Is embedded finance dead? Ahon Sarkar said your answer depends on where you fit into the ecosystem. Sarkar is the general manager of Q2’s Helix division. Helix works with companies to make personalized banking products.
He said embedded finance has entered the reconciliation stage of its life cycle. 2023 reminds him of the beginnings of the Dotcom bubble burst in 2000.
A quarter-century ago, many wondered if the Internet was a fad. They asked if websites were dead.
The Internet wasn’t a fad. But the industry’s self-perception at the time outpaced its reality. It was touted as more than it could deliver. The industry paused, took stock, reconciled and grew from there; its survivors shaped our future.
Embedded financial success begins with learning from the past
This is where embedded finance sits today. Sarkar should know; Q2 has existed since the early days. In 2017 when they spoke with non-banks about adding banking services, they got their share of weird looks. That’s because the non-banks were looking at embedded finance incorrectly.
“Even at that time, we were pretty clear that what it’s about is not how do you add a debit card or a bank account to your product,” Sarkar said. “What it’s about is how do you solve a problem with how your customers interact with your product today and improve that experience? Or how do you solve a unique problem and expand your relationship?”
Those investors and businesses skeptical of embedded finance in 2017 started coming around a few years later. Investors took notice as the Galileos and Helixes led to Money Lions and Acorns. They saw a business model ripe for disruption.
The Dotcom parallels continue. 2021-22 saw frothy valuations with little product. Seed-stage companies could attract $50 million.
What investors were reacting to, similar to how they acted 25 years ago, was the industry’s potential. There was this exciting new capability, and the possibilities enticed many. They didn’t dig deeper.
That allowed companies to focus on growth instead of profitability. But then, interest rates began to rise a year ago. That prompted closer investor scrutiny.
“Some of the initial ones that launched with some big promise are now living through the realities of that promise,” Sarkar said. “And an increased permeation of this across the financial system has meant a lot more people in the space, which has meant there’s more competition, which has meant it’s more expensive to acquire customers. You actually have to differentiate. You actually have to be profitable.”
It also means asking the right questions at the outset
Sarkar believes this is where embedded finance sits today. Now is the time to separate fancy marketing and cool ideas from real businesses. He likens it to a forest fire. There will be some endings, but in its wake will be an ecosystem more conducive to growth because there is less resource competition.
That makes it harder for entrepreneurs. Investors fund potential in headier times, mainly when the industry has never existed. Founders can subsidize their unprofitability by citing the potential to attract another round. That buys more time to find a profitability route.
Surprisingly (or not, perhaps), many founders don’t ask how they can become more profitable or profitable at all. Many mistakenly focus on user growth, thinking that if they scale that, the revenue magically follows.
Sarkar said getting users is easy, especially if you pay them to join. Generating a profit is much more complicated. A company doesn’t need millions of users if they generate a higher average profit from each one.
Inside the great embedded finance reconciliation
Embedded finance is working its way through this improvement cycle. We’re past the pure hype stage and into reconciliation. The industry is learning which factors produce durability. Those who master it grow fast.
“We are at the point where the great reconciliation of fintech is happening, where it doesn’t matter if the experience is cool,” Sarkar said. “It doesn’t matter if the branding is cool. What matters is if you have a business. The quote that comes to mind is that the reports of my death have been greatly exaggerated.”
Some companies have shut down. Others have good products but few customers. They are seeking new distribution channels. Simply buying customers has proven faults.
Some direct-to-consumer companies have pivoted to an embedded model. Initially thinking they had a product, they realized that what they actually had was a good feature that other companies could leverage to drive engagement. Solve your distribution problem by working through your new friends.
Why middleware is a middling solution
For a time, the answer to profitability was middleware, Sarkar noted. With a limited time to pivot, companies couldn’t rebuild or create needed tech from scratch. Their solution? Build middleware on top of a bank.
That is fine initially, but problems arise in the iteration stages. There’s no direct banking relationship and little ability to personalize. New infrastructure is needed.
Bring differentiation. Bring unique distribution models. That is what will attract smart money. It will also increase acceptance from the heavy hitters who invest nine figures into development.
Which embedded finance companies will be successful?
Which embedded finance companies will be successful? Simply put, they have cheap distribution and acquisition channels and a straightforward business model.
Profitability routes are equally simple. Earn revenue on swipes, interchange fees and maybe subscriptions.
Some seek to increase revenue through higher spending on rewards and cash back. Any increases can easily be chewed up through higher expenses and fraud rates. Interest income is higher but won’t last forever.
The lesson?
“The companies that will be successful are those that realized that embedded finance was not going to drive revenue and profitability by itself,” Sarkar observed. “It was going to drive revenue and profitability by catalyzing increased activity of the core product.”
Starbucks earns good interest revenue on money customers put into accounts so they can jump the line. Sarkar said that perk is a conduit to get them to buy more coffee. When the freelancing site Upwork added escrow accounts, more higher-value jobs were posted.
“That is the nub of embedded finance 2.0,” Sarkar said. “It’s cool to have fancy banking products and a better user experience. It’s really important to be able to serve lower-income users. All of these things happened in this last generation.
“Post-reconciliation, the companies that will have a durable competitive advantage are those that were able to successfully and seamlessly integrate the specific thing that solved the problem into their core business to drive up usage of their core business.”
The link between fraud and engagement
Sarkar said fintechs must realize that as engagement rises, so does fraud. Combatting this begins with understanding the three customer segments.
Super users generate your profit. Occasional users are testing your system but don’t drive the bottom line. The remainder, including dormant accounts, is where fraudsters lie.
Fintechs must balance curbing fraud while driving super users. In a one-size-fits-all system, they offer the same benefits to everyone. The more they use, the more they earn.
The problem with that is that it entices fraudsters to get involved. Curbing benefits discourages both con artists and profitable users.
The solution lies in AI. Ingest data and learn contexts. Identify trends and introduce incentives to move casual users to super-user status.
“Within that context is how you drive incremental profitability,” Sarkar said. “People are realizing personalization isn’t a fad. It is core to the fundamental thing they have to do: build a proper and nuanced business model around the space. By the way, this same personalized view will get people to use your other products.”
