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Embedded Briefing: Understanding the difference between BaaS and embedded finance

  • BaaS and embedded finance are two new emerging markets in the world of finance, but many professionals are still confused about the differences between the two.
  • Meanwhile, we look at consumers' use of embedded finance products and the growing VC interest in this sector.

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Embedded Briefing: Understanding the difference between BaaS and embedded finance

The difference between BaaS and embedded finance

Over the past year, BaaS and embedded finance have become buzzwords in the world of finance. The words are thrown around, often interchangeably, with professionals, let alone consumers, generating confusion around the difference between them. 

This confusion isn’t just theoretical, it is actively affecting business outcomes for fintechs across the board. A recent Aite-Novarica study found that fintechs are losing about $11m per year in product delays due to BaaS providers. Furthermore, 40% of fintechs saw their services take a hit, while 33% lost customers and 20% faced regulatory intervention due to BaaS. 

So, let’s get the definitions straight first. 

BaaS is an API-powered distribution model in finance whereby a bank provides white-label financial products to a client, which can be an FI or a non-FI. The product itself is developed by a holder of a banking charter. To ensure compliance, the client in question must set up its own regulatory compliance and risk management processes. 

Embedded finance is when a chartered FI directly embeds its program, like lending or checking accounts, into a client’s user experience without an intermediary. These offerings go beyond just the API integration stack, where regulatory compliance and risk management mechanisms are also embedded. In such an offering, the compliance element is taken care of by the FI powering the product.

Aite-Novarica group’s study found that most of the fintech professionals questioned across America, Europe, and Asia, were unclear on these differences. In fact, a clear majority of the respondents were unable to tell BaaS apart from embedded finance.

The above chart shows that the industry sees BaaS and embedded finance as similar ways to integrate financial services via APIs – that’s not the case. For example, respondents considered back-end API integration as equal parts to BaaS and embedded banking, when in reality it is a BaaS function.

But what stands out the most in the chart above is that regulatory compliance is considered to be a function fulfilled by the BaaS provider. Technically, that is incorrect. 

In BaaS, the client or the non-bank partner is responsible to hire a compliance team that makes sure the products meet the licensed BaaS partner’s compliance requirements. With embedded offerings, the licensed partner takes care of the compliance. 

Furthermore, around 50% of the respondents thought BaaS providers need a banking charter, whereas BaaS distributors do not need to be licensed FIs. 

Revenue opportunities and speed-to-market came forth as leading reasons why brands are seeking BaaS partners, with 60% of fintechs agreeing. An acceleration of growth, reduction of costs, and offering more services were also key reasons, at 53% each. Furthermore, 47% said it was because they couldn’t build the systems in-house. 

Other reasons included regulatory pressure (33%), improving customer loyalty (27%), concerns regarding financial crime (7%), and unrealistic customer pressure (7%). 

While there is much to gain for the brand from a BaaS partnership, and many have, an inadequate BaaS partner can actually end up costing a business more.

In the BaaS partnership arena, an 18-month association is understood to be a sufficiently lengthy one. In that context, the report found that around 25% of brands changed their partners within 6 months of entering an agreement. 50% changed them between 13-18 months, while another 25% between 19 to 24 months.

What’s behind this? Poor business outcomes and other issues surface in working together.

These issues have come to define how brands choose partners to work with, and what factors are key in making that decision. Having a banking charter is among the most important requirements from a partner, with 47% of the respondents saying so, in addition to the range of offerings, safeguarding services, and quality of customer service, with 35% reporting each of the three. 

Nearly 30% of respondents gave importance to each processing efficiency, single API access, and operational resilience. Other factors included reputation in the market (24%), being cloud-native (12%), fincrime offerings (12%), and whether funds were held at the central bank (6%).

The report also argues that the future of BaaS is embedded finance. Increasingly, non-FIs trying to launch financial products are looking to work with partners that manage the compliance and risk elements themselves. That way, all regulatory matters can be dealt with by the provider. So, with the responsibility of compliance, risk-taking, and pricing, BaaS providers will need to become embedded players, i.e, have banking charters.

BaaS and embedded finance are still fastly developing spaces, with new use cases and improved systems entering the market nearly every day. As the industry gets more mature, and regulators define the boundaries in terms of risk and compliance,  the two sectors are set to become critical to brands choosing a partner. That is also the reason that most BaaS providers now have embedded finance aspirations, seeking banking charters and expanding offerings.

Chart of the day

Source: Insider Intelligence

Topic in focus: Continued adoption of embedded finance and VC investments

Fintech has been experiencing a decline in funding since its boom in late 2021. VCs are spending more time scrutinizing business models, investors are pulling out, and regulators are questioning the thus far free-flowing nature of the industry. Despite all this, one region in fintech has displayed great resilience, and that’s embedded finance. 

And that’s because consumers are really adopting embedded solutions. As shown in the chart above, about 42% of people have started using mobile wallets, while 23% have used embedded investment solutions. Other uses include paying via social media, using payment experiences like BNPL, and acquiring co-branded cards.

Investors continue to funnel money into embedded. UK-based Railsr just raised $46 million in a Series C, while compatriot embedded players Toqio and Liberis too bagged around $23 million and $140 million, respectively. Pakistani embedded platform Neem was handed $2.5 million in seed, while Australia's Shaype landed $25 million. All this shows that even in bad times, investors are quite receptive to embedded finance. 

More than anything, the sheer adoption of embedded solutions by consumers has powered this. A recent Bain and Company report found that $2.6 trillion of US financial transactions in 2021 happened via embedded platforms, and that number is expected to hit $7 trillion by 2026. The chart above shows that consumers are using these solutions to avail a variety of financial services.

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