Embedded: dawn of an age.
From the steel mills and railroad expansion of the late 19ᵗʰ century to the global and digital economy of today, a lot has changed in the business panorama. Yet the need for credit is as immutable as the thirst for growth. Embedded finance carries an interesting duality to this matter. If on one hand it provides financial services, on the other it blends itself with the surrounding economy. That makes it somewhat different from traditional finance. And because of that, it is today a vibrant topic in the fintech space, capable of setting a new paradigm for business credit.
The Great Immoderation
I was born in the 80s and, while growing up, I experienced the Great Moderation in the first place, as a solid long-term plan towards prosperity. Actually, it was not even perceived as economic theory, but rather as the factual and undeniable truth that surrounded all of us. The cold war was over, we lived in the golden era we had all been promised. The European project was growing stronger. The monetary union was about to be a reality, meaning we were all going to be upgraded to the Deutsche Mark overnight. It was the go-go 90s. The bank, where you used to keep your savings, was suddenly your stock broker. Savings earning interest was a thing of the underdeveloped past. As it happened then, real estate always increased in value and credit was universally accessible. Inflation was always low and perpetual growth was, albeit slow, an axiomatic and inexorable assimilated truth.
We know today that the tranquility of that era was in fact a slowly building bubble, formed on a steady increase of debt-to-GDP ratios, that upon bursting opened the door for debt deflation, austerity, unemployment and defaults. The discussion that ensued often mentioned the practices of certain bankers as the root cause for that singularity. That together with the abundance of credit had created a perfect storm of non performing loans. But if the indiscretion of certain figures of finance was amply debated, we failed to take a closer look at the alleged abundance of credit. Perhaps because we had grown accustomed to the idea that there is no growth without debt, we were not as inquisitive about the nature of the available credit during that time. In fact, for most of that period from the 90s until 2007, much of the generated debt was to support house mortgages and other forms of non-productive credit (Bezemer, Grydaki, and Zhang 2016), while the productive credit issued in the same period remained stagnant.
A new form of industrialised finance
The debate around productive and non-productive credit is not exactly fresh. Often subjected to the biases and the influence of the ruling political doctrine, it has experienced a resurgence in the last years, in particular associated to the bisection of the “real” economy from the “wealth” economy (Minsky 1987; Bezemer and Hudson 2016). One of the questions that arose from this debate, more than a hundred years ago, was whether we would witness an industrialisation of finance or if instead industry would become increasingly financialised. Whereas common practices of these days, such as stock buybacks and leveraged buyouts, clearly demonstrate the latter has become the prevailing model, advocacy for the industrialisation of finance is not fully extinct. And the advent of embedded finance might have the inadvertent effect of resurfacing this economic view in full strength. The intrinsic nature of embedded finance potentiates this, through the way it adapts to fit the needs of other industry activities; the way it permeates those economic activities, enhancing them. Constantly shaping itself to match the enclosing context. It does draw a great parallel with the industrialised finance vision of the tycoons of old. Embedded finance being the blood vessel that irrigates the productive tissue.
It should not come as a surprise that most of the embedded finance initiatives we see today are primarily spearheaded by fintech companies. The tech suffix is not entirely misplaced here. Fintech companies are usually tech companies at heart, that happen to operate in the financial space. And because of that, they are born out of a problem solving culture. A culture of curiosity and of incessant search for the next big idea, the next solution for the problems that we face everyday. And this is how we have today’s vanguard industry championing century old ideas. A mere curiosity, I know. But a fascinating revelation nevertheless. Particularly when we start looking at how embedded financing can completely reshape the way the “real” economy operates.
High octane credit
In the previous section I tried to provide a historical and economic context to the appearance of embedded finance. Now I would like to explore the reasoning on why I believe embedded finance can become a revolutionary fuel in the modern economies. There are two key aspects to embedded finance that make it uniquely apt to be the catalyst for this industrialised finance vision. On one hand, it lives within the industry and it can quickly permeate new niches and opportunities. On the other, it is very strongly data centric. By being integrated in the industries it serves, it can drive richer data from those businesses and adapt and react to their needs. This has a colossal impact on the underwriting strategy and on how credit risk is managed. By having a richer understanding of how a business performs, we reduce the uncertainty, and therefore the risk. That means we can offer better conditions and ultimately offer a better credit product, for both creditors and debtors. Another interesting aspect of the embedded finance ecosystem is that, because you build this symbiotic relationship, you take a pro-growth approach to the businesses you support. You will often see embedded credit products offering revenue indexed repayment plans. This can be a game changer for the industry. By taking a non-extractive stance and not compromising future cashflows, embedded finance can become the preferred mechanism for industry growth, from manufacturers to retailers.
Notwithstanding, this scenario of a fully integrated, fully melded finance into the industry, does not come without its own series of challenges. Industry standards, namely on the bank facing side of the equation, are a fundamental requirement for embedded finance to spread and reach critical mass. Open Banking clearly points in the right direction. And becoming API-first is something that all players in this space, from the finance sector to the business platforms, need to interiorise. Without the ease of access to constant flows of rich data, underwriting becomes less insightful, and naturally the quality of the offer degrades.
Steel & Steam
Despite the recurrent invocations of industrial imagery, I do not wish to part without reinforcing the absolute universality of embedded finance. It can certainly fit the needs of manufacturing and supply chain — and what a great fit it would be to this extent — as well as it can empower retailers and service providers alike. But just as it can support traditional business, it can also fit the digital economy. Through data driven underwriting it is possible to look at the books of a certain business, but also to understand their customer engagement and product impact. Even when considering digital goods or digital content. Embedded finance can quickly adapt to new business models, such as subscription based models. In fact, this adaptability is one of its core strengths. That, together with the capacity to quickly reach relevant market segments, creates a value proposition that cannot be ignored. I cannot tell if embedded finance will answer for the lion share of issued productive credit in the future. But I believe it has the potential to do just that. However, in the meanwhile, I can only say that these are definitely interesting times for fintech.