DX, API Design & Documentation

From Open Banking to Embedded Finance

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The article is about embedded finance and why it is a $7.2 trillion market opportunity for those who can enable it. It’s one of the biggest trends in finance. And it’s essentially about helping other businesses to be more successful. Let me start with the problem that embedded finance is addressing. To not put it too bluntly, I would say that our financial system is not fit for purpose.

I’ll give you two examples here that bring this to life. We as humans cannot afford to retire; the gap between the amount of savings that we need overall and what we are likely to have is very, very wide. Indeed, it’s in the trillions of dollars. And that is a problem that is building up for all of us as we get older and older and live longer. There is a vast gap between savings and having enough money to retire.

If I take another example, a survey in the US of consumers about their satisfaction with banks. On one side, 86% were satisfied or very satisfied with their current bank, but only at dealing with 1% of their financial wellness needs. Indeed, a bank is an excellent place to keep your money safe. But is it helping you plan for the future, understand and manage debt, and make big decisions about purchases to plan for your retirement? Those are the things that consumers say are important to them. But the current suppliers are not helping them with that. That’s where a lot of start-ups are starting to play. That big white space you see on the right is the gap and the opportunity for it to be filled. On one level, as consumers, we’re not being well supported by the industry. On the other side, as an industry trying to support customers, we’re not making any money.

This chart shows the average economic profit of the top players in various sectors. Economic profit is the measure of profit after the cost of capital. It reflects a very pure measure of profits. It says, if we invest our money in this type of activity, these are the returns we get. Even before the pandemic, banks were making negative economic profits, which means that where they were placing their bets was not making a return. Due to digitization, that is due to get even worse. Digitization creates more competition and more transparency; it raises customer expectations. Sometimes it introduces new regulations like open banking. And that’s the same for insurance as well. We know that it is partly due to low interest rates, but all kinds of other things where the traditional financial service industry hasn’t leaped ahead to take advantage of digitization.

One sector that is doing exceptionally well and will do even better in the future is software-based businesses because that’s the nature and underlying underpinning of digitization. But some financial institutions have embraced software. They’re doing exceptionally well compared to the traditional incumbents. Companies like Stripe, Square, and Klarna would be good examples, which are now worth more than traditional financial institutions. As a result, the CEO of JP Morgan says he is rather worried about this chart. How do we, as a financial institution, change our business models to be fit for the future, to support customers with their real needs into the future.

The third problem is that the customers are changing. Soon millennials and generation Z will make up the most significant proportion of the workforce and be the most economically powerful group in the economy. Our propositions and ways of interacting with customers are not designed for this new cohort. People are spending more and more time on their mobile phones with mobile apps.

How do we play a role in that, beyond just creating our app that no one ever comes to? And at the same time, we think we’ve got a handle on new distribution channels or channels of engagement like Facebook, Twitter and Instagram, and so on. But innovation is happening so fast that new platforms are emerging. Tik-Tok didn’t exist a few years ago, and now it has over a billion users. We have all these things merging, making it very difficult for companies to succeed in this world.

We need to understand what types of business models work and are most powerful in a digital world. I did some work with the World Economic Forum and tried to create a taxonomy for the types of digital business models that are most powerful. The problem for most incumbent organizations is they spend 99% of their efforts digitizing their existing business model, creating an app, and trying to automate some of their processes. But that is essentially optimizing a business model, which isn’t very profitable.  

I’ve put a few examples to bring it to life. These are examples from outside of financial services and inside different aspects of financial service. Intelligence solutions are solving problems that existing propositions don’t do. They’re using artificial intelligence and digital technology to address friction. In our world of financial services, Klarna is a golden example. It sounds straightforward to buy now and pay later, but the way they do it and how they’ve made it very easy for other companies to embed that into their end-user experience means that they are now worth 50% more than Deutsche Bank. Now you have some traditional financial institutions fighting back and creating their intelligence solutions, like Marcus from Goldman Sachs, which has been hugely successful. IptiQ, a digital business and intelligence solution for embedded insurance is proving very successful in the insurance space.

Layer number three, “developer enablement,” is critical as well because developers are the new kingmakers. Goldman Sachs says the developers are our new customers. These are the people developing intelligent digital solutions for other brands, as big and small, worldwide. Twilio was hugely successful in the telco world, enabling people to embed messaging and communications into their propositions. We know how successful Stripe has been. We’re starting to see the same in insurance. Goldman Sachs has now created a developer platform called TSB. Online marketplaces are extremely powerful because they are asset-light. You don’t have to produce any products to make money out of products, e.g., eBay, Airbnb, etc. But these are pretty different. These are challenging businesses to get to scale. The ultimate business model is when you orchestrate a whole ecosystem of your products and intelligence solutions, enabling developers and creating marketplaces. That’s what the companies on the top have been able to do with enormous success. Most incumbent businesses are stuck at level one trying to get into number two. I contend that they need to be bolder at creating new business models that will suit the world we’re moving into.

Open banking helps to enable all of this; it’s a stimulant for innovation, embedded finance cuts across all of these business models, and it has a role in enabling them. 

Embedded finance is one of the biggest trends in the financial service sector. Essentially, it’s about abstracting financial service functionality into technology. So that any product or service provider, or any developer at any company, can very easily integrate financial service propositions into their own end-user experiences.

There are two types of embedded finance, one where it’s an add-on that is visible and complementary to your existing proposition. A very good example is “buy now pay later” at “point of sale.” It’s a visible add-on; it helps to convert a sale. Starbucks coffee has a digital wallet that you can store money on and use later. They’ve automated the process of you turn up; your coffee is ready. It’s been paid, and you don’t have to worry about it. That’s very attractive to customers; it makes things easy for them. It’s also very attractive for Starbucks because essentially, we who use that are lending Starbucks our money. There’s about $2 billion of float in Starbucks wallets, which is essentially us giving an interest-free loan to Starbucks to use as they wish. A visible complimentary ad on Shopify is also an example where Shopify runs a platform for many small businesses to create a shopfront. It now makes 50% of its revenue from financial services, payment services, lending services, and insurance.

The other aspect of embedded finance is it is entirely invisible. It’s just a component of the proposition and experience that the brand is creating. A classic example is Uber. They have embedded payments into their experience, so we don’t have to get a credit card out when we want to pay the driver. The driver also has insurance embedded within their service contract with Uber. The idea is that brands like Uber, Amazon, Shopify, and QuickBooks have more regular interaction with customers; they know more about their interests than financial institutions. Therefore, in theory, they’re in a better position. They’re at the right moment to be able to either offer financial services or have that as part of their proposition.

A good example of this is Intuit QuickBooks. QuickBooks is an accounting software system that many businesses use to run their operations. QuickBooks knows when you might need a loan or need insurance before you do. When you’re hiring more people, they can see when you’re expanding; it can see that you’ve got more invoices going out that need chasing, and it can trigger the offer of financial services before the customer even realizes.

That is very different from the traditional relationship with a bank or insurance company, where the customer has to think about all these details. All of that friction is collapsed because the ability to access the relevant type of financial solution can be made by a company much closer to the end customer than the financial institution. We’re looking at moving to a much more timely, personalized, and relevant embedding of financial services, which ultimately create much better customer experiences if they can get it right. And indeed, much cheaper, much fairer financial services than you can get through the traditional system. If you’re poor or have a bad credit history, you’re almost locked out of the financial system, significantly impacting financial inclusion. Data is the key enabler of this. It’s not just the brands’ data on customers but the ability to access open banking data.

Let us look at a few tangible commercial examples of why this is attractive. Suppose you are selling b2b software that businesses run their operations on. In that case, it costs you virtually nothing to offer payments, loans, and insurance that you’ve already acquired your customers with your software. You can increase your addressable market or the total revenue you make from your clients by a very significant amount. If you are a retailer and manufacturer, the ability to increase the order value by adding payment terms or, indeed, insurance at the point of sale can be very significant. The ability to increase the conversion rate when people are about to buy something is a bit too expensive.

In terms of inclusion, creating new markets that didn’t exist before this example on the right is very instructive about how the world is likely to move. This is where digital platforms like Alipay in China have daily interactions with millions of customers. Everybody uses Alipay to pay for things. Alipay has a whole set of other services wrapped around it, and it’s an essential part of people’s daily lives. So in rural China, hundreds of millions of people have no insurance, for example, and they also don’t have access to credit very well. But in terms of insurance, what Alipay and Ant group do is that they had decided to act as an intermediary and almost orchestrate a marketplace, whereby they educate and engage their customers about insurance making it understandable when before it wasn’t. They then work with a network of 90 insurance companies to design the right type of products that are affordable, relevant, and personalized. Because Alipay is managing a marketplace where people are competing for that business, they’re able to offer incredibly affordable Life Insurance, critical illness insurance, and essential types of protection that in the past were never available to this audience. I contend that the model will come to the West as well. We can include more people in having the right level of protection, credit, or other financial wellness products in the future.

In terms of the size of the market, if you look at payments, which of course is less regulated than other aspects of financial services, we started to see the emergence of businesses that were enabling other businesses to offer payments and make money out of it, rather than payments being a cost to their business. Suppose you look at the trends over the last few years and extrapolate forwards. In that case, this is from the US, and then extrapolate it globally, with different trend lines, you can see that the proportion of financial services distributed in an embedded way, i.e., through third parties enabled by software, is going to become quite significant. It’ll be about 40% in payments and 20% each in lending and insurance in the US. In other parts of the world, it’ll be slower. But if you add up all those figures, you get to a very significant amount. The companies enabling this are software companies; they are leveraging financial technology. Therefore, even at a multiple of five times revenue, the businesses enabling embedded finance could be worth something in the region of $7.2 trillion in 10 years or 15 years, or 20 years. But the point here is that this is an order of magnitude. To put it in perspective, that figure is double the total value of the top 30 global financial institutions today and about 50% more than the top 30 global software companies.

New businesses are being built on top of the enormous developments in financial technology. Businesses became famous on the back of the internet to leverage cloud and mobile technology. Financial technology is becoming the world’s innovation platform, creating the ability for embedded finance to take off.

For many years, the traditional distribution method of financial services has been very product-centric. Banks and insurance companies create products, do the underwriting, and sell those products through different channels. Now we’re seeing the fragmentation and modularization of that with new players entering the market. In principle, any product can now be bundled together with any other type of component from any source. This is being done by a new layer of developer platforms or Neo aggregators. Some people call this embedded finance infrastructure. It’s still in the earliest days of maturity.

This new layer can take these materialized components from any source and help other businesses configure them to suit the needs of their customers and those other businesses. Initially, it started with Fintechs and big Tech. But now, any company, whether it’s a retailer, a telco, a utility, or a bank itself, can potentially, with the enablement of this platform in the middle, take these components and create those types of experiences. The digital wallet becomes one of the key control points here. Customers will have digital wallets from many different brands that they work with. They will be able to get much more personalized, affordable, and compelling solutions to their problems, which are integrated into their daily lives. The brands that they interact with regularly through digital wallets and other apps will be the ones that succeed in this marketplace.

Let us look at a use case to stimulate how open banking is being used in a new innovative way and how embedded finance combines with that to help brands engage with their customers better. The engagement levels are not very high compared to some of the most digitally successful companies.

Let us take Boots, the chemist, as an example. Boots has a very simple app at the moment. You can shop on it and see how many loyalty points you’ve got. It’s a pretty simple app. But now, with embedded finance, you can turn that app into a wallet, and you can use it to make payments. You can do this very cheaply and quickly than you could have done in the past. Next, you make an incentive for your customers to link their bank accounts and credit cards to your app and its wallet using open banking protocols. The incentive is, if you connect your bank accounts to our app, which is secure and safe, anywhere you spend in your daily life, we will give you free cash if you spend it with specific merchants. If you use our virtual card to buy things, you’ll get even more free cash. Free cash is probably the best hook and the best incentive for any consumer. You get instant cash into your wallet. It’s not a point that you might redeem in 30 days, and you’re not quite sure how it works, but actual hard cash into a savings account in your wallet, which you have complete control of. Now once you’ve done that, you’re building up savings. That’s helping you with your financial wellness. Boots is much more closely interacting with you daily. You are now engaged with Boots, not just when you want to buy some cosmetics or pharmaceutical products. You’re now thinking about Boots when buying things in Sainsbury’s or Amazon. You are using your connected wallet to support those transactions, and you’re getting a reward for doing what you already do. This creates the hook for Boots to increase the types of services that it offers. It can then offer you insurance, loans, and other third-party digital services. You’re hooked into a more profound and more helpful experience with Boots that support you better in your daily life and help you with your financial wellness. The beauty of this use case in using open banking data is that you can see all the backdated transactions that the customer has done in the past. So you can make sure that the offers you’re integrating here are relevant to them. You have real-time insights based on actual purchase behavior, not just guessing what people might be interested in by their demographics. You know what they spend their money on, how much they spend on different types of things, where they spend, how old they are, etc. You can see how your brand performs against others. Ultimately, you can reduce your reliance on card schemes by making your app a payment mechanism.

I just showed you a brand like Boots, becoming more of a super app; it’s doing more for customers, supporting them in their daily lives, and integrating there. It’s taking advantage of embedded finance infrastructure to enable that. 

The benefits of this are –

  1. Real-time insights – you create important customers, focus on them, support them, and make them more engaged with you. So they spend more money and more time with you and share more of their data with you.
  2. 80% profits from 20% customers – getting ingrained into the lives of your most important customers, creating more value for them, creating higher lifetime value
  3. Less churn, better loyalty – you’re now engaged with them daily, and the cost of acquisition for new services to them, either your own or third parties, is very, very low. 
  4. New customers using targeted offers
  5. Low cost and fast implementation

But to make embedded finance work, whether you’re a third-party brand or a bank or financial institution, you’ll need to create a different organizational structure. The types of business models are not something that can flourish within the core of a business, which has been around for many decades and is all focused on the existing business model. You need to optimize your core by creating APIs. To participate in the digital world, you need to study everything you do and automate it. 

You need to support your existing business model, which, as we know, through digitization, is under increasing pressure. You need to create a separate space where you can create your internal or external ventures, collaborating with Fintechs to fast-track the future and create the types of propositions or businesses. You need to connect these so that future activity can leverage the core assets, the future can support the core, and the future can drive demand for the core. Getting that combination right is the key to a successful business model in the digital economy.

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