What Embedded Finance Can't Do
Banks missed on digital account opening. They can't afford to miss this time.
The impact of fintech is best observed by studying the evolution of convenience within financial services.
Take digital account opening (DAO) as an example.
20 years ago, every consumer lending product was a pain in the ass to acquire, regardless of how much money you were looking to borrow. You had to show up, in person, at the branch or the car dealership. Often, you had to wait days or even weeks to find out if you were approved.
In this environment, credit cards were by far the most convenient form of credit — not because they were much easier to sign up for initially — but because, once they were acquired, you could draw on your open credit line with no additional work.
When digital account opening first started to seep into the financial services industry 15 years ago, credit cards (one of the first products to be enabled for DAO) became easier to acquire, but the bigger effect was on larger installment loans. Suddenly it was easier (not as easy as credit cards, but easier) for a customer to apply for a personal loan or an auto loan or even a mortgage. Disruptive challengers like Lending Club and Quicken took advantage and many banks (slowly) followed suit.
What banks failed to understand was that the most significant impact of digital account opening wasn’t the ability to digitize the origination process for existing lending products. The biggest impact of digital account opening was significantly lowering the cost of origination, which unlocked the ability to create entirely new digital lending products.
The beauty of being able to create new digital lending products, without the cost-to-originate constraint, is the ability to fundamentally rethink how those products are delivered. If you can instantly and cost-effectively originate a loan, of any size, then you have the flexibility to embed lending contextually within any digital interaction, which improves the convenience of the experience for the end customer.
This is the insight that companies like Affirm and Klarna used to build the emerging Buy Now Pay Later (BNPL) lending model (a model that, in Affirm’s case, is rumored to be worth $10 billion). Now customers have a new, contextually convenient, alternative for financing the purchase of eye glasses, mattresses, and exercise bicycles (to name a few).
Banks Can’t Stop Embedded Finance
A year ago, Visa estimated that 5% of the U.S. credit card market had been disintermediated by fintech companies. Some of that competition came from online lenders offering an installment product through their websites (think Lending Club). A growing percentage of that competition, however, came from BNPL providers like Affirm. The key difference, as I mentioned above, is that the BNPL loan is presented within the context of the customer’s shopping experience (usually during checkout). This experience is significantly more convenient for the customer than visiting an online lender’s website directly. That convenience translates into a higher conversion rate for the merchant, which is why a great and growing number of merchants and other players in retail and e-commerce are partnering with BNPL providers (see Affirm and Shopify for a recent example).
This shift towards embedded finance is likely to accelerate, becoming even more deeply integrated into the experiences of non-FS companies. A recent overview of the vertical integration of fintech into SaaS by Andreessen Horowitz provides a good depiction.
Estimates of the overall size and growth trajectory of the embedded finance market support the idea that this shift is likely to accelerate. From a recent Forbes article by Ron Shevlin:
The Lightyear report estimates that embedded finance will grow to nearly $230 billion (in revenue) by 2025, up from $22.5 billion this year. At a five times revenue multiple, embedded finance will create more than $1 trillion of value by 2025. Assuming faster growth in the second half of the decade than the first, the estimate is in-line with Bain Capital Venture’s estimate of $3.6 trillion by 2030.
Banks Shouldn’t Chase Embedded Finance
So, how can banks effectively compete in the era of embedded finance?
If their response to the rise of Buy Now Pay Later is any indication, they have no idea.
Chase, Citi, and American Express all now offer installment lending features within their existing credit card products. These enable cardholders to convert large purchases into fixed-fee payment plans, or allow them to borrow money against existing credit lines and pay it back in fixed installments.
The big card issuers looked at the emergence of BNPL and the success that companies like Affirm have had in partnering with merchants to increase conversion rates and improve their customers’ shopping experiences and thought “customers must really like installment loans”.
Talk about missing the point.
To be fair, recent developments (like Citi’s partnership with Amazon) do indicate that banks are beginning to understand the importance of the ‘embedded’ part of ‘embedded finance’. Still, banks shouldn’t chase the embedded finance wave. Two reasons:
Tactically speaking (but not tactfully speaking) — most banks are going to suck at embedded finance. Embedded finance requires modern, flexible, API-oriented technology stacks and aggressive business development teams quickly building partnerships with a huge variety of companies. How many banks do you know that fit that description?
Strategically, the shift towards embedded finance disintermediates banks from their most valuable asset — the customer relationship. This is the ‘dumb pipes’ problem, which has most recently reared its head with the Google checking account initiative, but is equally applicable for any product area within financial services (see the a16z graphic above).
So, once again, how can banks effectively compete in the era of embedded finance?
Context vs. Perspective
I recently used Affirm for the first time, to finance a pair of glasses from Warby Parker. I, like 33% of Affirm’s customers, was offered 0% interest on my loan. This sparked a question:
I’m guessing it’s a lot. I’m certainly one of them. I didn’t need to break my $95 payment into three payments of $31.67. In fact, I missed out on earning 190 miles on my Capital One credit card by choosing financing from Affirm.
I did it because I’m a fintech nerd doing research for my newsletter, but why are the rest of the 33% of Affirm’s customers doing it?
I posed this question on Twitter and the most common response was that, because of how merchants embed and promote Affirm at the exact right moments in their checkout flows, it’s the most convenient option for customers. Simon Taylor’s tweet summarizes this reasoning well:
Zooming out, the implication of this is monumentally important:
By embedding financial services in the exact right context, companies can drive customers to make decisions that aren’t necessarily in their best financial interests.
That might sound a bit hyperbolic. After all, in the case of Affirm, the ‘cost’ to me in choosing Affirm was a couple hundred credit card reward miles. Grab your tiny violin.
But if we look forward into the world predicted by fintech VCs — where every company is a fintech company and banks are relegated to regulated infrastructure providers — I see cause for concern.
If financial services become exclusively embedded in non-financial activities then financial services itself stops being an activity.
That’s a problem because as easy as Uber might make it to get a checking account or Amazon to get a loan, there won’t be anyone around to help you make the hard choices necessary to achieve financial security and build wealth. If every financial choice is made in context, customers will lose the perspective to see how those individual choices impact their holistic financial health.
A New Vision for Fintech
In the age of the internet, the company that owns the best customers wins.
Take Apple as an example. The iPhone has successfully fended off Android not because of the quantity of its customers, but because of the quality of the customers its smartphone and iOS ecosystem attract. Here’s Ben Thompson:
iOS owns the best customers, i.e. the customers who are most willing to pay … platforms and ecosystems themselves depend on access to desirable customers. By extension, the companies who own that access — who own the funnel, to use a marketing term — are the ones who gain outsized influence and, in the long run, outsized profits.
Apple’s interest in embedding financial services is in increasing the value that customers get out of owning an iPhone and the value that developers and content creators get out of distributing their IP through iOS. Here’s Nik Milanović reacting to Apple’s acquisition of Mobeewave:
Tom Noyes @noyescltBIG Rumor.. Apple purchased mobeewave. If true that will spell trouble for Square, Samsung and SMB acquirers. Super short Blog https://t.co/a9IeZNIjfI
This is what fintech is to Apple and Facebook and Uber and (I’m just going to toss out a prediction for the next ‘everything is fintech’ headline) Spotify — a way to further lock in users and generate proprietary data to keep those flywheels spinning.
This is not what fintech should be.
Fintech should not be yet another weapon in companies’ fight to control today’s most valuable customers. Fintech should be a tool for financial services providers to create tomorrow’s most valuable customers; to help an Uber driver achieve the level of financial security necessary to no longer rely on side hustles to get by, to help an iPhone user objectively evaluate the wisdom of their digital media subscriptions, to prioritize customers’ long-term financial health above everything else.
The embedded finance vision for fintech will never be this. It’s up to banks (both incumbents and challengers) to paint a different vision for what fintech can and should be.