Embedded finance: the products taking centre stage

Written by Fiona Henderson, Charles Kerrigan and Laura Collins at CMS Law

Roll up, roll up - embedded finance is in town!

Companies that offer embedded finance products: think, Apple, Klarna, Liberis… the list goes on. The demand for embedded finance products is rapidly growing. As noted by Nik Milanovic (Founder of This Week in Fintech): “in a world where everyone has a supercomputer in their pocket… the most successful financial products will be those that move up the funnel to meet the customer where they are”. It is projected that by 2026, embedded finance products will exceed US$7 trillion of the total US financial transactions (an increase from US$2.6 trillion in 2021). But what is it that these companies offer - what is embedded finance? Put simply, embedded finance (EF) is the availability of financial products, integrated into a company’s infrastructure, provided by non-financial institutions and capitalised by financial institutions.

Source: CMS law

It’s a way of “funding the funding”.

Act 1: the embedded finance leading roles  

Broadly speaking, embedded finance products can be broken down into two “main” categories: business-to-business (B2B) and business-to-consumer (B2C). B2B involves a relationship between an embedded finance firm and a corporate (i.e., a large corporate, or a small-and-medium sized enterprise (SME)). B2C involves a relationship between an embedded finance firm and an individual (much like you and I).

So far, so good. It’s important to separate these two distinct products (B2B and B2C) as they are treated differently from a regulatory perspective. For example, from a UK regulatory perspective anything falling into the scope of B2C products is subject to additional regulatory reporting requirements and will need to comply with the Financial Conduct Authority’s Consumer Duty (Consumer Duty). But we all know anything that starts with “reg” and ends with “lation” is far from simple. So, lets add in a legal nuance. The B2C definition sometimes captures SMEs. This is if they are partnerships which fall into the category of SME, meaning that each product needs to be evaluated on a case-by-case basis with legal analysis to establish which category (B2B or B2C) it falls into.

Source: CMS law

Act 2: the embedded finance chorus line

B2B and B2C embedded finance products can be broken down further. There are three principal categories: payments, banking, and lending. Under these categories, there are various sub-sets of products. The most common products are as follows:

·      B2C Buy Now Pay Later (BNPL)

These products are becoming commonplace in a world that demands a one tap solution; they are well established products. The average online checkout abandonment in the US is 70.19%. B2C BNPL products aim to reduce this number, offering a solution to this. Embedding technology to reduce the number of clicks required from a customer, and offering a payment solution to combat economic struggles. The characteristics of B2C BNPL is repayment of a purchase by an individual customer later - either in one payment, or in instalments. The standard model is that B2C BNPL products are interest free, although there are likely charges to the intermediary (e.g. the shop utilising the embedded finance offering as a payment method for their customers). In the UK, B2C products are subject to heighted regulatory requirements, including the Consumer Duty and the proposed BNPL legislation (BNPL Legislation). However, there is uncertainty as to whether the BNPL Legislation will be enacted; BNPL players within the UK market have expressed concerns. This demonstrates the careful balance that needs to be achieved between protecting consumers and providing a market which allows development for EF Firms. Legal input is required to ensure compliance with these regulatory regimes.

EF Firms: Klarna and Apple’s Pay Later products are widely known in the B2C BNPL market.

·      B2B BNPL

This embedded finance offering bears similarities to that noted above. It is the availability of a financial product, which can be paid back at a later point in time. The difference? It’s offered to businesses. So, does this make a difference? Think you can roll out the same products? Think again. Currently in the UK, B2B lending is subject to less regulatory scrutiny. EF Firms offering these products are not subject to the Consumer Duty, or the BNPL Legislation (although note that they are subject to certain regulatory considerations, such as, in most cases, the requirement to hold an anti-money laundering license). Practically, EF Firms offering such products can be let (somewhat) loose with their product terms. However, this is not the reality. It is commonplace for B2B BNPL products to align to the regulatory requirements of B2C BNPL. Whilst this approach is not legislated, it certainly seems that consumer protection is key and this heightened awareness is high in the minds of EF Firms. BNPL products are not being created as a sub-set of pay-day loans. Instead, they are utilising technology to provide a viable financing offering.

EF Firms: Hokodo offers B2B BNPL products.

·      Revenue-Based Finance (RBF)

RBF products offer flexible financing, well-suited to SMEs. They look to bridge the SME funding gap. This gap was estimated by the Bank of England to be £22bn. in the UK in 2019, and Goldman Sachs flagged a $2tr. ‘corporate debt wall’ in August 2023. RBF products differ from B2B BNPL - the recent Hokodo blog clearly sets out some of these differences. In short, the customer (here, an SME) only pays the EF Firm as the customer itself gets paid. The trademarks of RBF products are that an initial cash amount is advanced, the advance is repaid from a share of the revenue generated by the SME’s business activity (i.e., if the revenue reduces, the amount of revenue to be repaid similarly reduces, and if the revenue increases, the amount of revenue to be repaid similarly increases) and no interest is charged (instead one-off fees apply).

EF Firms: Liberis, Uncapped and Bloom are well known in the RBF space.

The finale: embedded finance product terms

Now that we’ve set out some common embedded finance products, it’s important to discuss key considerations for EF Firms when drafting their underlying product terms.

Considering regulatory frameworks: as you will have likely gathered, the embedded finance space is fast changing. With this comes evolving regulatory regimes, which (somewhat unhelpfully for scaling EF Firms), differ across jurisdictions. So, if you start off in the UK, this doesn’t mean that you can roll out the same product terms in Germany. It’s likely you’ll need to establish a specific entity in this jurisdiction which transacts with customers, and different regulatory licences will be required. In fact, in some jurisdictions (such as Italy), a partnership with an institution that holds a banking licence in that jurisdiction may be required, even if on the face of it, the embedded finance product in question is not one that would be traditionally offered by a bank.

Variation clauses: so, with the ever-changing nature of the regulatory and legislative sphere surrounding embedded finance products, coupled with the current uncertain economic environment, it’s important for EF Firms to allow themselves the opportunity to update their product terms from time-to-time. This means that variation clauses must be carefully considered in the underlying customer terms. They provide the EF Firm with the ability to adapt a product already in use. However, the EF Firm must consider how much flexibility they afford themselves to alter products, coupled with providing customers with a period to reflect on any proposed changes. 

Assignment clauses: additionally, as EF Firms grow and scale, it’s likely that their corporate group will also. Moving through the funding stages from family and friends, to venture debt and finally securitisations, it may be that the group entity engaging with customers is set to change as additional entities and orphan vehicles are established in line with the funding rounds. EF Firms should consider whether the assignment provisions in their underlying customer terms, permitting successors in title, assignees and transferees, are sufficient to cover their contemplated plans to expand.

Integrating embedded finance: the rising stars

The use case for embedded finance continues to develop. Whilst once the emphasis was on developing additional embedded finance products, there is now market consideration about how the technology behind these products can be integrated into other systems and market areas. For example, @Pay provides an example of a decentralized finance protocol adopting embedded finance technology to enhance its offering. Embedded finance can be coupled with Web3 to enhance frictionless and borderless transactions, including reducing the load on operations teams by improving efficiency and reducing time spent on payments. Blockchain could be integrated into embedded finance products to enhance security procedures, limiting data breaches and decreasing consumer security concerns with sharing personal or confidential information with EF Firms.

Lawyers in the wings: directing

Within our practice we have assisted with establishing over 25 of these products for key market players. It is only now that we are starting to see consistency in practice and terms. When working with third parties (be that lawyers, financial institutions or corporate services providers), EF Firms should consider whether these parties know and understand the underlying nature of the EF Firm’s business. This is integral to achieving a product with carefully balances all of the considerations we have discussed above.

Curtain call: summary

Embedded finance offers a new way of generating cash, leaning on ever-advancing technology to develop in line with consumers demands. The use case for embedded finance is expanding. Whilst the term embedded finance was once arguably synonymous with retail shopping, and providing an alternative payment method for this, embedded finance is expanding to other sectors.

It’s time to roll out the red carpet, the era of embedded finance has arrived.