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In the latest installment of the Salzburg Questions for the Future of Finance, we hear from Matthew Saal, a digital finance specialist in the International Finance Corporation's Financial Institutions Group
This article is part of the Salzburg Questions for the Future of Finance series by the Salzburg Global Finance Forum
Embedded finance (EmFi) is two years old and yet also two millennia old. Embedding financial services into other products and services improves the user experience, generates data that can be used to manage risk (among other uses), reduces costs, and makes finance more inclusive.
The term “embedded finance” was coined – or at least popularized – by venture capital investor Matthew Harris in 2019 to describe how technology has-enabled financial functions like payments, lending, and insurance to be woven into the fabric of any company, just as Internet and mobile connectivity have become ubiquitous parts of product offerings and business operations. Buy-now-pay-later (BNPL) offerings from a wide range of merchants, enabled by fintech companies, is one prominent example of EmFi. BNPL, as a product, is going mainstream with banks and established payments networks devising BNPL offerings.
But is there anything new under the sun? Since the dawn of commerce, individuals engaging in barter or monetary exchanges have agreed to take goods now and pay later: when I come by tomorrow, when the hog is slaughtered or the rice harvested, when payday comes around, or according to an agreed accounts payable schedule (also known as an “open account” transactions) offered to known counterparts.
What’s new is the ability for any seller to incorporate credit, payments, insurance, and other financial services easily into an existing workflow or customer experience. EmFi uses data to move beyond known and trusted counterparts and automates underwriting and processing to reduce the costs and risks. Thus, to continue the delayed payment example, “open account” type terms are being offered to a broader range of customers, including small retail purchasers.
EmFi models have increased, including:
Across these and other applications, the attraction of EmFi stems from three inter-related features: incorporation into a core activity in which the customer is already engaged, leveraging data and automation, and expanding access.
Making finance part of another activity or workflow improves the user experience because no one actually wants most financial products for their own sake. For example, the individual wants a mortgage because of the home purchase; the business owner wants a working capital line to buy goods or pay salaries; insurance protects an asset. EmFi enables individuals to focus on the core functions of purchasing a home, ordering raw materials, or acquiring and using an asset without procuring funding or protection separately.
Leveraging data and automation enables EmFi providers to increase visibility to credit risk and recourse in the event of default. For example, a platform that is arranging cargo loads for a truck owner or enabling a small merchant to sell to a large customer base will know the borrower’s revenues and the quality of their business (returns and customer complaints) as well as the trends in the overall market. The platform can also deduct loan repayments from revenues at source, and borrowers who depend on the platform for access to their customers are likely to prioritize repayment to that creditor should they encounter financial distress.
Understanding the underlying transaction and use of funds and leveraging improved visibility and recourse enables EmFi to provide access to finance, and, crucially, to their own products, to a broader range of customers, including those without credit histories or even a prior trust relationship, depending on the application. BNPL, for example, enables any retailer to offer short-term credit like neighborhood merchants might give their “regulars,” driving increased sales volume and choice of higher-end products. Amazon is already a multi-billion-dollar lender to small businesses. In many emerging markets where working capital for small businesses is scarce, a credit line for sellers is a crucial driver of business volume and transaction fees for e-commerce platforms.
Together, these features potentially create intrinsic advantages for EmFi over third-party financial services, such as a bank loan. EmFi can be more convenient for the customer, offered at a lower cost by the provider, and be less risky. As such, these models may present a competitive threat to banks and other traditional lenders. Incumbents’ responses to the rise of fintech BNPL offerings indicate that EmFi is indeed perceived as a competitive threat.
Those three-interrelated features also give rise to new regulatory challenges concerning whether and how the provision of financial services by non-financial companies should be regulated and supervised, how to safeguard data ownership and use, and how to bolster consumer protection. The economies of scale and scope evident in technology-driven business models have already created concerns about market concentration and potential abuses of dominant market positions. Embedding can carry existing dominance in data or customer networks into the adjacent financial services space. (1)
Financial regulators will need to look carefully at the business models of EmFi. In some cases, tech platforms work with regulated payment service providers and banks that sit behind the scenes. In other cases, new entities take on intermediary roles outside the current regulatory perimeter or the remit of safeguards and consumer protections such as credit information systems.
The entry to financial services of new players via EmFi could present welcome competition to entrenched incumbents. There are examples of free or low-cost services enabled by the cross-subsidization an EmFi business model can incorporate. These may call into question longstanding financial stability and antitrust concepts such as the separation of banking and commerce and anti-tying provisions.
Most jurisdictions protect financial data, but we are still in the early stages of rolling out broader data protection frameworks. The increased linkage of non-financial information to financial services and access to finance should spur more urgent efforts in this area. In addition, coordination with other sector regulators and market conduct authorities will need to be enhanced to ensure data integrity, consumer protection, and fair competition.
Despite these challenges, regulators should look to welcome, rather than restrict, the flourishing of EmFi. As noted above, accounts payable finance has long been part of commerce, and by some estimates, the finance implicit in supply chains dwarfs global bank lending. Technology-enabled EmFi may disintermediate banks in some products but can also bring more transparency to the supply chain and other areas of finance, ultimately improving monetary and supervisory authorities’ ability to monitor and understand credit conditions.
The intrinsic cost and risk management advantages of EmFi should translate to lower risks and lower costs, if monopolistic abuses can be avoided. Furthermore, EmFi could improve stability and resilience at the systemic level as lenders with superior visibility and recourse – along with business motivations to provide capital – may be less likely to pull funding in a general downturn. They are also more likely to be confident to selectively re-start lending after a shock such as a global pandemic. (2)
EmFi is already a significant market force, and it will only grow as economic activities are increasingly digitized. Therefore, policymakers and market participants might consider:
Matthew Saal is a digital finance specialist in the International Finance Corporation’s (IFC) Financial Institutions Group. Matthew joined IFC in 2016 and covers digital financial services and financial infrastructure advisory work, partnerships, and investments in innovative financial services providers. During 2018-2019 Matthew was a World Bank Presidential Fellow seconded to the Finance Competitiveness and Innovation Global Practice, focused on fintech policy and fintech for inclusion. Prior to joining IFC, Matthew was associate director in the local currency and capital markets development initiative of the European Bank for Reconstruction and Development (EBRD). Before joining EBRD in 2010, Matthew worked in emerging markets finance, private equity, venture capital, fintech strategy and business development, consulting, and international economics. Matthew holds an A.B. in chemistry from Princeton University and an M.Phil. in economics from Oxford University, where he studied as a Marshall Scholar.
The Salzburg Questions for the Future of Finance is an online discussion series introduced and led by Fellows of the Salzburg Global Finance Forum. The articles and comments represent opinions of the authors and commenters and do not necessarily represent the views of their corporations or institutions, nor of Salzburg Global Seminar. Readers are welcome to address any questions about this series to Forum Director, Tatsiana Lintouskaya: tlintouskaya@salzburgglobal.org