The Next Decade in Fintech is Embedded

On the 9th November 2020, Simon Taylor from 11:FS posted a tweet related to the UK stock market, and an interesting discussion started about TransferWise:

What people often miss about TransferWise, is that they are not only a great marketing machine that has saved hundreds of millions in hidden fees to their clients, but they have also built a global cross-border payment infrastructure which represents a significant competitive advantage and a barrier to entry.

TransferWise is not relying on a small pool of banks or on a credit card scheme to send money on their behalf. They have opened local banks in multiple countries in order to achieve a local/global infrastructure, allowing them to move money in seconds in some corridors, to avoid intermediaries and to be fully in control. This requires, on the one hand, the vision that comes from a simple company mission coupled with an outstanding ability to execute and to sell. And on the other, the capacity to build a complex machine.

Many of its competitors have failed in that game, and while it is true that part of its recent growth has come from partnerships with neo-banks and banks, the company is now a clear challenger to banks and Western Union in terms of market share. Congrats Taavet and Kristo!

The Fintech space is now much more mature than when I wrote "The next 10 years in Fintech" in 2017. Let's have a look at some current trends in fintech and compare them with my past predictions.

Competition is fierce in most B2C and B2B (SME) segments. Funding is still going strong despite Covid. The public market capitalisation of fintechs has started to become "visible" compared to that of banks, and market share (at least in terms of users) is now a real concern for banks. To be fair, some segments like robo-advisors or online lenders are also going through an existential crisis. This is not surprising as it is a typical step in the innovation cycle. Whether these products make more sense when offered inside a broad range of financial products and not on a stand-alone basis, time will tell.

First, as we predicted in 2017, the Fintech tsunami is happening, and there is no way back. While some players remain laser-focused on a specific product, the re-bundling has started, with some neo-banks looking more and more like traditional banks in terms of product range. As a user of Revolut, I definitely have everything I need for my day-to-day banking: accounts in many currencies, some simple (and some more exotic) investment products, and an unmatched user experience compared to any bank that I have been using so far. The only key product missing is mortgages (we spoke about that in the past: “The Ultimate Neo-Bank Battle will be About Mortgages”). Congrats Nikolay!

Second, GAFAM are more active than ever in the Fintech space:

• Amazon is embedding more and more financial services into its eCommerce platform (payments, lending, cards etc.).
• Facebook, after a failed launch in Brazil, is now offering WhatsApp payments to its 400 million Indian users.
• Google is offering bank accounts in the US in collaboration with Citi.
• Chinese tech giants are stronger than ever in the Fintech space. The suspended Ant Financial IPO should not change the situation over the long-run.

That said, as we predicted already in 2014 ("Why Tech Giants Google, Apple, Amazon, Facebook… will Probably Never Become Banks!") none of them have pretended to become a bank, to get a banking license and to assume the heavy regulatory burden. 

Third, banks have definitely increased their investments in the fintech space, and more and more partnerships are being announced. Despite this growing appetite, it is always challenging to have large organisations and nimble ones working together. Many partnerships will probably fail; it is definitely part of the game.

What we have learned since we partnered with BNPP and SVB is that it’s key to have everyone aligned in the bank as soon as possible. This includes the business line you partner with — with a clear champion supporting the partnership. It helps if this champion is a senior figure, with real influence not only inside the bank but also in terms of compliance, legal, IT and security. Then, and maybe most important of all, you need to ensure that the people executing the partnership on a day-to-day basis have a real incentive to succeed. In the case of Kantox, we try to highlight the extra and unique value brought to the bank’s corporate client thanks to our currency management automation software. In the end, there is nothing better than happy clients to show the true value of a partnership.

Considering the above, where are we heading? What will happen in the next decade?

While I definitely have no crystal ball, I am doubling down on my vision that sophisticated (embedded) technology will be the key driver, more than UX or marketing, and that growth at all cost will not necessarily be the ultimate game anymore.

Let’s be clear, UX and marketing will always be important, but they will hardly remain competitive advantages in the long run. Nowadays, even (some) banks are able to offer reasonably good quality UX, maybe not state-of-the-art but good enough. Using a punchy marketing message and repeating it, again and again, will hardly do the job.

Growth is, and will always be, the main driver for venture-backed startups. That said, growing fast by spending millions is not necessarily a healthy way to grow, to create a long-term competitive advantage and a robust company. Think about neo-banks, in particular the ones that depend only on interchange fees to generate revenue. They have been under massive pressure due to the Covid lockdown despite having millions of users. Fewer users but a more diversified product/revenue stream would have mitigated the impact.

If I take our case in Kantox (sorry, but it is the one I know best), our decision in 2017 to move from pure transactional FX and cross-border payments to “currency management automation software” was a game-changer. It allowed us to focus on building much more unique and embedded technology that completely changed clients’ trading patterns and that fundamentally improved our unit economics. 

As Matt Harris from Bain Capital —maybe the best VC in Fintech globally— said in 2019 in what is maybe the most important article in Fintech in the last years: “While there won’t be ‘fintech’ companies as such, over time, many or even most technology companies will need to incorporate embedded financial services in order to win in their segments”. This sentence is probably more of a vision than a reality.

The truth will be somewhere in the middle, with some Fintech companies acting as stand-alone players where clients go to buy financial products, and others working in the back end, completely embedded in a product or service. Some fintech players are already doing both. TransferWise, again, is directly accessible but also powers the likes of N26, Monzo and several incumbents. Shopify is becoming a Fintech company and will soon generate most of its revenues that way.

Two great advantages of embedded financial services are that they can grow fast without needing much funding. And they are very sticky. Think about embedded KYC solutions that are benefiting from the explosive growth of neo-banks and Fintech in general.

But the ultimate beauty of embedded financial services is that it allows players to disrupt an entire industry by using a fundamentally different business model.

Let me explain. Most industries make money by directly charging their customers for buying or using a product or a service on which they have applied a margin. Think about any e-commerce operation. Usually, they sell a product to you with a margin on top. In some cases, they have bought the product (they have inventory); in other cases, they act as an intermediary (marketplace). Sometimes it is a hybrid model. In any case, to the extent that you pay the eCommerce with your credit/debit card, they have a Payment Service Provider (e.g. Adyen, Stripe) that collects payment on their behalf. 

To sum up: eCommerce makes money from the margin they apply. They pay the PSP out of this margin. Now, imagine you are a new player in this industry. You can choose to sell at cost, with 0 margins on top, and to build yourself the PSP infrastructure to make money out of it. This is an oversimplification — applying no margin and making money only out of payments will require you to be much more cost-efficient, and to reach a massive scale to turn the business profitable. 

But then you can add more products on top like credit, and it becomes a lot more interesting. If you focus on specific market segments where you know that most customers will require credit, the revenue stream will be much more significant, boosting the profitability of your business model. Existing eCommerce players could also offer credit to compete with you — but they are by design much less competitive as they built their company and business model on intermediation margins, first and foremost. 

In other words, embedded financial services are not only something you add to your stack to increase your revenue stream or to offer more services to your clients. It may actually be the fundamental angle you use to disrupt incumbents from scratch in many industries. In a nutshell, you just replace fees and intermediation margin by embedded financial services.

 Think about the old-school automotive industry. Many manufacturers are not really making money anymore out of car manufacturing and distribution. Instead, they derive almost all of their profits from financial services associated with car sales. Even if it is not directly comparable —as it is not something they have decided to do on purpose - it probably gives you a sense of what I mean. Your business model can eventually have nothing to do with what the end-client thinks it is.

So, if I had to bet on one fintech trend for the next 10 years, it would be the trend of embedding fintech in new contexts. I believe embedded financial services will eventually become the driver of the next wave of disruption across many industries and business models.