I'm back this week with another Embedded Finance blog post, as promised last week. I hope you enjoyed the first post, and I appreciate all of your comments. Just a reminder that my posts are aimed at builders of Embedded Finance products.
In this post, I'll look at the differences between Open Banking and Embedded Banking. I spent five years at an Open Banking startup and nearly two years at an Embedded Finance startup. I've worked with hundreds of startups and founders over the years, and many have asked me whether they should go with Open or Embedded Banking for their startup, and what the implications are. So I'm going to go into the following topics:
- When is it Open? When is it Embedded?
- What is currently possible?
- The advantages and disadvantages of each approach
- What is the best option for your service?
When is it Open? When is it Embedded?
While the headline mentions two terms: Open Banking vs. Embedded Banking, we can expand this to include Open and Embedded Finance as well - and I have already used these terms above. Thus, there are four terms that are frequently used, and I would like to define them before proceeding. Let me break it down into two parts:
Embedded vs. Open
When we say "Open," whether in Banking or Finance, we are referring to the activity of connecting a third-party service to an existing financial product. When we talk about "Embedded," whether in Banking or Finance, we are referring to the activity of creating a new financial product within a third-party service. For example, an accounting service such as Xero could allow customers to connect an existing bank account such as a Deutsche Bank or Revolut account to their service (Open Banking) in order to match incoming payments to open invoices. Xero, on the other hand, could (at the same time) allow users to create Xero branded accounts or cards for the benefit of creating separate virtual accounts for each client for easier reconciliation or cards for a better user experience (Embedded Banking).
Finance vs. Banking
But what is the distinction between banking and finance? Banking refers to financial products such as payment accounts and debit/credit cards that we use to conduct transactions. Finance, on the other hand, is one layer higher and includes a wide variety of financial products. This means that finance includes not only lending and investing, but also banking. For example, when Shopify provides bank accounts and cards to their merchants, we can call it Embedded Banking (or Embedded Finance because Banking is part of Finance), but when they provide a lending product, we can definitely call it Embedded Finance (or of course Embedded Lending).
I'm hoping you're still with me. The following diagram may help you understand it better:
One distinction is that "Embedded" is always provided by a non-banking provider, whereas Open Banking/Finance powered solutions can be provided by both a bank and a fintech. Personally, I think this makes a lot of sense because the true "embedded" benefits are only realised when financial products are integrated into a non-banking offering. An Open Banking/Finance solution, on the other hand, does not.
What is currently possible?
Since we've discussed what the various terms mean and what they enable, I believe it's appropriate to briefly discuss how far developed each of them is - with a focus on Europe.
PSD2 regulates connecting a third-party service to an existing bank account, and every bank in the EU (and the UK) must provide an API to allow regulated third-party providers to read data and initiate payments from payment accounts.
Connecting a service to an existing lending or investment account is not regulated, and some providers offer connectivity to such accounts using Screen Scraping (or possibly reverse engineering) technology. Because this connectivity is not based on an API, its quality and coverage are typically limited. As of this writing, various consultations are ongoing in which market participants can provide input that will be used to review PSD2 and determine whether Open Finance requires a regulatory push in Europe (see here).
Embedded Banking & Finance
There are several ways for a company to offer banking or other financial products. The "Embedded X" trend began in banking, and there are various types of providers available. This has been followed by embedded lending, with a few providers already active or about to go live. Finally, the Embedded Investment space is just getting started, with the first providers expected to go live soon (in Germany).
There will be another blog post where I go into detail about how to build an Embedded Finance solution, but I wanted to touch on it briefly here. You must have the appropriate technology and licence for each approach (Embedded or Open). There are providers for each approach who can provide you with all of it or parts of it. Once you've determined which approach is best for you, you can investigate your specific options. But how do you know which method is best for you?
The advantages and disadvantages of each approach
Connecting to an existing financial account versus creating a new one are two distinct approaches. There are dozens of use-cases available, and for some, only one or the other is an option. For example, if you are a lender and want to use Open Banking for loan underwriting, opening a new financial account is not an option. Nonetheless, for the vast majority of use-cases, Open and Embedded are frequently viable options. The benefits and drawbacks of each approach are illustrated in the image below. To avoid overcomplicating things, I've only focused on Open Banking vs. Embedded Banking:
Personally, I think both approaches are still at the very beginning. The challenge of Open Banking is that it relies on third party banks which do not have a financial incentive to provide good APIs. Therefore, if and when banks adopt to an Open Finance mindset, this approach could be extremely more valuable than it is already today.
What is the best option for your service?
Both Open Banking and Embedded Banking are powerful tools with distinct advantages. Choosing one or the other for your service is most likely a critical decision. While I don't believe there is an easy decision tree, there are a few instances where one makes more sense than the other (personal selection of points).
When to use Open Banking
- When data from banking accounts is only needed once (e.g. underwriting or identity check)
- Aggregation of multiple accounts required
- The brand or use-case is insufficient to persuade users to open a new financial account.
- The provider does not have enough resources or focuses on its own financial products (yet).
When to use Embedded Banking
- The use case requires the use of specific capabilities or limitations of it.
- Financial product branding is critical.
- It is critical to monetise financial products.
- Strategically important to offer financial products.
To put it another way, Open Banking is the quickest and easiest way to provide some form of financial integration. The user has to put in very little effort and can reap the benefits very quickly. However, because the financial product is offered and controlled by a third party, there are restrictions on what you can access and do. Embedded Banking, on the other hand, has much more in-depth capabilities that enable new use cases and give the business control over branding. However, the cost of onboarding users is higher, and stronger persuasive abilities are required to persuade users to open a new financial product.
That being said, many businesses are leveraging both approaches and I hope you understand why and what they hope to achieve after reading this blog post. Personally, I believe that both - Open and Embedded - are two crucial elements of our banking industry of the future. They don't compete but complement each other.
Thank you for taking the time to read my blog post. As a reminder, you can subscribe to receive all new posts in your inbox. I mentioned last week that I would publish a new post every Friday. As you can see, I published on Sunday this week, and I've decided to experiment with different days of the week for my next posts before settling on one (or not).
Also, starting this week, I'll include the best Embedded Finance articles of the week at the bottom of each post:
Embedded Finance in the news