS companies such as SynapseFi, Bond, and Unit provide the infrastructure that powers a fully FDIC insured banking experience.
Card issuance refers to the ability to issue virtual or physical cards that allow end users to make purchases anywhere cards are accepted. This category is closely related and highly complementary to both embedded banking and embedded lending and oftentimes overlaps with one of those offerings (but not always).
There’s a couple types of cards that are commonly seen today:
- Traditional Debit: Cards are tied to a checking account opened in the customer’s name. Funds are drawn from the bank account as purchases are made. These cards are good for use cases that aim to capture a significant proportion of a users’ financial activity.
- Prepaid Debit: Funds are pre-loaded onto a card with a set amount of money. These cards are not tied to a full-functioning checking account and are commonly utilized in use cases addressing the underbanked or one-time transactions (e.g. insurance claims payout directly onto a card)
- Charge Cards: A type of credit card where the card provider sets a line of credit but balances are paid in full every month. The card provider takes on the risk of underwriting the user and advancing funds that are being spent but has more flexibility around dynamically adjusting card limits.
- Traditional Revolving Credit: Similar to a charge card except remaining balances can be rolled over from month to month and accrue interest. Card limits are set at the point of underwriting and are infrequently updated. This is the most common format for a traditional credit card.
While many of the new BaaS providers allow for the issuance of cards as part of their platform, not all use cases require both a checking account and debit card. Modern card issuing infrastructure providers include companies like Marqeta and Lithic.
Embedded insurance can run the gamut from simply offering insurance products at the point of purchase (e.g. travel insurance after a flight purchase or extended warranty for an expensive gadget) to insurance being a feature of the product itself. For instance, ZhongAn, a Chinese insurtech company, offers protection for minor, but frequent occurrences such as returning an online purchase or replacing a broken phone. Rather than sell through agents, ZhongAn reaches customers through it’s network of 300+ ecosystem partners. Whereas a typical insurer may dedicate 30% of its personnel to sales, for ZhongAn it’s less than 5%.
As with embedded lending, access to proprietary data makes it easier for embedded insurers to underwrite and dynamically update policies in a way that is not possible in traditional distribution channels. This can also help expand coverage to categories or consumers that are tricky to underwrite or cost prohibitive to acquire and thus have gone underserved. For example, Tesla owners long complained of high costs when trying to get auto insurance. This prompted Tesla to launch their own insurance product that leverages a unique understanding of the hardware, usage, and repair costs to provide competitive rates. Similarly, Carvana recently partnered with Root Insurance (a Redpoint portfolio company) to deliver an integrated auto insurance experience at the point of car purchase.
Let’s face it, buying insurance is terrible. Applications can be opaque, products are largely commoditized, and coverage and quotes are confusing. That’s why the insurance industry spends nearly $8B a year on advertising alone to try and stand out. Embedding it into existing purchasing flows or platforms that can identify signals of intent has the opportunity to reshape the way the industry distributes.
Payroll is a core function for every business. For the majority of businesses that have fairly stable cycles (i.e. mostly salaried workers or simple calculations) traditional solutions like ADP or Gusto can be sufficient. However, the nature of work is evolving rapidly. As new categories of workers grow (e.g. gig workers, independent contractors, remote employees), payroll calculations become more complex. For the most part, incumbent payroll providers have not kept up.This creates an opportunity for platforms that serve these complex businesses to add payroll to their offering.
Toast is a great example of a company that capitalized on this opportunity. In 2019, Toast launched a payroll and HR management system designed specifically for restaurants. Because data about employees’ shifts and tips is already in the Toast POS, restaurant managers don’t need to spend tens of hours every week manually inputting this data into a separate payroll system. While payroll is still relatively nascent as an embedded fintech service, startups like Check and Zeal are working to make it easier for others to do what Toast did.
The era of the meme stock means that more people than ever are participating in the equity markets but it’s still far from ubiquitous. Today, about 56% of Americans report owning stocks. New API-based companies have emerged that make it easy to connect to the equity markets and add trading functionality. Importantly, these players have also enabled fractional trading — making it possible to buy $100, $10, or even $1 worth of Amazon stock rather than paying the full $3,525 for a share ( at the time of writing this).
To date, most of the companies we’ve seen adopt these have been other fintech companies looking to expand into a new product line and build new consumer experiences. Cash App, Venmo, Revolut, SoFi have all added native trading capabilities.
We see opportunities for applications beyond this — for example, in loyalty. Imagine if instead of a loyalty program or offering discounts to get people to sign up, Lululemon could offer a 10% of the value of your first purchase in LULU stock. Offering customers “ownership” in the company could be a powerful lever for loyalty. Another potential avenue is social media platforms. As trading becomes more and more of a social activity (remember Gamestop?) companies that start out as messaging or social media platforms could contextually add brokerage capabilities into their experience.
The categories we’ve outlined above are solutions we’ve seen considered most frequently but it is by no means an exhaustive list of what’s possible. Innovators are constantly pushing the envelope and recombining experiences and financial products in new ways that fit the needs of their customer base. With the wealth of building blocks that are now available (and continuing to be built!), we’re excited to see builders continue to push the boundaries of what is possible.
In upcoming posts we will do a deep dive on which types of companies are best positioned to embed financial services as well as how to think about launching them. In the meantime, if you’re building enabling infrastructure for embedded finance, we’d love to chat!