A reproduction of Martin McCann’s presentation at BCR’s A&RF Forum 2022
Embedded finance and Banking-as-a-Service (BaaS) have arguably received the most hype in the world of fintech for the past two years. With embedded lending - and its' more complex subset; embedded working capital - stepping up to take the limelight more recently.
But, as the saying goes “a little knowledge is a dangerous thing”. This is especially true for embedded lending in the commercial space. There is no standardised use of terminology or categorisation. As an industry we are struggling to actually define what BaaS and embedded lending mean.
We see this everyday in conversations with customers, journalists and partners. People often use the terms ‘Open Banking’, ‘Embedded Lending’, ‘APIs’ or ‘Lending-as-a-Service’ interchangeably. And they're not interchangeable.
But, it is very important that we all understand what those terms mean and how they relate to each other.
As a provider of working capital technology to some of the world’s largest banks (e.g. HSBC and Barclays) and alternative lenders (ScotPac) we wanted to add some much needed clarity on the topic.
In this article, we will focus on embedded lending, as opposed to embedded finance, how this relates to open banking and lending-as-a-service (more specifically working-capital-as-a-service) and how APIs fit in.
We’ll also talk about some of the market projections, behaviours and risks in relation to secured or asset based lending to businesses - and a really interesting opportunity within that; embedded receivables finance.
There’s a lot of ground to cover so grab a coffee and read on…
What's really interesting about this research is two things:
This is not an academic topic. This is something which is happening right now.
If you're a provider of a financial service, you need to have a perspective on what embedded finance is and what it's going to do to your business model. And you need to know in a matter of months, not a matter of years.
Currently, most of embedded finance research we've been reading calls out two main embedded product or BaaS categories:
If you look at the Banking-as-a-Service category in the UK, a few of the big players are Railsr and Weavr. Most of their business appears to be embedded payments and providing white labelled account services to other providers of financial services.
Lending is coming. We believe that embedded lending is potentially the biggest category in the long-term for embedded finance - and it's going to be a big focus in 2023.
Despite a tumultuous couple of years, the widespread adoption of Buy-Now-Pay-Later solutions in the retail lending segment, not least by Apple’s embedded iPhone solution, have given us a view of what could be in store for embedded lending.
To explain embedded lending, through the lens of business lending, we look to a piece of research from our partners at KPMG.
To embed something is to actually decompose it. So what are you decomposing it into?
There's a massive supply and demand mismatch for working capital solutions and businesses.
There’s an estimated credit gap nearing US$10 trillion.
It’s our estimation that in any segment of the market, any region of the world, there's about a 30% mismatch between the supply of working capital solutions and the demand for them.
The smaller the company the larger the mismatch.
This demand is starting to surface through a wide variety of digital channels. We saw through the covid period that more and more business and supply chain transactions were happening online. Physical locations weren't an option.
Through necessity, more transactions became digital. Those channels now have a huge amount of power in distribution across the supply chain.
The supply chain is the one point where all transactions happen, and where all the data passes through.
The data and technology have existed for a few years now. But the rate of change has been slow - until now. So, technology and data are not the drivers here. It’s the demand from customers.
We are at an inflection point. This opens up some big opportunities - or risks, depending on how lenders decide to respond.
What about receivables finance becoming the main channel for trade credit insurance (TCI) distribution? Why are there specialist PCI insurers when most of it is actually sold in conjunction with some kind of a credit product?
So that's one opportunity, but it's not the only one. It's just an obvious one. There are lots of different pairings of other value-add services which can be sold alongside receivables financing.
One of the biggest benefits for capital providers for embedded working capital is scalability and the ability to specialise in the things that you're really good at.
Working capital products like receivables finance, invoice finance and asset based lending, are complex products. Not all lenders have (or want to have) the skillset to provide the specialist operations around credit and risk management origination and distribution.
Some lenders are better at it than others.
There's an opportunity for 10x scale by doing the things that you're really good at.
With access to more distribution channels, lenders can focus on the economy of scale - essentially make more money doing less, but doing it better.
Now, let’s talk about product improvement.
Risk management holds a lot of growth opportunities - for lenders and businesses. One of the problems with working capital finance, as it stands, is that the products are not fit for purpose for some of the demands of the future.
Traditional risk teams have functioned much the same way for decades. With real-time data becoming readily available via APIs, risk teams can truly understand the nuances of a business.
When you see all of the data all of the time, the data tells a different story. A more accurate one.
This will impact the way you think about risk. And the risk models that you build will probably change too.
Risk models that will improve your credit and business operational risk, as well as your ability to stress test your overall risk portfolio.
This is the closest example of embedded working capital that we have today.
Merchant working capital facilities, specifically merchant cash advance, through point of sale (POS) terminals prove that the market has changed recognisably in the last 5 years.
Below is a list of the top five providers of merchant cash advance facilities and merchant working capital facilities.
None of them are banks. But, the capital in a lot of cases comes from banks or alternative lenders.
The aggregate amount of lending through these five players is expected to be somewhere north of $100 billion dollars.
Bad news is, if you want to be in the merchant cash advance facilities business, that ship has already sailed.
But, there’s good news if you want to dominate the receivable finance market.
The space is still wide open. Now's the time to be making investments in the proposition, the operating models, the technology and data.
But you’ll want to move quickly.
Amazon describes it’s product as follows:
‘A flexible payment schedule is determined by a fixed percentage of the seller’s Gross Merchandise Sales (GMS) until the funding is paid off, with no minimum payments, no interest (only a fixed capital fee), and no collateral required.’
According to leaked documents from Amazon, the company’s economists expect that loans to sellers will double in 2023. The documents forecast that third-party sellers will owe Amazon $2B in 2023. The growth is impressive.
However, Amazon plans to tighten its underwriting and credit management policies. This is an opportunity for lenders who are using the right technology to become the core Working-Capital-as-a-Service provider for Amazon (and similar platforms) embedded channels.
In this section we will attempt to explain and simplify the complexities behind embedded receivables finance. We will talk about the changes lenders need to make in order to become ready for the wave of demand, as well as considerations lenders need to make around their business models.
To start, we have expanded on the three components of embedded lending identified by KPMG above.
Two key clarification points that we want to make:
There’s a lot of the focus on infrastructure and data aggregation in the market. However, this is not the same as embedded lending. Although without the right infrastructure, lenders are unable to offer embedded lending.
Open finance (which includes open banking) is a specific service. It essentially gives organisations access to transaction data e.g. accounting and bank account data. It's not a financial services product in its own right.
The same applies to APIs. A lot of people talk about APIs as if they are a product in its own right. However, APIs are just a technology capability. APIs connect multiple infrastructures together to allow data to flow seamlessly between marketplaces, product manufacturers, capital providers, data and process providers.
There's very little evidence of any real innovation on the types of products that are being embedded. There is more to embedded lending than Buy-Now-Pay-Later (BNPL) and cash flow advances (more on this below).
If the products were fit for purpose, then we would have supply and demand in perfect harmony - this is not the case today.
To meet the demand of businesses, the products offered need to change.
This demand will be met in the marketplace and, therefore, these products need to be embeddable.
If you're a receivables finance provider, how do you get ready for embedded lending? How do you take advantage of the new opportunities and avoid them becoming risks?
As lenders invest in the digitisation of their lending journeys, there are three aspects they need to consider when it comes to their business model:
The first step is the componentisation of the product. So what do we mean by this?
Let’s look at risk modelling, as an example. Credit bureau services have started offering a complete risk modelling and decision capability - which some banks are taking up. So banks are now outsourcing their risk models to a third-party.
This is only possible because those lenders have broken down the functions within a loan journey into individual components. These components can then be assembled (using APIs) with a lender's unique mix of in-house and third-party capabilities.
You're going to see this become commonplace in the next few years. And will be the foundations for the next step.
The second step is to delayer your value chain by decoupling origination from product manufacturing. Lenders will now have products which can be embedded or completely white labelled by a third-party. By doing this, lenders are essentially allowing the marketplace to package, sell and distribute your products.
Early Adopter Example: a Trade Ledger customer in Asia originates 70% of Receivables Finance (RF) through brokers. It now offers aggregators a single API to embed RF into the existing broker portal. The result? 300% growth rate since implementation.
But this case study only scratches the surface of what is achievable.
We could find ourselves in a situation where a receivable finance provider never actually talks directly to the customer that they’re providing capital to. We talk through a large-scale example of where this is happening in the next section.
The third step is to reassess where you sit in the lending ecosystem and how your business model supports this.
Rather than looking at the vertical lending stack and saying “We’re going to originate, manufacture, distribute and manage the product end-to-end” ask “What are we really good at?”
You need to think about scale. What are the unique and specialist capabilities you want to provide to the market?
By asking these types of questions you may find, as an example, that it’s more cost effective to focus on managing risk for a $5 billion loan book where margins are higher, rather than doing everything for a $500 million loan book.
Those are the kinds of options you should be considering. Once you have the answers that you need to start thinking about building a composable ecosystem. Which ecosystem partnerships will you put in place and what technology/infrastructure will you invest in.
There are a lot of different projections around how big embedded finance is going to be. They vary a little bit, but the numbers are big.
At Trade Ledger, we believe - not just from the research, but from our experience working with some of the world’s largest banks - that there will be somewhere above $5 trillion dollars of new value created between now and 2030 in embedded finance. We also think the majority of that will be in lending.
There's an opportunity to generate another $15 to $20 billion of revenue that the market doesn't generate today.
That's why this is an important topic to talk about and have a point of view on.
The Trade Ledger platform is an API-driven loan orchestration application that processes the entire loan journey:
Using our ‘Embedded Lending APIs’ lenders have the ability to partner with B2B platforms and marketplaces and embed their loan journey - in a matter of weeks, not months or years. Our suite of open APIs also allows lenders to aggregate data from across the lending ecosystem.
Below are just a handful of embedded lending opportunities open to lenders on the Trade Ledger platform:
If embedded lending is a top priority for your organisation then get in touch and chat to us. We work with a number of global multinational banks and specialist alternative lenders to transform their working capital offerings.
Watch CEO and Founder, Martin McCann, talk about embedded lending in his own words at BCR’s A&RF Forum 2022: