Embedded Lending

There has been a lot of interesting discussion in the fintech community in the last year around embedded finance. It typically refers to financial products being seamlessly integrated into any non-financial business or service, with a common example cited being how Uber and Lyft integrated payments into their ride-sharing and mobility offerings. Many industry insiders are now predicting that this trend represents the next stage of the evolution of fintech and will spread beyond payments into all of banking and finance.

Based on some of the new business models that have been emerging in the last couple of years, embedded lending represents a particularly interesting subsegment worth highlighting here. Embedded lending is by no means a new phenomenon, and to understand how powerful embedded lending can become in the future, it is worth doing a short recap of the journey thus far.

Early examples of embedded lending include products such as the credit card, which one can think of as a payments product with lending embedded into it. Likewise, Fintech 1.0 companies such as QED investments GreenSky and Klarna are both great examples of how lending can be seamlessly embedded into retail and e-commerce, enabling a very smooth point of sale finance experience for end users.

Today’s embedded lending builds on this rich heritage of financial innovation and uses modern technology to take the product and user experience one step further. These new and innovative companies are characterized by three key features that they have in common.

The first key feature is seamless operational integration. With the APIfication of data, cloud computing, and all other innovations taking place in the info tech and data tech space, financial products can now be integrated with operational processes so seamlessly that much like the invisible man of H.G. Wells’ famous book of the same name, they are very much there but one cannot notice them. This integration is in turn supported by the rich ecosystem that has emerged in financial infrastructure and reg tech, where modular business processes can be used like Lego blocks to build new business structures, all connected to each other with API calls. Needless to say, it took decades of innovation in information technology to get here, from the emergence of C++ and Java as modular coding languages to today’s academic work on how to create abstraction layers from any computer language.

The Invisible Man of H.G. Wells – he’s there but you cannot see him

The second key feature is a realignment of business relationships and incentives to enable better commercial outcomes for all parties involved. Because legacies weigh heavy on institutions (and societies too in many cases!) some of the business and commercial relationships of today are shaped by the technological constraints of the past that no longer exist. There are countless examples of this, but just to pick a random one, consider the signature. In today’s world of Face ID and digital documents, why do I need a wet signature to prove my identity? Or why do I even have to show up in person to prove who I am in the first case? Undoubtedly, the list can go on, but the point here is that the new models that are emerging not only use new technology, but use that new technology to challenge the business logic and conventions of the past, especially where these were driven by constraints that no longer exist.

The third key feature, which is a direct consequence of the two prior ones, is that losses tend to be an order of magnitude lower compared to a legacy lending product. Both because of the closer integration as well as the new alignment of incentives, where in many cases significant credit risk existed, this credit risk starts to approach levels close to zero, instead being replaced by various levels of operational or systemic risk. Alternatively, in some cases an entity’s high credit risk gets replaced by another entity’s significantly lower credit risk. Again, there are countless examples one could give here, but just to consider a fairly common example, one can think of supply chain finance, where a small business is selling products to a large corporation, for example a small supplier selling tomatoes to Tesco. In the legacy world, when the small supplier would go to the bank to request a loan for working capital to fund its tomatoes, it would be charged a high rate of interest because it would be seen as a risky business due to being small and having little capital. But with the right kind of integration and fintech product (such as an invoice finance solution), the risk of the small supplier can be substituted with the risk of the big client (Tesco in this example), so the supplier can now borrow close to the low rates that Tesco can borrow at.

Another interesting example of embedded lending is Wayflyer, which provides e-commerce companies with software to optimize their marketing spend on platforms such as Google and Facebook. Wayflyer’s software is fully integrated with the e-commerce companies, and it helps them allocate their marketing spend online to best capture new customers and grow online sales. However, as a function of doing this, Wayflyer also sees where these e-commerce companies hit pay dirt when for example a new segment of customers that are very hungry for that particular product is uncovered. In this particular case, Wayflyer, which is integrated with the company can seamlessly offer its client extra marketing dollars, which quickly get converted into sales, and then get paid from the proceeds of this incremental sales automatically when the sale happens. From the e-commerce company’s perspective the financing is almost invisible – they just think of Wayflyer as a partner who helps them grow faster by making better marketing decisions and serving as an extra pocket to boost their marketing spend where needed. There are certainly many more examples of this, and some of these businesses are yet to emerge at scale, though they will undoubtedly do so in the not too distant future.  Two particular areas that are very interesting are student finance and property purchases. In the case of the former, Student Finance is working on a model where anybody can go to a vocational training program with no upfront payment, and only pay back the cost of the education when they get a higher paying job as a result of that training. While this is technically a student loan it is very much embedded into the education process itself, and from the perspective of the student they are investing in their intellectual capital and getting a better job in the process – the loan itself is invisible!

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