Embedded finance providers: friend or foe?

May 2023  |  SPECIAL REPORT: FINANCIAL SERVICES

Financier Worldwide Magazine

May 2023 Issue

Traditional financial institutions (FIs) are, and have been, synonymous with holding money on deposit, managing payments, and originating and advancing loans. However, FIs are no longer the sole market players in this field. Embedded finance (EF) providers – a sub-stack of FinTech – do these things now too.

What is EF?

Put simply, EF is the offering of financial products, integrated into a company’s infrastructure, provided by non-FIs (EF providers) and capitalised by FIs.

EF covers a range of products, including business-to-business buy-now-pay-later (BNPL), business-to-consumer (B2C) BNPL, embedded lending and payments, revenue-share lending (rev-share), income share arrangement and embedded insurance. These products cut across many sectors.

In its earliest stages, B2C EF was used only to finance large items, but it is now much more widely available. A person may have traditionally used BNPL to purchase a luxury holiday but they are now turning to EF providers (such as Klarna) to purchase their clothing for these holidays, too. EF’s unique selling point is that it is fast, flexible and available when consumers need it (for example, point of sale in respect of BNPL).

The technological capabilities of EF slide seamlessly into the ecosystems of millennials, generation Z and generation X, where the pace of life is fast and there is an expectation that the capabilities of financial products are too.

Gone are the days of paying a cab driver in cash. Now, we book an Uber, Bolt or Grab on our iPhone. The app is already connected to our e-wallet and the payment is taken automatically upon concluding the journey. All in a few clicks.

Growth

The capability of EF is impressive, and the growth case for EF providers is significant. Bain & Co. predicts that by 2030 EF will be a $7.3 trillion industry in the US alone, and EF was highlighted as an expected investment area for 2023 in an FIS global survey of 2000 executives. As an example, 59 percent of non-financial firms included in the FIS global survey said they see an impact on their business from EF and will respond to this by increasing their technology and research and development budget this coming year.

These statistics demonstrate that non-financial companies can see the benefits of providing customers with EF. The desire by such companies to provide this customer-centric technology is likely to accelerate EF as an industry.

McKinsey recently reported that the global banking return-on-equity was around 9.5 percent in 2021 (a decline from 15 percent prior to the 2008 financial crisis). EF providers make money differently to FIs. Their products are different.

Over the weekend of 11 and 12 March 2023, prior to the announcement of the sale of SVB UK to HSBC, numerous EF providers came together to actively reach out to companies with capital locked (and potentially lost) in SVB to offer emergency funding. Uncapped, a rev-share EF provider, reported receiving an application every three minutes during that period.

EF is set to blur the lines of FinTechs and FIs, providing what would traditionally constitute a banking service to customers. FIs are no longer the only institutions that lend money.

White-labelling

White-labelling is one of the catalysts responsible for the EF boom. It gives EF providers the ability to integrate financial services into their offerings, demonstrating the power of partnership. We are moving toward a platform-based world, where the ability to embed financial products is intrinsic.

Power in partnership

For FIs, there is a dichotomy between customer demands and the technological capabilities that they can support. A solution to this is partnering with EF providers – and the benefits are not one sided. Collaborating with FIs allows EF providers to access a bank’s wide pool of customers. EF providers have the technological tools to develop the products, but it is FIs that (at least currently) have the distribution channels and existing customer base.

Partnering between FIs and EF providers creates a platform for launching an EF product. Collaboration leads to increased capabilities. The partnerships created are vital for not only the provision of products, but also the development of technology and the banking sector.

There is an increase in partnerships between FIs and EF providers. For example, Liberis joined forces with Barclaycard on its EF rev-share product to small and medium-sized enterprises. While the product is provided by Liberis and offered to Barclaycard customers, it is packaged, on the face of it, as a Barclaycard product – the ‘Barclaycard Business Cash Advance’. Only when clicking through to the application page are prospective customers redirected to Liberis’ webpage (where they are asked to consent to Barclaycard providing Liberis with their customer details).

There are examples of FIs providing EF products without a partnership with an EF provider. FIs are traditionally set up to provide capital, whereas EF providers’ creation is centred on technology. As such, the EF industry, without an EF provider partnership, is, for FIs, difficult to enter. For example, Barclays announced in February 2023 that it is not to conclude its consumer lending product to improve underlying technology.

Partnership is not limited to FIs and EF providers, but has long been explored in the FinTech world. In February 2023, the partnership between NatWest and Cushon (a pensions and savings FinTech) was announced. NatWest acquired an 85 percent stake in Cushon for £144m. This demonstrates that FIs acknowledge the power of partnership. Each party brings a different strength to the relationship. The power of partnership is not limited to EF. It is a trait that also impacts the wider FinTech market.

Regulatory considerations

It is well-known that FIs have to comply with regulations. Generally, FinTechs are not required to comply with the full set of regulations that FIs are (albeit there are FinTechs that provide regulated products and have the necessary regulatory permissions to provide such products). But does this mean that users of EF products should be wary?

In its March 2023 Dear CEO letter, the Financial Conduct Authority (FCA) recognised that FinTechs provide ‘improved choice, convenience and value’ in the payments sector, but are concerned that FinTechs do not currently have sufficient robust controls in place to provide adequate protection for customers. EF providers are coming under increasing regulatory scrutiny. Two examples are the new FCA Consumer Duty and the incoming B2C BNPL regulations. The FCA identified in its letter three key objectives for payment firms: (i) safety of customers’ money; (ii) non-compromise of the integrity of the financial system; and (iii) meeting customer needs.

There is a move toward EF providers wanting to align their governance and products to regulation and legislation, regardless of whether this currently bites on their business. There is a desire among EF providers to create a market standard of consumer protection. This comes from EF providers’ deep level understanding of customer needs, not just an external tick-box exercise.

Legal considerations

The fast-paced environment of the EF sector makes it essential that careful legal consideration is undertaken. Legal advice is required at each stage of the EF lifecycle, by both EF providers themselves, as well as partnering FIs, in the areas outlined below.

Structuring. It is important to fully consider and understand existing and upcoming regulation and legislation.

Product. The current economic landscape makes it especially important to consider how easy (or difficult) it is for EF providers to amend the terms of their underlying customer documents. An environment in which product pricing changes regularly (particularly considering increases to interest rates in the last 12-months) was a factor specifically identified by Affirm in its Q4 2022 accounts. It should be carefully considered whether EF providers require consent to amend product terms, or if unilateral amendments can be made.

Funding documents. The security package (the collateral that the bank can enforce upon a debt default by the EF provider) is important from both a bank and EF provider’s perspective. FIs should carefully consider what asset security can be taken over on a case-by-case basis. For example, there are legal issues with taking security over accounts held with electronic money institutions.

Expansion. Regulatory requirements will vary on a jurisdictional basis. Many products in certain European jurisdictions require a specific banking licence from that jurisdiction (or, where possible,

by way of the EU passporting scheme), or complex regulatory permissions, and it may be sensible to partner with a recognised bank in that location. Additionally, tax implications should be considered (such as stamp tax).

The EF industry is ever-growing. Will partnerships between FIs and EF providers continue to grow offerings in this industry, and will the current level of white-labelling be maintained?

 

Charles Kerrigan is a partner, Fiona Henderson is a senior associate and Laura Collins is an associate at CMS. Mr Kerrigan can be contacted on +44 (0)20 7067 3437 or by email: charles.kerrigan@cms-cmno.com. Ms Henderson can be contacted on +44 (0)1224 267 170 or by email: fiona.henderson@cms-cmno.com. Ms Collins can be contacted on +44 (0)20 7367 3658 or by email: laura.collins@cms-cmno.com.

© Financier Worldwide

BY

Charles Kerrigan, Fiona Henderson and Laura Collins

CMS

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