Embedded Finance Explained

Embedded finance is essentially the integration of a financial service directly into a non-financial platform.

This new approach represents one of the most profound changes in the financial sector ever since credit cards were first introduced.

The transaction value of embedded finance now exceeds trillions of dollars each year, and is taking an ever-larger slice of the digital economy.

How Embedded Finance Works

With the traditional model, making large purchases like a new car involves having you go to a dealership and then deal with a third-party bank to secure a loan.

Embedded finance allows for this process to be offered, underwritten and approved within the car manufacturer’s own native app at the moment of purchase, effectively cutting out the middleman and shortening what could be a time-consuming and arduous process.

The technology making this possible is powered by Banking-as-a-Service (BaaS) and APIs (Application Programming Interfaces). 

These modern tools are what allow banks or other traditional financial institutions to rent out their regulatory licenses and balance sheets to a tech company, which then wraps these services into their own interface.

This synergy allows for business in various consumer sectors to offer financial products without having to spend years obtaining a banking charter.

Pillars of the Embedded Ecosystem

Embedded finance is mostly used in four major categories right now:

Embedded Payments

This is easily the largest segment of the embedded finance market, taking up around 39% of the entire market share. 

Most modern payment apps for brands like Uber, Apple Pay and Google Wallet use embedded payments, reducing transactions into seamless and quick events without any checkout friction.

Embedded Lending

Another major sector is in the lending space, and is currently being driven mainly by the massive popularity of Buy Now, Pay Later services, through which you can buy things like groceries or travel reservations and pay in short-term, often interest-free loans.

Embedded Insurance

Insurance is also increasingly being impacted by embedded finance, as air companies for example offer additional insurance against trip cancellations, and car companies like Tesla now offer their own insurance, with premiums that can be significantly cheaper than with traditional insurers.

Embedded Investments

The last big sector impacted by embedded finance is the investing market, as is evident by the rise of real-estate platforms offering fractional property ownership, of investment apps like Acorns that embed a micro-investing platform into your daily spending habits. 

Embedded finance here allows you to buy crypto, stocks or ETFs without having to go through different apps and platforms.

The Benefits of Embedded Finance

Embedded finance has some incredible benefits in both the consumer and business sectors, acting as a fundamental value creator.

The primary benefits for average consumers has all to do with convenience. Embedded finance reduces friction in the payment processes, reducing the amount of different apps you need to toggle to check a balance or apply for credit, for example.

It also helps provide credit to the underbanked, as it uses data like your purchase history instead of just a FICO score. 

Lastly, embedded finance can provide insurance coverage or loans whenever you need it due to hyper-personalization in AI-driven platforms.

For businesses, this new digital approach can lead to increased revenue, as companies earn a share of transaction fees or interest that were once only available to banking institutions. 

Embedded finance has also shown to drastically reduce cart abandonment, leading to higher conversions as it offers credit at the point of sale, while also providing owners of the apps with invaluable data insights into their consumer spending habits.

Traditional banks also benefit here, as they can reach millions of new users through partner apps without having to spend anything on branch maintenance or new infrastructure. 

Lastly, the volume of transactions that goes through the apps connected to their system boosts their bottom line.

The Potential Risks of Embedded Finance

While embedded finance obviously brings a high level of convenience to the digital financial market, it also comes with its own set of issues, and a higher level of responsibility required of consumers.

Regulatory "Grey Zones"

Because this is a new and digital approach that connects tech companies and banks, regulators are still trying to catch-up due to the issue of responsibility. 

If some large issue arises for customers, the question of whether the app owner or the bank behind it is the responsible party is still a major focus for regulators and something that has not been cleared.

The "Invisible Debt" Trap

This has become a major issue in the US in the past few years, as embedded finance has infiltrated a number of sectors where previously you couldn’t become indebted. 

Consumers are increasingly using these systems to purchase everyday items like groceries or clothes on a number of different apps, so it has become too easy to lose track of your total debt obligations across multiple platforms.

Data Privacy and Cybersecurity

As we mentioned earlier, the collection of user data is massively increased through embedded finance solutions, so this opens a whole new can of worms when in a world that’s already dealing with degradation of privacy and massive sales of their private data.

There is also an increased chance that a bank can be compromised via a breach of their partner, so it’s imperative that both financial institutions and their partners move beyond basic compliance toward a security-by-design framework.

Brand Dilution for Banks

Lastly, banks are at a risk of having their brands be diluted as they increasingly become infrastructure providers and losing direct relationships with their customers.

Final Words

Embedded finance is quickly changing how consumers and financial institutions interact with each other through the integration of an increasing amount of apps. 

This integration has led to a number of quality-of-life changes for the average person, but has also birthed a number of new major issues and risks that are still not properly dealt with, both in regulatory and consumer behaviour ways.