Embedded Finance - What is in it for Banks and Financial Institutions?

Dheepak Rajoo, Head IT & SVP, RBI

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The market value of the e-commerce industry in India is currently (2021) at $84 billion, expected to grow at an exponential rate to reach $200 billion by 2027.

This data indicates an increase in the potential demand for ﬁnancial services from more companies keen to leverage the benefits of embedded ﬁnance into their business model to provide an enhanced customer experience.

Besides, while traditional businesses facing bottlenecks from non-compliance are slowly embracing digital transformation, start-ups/ digital businesses are keen on implementing innovative ﬁnancial services embedded into their operations for capturing new and repeat customers.

Therefore, while global brands have started offering banking services, is there much left for Banks and FI's?

Well, there is a lot more to do. Let’s take a sneak peek.

What is Embedded Finance (EF)?

It is simply the integration of ﬁnancial services into a non-ﬁnancial business or service.

Some view it as Banking as a service ( BaaS) to create embedded journeys. Like e-commerce where we buy stuff and payment is just simply embedded.

An important aspect that fascinates me about EF is the opportunity to ingrain/plant the complex ﬁnance part into a customer’s purchasing experience.

Here is a real-life scenario - For a long time, Mr.Sivasu has been planning to upgrade his 42” smart TV to an ultra HD 50” model. A popular online sale (that has somehow got included in our festival calendar) target markets him with a one-day deal price.

Here comes the win-win deal. A no-cost affordable EMI coupled with a handful of offers to make his desire come true and the entire online shopping exercise offers him a fulﬁlling customer experience. (Seamless Integration of embedded ﬁnance and payments into fulﬁlling customer experience)

Without a doubt, companies across all sectors, small to big, retailers, e-commerce, tech companies, automotive industry, health care, Insurance providers, logistics, education have started using the beneﬁts of embedded ﬁnance to reach their respective consumer segments.

What beneﬁts does EF offer to businesses and ﬁnancial institutions?

Is embedded ﬁnance a competitive advantage or just an IT compliance exercise?

Rationally thinking, it is indeed a competitive advantage for ﬁrms and ﬁnancial institutions.

Moreover, compliance resilience is key to sustainability in response to a changing business climate.

In short, EF o"ers both businesses and ﬁnancial services a point of intersection to co-create new value chains and integrate seamless value propositions for each other.

Metcalfe’s Law of Connectivity and Reed’s Law - An analogy

Borrowing some thoughts from Robert Melancton Metcalfe’s
Network e"ects. It states that “the value of a telecommunication network is proportional to the square of the number of connected users of the system (n2).”

Based on the same principle, David P.Reed’s Law, “A network becomes more valuable when people can easily form subgroups to collaborate. Not only does its value increase exponentially, but the network effects (Metcalfe’s Law) also kick in and dominate the overall economics of the system.”

Similarly, the supply of embedded finance is the outcome of aggregate demand from the network effects of the internet, mobiles, the birth of open API Banking, financial inclusion, and many more.

The vertical integration model of traditional banking is now horizontally distributed and has contributed to enormous value creation and the explosion of financial services. What was once just an integration point has now become a revenue generator for Banks and platform providers as operating margins of companies are relatively thin.

Ultimately, embedded finance can become a key business growth driver and an opportunity to leverage a differentiated positioning for many companies.

P.S: Deﬁ, Cryptocurrencies, Blockchain, Smart contracts are also typical examples exhibiting network effects. Both value and security increase as more users join the network.

Cloudification

Beyond just migrating data from a computer/server to a web-based equivalent, cloudiﬁcation is a new business model by itself embedded with immense growth opportunities.
As I mentioned above, transformation is often a response to changing consumer needs. Since the dawn of the internet, followed by mobile devices, borders have blurred, markets and products that customers need are more accessible than before.

Therefore, every business attempting to transform, not only needs to focus on digital transformation but to revisit and redesign its entire business model to ﬁt itself into a constantly evolving ecosystem. In short, digital transformation and business transformation always work together. One without the other makes it incomplete.

Along the same lines, cloudiﬁcation is an essential component of every business transformation journey to help ﬁrms fully exploit the beneﬁts of agility, reduced cost, and quickness to market. It also brings with it immense business opportunities to adopt technology such as blockchain and AI.

Adopting cloud computing technology in banking comes with its own merits and challenges. Since the nature and scale of customer data that the banking industry handles are often huge, digital transformation provides unprecedented security and transparency.

Sunset for traditional banking and Sunrise for emerging business models

While traditional banks are witnessing a sunset, on the other side, embedded ﬁnance and distributed banking models are basking in the sunrise.

Decentralized Finance aka DeFi is a movement that is aimed at making a new ﬁnancial system that is open, permissionless, and does not require any ﬁnancial intermediary, broker, exchange, or bank. It uses smart contracts on the blockchain that are built on Ethereum. Other use cases of DeFi are Decentralized Exchange, Insurance, Margins Trading, etc.

In short, DeFi would create a new ﬁnancial ecosystem simultaneously disrupting traditional ﬁnance models and eventually establish a paradigm shift in the use and transaction of currency.

Wrap up

Today, consumers have proactively adopted embedded ﬁnance at such increasing levels that it has left traditional banks to mandate offering BaaS business lines.

On the other hand, in order to meet the rising demand for embedded ﬁnance, Fintech companies, Financial institutions, and non-banks have started offering BaaS services.

At the same time, Banks will have to formulate a new business model such as pay-for-use monetization, (IaaS, SaaS, PaaS) B2B2C and B2B2B distribution capabilities, along with careful consideration of Co-branding. Therefore there is a need for strong risk and compliance management to govern embedded ﬁnance partners.

Takeaways

● Digital and business transformation together will support organizations to remain competitive and di"erentiated in their chosen markets.

● Cloudiﬁcation is a signiﬁcant milestone in the roadmap of transformation strategies for banking and ﬁnancial institutions.

● Industries and organizations need to focus on total transformation.

● Embedded Finance offers an opportunity to acquire the ultimate customer experience.

● DeFi would create a new ﬁnancial ecosystem simultaneously disrupting traditional ﬁnance models and eventually establishing a paradigm shift in the use and transaction of currency.