Happy Friday, Fintech Takers!

If you haven’t had a chance yet, I would strongly encourage you to check out my new podcast series, Model Citizens, which I created in collaboration with FairPlay.

In the series, Kareem Saleh (Founder and CEO of FairPlay) and I explore how AI, lending, and compliance are crashing together and what those collisions should mean for banks’ and fintech companies’ strategies.

All six episodes are now available (1, 2, 3, 4, 5, 6), and, to paraphrase one of my all-time favorite TV shows, if you have half as much fun listening to the podcast as we had recording it, well, then we'll have had twice as much fun recording the podcast as you've had listening to it.

- Alex

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BaaS, Vertical SaaS, and StablecoinsCopy anchor linkCopied

It feels like I wrote this essay on banking-as-a-service (BaaS) one million years ago. However, in reality, it was only three years ago, and, obviously, a whole lot has happened in BaaS since then.

The relevant bit that I want to focus on today is the section on BaaS middleware platforms. 

Here’s how I defined BaaS middleware platforms in the essay:

[BaaS platforms] provide the technical, operational, and legal middleware between banks wanting to offer BaaS and fintech companies that need to find and integrate a bank partner (or partners).

For fintech companies, these platforms match them up with the bank partners that will best fit their vision and reduce their time to market and upfront and ongoing expenses by orders of magnitude. 

For banks, these platforms match them up with the fintech companies that best fit their target risk/return profile and significantly streamline the process of evaluating, onboarding, and supporting those fintech partners.

In exchange for these benefits, BaaS platforms take a cut of the revenue generated by the partnerships they facilitate.

Now, to be fair to me, that overview, as a definition, actually holds up pretty well!

However, if we dig into it a bit further, it becomes clear that my 2022-era analysis of the BaaS middleware market is out of date. And it’s not just the logos in the graphic, many of which — Technisys, Productfy, Synapse, Bond, Solid, Rize — have been either acquired or shut down.

No, it’s the market itself. It has changed. And it has put all the remaining BaaS middleware platforms (along with new ones that have entered the market since 2022) in a challenging spot.

Regulatory ScrutinyCopy anchor linkCopied

One of the main themes in fintech over the last couple of years has been a significant increase in regulatory scrutiny applied to BaaS. Regulators expressed their concerns, as they often do, through enforcement actions, which focused on specific issues with BaaS arrangements, including third-party risk management, AML/BSA compliance, and the day-to-day oversight of fintech partners. Examples include OCC and FDIC consent orders at BaaS banks, such as Blue Ridge, Sutton, and Thread Bank, as well as the Federal Reserve’s eventual enforcement action against Evolve Bank & Trust.

In the wake of the Synapse catastrophe, regulators (understandably) began to express concerns about the role that BaaS middleware platforms play in bank-fintech partnerships and the additional risks those platforms might introduce. 

Many of these risks were seen to stem from the potential of these platforms to disintermediate the banks from their fintech partners. Historically, this disintermediation had been positioned as a benefit by many BaaS middleware platforms (often referred to as “program management”), which understood how uninterested banks and fintech startups were in working together directly to manage the operational and compliance work generated by their partnerships.  

In an RFI put about by the OCC, Federal Reserve, and FDIC, the agencies specifically asked about these “intermediate platforms” and the risks posed by program management:

Describe the range of practices regarding the use of an intermediate platform provider. Describe how the use of an intermediate platform provider may amplify or mitigate risk, and to what extent, if any, intermediate platform providers influence how banks handle operational, compliance, or other issues when dealing with fintech companies within the intermediate platform provider’s network.

And in their responses to the RFI, both banks and fintech companies sought to distance themselves from the intermediate platforms, instead emphasizing the importance of “direct” relationships.

Here’s Chime:

Complexity … makes it more difficult to clearly allocate responsibilities and to have open lines of communication. Where, for example, a bank-fintech relationship involves multiple intermediaries, operational and other risks are necessarily heightened. A bank may be unable to effectively oversee other parties in the relationship, especially if the bank does not have a direct, contractual relationship with one or more of those parties. A fintech may also have no ability to monitor the bank with which it is working. Moreover, if a bank lacks a contractual relationship with either the consumer or the platform that interfaces with the consumer, the bank must rely on intermediaries to implement effective consumer protection.

And here’s The Bancorp:

With respect to the various bank-fintech arrangements noted in the RFI, the Bank views the direct partnership model between the bank and fintech as the most effective in assuring the bank’s fulfillment of its risk management, compliance and safety and soundness obligations (as opposed to bank-fintech arrangements established and managed through an intermediary or “middleware” platform provider).

Under the direct partnership model, the bank and fintech are collaborative partners, with the bank having the critical advantage of a direct “line-of-sight” into both the fintech itself and the underlying fintech program. This level of visibility is absolutely essential, given that in most bank fintech relationships, the bank issues the fintech product, and the fintech in turn provides services in connection with the product on the bank’s behalf.

In response to this regulatory pressure, BaaS middleware platforms have taken one of two different paths.

Two Paths ForwardCopy anchor linkCopied

The first path is what I’ll describe as “We’re just a tech vendor for banks.”

Treasury Prime is a great example. The company has always positioned itself as a technology platform for banks. However, previously, it would also assist banks in acquiring and contracting with fintech partners. Last year, the company announced that it would fully transition out of that business development role and focus exclusively on being a tech service provider (emphasis mine):

Treasury Prime is a “Banking as a Service” operating system that provides modern banking software so that fintechs or corporate clients can directly connect to the underlying infrastructure of banks through its APIs, and banks can distribute their products through fintechs or embed them in apps and other new channels.

Treasury Prime will continue to provide dedicated support for all parties on its BaaS operating system. Going forward, however, it will focus its sales efforts and software development to enable banks to directly sell and serve fintechs and other embedded banking brands.

This bank-direct approach reflects two major developments as the fintech marketplace has matured. First, banks have expanded their own, in-house business development capabilities and are looking for a BaaS operating system that can enhance their ability to sign up, manage, and support those clients. Meanwhile, regulators are calling for more rigorous oversight and compliance, and have made it clear that banking institutions – not intermediaries – are best positioned to manage the fintech customer relationship.

The second path I would describe as, “We’re an embedded finance platform for non-finance brands.”   

Unit is the prime example here. Instead of running away from its role as a program manager, it has embraced it, arguing that the operational support that it provides, when combined with highly standardized processes and product templates, can be a safe approach to BaaS, especially for non-finance brands (similar to how co-brand credit cards have historically been implemented).

Here’s an excerpt from Unit’s comment letter to the regulatory agencies (emphasis mine): 

Over the last several years, a significant number of new digital infrastructure providers, like Unit, have emerged to help banks better manage their bank-fintech arrangements. We recommend considering how digital infrastructure solutions can strengthen and make more efficient the bank’s oversight of its service providers. By centralizing important end customer and program information, utilizing consistent processes and tooling, and reducing the number and permutations of third and fourth parties used by the bank, digital Infrastructure companies can reduce the total “surface area” of responsibilities requiring oversight and enable a bank to better focus its oversight efforts.

More recently, Unit has doubled down on this approach:

Today we’re making Unit's biggest announcement to date: ready-to-launch solutions.

They help software companies offer a full money dashboard to their customers: capital, banking and bill pay.

We’ve built ready-to-launch to make it the simplest to launch + succeed in embedded finance:

- Build: 1 line of code expands into a full money dashboard for your customers - capital, banking and bill pay. You can start with just ONE of these.

- Operate: fully managed customer support.

- Profit: revenue share + no exposure to fraud losses.

- Succeed: marketing materials that drive adoption, including automatic emails + hosted content.

WHY?

There are 36m+ small businesses in the US. For them, money boils down to 4 tasks: (1) get capital (2) get paid (3) manage my money (4) pay others. That’s all they need - ideally simply, and in one place.

The THEORY of embedded finance: software companies are in the perfect position to solve this. They already do (2) - accepting payments - so why not expand to the other 3 tasks and become the all-in-one money dashboard?

The REALITY is usually messy. Software companies aren’t experts in building money solutions. Building strong, secure and responsive UX is a multi-year commitment, even with great infrastructure. Building support + fraud is hard and expensive. It takes time to drive adoption with the right marketing and terms. Thinking about a new product, like capital? It’s a whole new journey.

Ready-to-launch is now a new implementation path, alongside our “custom build” path.

The feedback from customers that chose it teaches us that we’re entering a new era in embedded finance.

What Unit is arguing here is that there is a growing number of vertical SaaS companies that have built “operating systems” for small businesses in different industries, and these vertical OS platforms are the ideal distribution channel for embedded payments, banking, and lending products.

The crucial point here is that these vertical SaaS companies don’t have the same incentives fintech companies have to build highly customized financial products (because they are differentiating themselves through their core software products) or to own as much of the unit economics as possible (because embedded finance is an add-on to the core business).

Thus, Unit’s approach is to bundle standardized embedded finance product constructs (banking, bill pay, capital) with full program management and customer support. Essentially, embedded finance in a box.

Competitive PressureCopy anchor linkCopied

The two paths described above are both theoretically sound.

The challenge is that we are seeing a significant increase in competition for BaaS middleware platforms, converging from multiple directions.

Embedded Finance Infrastructure 

Unit is astute in noting the growing opportunity that vertical SaaS creates for B2B embedded finance infrastructure. The problem is that they are not the only ones who have noticed.

Matt Brown, an investor at Matrix and (for my money) the best analyst of embedded finance and vertical SaaS, writes:

Platforms with embedded financial services play a critical role in acquiring users and customizing both financial and non-financial products for their specific customers. But financial products come with onerous regulatory, compliance, risk, and capital requirements. Those requirements are why these platforms rely on a rising number of embedded fintech vendors (EFV) to embed and monetize financial products.

EFVs serve as a critical abstraction layer between software platforms and financial infrastructure providers like sponsor banks, card issuers, and lenders. Those providers don’t have the technical chops or embedded expertise to support fast-moving software platforms, and the individual platforms are unlikely to have the scale or expertise to work directly with a financial infra provider.

EFVs meet the challenge of making financial infrastructure easy to embed, customize, and use across diverse platforms and use cases. Their success depends on mastering both the financial primitives they're built on and the unique requirements of each vertical market they serve. Most importantly, they need to deliver an exceptional experience both for the developers who integrate their solutions and for the end users who interact with them. 

Interestingly, many of the companies in this space (such as Stripe, Pipe, and Fundbox) have pivoted (fully or partially) into the embedded finance infrastructure space, rather than competing directly with vertical SaaS companies to serve small businesses.

And, as Matt notes in his explainer, the embedded finance infrastructure market does not appear to be a winner-take-most market, nor a market that exclusively wants highly-configured, out-of-the-box offers:

Although embedded fintech vendors (EFV) is a broad and fast-moving model, there are a few noticeable trends. EFVs are supporting a broader sliding scale of integration options, from fully built-out white-label components to raw APIs and platform ownership of critical functions like risk and underwriting.

Many platforms are launching multiple embedded products and want the ability to pick and choose the best vendors for different functions like payments and lending. This development is leading EFVs to be more composable and interoperable — witness the integration of Rainforest with Unit. Many scaled EFVs are themselves going multi-product in an attempt to capture multiple financial use cases.

In this market, Unit is just one of many providers, as Matt’s graphic helpfully illustrates:

And even in its core area of competitive strength (embedded banking), it’s not clear that Unit will be the best-in-class provider.

BaaS Warp Cores

“BaaS Warp Core” is my term of art for a bank that was (re)built from the ground up for developers. Here’s a slightly more detailed explanation:

A BaaS Warp Core is the best of both worlds — a world-class technology platform that delivers an exceptional developer experience, built directly on top of a community bank charter and balance sheet.

BaaS Warp Cores are appealing because, like the engines of the USS Enterprise, they allow fintech companies to move fast. 

This is especially appealing to the largest and most sophisticated fintech companies in the market. At these companies, the decision on which BaaS providers to work is made by the engineering teams. These teams want to work with BaaS providers that can match their engineering velocity, and that will expend the necessary resources to implement exactly what they want (these fintech companies don’t pick off of a menu, they expect custom implementations). They look for technical credibility, above all else, which is an advantage that these well-known executives from Stripe, Plaid, and Square lean on heavily to help their companies win business. 

To be blunt, the success of BaaS middleware platforms has only been possible because the vast majority of BaaS banks (which are, predominantly, community banks) have antiquated technology that is anathema to fintech developers.

By contrast, BaaS Warp Cores, such as Column and Lead Bank, have modern, built-for-purpose technology that is irresistibly attractive to fintech developers.

The problem for BaaS middleware providers — both those, like Treasury Prime, that focus on empowering banks and those, like Unit, that focus on embedded finance — is that we are likely to see more BaaS Warp Cores come online over the next four years. 

Trump-appointed banking regulators have signaled an openness to both granting new bank charters (the OCC has received considerable interest in the last six months) and allowing non-bank individuals and companies to acquire existing banks.

And tech entrepreneurs are starting to do just that.

Darragh Buckley, CEO of BaaS middleware platform Increase, has purchased a large share of Twin City Bank (a small community bank in Washington). While he has publicly stated that he has no intention to move the bank into BaaS, it’s reasonable to assume that might change in the future (as some of his competitors in the BaaS space apparently fear … read this very weird TechCrunch story for more details.)

Palmer Luckey, co-founder of Anduril, has started a digital bank — Erebor — focused on serving the innovation economy (stepping into the void that he believes SVB’s failure created). The company has applied for a national bank charter from the OCC, and it is reportedly very confident that the charter will be granted quickly, thanks to Luckey’s extensive political connections. And while I haven’t seen any specific information to suggest that Erebor will get into the BaaS/embedded finance infrastructure space, it wouldn’t be a huge leap.

Bottom line — banks, which were once an important but relatively commoditized supplier for BaaS middleware platforms, are becoming more formidable direct competitors to BaaS middleware platforms.      

Stablecoins

And it’s not just banks!

As I have written previously, it seems likely that one of the primary uses of stablecoins in a post-GENIUS Act world will be as infrastructure for fintech developers.

To avoid quoting myself excessively, here’s Chuck Okpalugo over at This Week in Fintech, writing about Stripe’s attempt to bring BaaS “on-chain”: 

Stripe’s emerging “Bank in a Box” stack: one built not on traditional bank custody, but on non-custodial crypto rails.

Here’s the shift: In traditional fintech, holding customer balances (fiat or crypto) requires sponsor banks, custodians or you have to take custody yourself. With non-custodial wallets, platforms can avoid legally holding customer funds, and sidestep complex licensing and banking integrations.

This effectively enables a powerful model of Regulatory Arbitrage as a Service:

• • Bridge provides compliant fiat on/off ramps for customers from 100+ countries (via Lead Bank)
  • Privy enables embedded self-custody wallets
  • All through a Stripe-grade developer experience

This is “Banking as a Service” reimagined, built for global scale, with no dependency on holding funds or bank partnerships and therefore no Synapse-style bankruptcy risk. Just programmable, permissionless financial infrastructure.  

I think this is exactly the right reading of Stripe’s strategic intentions, which is important because Stripe is already a major provider of traditional BaaS and embedded finance infrastructure. 

The company clearly sees potential in stablecoins as infrastructure (it was recently reported that Stripe is working on its own L1), and executives at competing BaaS middleware providers have (in the past, at least) expressed doubts about stablecoins:   

It’ll be interesting to see who turns out to be right and just how disruptive stablecoins ultimately prove to be in BaaS and embedded finance.

You can bet that the BaaS middleware providers who are left will be watching closely.

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MORE QUESTIONS TO PONDER TOGETHER

Big news for the endlessly curious (yes, you): I’m collecting your fintech questions on a rolling basis. 

What’s keeping you up at night? What great mysteries in financial services beg to be unraveled? Think of it this way, if a stranger is a friend you just haven't met yet, your question is a Fintech Takes conversation waiting to happen. 

One that could headline a Friday newsletter or be answered in an upcoming Fintech Office Hours event.

Drop your question here, whenever inspiration strikes!

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INPUT REQUESTED!

I’m working with Dilly Labs and the wise and powerful Tom Johnson on a little research project and I am looking for folks who work at a consumer lending company (bank, credit union, non-bank lenders, etc.) and who have experience buying/implementing/working with credit decision engines to fill out a quick survey.

Credit Decision Engine Vendor Survey

I promise it won’t take long! And it will be extremely helpful! So …

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Thanks for the read! Let me know what you thought by replying back to this email.

— Alex