Beyond Banking: Embedded Lending, Brokerage, Crypto Infrastructure
Our post last week (“FinTech Infrastructure in Banking Programs”), covered the schematics of what’s underneath the everyday banking apps in our smartphone. Regardless of features or front-end design, the combination of a bank partner, tech provider, program manager, compliance/risk function, payment processor, and card issuer — leads to a fully functioning banking services program. Users can create an account, make transfers & payments, and swipe cards for spend.
How about the apps that deliver products beyond core banking?
As the industry gets saturated with neobank and challenger bank offerings, companies are launching credit, crypto, and brokerage products. The infrastructure behind these products has similar elements, but there are unique components to consider based on each sector.
Lending
Credit is the most popular follow-up for existing bank offerings. Startups invest in acquiring a customer and providing a deposit relationship — but in retaining or incentivizing activity from users, more products/services are needed. Lending is a strong next step for platforms to show trust in their users and gain more wallet share.
There’s no immediate need to launch a robust loan or credit program. Many fintechs start off with cash advances that deliver overdraft protection or emergency cashflow between paychecks.
Despite credit being available, advances have no formal loan agreement (or recourse in the case of customer default) — firms are unable to collect or penalize those who don’t pay. No APR or advance fees are charged, but the user pays a monthly subscription for access.
For companies in the market to offer a Buy-Now-Pay-Later loan, traditional credit card, or credit-builder lending program — here are additional requirements to consider:
Lending licenses: Companies can choose to gain their own licensing at the state level (a process with its own costs and timeline up to 18 months for coverage throughout the US). The other option is to partner with banks or other licensed entities, who would be the lender of record for newly issued credit products;
Underwriting criteria: The guidelines used to approve or decline an applicant must meet federal and state regulations, which protect consumers against discrimination and disparate impact. Customer complaints based on lending regulations can carry significant penalties (such as product suspension) and fines;
Business model: The APR and fees charged on lending products must fall below thresholds set by each state — this can be in the form of maximum APR and annual fees, or no other fees being charged. States can also place additional loan application requirements (such as spousal consent or income verification) before a new loan or credit card can be issued. Failing to adhere to these limits can lead to platforms being shut down;
Capital requirements: Partner banks or licensed entities may provide an operational framework for companies, but not the necessary capital to fund loan products. Platforms would need to fund a program themselves or work with a capital partner (such as a debt facility with a warehouse line of credit). A third option comes from secured products in which users provide a security deposit that represents a loan reserve (or credit limit).
There are Lending-as-a-Service (LaaS) providers able to provide the majority of an end-to-end lending solution. These companies are able to be embedded within fintech apps and work alongside lenders and banks via APIs. Some of the LaaS firms include: Calyx, Alchemy, Roostify, Blend, DigiFi, ODX, and Peach Finance. The heavy lifting of gaining a capital partner and negotiating with financial institutions would still fall on the fintech platform. Top financial institutions are getting more involved in this space, opening up their licensing and capital access.
Brokerage AND INVESTMENTS
Licensed companies that provide investment products/portfolios and custody of user funds are becoming more and more popular. They serve as strong add-on partners to existing neobanks or digital wallets, who have already performed Know Your Customer (KYC) checkpoints and received customer funds available for investments.
Bank partners can work with these brokerage platforms for a specific flow of funds the debits a user’s wallet and transfers the amount to be invested. When a user liquidates an investment, their funds can be transferred back to their wallet or deposit account. Based on the volume of requests, a lump sum (or batch) payment can be sent to a brokerage (instead of multiple, small dollar transfers from clients).
Key components to consider:
ID and KYC process: Brokerage platforms may not provide their own user onboarding checkpoints, therefore relying on banks (traditional or challenger banks) to handle this. These companies would still need to verify and approve appropriate measures are being taken by the user’s financial institution;
Payments flow: The batching of payments may be required by certain platforms, especially if they’re legacy providers unable to accept/track multiple individual transfers throughout the day. There can also be specific requirements or preferences in the payment rail used (e.g. ACH wires, checks);
Proper disclosures: Licensed companies acting as registered investment advisors or broker-dealers must properly disclose their registration and details on the investment offering. Statements regarding insurance, not being FDIC-insured, or that a product may lose its original value can be required by regulators (especially for self-directed platforms). The website and account agreements at these 3rd party partners typically have the necessary level of disclosure in place;
A final consideration is on the investor type. “Accredited investor” has its own designation and investment options available that may be unregistered with financial authorities. This level of investor is able to meet a particular requirement regarding income, net worth, asset size, governance status, or professional experience. The burden of verification is on the brokerage platform or licensed entity offering private placements as investments.
Some of the leading API providers in this sector are Alpaca, APEX Clearing, and Drive Wealth.
CRYPTO EXCHANGES AND WALLETS
Coinbase and Robinhood are household names to retail investors and institutions when it comes to the crypto sector over the last decade. The next wave of crypto platforms are not as direct to consumers or businesses. New startups are supporting existing fintechs and their users with embedded access to crypto trading, investing, and digital rewards in BTC. The inherent value of layering crypto as an add-on product comes from having verified users with fiat deposits (ready to be converted).
At a high-level, cryptocurrency platforms take individual transfer requests from users, group (or batch) the amounts in one larger sum, and execute a trade or conversion at a favorable market rate. This flow requires that the company take possession of user funds in order to fulfill the transaction, which can be considered money transmission (requiring separate state-by-state licenses). Some firms do take this path of obtaining money transmitter licenses on their own over a period of up to 18 months and (in parallel) conducting a state-by-state rollout with each new license approval. Others take an expedited approach and work with banks or licensed entities for an account structure and flow of funds that mitigates money transmitter risk.
Here’s a summary of items to consider:
ID and KYC process: Similar to the discussion on brokerage above, crypto platforms may not provide their own user onboarding. These firms would verify proper measures are being taken by the user’s banking provider;
Payments flow: We touched on the money transmission risk in the crypto conversion funds flow. Companies would want to ensure (with a legal counsel) their own understanding of federal and state requirements as it pertains to their product and users, and overall liability.
Licensing: More partner banks and liquidity providers are working together to provide companies with a path of operations that doesn’t require separate licenses. As financial institutions become more comfortable with custody of crypto, there should be an increase in embedded crypto offerings from neobanks, digital wallets, and retailers;
Coins / tokens: The abundance of digital assets available puts pressure on platforms to offer new coin access for trading or investing. Beyond standard coins (such as BTC and ETH), critical decisions must be made based on legitimacy, usage, stability, and ideal customer profiles. Stablecoins in particular offer higher-yields on deposits (above current bank rates) — as a result, the demand for USDC has skyrocketed in the last year.
Within these considerations, custody and currency conversion are the most critical themes — impacting payment flow, licensing needs, and choice of tokens. Some providers are able to offer both core components or just custody (such as banks). Coinbase, Kraken, and Paxos provide varying levels of coverage for companies (from startups through enterprises).
BRINGING IT ALL TOGETHER
It’s easy to look at the overall potential of products/services available and try to make the case for each vertical within your platform. The reality is that companies struggle (especially new startups) in establishing a core competency in one area — a generalist OR ‘jack-of-all-trades’ path doesn’t make sense in today’s financial services environment. The exception comes from Square, PayPal, and other mature fintech firms with a high-volume of established users.
The most compelling value drivers in expanding off of banking into lending, crypto, and brokerage are increased wallet share and transaction activity, higher volumes of deposit and card spend, and customer retention/loyalty. Success of the banking offering needs to be there first, before adding to the product roadmap. Startups (and even banks) have failed recently to generate sufficient banking activity in order to stay in business.
Some platforms are uniquely starting with non-deposit offerings (such as lending) and then adding banking services (deposit account, card, payments) after initial success of their core product. Deposit solutions typically have the highest switching cost for users, which results in a higher customer acquisition cost (CAC) for platforms (in the form of marketing campaigns, targeted outreach, and new account bonuses). Ultimately, the intangibles of differentiation and value-added services are the most critical factors to carry new companies or products forward — regardless of sector or category.
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