How embedded finance is driving the banking-as-a-service revolution

The world of payments is undergoing a radical transformation and Banking-as-a-Service (BaaS) is playing a starring role. This article is an excerpt from the Future of Digital Banking in Europe report.

BaaS is the delivery mechanism that underpins embedded finance, allowing the provision of banking solutions directly into the websites and apps of brands consumers use every day. BaaS providers combine modern, API-based platforms with regulated financial infrastructure to enable new, specialised financial propositions and bring them to market faster. BaaS creates value and opportunity for both financial and non-financial businesses. For banks, BaaS provides the ability to leverage API-based technology to quickly embed banking products into client ecosystems. For brands, seamlessly integrated financial products that meet customers at the point of need are driving conversion and revenue, as well as enhancing loyalty and retention.

Embedded payments are the foremost BaaS use case, with this sub-sector of embedded finance growing rapidly – revenues for the embedded payments sector are predicted to increase from $43 billion in 2021 to $138 billion in 2026.

How embedded payments have changed the game

Traditionally, businesses relied on banks or payment service providers (PSPs) for payment processing. These institutions would charge transaction fees for services that were often inflexible and slow, hindering agility, growth and profitability.

Today, BaaS-powered embedded payments allow businesses to integrate innovative, fast and cost-effective payment solutions directly into their customer journey. This is a game-changer in addressing businesses’ longstanding payment challenges, while also creating a better consumer experience and building stronger relationships with customers.

In this article, we will explore:

• Existing payment challenges are and how embedded payments are solving them
• Embedded payments as the foundation for a better customer journey
• How to create a frictionless payment experience, including the role of the BaaS provider
• The impact of PSD3 and evolving regulation
• What’s next for BaaS and embedded payments

What are the main payment challenges?

The ability to offer a quick and frictionless experience when processing transactions is the foundation of any good customer experience. It is no surprise that solving payment headaches is a common starting point when companies engage with BaaS providers.

These headaches vary based on a company’s industry, size, and location – but here are the most common:

• Complexity of payment processes

Payment processes can be complex, especially for multinational companies dealing with multiple currencies, payment methods, and regulatory requirements across different markets. Streamlining payment processes and adopting efficient payment solutions is essential.

• High transaction costs

Traditional payment methods like wire transfers and credit card transactions often mean high fees, particularly for cross-border payments. Companies must find more cost-effective alternatives to protect their profit margins.

• Fraud and security

As payment systems digitise, companies face increased fraud risks, including unauthorised transactions and identity theft. Implementing robust security measures is vital to protect financial information.

• Regulatory compliance

Companies must comply with various regulations governing payment transactions, including anti-money laundering (AML), know your customer (KYC), and data protection laws. Non-compliance can result in financial penalties, reputational damage and legal repercussions.

• Customer preferences

It can be challenging to cater to diverse customer payment preferences, particularly if a customer base comprises wide-ranging demographics. Doing so requires the business to offer a variety of payment methods such as credit and debit cards, digital wallets and bank transfers.

• Cross-border payments and currency fluctuations

For businesses operating globally, fluctuations in exchange rates can impact the value of international transactions, affecting profitability and financial planning.

• Technology integration

Integrating payment systems with existing business processes and IT infrastructure, particularly for companies with legacy systems or those undergoing digital transformation, is challenging.

Overcoming these payment challenges involves strategic planning, technological innovation, adherence to regulations, and proactive risk management. Companies that successfully manage these issues can boost their financial stability, operational efficiency, and competitive edge in the market.

How embedded payments improve the customer journey

BaaS-powered embedded payment solutions address these challenges. Unlike traditional integrated payments, where payment processing is connected to a third-party service, embedded payments are native to a company’s ecosystem.

There are many benefits to this approach, especially in enhancing the customer journey. For one, it ensures a streamlined checkout experience for customers, allowing them to quickly complete transactions without leaving the platform. Not needing to switch between websites or apps – and by extension, not having to re-enter information – creates a faster, more frictionless experience.

Improving the customer experience at checkout is proven to result in higher conversion and better loyalty, particularly among younger generations. Recent Vodeno/Aion research surveyed more than 3,000 European consumers and found that most (52%) 25-34-year-olds prefer using financial products and services from their favourite brands over traditional banks, while 50% will only stay loyal to brands offering financial embedded financial products and flexible solutions like Buy Now, Pay Later (BNPL) and cashback. One of the key benefits of BaaS is its ability to offer choice when it comes to payment, empowering consumers to choose when and how they would like to complete the transaction.

In consumer-facing industries, such as retail and eCommerce, where competition is intense, boosting conversion is essential. Also, keeping customers on their platform, owning the entire customer journey, and ensuring control of every aspect of the user experience from browsing stage to checkout leads to a more cohesive experience. The combination of an easy and efficient customer journey alongside the availability of the right financial solutions when and where they are needed drives better conversion and creates brand advocates.

For those adopting embedded payments solutions, ownership of the entire customer journey also provides valuable customer data. These data-rich insights on customer behaviour, transaction patterns, and preferences can be used to optimise their offerings, creating a feedback loop that creates the ability to continuously enhance the overall customer experience and product offering.

Achieving frictionless payments

The key to making payments a more frictionless experience lies in simplifying the process for users while providing trust by ensuring security and reliability.

Here are some of the most common strategies – often deployed in tandem – to create that experience.

• Seamless integration:

Payment options integrated directly into the user’s journey, without redirecting to external websites or third-party platforms during checkout. For example, eCommerce websites can offer one-click payment options that remember user details and preferences, and securely process transactions without additional steps.

• User-friendly interfaces:

Intuitive and straightforward payment interfaces with clear labels, minimal steps, and visual cues. They can autofill relevant information (such as credit card details and address) whenever possible to reduce manual input.

• Biometric authentication:

Biometric authentication methods (such as fingerprint or facial recognition) for secure and convenient payments – removes the need to remember or input passwords and PINs.

• Tokenisation:

Replace sensitive card data with unique tokens; tokens are meaningless to hackers, enhancing security while allowing for smooth transactions.

• Real-time notification:

Ensure instant feedback during payment processes, notifying users when a transaction is successful or if there is an issue.

• Robust security measures:

Implement encryption, fraud detection and compliance with industry standards.

Leading BaaS providers are able to tick these boxes when delivering embedded payments solutions, combining the necessary technology, access to multiple payment methods – both cross-border and local schemes – and regulatory compliance expertise to create frictionless customer journeys.

BaaS providers versus Payment Service Providers

The emergence of BaaS providers has given businesses a greater choice of payment solutions, lessening the reliance on traditional banks. It is important to understand that the types of licences held by BaaS providers can differ. Some providers hold the Electronic Money Institution (EMI) licence, which authorises their customers to issue electronic money and provide payment services. These are essentially Payment Service Providers (PSPs) vs full BaaS providers. Additionally, PSPs may lack access to local clearing houses/IBANs and would, therefore, be unable to offer a full suite of solutions, including accepting deposits or offering lending services.

Yet, businesses must still assess which choice is right for them – BaaS providers and PSPs cater to different business needs with distinct offerings, so understanding those differences and their relative merits is important.

On the one hand, BaaS providers with a banking licence enable businesses to embed a wider range of solutions directly into their ecosystem without needing their own banking licence. Those banking services extend beyond payment processing to lending, accounts, and savings and investment products. The best BaaS providers will also handle regulatory compliance, helping to navigate through complex (local) regulations.

On the other hand, PSPs focus primarily on efficient payment processing, providing easy integration with existing business systems and quick setup, allowing businesses to choose payment solutions that align with their targeted geographies, budget and transaction volume.

Compliance requirements can vary significantly from one BaaS product to another. While requirements are relatively light for simple payment processing solutions, lending solutions like Buy Now, Pay Later loans (BNPL) are much more demanding due to demanding regulations and the accountability and decision requirements for lending money to customers. Without the right level of regulatory and compliance support, BaaS adopters may find themselves under-serviced, and as a result, they may have to outsource compliance responsibilities to another BaaS provider or hire a dedicated team to handle compliance in house. Companies that envision launching additional products outside of payments as they scale will need to make sure their BaaS provider is able to both offer the products and provide the necessary supporting compliance expertise.

Beyond payments: Expanding your BaaS offering and the bottom-line benefits

Integral to many businesses and often blighted with inefficiencies and challenges, payments is typically the starting point for any business exploring BaaS. For those that have successfully taken this first step, the adoption of other BaaS-powered embedded finance solutions offers further benefits.

BaaS providers with the right licence can provision additional financial solutions, such as lending, accounts and savings products. By offering a comprehensive suite of financial solutions and creating a better customer journey, companies can increase their revenue per customer and drive additional value from their existing user base. The potential benefits to a company’s bottom line include: revenue generation, cost savings, and enhanced customer retention. Here are some examples:

• Enhanced product offering:

By integrating BaaS functionalities, companies can offer or upsell a wider range of financial services, such as savings accounts, payment processing and lending solutions. This diversification can attract new customers and increase the loyalty of existing ones.

• Transaction fee revenue:

Customers can earn a share of the transaction fees when their customers use the banking services provided in their ecosystem.

• Interest revenue:

If the BaaS integration includes deposits or savings solutions, the company may earn interest from these financial products, similar to traditional banking.

• Reduce cost and improve efficiency:

By utilising BaaS for complex banking infrastructure, companies can reduce the overhead costs associated with developing and maintaining these services themselves.

• Data monetisation:

Companies can leverage the data gathered from customer interactions with their financial services to improve product offerings and the user experience.

Future trends for BaaS and embedded payments

The payments landscape is constantly evolving, with customer demands and regulations requiring businesses – and BaaS providers – to take an agile approach to payment solutions.

Looking ahead, numerous trends are likely to influence the payments sector.

These include:

• Real-time payments:

Demand for instant transaction processing is rising all the time, meaning there will be even more need for businesses to offer real-time payment capabilities.

• Cross-border:

The need for efficient cross-border payment solutions is ever-growing, meaning greater support and improved solutions for multi-currency transactions and reduced cost and complexity with international payments.

• Digital wallets and mobile payments:

Consumers are increasingly adopting mobile payment solutions, meaning that BaaS providers need to be able to support wallet solutions and mobile payments seamlessly.

• Security and compliance:

There is a heightened focus on security measures such as encryption, tokenisation, and fraud detection technologies. Compliance with evolving regulations like PSD3 in Europe, will also be crucial.

• AI:

Artificial intelligence will become more integral to BaaS platforms, for example in the improvement of risk
management, fraud detection, personalised services and operational efficiencies.

• Encapsulated payments:

This is likely to be the next iteration of embedded payments. This concept will take the embedding of payments a step further, with the inclusion of data and other functionality along with the payment. In business payments, wrapping data around the payment would permit functions like automatic reconciliation on the payer’s end. This data could also support payment authorisation and approval processes.

• Payment authorisation:

Going forward, payment authorisation will require little or no human interaction. The blend will include biometrics, geolocation, device fingerprinting (data that identifies a remote computer or other machine), and localised AI.

• Blockchain technology:

This has the potential to provide cheaper global, real-time payment transfers. Indeed, while typical money remittance costs might be as high as 20% of the transfer amount, blockchain may allow for costs just a fraction of that, as well as guaranteed and real-time transaction processing speeds.

BaaS and embedded finance are powering a shift in how consumers engage with and access financial services. There is a clear appetite for banking products from the brands consumers use everyday, offered in a contextual way at the point of need. Embedded payments are the clearest example of this trend, and we should expect exponential growth in this area over the coming years.

The opportunities of embedded finance are vast, and working with the right BaaS provider will provide a business with access to a full range of financial products and services. The single most important factor in determining the success of an embedded finance solution is aligning the product to customers’ needs. Businesses must identify via research: what key challenges their customers face, how these can be solved by integrating financial services into their customer journey, and what benefits they can unlock for their customers through embedded finance.

But, don’t run before you can walk.

While there might be a plan in place that involves the business deploying multiple embedded finance solutions, it is best to start with one. Try it out. Build the relationship between the business and the BaaS partner. Establish a successful use case. Then scale it.