The Evolution of Embedded Finance
Article 5 in 'The Transformative Potential of Embedded Finance'
Today, for the most part, embedded finance focuses on incorporating financial services into channels convenient for users. Payments is an excellent example here owing in large part to the shifting attitudes driven by PSD2 and Open Banking, which has seen new entrants and propositions build value-added services to justify invisible payments. This is reminiscent of how at the dawn of the internet, email was a flagship product, and now has been commoditised as part of most application ecosystems where value is derived and delivered from a combination of applications.
We expect this to expand in the coming years, driven in part by future initiatives such as Open Finance, which will compel lenders, credit agencies, asset and investment managers to offer similar democratised interfaces to Open Banking. Finance until recently was a siloed industry, walled off from customers and corporates, where interactions happened through a finite number of avenues. With the changing regulatory environment and advances in technology, finance is becoming more akin to data, a stream that horizontally permeates industries and actors but also can enable businesses to be more financially ambitious than in the past.
As corporates get more and more comfortable with embedding finance into their business models, we are beginning to see the wide variety of products they can and already have begun to expand into:
Digital Identity
Identity is another function (often delivered by public bodies) that has begun permeating all industries with the growth of technology. Whereas in the past all one generally needed was a driver’s license and a passport, digital identity has grown exponentially with the average user now having approximately 100 passwords and logins.
The treasure trove of data that corporates have about their ecosystem (in this case primarily suppliers, many of them small businesses) positions them as potential market leaders in offering identity verification services. Embedding digital identity as a service can be seen as a further value offering, where corporates can be trusted entities who can use the data they have to verify the identities of many of their suppliers or companies they work with. This is of particular interest to those participating in embedded finance, where much of finance is knowing who you are making transactions with, and in some instances can offer immediate savings to corporates.
Many people use someone else’s login for subscription services – they want to see WandaVision, but not fully commit to Disney+ – and it's not the hardest thing to find a login and have a bit of a gander. However, this disconnect between who is using the product and who is actually paying, means that companies like Netflix, Hulu, Disney and Amazon lost approximately $9.1 billion to password privacy and sharing in 2019. Integrated digital identity could mean the end of sharing passwords for streaming sites.
Another example is Zara, who work with more than 1,900 suppliers in over 8,000 factories. If a printing supplier is approached by another corporate for their services, for example, traditionally that corporate would require the supplier to go through time-consuming and potentially costly KYC/AML onboarding checks. Zara can step in here and verify the printing supplier’s identity; they can charge a price that is lower than the cost of conducting the KYC/AML checks and simultaneously reduce the time it takes to onboard the supplier. This can diversify Zara’s revenue streams and strengthen its relationships with its suppliers.
The below diagram, harkening back to Shopify’s ‘Finance in a Stack’ solution from Exploring Models of Embedding Finance, shows how a Digital Identity solution would fit into and enhance Shopify’s product stack:
Payroll-based
Living paycheck to paycheck is a phenomenon that has become more prominent over the last few years and reflects the increasing cost of living and expanding amounts of debt for most people. 59% of adults in the US live paycheck to paycheck. Corporates and payroll-based lending can play a leading role in alleviating the strain so many workers face on a daily basis.
Corporates can access payroll data via APIs through FinTechs like Argyle and Pinwheel who provide access to this data. They can use the data to provide lending products to their employees by using their own balance sheets, or partner with lenders to provide them with higher-quality data to better underwrite loans. They can also provide the APIs to the suppliers and SMEs they work with, gain access to their payroll data, use it to improve their (or their partner lenders’) credit risk models, and offer bespoke lending and other financial products to the SME / suppliers’ employees.
The lender can also use ‘payroll-attached lending’, i.e., taking loan repayments directly from the customer’s paycheck, which can reduce losses for lenders and enables them to offer lending products to customers within a wider risk band. Overall, payroll-based lending aids corporates in strengthening their ecosystem and improves returns by allowing them to effectively deploy cash.
Trade and Working Capital Finance
International trade occupies a core component of the global economy and is set to grow in the aftermath of COVID-19. The trade finance gap (i.e., the number of businesses that have applied for financing for trade but been rejected) has hovered around a staggering $1.5 to $1.6 trillion mark over the last few years, with most of the rejected companies being SMEs. Additionally, the importance of liquidity and working capital has been thrust into the spotlight following the onset of COVID-19. According to BVA-BRDC’s SME Finance Monitor report, 18% to 24% of all UK SMEs were concerned about cash flow and late payment in Q2 2020, with business interruption and lockdowns eroding revenues.
Corporates, by providing financial services, have a unique opportunity to capture a sizeable portion of the market for trade and working capital finance products. Global brands have an immense number of suppliers, with Procter & Gamble having over 75,000 suppliers and Walmart over 100,000. Many of these suppliers are SMEs, a proportion of whom will be trading internationally. Corporates can leverage this data to provide trade financing, in the form of letters of credit, bills of lading, guarantees, etc., to their suppliers or solving financing difficulties for their suppliers, via services like receivables discounting, payables finance and factoring. Companies like Siemens (via its subsidiary Siemens Financial Services) are already capitalising on this opportunity and offering working capital finance and vendor finance solutions.
In the same vein as financing their own suppliers, corporates (especially large ones with big balance sheets) can take this a step further by providing working capital and trade finance to their supplier’s suppliers, and even beyond through deep tier financing. The figure below demonstrates this:
Sellers deep in supply chains are often desperate for access to cash and have limited options, such as waiting up to 120 days for payment or using expensive alternative lenders with high interest rates to fund their working capital. Having easily accessible, cheaper and faster financing can thus serve to inculcate trust in corporates like Walmart, bolster the resiliency of the supply chain and better protect it from supply shocks like the pandemic. Banks and technology providers are taking their first steps into the world of deep tier financing. Standard Chartered has invested in Linklogis, a blockchain-based supply chain finance platform that will allow the bank to ‘provide large corporate buyers with greater visibility and transparency of their extensive network of suppliers, as well as cheaper and easier access to financing for suppliers further upstream’. Corporates should aim to form similar partnerships to begin the process of making inroads into this market and not lose ground to their banking competitors.
Securitisation and the Secondary Market
In the distant future, when corporates’ grasp on the financial services space is well established from both a business and technological standpoint, a corporate that has embedded B2B or B2C lending services or provides treasury services to its B2B customers can potentially securitise these loans and sell them on a secondary market. Securitisation refers to various loans (such as trade finance assets) being pooled into one group as a ‘package’ or a security and then being sold on to external investors.
These assets can be sold on secondary markets, enabling the corporates to originate more loans without violating any lending limits and thus earning higher origination fees. Historically, trade finance assets have had lower default rates (<1%) than traditional assets and the data advantage that corporates have would further aid in lowering the risk of default of these loans. Investors will moreover be able to access assets that are shorter term than standard loan pools and cover the gap in the market for assets in the bucket of 6 to 12 months maturity, enabling portfolio managers to diversify their portfolios.
Securitisation of traditional loans has been occurring for decades, with the practice cast under a (rightfully) negative light following the Global Financial Crisis. However, with the advent of technology like blockchain and AI, plus access to large volumes of data that have significantly improved credit risk analysis, loan securitisation once again has the potential to fulfil its primary mission of risk diversification.
A number of FinTechs have emerged that are attempting to capitalise on this development, including secondary marketplaces like CCR Manager, TradeAssets and LiquidX and companies like Tradeteq with offerings like Repackaging-as-a-Service (i.e., Securitisation-as-a-Service) which can be done on an asset-by-asset basis or on a continuously replenishing basis for pools of debt. By the time corporates are able to securitise their loan books, the likelihood is that these will be well-established companies with high transaction volumes that the corporates can partner with.
Embedded Finance Is Here to Stay
The financial potential in embedded finance is immense and the future for new product offerings is bright. It is imperative for leading corporates to take full advantage of this opportunity and avoid being left behind in the wake of their more nimble, mercurial peers.
As we have seen through the course of this series, scores of corporates have taken their first steps into the world of embedded finance, and a few are already at the front of the pack. It is of vital importance for the remainder to mobilise rapidly and realise the transformative ability of this new business model.
Finance is no longer the sole purview of the financial industry. It will ultimately be a ubiquitous service intertwined throughout all of our daily interactions.
Related Reading
The Big Short by Michael Lewis
The New New Thing by Michael Lewis
Articles in this Series
Article 1: The Rise of Embedded Finance
Article 2:The Perfect Storm
Article 3: Exploring Models of Embedding Finance
Article 4: Embedded Everything
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