Four Embedded Finance Strategies for Incumbents


This blog is based on a presentation I gave at the Dubai Fintech Week


Goldman Sachs and Standard Chartered are so far leading the way, establishing playbooks for others to follow.

This is a great time to be an incumbent bank. The best time for decades.

Net interest margins (NIMs), the spread banks make over what they charge borrowers and what they pay to depositors, are rising on the back of rising interest rates. This is lifting banks’ profits, giving them the money to invest in digitizing their business processes and renovating their business models. It’s also giving them the money to do acquisitions that can accelerate the same process of innovation.

Their digitally native competitors are faring less well. Challenger banks, and other B2C fintech companies, continue to struggle with basic unit economics and profitability. Apple’s privacy changes have added to already very high customer acquisition costs. The interest rate environment is, in general, not helping much since most do not have a lending business and tend to make money from fees (especially interchange) rather than NIM. Furthermore, VC funding and valuations are falling, making it harder to fund loss-making models and making the better-quality firms ripe targets for acquisition.

Publicly-quoted FinTech stocks are down by more than 50% over the last 12 months

Essentially, the flaw in most B2C business models has been laid bare. Distribution is splitting from manufacturing and what counts for the former is large, loyal customer bases and what counts for the latter are large balance sheets, underpinned by sticky deposits and good risk management. Most B2C fintechs have a vertically integrated model that benefits from neither; subscale in both distribution and manufacturing.

The question for incumbents is how best to capitalize on their strengthening relative position. Our view is that such a strategic discussion has to take place through the prism of new routes to customers. And the most structurally important shift in this regard is the move to embedded finance, which we define as the phenomenon that:

“allows (typically) non-financial companies to offer financial products and services seamlessly through existing user journeys, without having to produce the services themselves.”

What follows is a discussion of four strategies that incumbents can employ — and are employing — to take advantage of this embedded finance phenomenon.

Citadels (doubling down where there’s a moat)

There is no question that embedded finance is evolving. It started with discrete, transaction-focused services, such as buy now pay later (BNPL) and payments-as-a-service. But it is clearly expanding to include more relationship-based services, such as mortgages, wealth management and life insurance. This is happening because non-financial channels have more data with which to personalize these services (at a lower price point and at greater scale) and benefit from the right contextualized opportunities in which to offer them to customers. Furthermore, financial services companies no longer enjoy any inherent trust advantage over non-financial brands when it comes to distributing relationship-based financial services — a recent survey from additiv, for example, shows that two-thirds of consumers would readily take wealth management services from a non-bank.

A diagram reproduced from aforementioned additiv report

This being said, there are still several areas of banking and financial services that will for the foreseeable future not be easily embedded into non-financial channels — citadels protected mostly by high complexity where incumbents will continue to dominate distribution. These include areas like private banking (as opposed to wealth management), investment banking and corporate lending.

It makes sense for incumbents to continue to make big investments in vertically integrated models for the distribution and manufacturing of these services. That is not to say that can ignore innovating in the way they source, operate and distribute these services, only that for these services they can defer — for now — thinking about embedded distribution channels.

And where distribution and manufacturing remain bundled, it is much easier to control one’s destiny — to set pricing, manage margins, enjoy entry barriers. As a result, this continues to make these business relatively very attractive for the (scaled) incumbents — e.g the bulge bracket investment banks — who will continue to lead them.

Market development

If the first strategy is about doubling down in areas less likely to disrupted by embedded finance, the second is about going on the offensive without triggering the corporate immune system.

Embedded finance represents a business model change for incumbents. In short, it involves giving up direct distribution in exchange for lower customer acquisition costs and greater volumes, improving scale economies and lowering average costs. Like any change in business model, it impacts organizational structures and compensation and will inevitably trigger an immune system response; a backlash from the people and teams that feel threatened or stand to lose out.

One strategy to minimise this immune system response is to focus on new markets. So far, we see largely three permeations of this strategy:

  1. Using embedded finance to build scale in markets where an incumbent operates, but has only a small presence. A good example of this is Standard Chartered Bank (SCB). In 2020, SCB created Nexus, its banking as-a-service platform. In our view, SCB did two things right from the outset. First, it created Nexus through its venture arm, SC Ventures, which freed it from many of the tentacles — antibodies — of the immune system since it had separate leadership, measurements, budgets and systems. Second, it focused the activities of Nexus on markets — such as Indonesia — where SCB has a banking license and banking operations, but not a large market share. As such, when it signs up a big e-commerce partner like Bukalapak (which has 130m users!), it generates net new business with minimal risk of cannibalizing existing revenue streams.

2. Using embedded finance partners to distribute services which the incumbent does not presently or actively offer. An example here could be Goldman Sachs (GS), both for consumer and transaction banking.

While GS does have a consumer-facing business in Marcus, it seems that the strategy is changing and go-to-market will increasingly be through partners such as Apple, whose co-branded credit card boasts 7m customers, and with whom GS has now partnered to offer both BNPL and high-yield savings. This allows GS to continue to enjoy the strategic benefits of a retail banking business — such as diversification and a lower cost of group capital — but without having to acquire customers directly (for which it has been much criticized by investors), nor diluting the strength of the GS brand in Capital Markets.

What GS is doing with TxB is also ambitious and interesting. TxB from GS is self-service tech platform covering deposits, virtual accounts, payments, escrow and liquidity management. It takes GS into the new realm of transaction banking dominated to date by players like Citi and Bank of America. GS, a la Amazon/AWS strategy, initially built the platform for its own needs before rolling out to external parties. Notable users include American Express and Stripe. The latter used it as the basis for its Stripe Treasury service, which brings transaction banking to millions of Shopify merchants, exemplifying the multiplier effect of BaaS for progressive players like GS, which expects TxB to be active in 36 countries by 2023 and generating $1 billion in revenues by 2025.

3. Using embedded finance to access net new territories. An example here could be Aion Bank, a Belgium digital bank backed by Warburg Pincus. Aion operates a direct-to-consumer model in Belgium, but it also offers a pan-European banking-as-a-service model, together with its tech partner Vodeno, which enables it to acquire customers all over the EU without having to have a physical presence outside Belgium, massively leveraging its sunk investments in compliance, processing and systems.

Distribution play

Another strategy is for incumbents to look to leverage their existing customer numbers and distribution power, embedding third-party services into their offering in the same way as a non-financial institution.

This could easily be compatible with other strategies. For example, private banks, relatively protected from embedded finance disruption for now, may wish to bolster further their position by embedding services from other providers to broaden their offering and bring services to market quicker, especially to appeal to changing demographics. This could be for, say, crypto services, as LGT Bank has done by partnering with SEBA, rather than having to develop and operate these trading and custody services for themselves, or for private assets, as Bordier & Cie did when it partnered with Moonfare.

Revolut has embedded more than 10 third-party services into its offering

However, we see a more common use case with challenger banks. The aforementioned issues with respect to challenger bank business models (high CAC, reliance on interchange fees) are compounded by the fact that they tend to have a limited product offering. For a challenger bank to start offering additional embedded services allows them the possibility to quickly grow lifetime value without the expense and lead time of having to build these products. Further, if they are able to move into more advice-based services, and extend their relationship from payments and accounts, to saving, protection and wealth management, they are also likely to see lower churn. This strategy will, of course, work better with challenger banks that have already hit escape velocity and become viable aggregators in themselves, like Revolut.

Move upstream

As discussed, the value chain in financial services is splitting between distribution and manufacturing. In most discussions around embedded finance, it is assumed that incumbents will only play the role of manufacturer, opting to become highly-scaled supply-side platforms. However, there is another highly lucrative role to play in the value chain.

This role is to mediate between demand and supply, between manufacturers and distributors. For now, this role is mostly being played by fintech companies like Stripe and Matchmove, who do not have a foot in either production or distribution. Nonetheless, incumbents can strategically enter this space, either through organic development or through acquisition.

As before, Standard Chartered provides a great example.

Audax, which is expected to launch in 2023, is a new company being formed out of SC Ventures. It’s a spin-out of a spin-out, so to speak, in that it packages up the technology created for Nexus and offers it to third-party banks also looking to move into BaaS, but which do not want — or can’t afford — to develop their own technology. Unlike Nexus, which is a vertically integrated BaaS provider, covering everything from balance sheet and compliance to connectivity, Audax is solely a technology provider, offering product configuration, data and analytics, as well as low-code integration. As a result, Audax is a highly scalable modular BaaS platform, an asset light provider able to operate easily across borders, working with multiple banks and distributors.

While some incumbents may try to emulate SC in building a modular BaaS platform, it seems likely that many will seek to acquire these types of platforms in their quest to move upstream. A recent example would be JP Morgan’s acquisition of WePay, but we are likely to see many more as valuations fall and incumbents realise their strategic importance.

Getting in shape

Every incumbent needs an embedded finance strategy. Arriving at the strategy can take time and, as we’ve shown, it can (and should) be more nuanced than just deciding to open up the business to any type of third party distribution (see, for example, some of the challenges Evolve Bank is facing).

An embedded finance strategy should be based on strategic objectives and an assessment of where best to play and how to win. It should then inform what capabilities, structures, governance and systems need to be put in place.

However, two things are clear from the start. The first is that any business model change is extremely difficult to execute from within existing structures. This favours either creation through venturing (e.g Nexus) or through acquisition (as long as the acquisition is given the autonomy to grow, supported by the group, but not killed off by its immune system). Once the business has reached critical mass, it can be fully integrated within existing structures. In this regard, it is interesting that GS has decided to break out the financial performance of its embedded finance operations (“platform solutions”), since as David Solomon put it on the Q3 earnings call, it “allows [GS] to shine a brighter, more transparent light on them.”

GS new reporting segments (from Q4 22). Slide taken from Q3 earnings presentation

The second is that, even before a concrete strategy is defined, every incumbent needs to upgrade its infrastructure to operate in a different business model and at a different scale. As mentioned, embedded finance is moving from discrete, transaction-based services into bundles of personalised services. This requires services to be opened up and made more composable, for risk management to be made real-time, and for transaction processing to be moved to the public cloud. This takes time and ambition. BaaS is not an overnight pivot. GS and many other incumbents have been laying the foundations for years. As Marty Chavez, then CIO of GS, put it back in 2017:

“We’re packaging everything we do, and actually, we’re redesigning the whole company, around APIs.”

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