Everybody knows what embedded lending is, but nobody knows what embedded lending is

A reproduction of Martin McCann’s presentation at BCR’s A&RF Forum 2022

Embedded finance and Banking-as-a-Service (BaaS) have arguably received the most hype in the world of fintech for the past two years. With embedded lending - and its' more complex subset; embedded working capital - stepping up to take the limelight more recently. 

But, as the saying goes “a little knowledge is a dangerous thing”. This is especially true for embedded lending in the commercial space. There is no standardised use of terminology or categorisation. As an industry we are struggling to actually define what BaaS and embedded lending mean.

We see this everyday in conversations with customers, journalists and partners. People often use the terms ‘Open Banking’, ‘Embedded Lending’, ‘APIs’ or ‘Lending-as-a-Service’ interchangeably. And they're not interchangeable. 

But, it is very important that we all understand what those terms mean and how they relate to each other. 

As a provider of working capital technology to some of the world’s largest banks (e.g. HSBC and Barclays) and alternative lenders (ScotPac) we wanted to add some much needed clarity on the topic. 

In this article, we will focus on embedded lending, as opposed to embedded finance, how this relates to open banking and lending-as-a-service (more specifically working-capital-as-a-service) and how APIs fit in. 

We’ll also talk about some of the market projections, behaviours and risks in relation to secured or asset based lending to businesses - and a really interesting opportunity within that; embedded receivables finance.

There’s a lot of ground to cover so grab a coffee and read on…

More than 5% of all US financial transactions are already embedded

What's really interesting about this research is two things:

1. That's a bigger number than expected 

This is not an academic topic. This is something which is happening right now. 

If you're a provider of a financial service, you need to have a perspective on what embedded finance is and what it's going to do to your business model. And you need to know in a matter of months, not a matter of years. 

2. Lending is not a big contributor to embedded finance

Currently, most of embedded finance research we've been reading calls out two main embedded product or BaaS categories:

• Payments 
• Account services / wallet

If you look at the Banking-as-a-Service category in the UK, a few of the big players are Railsr and Weavr. Most of their business appears to be embedded payments and providing white labelled account services to other providers of financial services. 

Lending is widely accepted as being next

Lending is coming. We believe that embedded lending is potentially the biggest category in the long-term for embedded finance - and it's going to be a big focus in 2023. 

Despite a tumultuous couple of years, the widespread adoption of Buy-Now-Pay-Later solutions in the retail lending segment, not least by Apple’s embedded iPhone solution, have given us a view of what could be in store for embedded lending.

What is embedded lending? 

To explain embedded lending, through the lens of business lending, we look to a piece of research from our partners at KPMG. 

To embed something is to actually decompose it. So what are you decomposing it into?

Delayering the value chain into three distinct components:

1. Providers of capital: This is a well known practice in the industry, just look to alternative lenders who are aficionados when it comes to lending somebody else's capital. 
2. Infrastructure providers: This is what companies like Trade Ledger and our technology partners do. We provide cloud-based, API-driven infrastructure that allows data across the lending ecosystem to flow freely so it can be processed into something useful - in real-time e.g. accounting, credit bureau, logistics data etc. The Trade Ledger platform aggregates all these sources of data to surface it up into a single customer view.

3. Platforms and marketplaces: This is anywhere a business spends time managing their business e.g. buy stock, manage accounts and cash flow, engage with customers and suppliers. Think of these as a channel for distribution.

Embedded lending: It's not technology driving change. It's demand. 

There's a massive supply and demand mismatch for working capital solutions and businesses. 

There’s an estimated credit gap nearing US$10 trillion.

It’s our estimation that in any segment of the market, any region of the world, there's about a 30% mismatch between the supply of working capital solutions and the demand for them. 

The smaller the company the larger the mismatch. 

This demand is starting to surface through a wide variety of digital channels. We saw through the covid period that more and more business and supply chain transactions were happening online. Physical locations weren't an option. 

Through necessity, more transactions became digital. Those channels now have a huge amount of power in distribution across the supply chain. 

The supply chain is the one point where all transactions happen, and where all the data passes through. 

The data and technology have existed for a few years now. But the rate of change has been slow - until now. So, technology and data are not the drivers here. It’s the demand from customers.

We are at an inflection point. This opens up some big opportunities - or risks, depending on how lenders decide to respond.

Benefits for lenders of working capital

• Revenue diversification and growth 

What about receivables finance becoming the main channel for trade credit insurance (TCI) distribution?  Why are there specialist PCI insurers when most of it is actually sold in conjunction with some kind of a credit product? 

So that's one opportunity, but it's not the only one. It's just an obvious one. There are lots of different pairings of other value-add services which can be sold alongside receivables financing. 

• Increased specialisation and scalability

One of the biggest benefits for capital providers for embedded working capital is scalability and the ability to specialise in the things that you're really good at. 

Working capital products like receivables finance, invoice finance and asset based lending, are complex products. Not all lenders have (or want to have) the skillset to provide the specialist operations around credit and risk management origination and distribution. 

Some lenders are better at it than others. 

There's an opportunity for 10x scale by doing the things that you're really good at.

With access to more distribution channels, lenders can focus on the economy of scale - essentially make more money doing less, but doing it better. 

• Real-time risk management

Now, let’s talk about product improvement.

Risk management holds a lot of growth opportunities - for lenders and businesses. One of the problems with working capital finance, as it stands, is that the products are not fit for purpose for some of the demands of the future. 

Traditional risk teams have functioned much the same way for decades. With real-time data becoming readily available via APIs, risk teams can truly understand the nuances of a business.

When you see all of the data all of the time, the data tells a different story. A more accurate one.

 This will impact the way you think about risk. And the risk models that you build will probably change too. 

Risk models that will improve your credit and business operational risk, as well as your ability to stress test your overall risk portfolio.

Merchant cash flow lending is already embedded

This is the closest example of embedded working capital that we have today. 

Merchant working capital facilities, specifically merchant cash advance, through point of sale (POS) terminals prove that the market has changed recognisably in the last 5 years. 

Below is a list of the top five providers of merchant cash advance facilities and merchant working capital facilities. 

None of them are banks. But, the capital in a lot of cases comes from banks or alternative lenders. 

The aggregate amount of lending through these five players is expected to be somewhere north of $100 billion dollars.

Bad news is, if you want to be in the merchant cash advance facilities business, that ship has already sailed. 

But, there’s good news if you want to dominate the receivable finance market. 

The space is still wide open. Now's the time to be making investments in the proposition, the operating models, the technology and data.

But you’ll want to move quickly.

Amazon embedded model is bypassing traditional RF for sellers 

Amazon describes it’s product as follows:

‘A flexible payment schedule is determined by a fixed percentage of the seller’s Gross Merchandise Sales (GMS) until the funding is paid off, with no minimum payments, no interest (only a fixed capital fee), and no collateral required.’

According to leaked documents from Amazon, the company’s economists expect that loans to sellers will double in 2023. The documents forecast that third-party sellers will owe Amazon $2B in 2023. The growth is impressive.

However, Amazon plans to tighten its underwriting and credit management policies. This is an opportunity for lenders who are using the right technology to become the core Working-Capital-as-a-Service provider for Amazon (and similar platforms) embedded channels. 

Embedded working capital is complex. Embedded receivables finance even more so.

In this section we will attempt to explain and simplify the complexities behind embedded receivables finance. We will talk about the changes lenders need to make in order to become ready for the wave of demand, as well as considerations lenders need to make around their business models.

Embedded receivables finance ecosystem:

To start, we have expanded on the three components of embedded lending identified by KPMG above. 

Two key clarification points that we want to make:

1. Infrastructure Providers: This is where a lot of the confusion in the market starts to percolate. 

There’s a lot of the focus on infrastructure and data aggregation in the market. However, this is not the same as embedded lending. Although without the right infrastructure, lenders are unable to offer embedded lending.

What is open banking, open finance, APIs etc.

Open finance (which includes open banking) is a specific service. It essentially gives organisations access to transaction data e.g. accounting and bank account data. It's not a financial services product in its own right.

The same applies to APIs. A lot of people talk about APIs as if they are a product in its own right. However, APIs are just a technology capability. APIs connect multiple infrastructures together to allow data to flow seamlessly between marketplaces, product manufacturers, capital providers, data and process providers. 

2. Providers of Financial Services: We’ve broken this into two boxes because sometimes the products are manufactured by a different organisation to the one that provides the capital. And sometimes an organisation provides both.

There's very little evidence of any real innovation on the types of products that are being embedded. There is more to embedded lending than Buy-Now-Pay-Later (BNPL) and cash flow advances (more on this below). 

If the products were fit for purpose, then we would have supply and demand in perfect harmony - this is not the case today.

To meet the demand of businesses, the products offered need to change. 

This demand will be met in the marketplace and, therefore, these products need to be embeddable.  

If you're a receivables finance provider, how do you get ready for embedded lending? How do you take advantage of the new opportunities and avoid them becoming risks?

Three actions receivables finance lenders must take

As lenders invest in the digitisation of their lending journeys, there are three aspects they need to consider when it comes to their business model:

1. Breakdown your receivables finance offering into embeddable components.
2. Delayer your value chain to delink product manufacturing, from proposition packaging, sales and distribution.
3. Build an ecosystem where different parties own different layers.

The first step is the componentisation of the product. So what do we mean by this? 

Let’s look at risk modelling, as an example. Credit bureau services have started offering a complete risk modelling and decision capability - which some banks are taking up. So banks are now outsourcing their risk models to a third-party. 

This is only possible because those lenders have broken down the functions within a loan journey into individual components. These components can then be assembled (using APIs) with a lender's unique mix of in-house and third-party capabilities.

You're going to see this become commonplace in the next few years. And will be the foundations for the next step.

The second step is to delayer your value chain by decoupling origination from product manufacturing. Lenders will now have products which can be embedded or completely white labelled by a third-party. By doing this, lenders are essentially allowing the marketplace to package, sell and distribute your products. 

Early Adopter Example: a Trade Ledger customer in Asia originates 70% of Receivables Finance (RF) through brokers. It now offers aggregators a single API to embed RF into the existing broker portal. The result? 300% growth rate since implementation.

But this case study only scratches the surface of what is achievable.

We could find ourselves in a situation where a receivable finance provider never actually talks directly to the customer that they’re providing capital to. We talk through a large-scale example of where this is happening in the next section. 

The third step is to reassess where you sit in the lending ecosystem and how your business model supports this.

Rather than looking at the vertical lending stack and saying “We’re going to originate, manufacture, distribute and manage the product end-to-end” ask “What are we really good at?”

You need to think about scale. What are the unique and specialist capabilities you want to provide to the market? 

By asking these types of questions you may find, as an example, that it’s more cost effective to focus on managing risk for a $5 billion loan book where margins are higher, rather than doing everything for a $500 million loan book. 

Those are the kinds of options you should be considering. Once you have the answers that you need to start thinking about building a composable ecosystem. Which ecosystem partnerships will you put in place and what technology/infrastructure will you invest in.

What will you focus on and what will you outsource?

Real market value

There are a lot of different projections around how big embedded finance is going to be. They vary a little bit, but the numbers are big. 

At Trade Ledger, we believe - not just from the research, but from our experience working with some of the world’s largest banks - that there will be somewhere above $5 trillion dollars of new value created between now and 2030 in embedded finance. We also think the majority of that will be in lending. 

There's an opportunity to generate another $15 to $20 billion of revenue that the market doesn't generate today. 

That's why this is an important topic to talk about and have a point of view on. 

Trade Ledger embedded lending infrastructure

The Trade Ledger platform is an API-driven loan orchestration application that processes the entire loan journey: 

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Any lender on the Trade Ledger platform is essentially a Working-Capital-as-a-Service provider. 

Using our ‘Embedded Lending APIs’ lenders have the ability to partner with B2B platforms and marketplaces and embed their loan journey - in a matter of weeks, not months or years. Our suite of open APIs also allows lenders to aggregate data from across the lending ecosystem. 

Below are just a handful of embedded lending opportunities open to lenders on the Trade Ledger platform:

A simple terminology recap:

• APIs: The glue. Application Programming Interface (APIs) is what connects all players within the embedded finance ecosystem to ensure the free flow of data between providers. APIs are a technology capability.
• Embedded Finance: Giving customers access to financial services WITHIN non-financial institution channels. Applicable to both consumers and businesses.
• Embedded Lending (A subset of embedded finance): Giving customers access to credit WITHIN non-financial institution channels. Applicable to both consumers and businesses.
• Embedded Working Capital (A subset of embedded lending): Giving customers access to working capital (Receivables Finance, Supply Chain Finance, Merchant Cashflow Finance etc.) WITHIN non-financial institution channels. Only applicable for businesses. 
• Banking-as-a-Service (BaaS): The provision of banking products (e.g. current accounts and credit cards) TO non-bank third parties, through APIs, that they will then sell on to customers. 
• Lending-as-a-Service (A subset of BaaS): The provision of loan products (e.g. BNPL and term loans) TO non-bank third parties , through APIs, that they will then sell on to customers. Available to consumers and businesses.
• Working Capital-as-a-Service (A subset of LaaS): The provision of working capital loan products for businesses (e.g. receivables finance and cash flow advance) TO non-bank third parties, through APIs, that they will then sell on to customers.
• Open Finance: Is a service that provides third-party access to all types of financial data (e.g. accounting, insurance, pension, tax) through the use of APIs.
• Open Banking: (A subset of Open Finance): Is a service that provides third-party access to banking data (e.g. payments, current account, loans) through the use of APIs.

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Key takeaway: All lending value chains are at risk of being disrupted

• Lenders should be trying to leap-frog not just catch-up : The receivable finance market is further behind than a lot of other markets. But, if you’re just digitising the offer you're wasting your investment. Instead, reconstruct your business model based on the availability of the technology and services you can invest in today. 
• Product innovation is where the money is: If you want to be competitive, look at product innovation. Embedding new types of products and new variations of products in digital channels. It’s going to take big swings rather than little changes and small drops in cost. There's going to be winners and losers. And we're already starting to see winners amongst the customers that we work with. 
• Figure out what your unique differentiator is: Look to decouple the balance sheet, the compliance obligations, the origination, the risk management. All of that can be assembled in different ways. In a really quick time. If you want to work at the speed embedded lending happens, your business models need to match this.
• The opportunities are huge. Lenders are looking at 10 x growth in transaction volumes. That should be the bar by which you judge investments. 
• Collaboration is key. So you have to think differently. Culture and organisation boundaries are actually the biggest problems to capturing the opportunity of embedded lending. The technology and the data already exists. 
• Reinvention how you think about risk in the receivable finance asset class. Most of the risk models we've seen haven't changed fundamentally since 1990. But the data that exists has. 

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If embedded lending is a top priority for your organisation then get in touch and chat to us. We work with a number of global multinational banks and specialist alternative lenders to transform their working capital offerings. 

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Watch CEO and Founder, Martin McCann, talk about embedded lending in his own words at BCR’s A&RF Forum 2022: