Embedded Finance: The basics you need to know

Embedded finance is a rapidly growing field in the financial industry that is poised to transform the way we interact with financial services. The embedded finance definition refers to the integration of financial services into non-financial applications, platforms, and ecosystems, allowing for seamless and convenient access to financial products and services. The rationale behind embedded finance services is quite simple:  They aspire to make the financial trip more straightforward and convenient for customers by integrating it into their typical non-financial journey.

In the past, financial services were almost always offered by traditional banks and financial institutions. With the rise of digital technologies for finance applications, businesses across various industries are now able to offer financial services to their customers. This can boost the democratization of financial services, making them more accessible to a wider range of people. Most importantly, it is expected to contribute to the disintermediation of financial services. Why should you always require a bank or another financial institution to mediate between two entities that would like to perform financial transactions? One may argue that financial organizations act as the trusted third parties that ensure the trustworthiness of the financial transactions. While this is largely true, it is also true that this trust may be offered by other types of organizations in the scope of a properly regulated digital finance landscape.

One practical example of embedded finance is the integration of payment systems into e-commerce platforms. This allows customers to make purchases directly from the platform without having to navigate to a separate payment portal. Similarly, the integration of insurance products into ride-hailing apps provides customers with the option to purchase insurance coverage for their trip directly within the app. In principle, trusted entities that possess the proper data are candidates for acting as online banks and providing embedded finance services as part of their offerings.  This is a practical manifestation of the fact that data is the new oil.

Benefits, Challenges and Risks

The benefits of embedded finance are numerous. For consumers, it provides greater convenience and accessibility to financial services. For businesses, it can help increase revenue and customer loyalty by offering a more comprehensive suite of services. Additionally, embedded finance can help reduce the cost and complexity of financial services by leveraging the infrastructure of existing platforms and ecosystems.

Nevertheless, embedded finance also raises important questions around data privacy, security, and regulatory compliance. As financial services become more integrated into non-financial applications, it is crucial that proper safeguards are in place to protect consumers and ensure that financial institutions are adhering to regulatory requirements.

The risks of embedded finance services are quite similar to the risks of financial technology (FinTech) services. They include:

• Privacy and Data Protection Risks: Embedded finance applications collect and process large amounts of sensitive financial information, such as customer profiling data. The latter can be very attractive to cybercriminals, which increases the risk of potential data breaches and identity thefts.
• Cybersecurity Risks: Security is a critical concern for embedded finance services. Fraudsters and hackers are very likely to attack such services that offer opportunities for embezzling funds, while being typically less protected than conventional digital finance services.
• Regulatory Compliance Risk: Embedded finance applications are subject to a range of regulations, such as data protection laws, anti-money laundering regulations, and consumer protection laws. Therefore, embedded finance service providers must comply with these regulations to avoid regulatory penalties and other forms of legal action against them. This is a risk for services providers.
• Consumer Protection Risks: Embedded finance applications may offer loans or other financial products to consumers, which can expose them to financial risk. It is important to ensure that consumers are fully informed of the terms and conditions of these products and that appropriate consumer protection measures are in place.
• Market Risks: Embedded finance applications may rely on third-party providers for certain services, such as payment processing, data analytics or data storage. As a prominent example, such services can be provided by cloud providers. Any disruption in these services is likely to result in market risk for the application provider.
• Reputation Risks: Failure to address some of the above risks can result in reputation risk for the embedded finance application, which can impact customer trust and ultimately, business performance. Specifically, reputation risk can result in brand damage for the provider of the embedded finance service, which can be proven catastrophic for their core business.

Embedded Finance Examples

Some of the most prominent examples of embedded finance applications include:

• Buy Now Pay Later (BNPL): BNPL services are the most characteristic and most popular Embedded Finance services. They allow customers to make purchases and defer payment over a set period of time. In this direction, BNPL providers leverage data to assess the creditworthiness of the customer and the overall risk of the BNPL transaction. The benefits of BPNL include increased customer loyalty and greater flexibility in how customers use their money.
• Digital Wallets: Digital wallets are mobile banking applications that allow users to store and manage their payment information. Nowadays, digital wallets are offered by non-financial companies. This is the case with the most popular digital wallet services like Apple Pay, Google Pay, and Samsung Pay. Beyond mainstream payment technology providers, it is now possible for other entities to provide digital wallet services. For instance, smart cities can offer wallet like services to their citizens.
• Investment Platforms: Investment platforms allow users to invest their money in a range of assets, such as stocks, bonds, and cryptocurrencies. In several cases investment platforms are offered by netbanks and non-financial entities such as asset managers and private equity firms.
• Banking Services: There are embedded banking services that allow users to perform traditional banking activities, such as depositing and withdrawing moneys. Such services are offered by non-financial organizations based on a Banking-as-a-Service (BaaS) paradigm.
• Insurance Products: Insurance products can be integrated into various platforms to offer users convenient and affordable coverage. Such insurance services are offered by Insurtech enterprises and are sometimes integrated in other types of electronic services.
• Loyalty Programs: Loyalty programs can be integrated into various platforms to offer customers rewards and incentives for using a particular service or making purchases. For instance, companies like Uber and Starbucks offer reward services to their customers.

Overall, embedded finance represents a significant shift in the financial industry and has the potential to revolutionize the way we access and interact with financial services. As the field continues to grow, it will be important for businesses, regulators, and consumers alike to stay informed and engaged with the latest developments. In the years to come, embedded finance is likely to become a powerful tool that can help organizations to grow and thrive. It’s therefore important for businesses to understand how embedded finance works and to explore the best possible solutions that address their needs.