Banks, middlewares and Unit: making sense of banking infrastructure
February 23, 2021
In the process of designing and building Unit, we’ve met over 100 companies that have offered or are looking to offer financial features to their end-customers: accounts, cards, payments, lending and more.
If you’re a founder or executive who knows what financial features would serve your end-customers best, but aren’t sure where to start, this post is for you. We’ll explain three very different options you can choose from and how they affect your company’s time-to-market, budget and areas of responsibility. Our goal is to help you make sense of banking infrastructure and understand the various approaches.
To explain the problem, let’s use an example. Say you are the CEO at Freelance Genius, a company that serves 15,000 freelancers who make $50–80k / year. After deep research, you’ve built a financial feature roadmap to boost your monetization and deliver a radically better experience. This roadmap includes high-interest checking accounts (FDIC insured), automatic tax deductions, debit cards with neat loyalty programs, payments and smart financing in the form of cash advance. The end game in 2022 is a full banking experience:
How do you go about building all of this? It should be simple, but it’s really not. Overall, you’ll have to choose between three very different options. Before we elaborate on each of them, here is a high level overview:
Finding a bank relationship: harder than you think
As you can see, options 1 and 2 involve finding a sponsor bank. Let’s explain this critical first step.
There are more than 4,500 banks in the US, and 30–40 of them have made themselves a name by partnering with tech companies. For several reasons, these banks tend to be smaller institutions (think <500 employees and <$10b in deposits). They would refer to Freelance Genius as a program manager. Program managers are simply companies that the bank certifies to be white-label distributors of the bank’s services (accounts, cards, payments, lending etc.).
Being able to find the right sponsor bank is harder than you think. Banks differ in critical areas that tech companies simply aren’t educated enough to know to ask about. Here are some important examples:
Terms: it’ll take you about five weeks of conversations to discover that most banks will offer you a flat 0% interest on accounts, even if the current fed rate is at 1%+.
Product limitations: most banks don’t support business accounts, and some of your end-customers at Freelance Genius will need them, because they’re incorporated. Another example is that most banks won’t look at lending or cash advance products – they’d rather use every dollar of deposits towards mortgages and other regional lending activities.
Compliance: the bank’s business development people aren’t qualified to tell you what set of personal data and documents you’ll need to ask your end-customers to provide when they open an account. It’s only the bank’s compliance team that would inspect your plan months after you’ve signed and (very likely) tell you that you need to ask for extra heavy documentation, causing you to pay a “conversion tax” that you wouldn’t have to pay with other banks. You won’t know until it’s too late.
You’ll likely need to talk to at least 10 banks before you identify one or two good candidates (at Unit, we’ve met precisely 50 banks before making our decisions). Now let’s try to explain what goes into building on top of a bank.
Option 1: Bank (example: Bancorp)
To become a program manager on top of any bank, you’ll have to master and build on two very demanding fronts: tech and compliance. Let’s break it all down.
Becoming a program manager: investment in tech
Your team set out to reinvent banking for 15k end-customers. Those end-customers grew to expect a lot from Freelance Genius over the years. But you’ll soon discover that your partner bank’s core systems were likely built before you were born. How do you go about building modern experiences on top of them?
Well, you don’t. In 98% of the cases, your partner bank will not grant you API access to those systems. Rather, the bank will create one account on its systems, called an FBO account, where all your end-customer deposits will sit as one bulk deposit. FBO stands for “For Benefit Of” Freelance Genius’s end-customers. It’s one account, but legally, the “real owners” or beneficiaries of the funds are your end-customers. FBO accounts are essentially a hack that became very prevalent in fintech to work around the limitations of the bank’s existing systems. This hack is the root of most of the problems you’ll encounter in the next five years.
FBO accounts are external to the bank’s operations, so they create a painful domino effect that puts the entire burden of tech on your engineering team. It’s on you to:
Maintain ledgers that keep track of individual end-user balances
Generate statements that comply with applicable rules and regulations
Build and integrate multiple KYC, KYB and fraud prevention solutions
Build a whole security stack to protect against data leaks and malicious activity (e.g. second factor authentication when end-customers send large amounts of funds)
Implement extremely strict data policies (e.g. PII encryption or PCI compliance)
Build layers of reporting and data access
You will also have to implement every aspect of money movement and reconciliation:
Card issuing, processing and exception management (e.g. dispute handling)
Connectivity to the payment networks (e.g. ACH, Fedwire, checks, bill pay)
Interest calculation and deployment
Support for diverse account terms and fees
In addition to the above, you’ll have to monitor your own ledgers against the FBO account to ensure that balances and transactions are reconciled and matched perfectly.
If you read the above lists carefully, you’ll realize that you (and every other program manager) are essentially building a full banking stack on top of your partner bank. Perfecting these processes requires specialized engineering, product and business talent and takes up to 18 months. Errors can cost your company millions.
But tech is not the only area you will need to invest in.
Becoming a program manager: investment in compliance
For program managers, compliance is a much bigger investment than tech. Most tech founders are shocked by the amount of compliance work and compliance knowledge that goes into becoming a program manager. Chances are that you will be too. And we don’t blame you.
In most cases, you will be required to hire a CCO (Chief Compliance Officer) before signing even a non-binding term sheet with the bank. CCOs are in extremely high demand. Your CCO will have to draft 15–20 policies and present them to the bank, including:
Compliance Management System: governing your entire book of policies
Customer Identification Program (CIP): describing data points, documents, tools and processes you use to verify the identity of end customers and protect against fraud. The answers vary greatly if you happen to serve individuals vs. businesses as end-users
Anti-Money-Laundering Policy (AML): describing all tools and processes you use to identify, mitigate and report money laundering and financial crimes
Complaint Management Policy: describing all tools and processes you use to take end-customer complaints (e.g. unauthorized activity in the account), investigate those complaints, issue credit and provide timely responses within the strict regulatory timelines set by Reg E
Information Security Policy: classifying all the information in your organization and ensuring strong controls.
Third Party Risk Management Policy: classifying all your vendors into low/medium/high risk and requiring many of them to provide audits to you.
This is a very partial list. Your policies will likely add up to 200–400 pages. Each one of them will have to be operationalized through written procedures. Banks will ask to see and approve the actual written procedures before you’re able to launch. The process typically takes 4–6 months.
As a program manager, your investment in compliance never stops. Over time, you’ll need to:
Build a compliance team. Even if your CCO comes with 15+ years of relevant experience, you will be required to hire a BSA/AML Officer who is qualified to manually investigate and make decisions around account openings and transactions. A compliance team will be required whether banking is your main business or a secondary business line.
Perform dozens of regular compliance activities. You will have to continuously build and submit audits, data and policies to the bank for review and approval.
Build and maintain tech to satisfy the bank’s compliance requirements. Including regular reports required to maintain FDIC coverage, internal decisioning tools & more.
Find, implement and pay for third party tools. The average program manager has to find, implement and connect 5–10 vendors to satisfy compliance requirements in many areas, including KYC, audits, third party oversight, fraud and financial crime prevention.
Mastering compliance could easily overwhelm you.
Option 1: the bottom line
As we explained, tech and compliance are the two continuously demanding and expensive fronts when working with banks.
Outside the “hard costs” of tech and compliance, you’ll need to consider expenses like legal costs ($80k+ for policy drafting and $100k+ for contracts with the bank and all other vendors), bank setup and minimums ($550–850k over 3–5 years) and insurance (5 types of coverage that add up to $30k+ / year).
The costs add up really quickly between engineering headcount, compliance headcount, bank minimums, third party tools and legal work. When building directly on top of a bank, Freelance Genius’s bottom line is:
15–18 months and ~$2.1m to launch
~$2.5m / year from launch
Option 2: Bank + middleware (example: MetaBank + Galileo)
In the last 5–10 years, banks started working with middleware solutions to assist companies like you. Many of those solutions (e.g. Galileo, i2c) were built 20+ years ago as card processors. Others are more recent additions.
Middlewares typically help program managers reduce about 40% of the tech investment. It’s a step in the right direction, but almost all companies that choose this option claim that it’s not nearly enough. Here are the problems that tech companies consistently face when choosing the option of bank + middleware:
Middlewares don’t help with the most demanding and expensive fronts: bank relationships and compliance. It’s still your job to find a bank, work directly with it and manage everything with regards to compliance.
Middlewares are another expensive vendor on your list: we explained why working directly with a bank (option 1) easily gets you to ~12 vendor relationships. Middleware vendors are a complex and expensive addition to that vendor list. Middleware companies will hand you 50–100 page contracts, aim for 3–5 year terms and introduce monthly minimums that often exceed $30k.
You still end up investing heavily in tech. A 40% reduction means you’re still left with product and engineering work that costs $1m+.
When building on bank + middleware, Freelance Genius’s bottom line is:
9–12 months and ~$1.2m to launch
~$2.1m / year from launch
Option 3: Platform (example: Unit)
Unit represents a new generation of infrastructure: platforms. Platforms are designed to be the one tool that tech companies like Freelance Genius need in order to bring their financial feature roadmap to life. Another player in this category is Synapse.
It’s easy to compare the value of platforms to the value that Stripe brought to an entirely different space (payments acceptance). They act as program managers, absorb the most demanding fronts and offer Freelance Genius a radically better experience. Let’s look at how platforms solve for the key fronts:
Tech: the promise of platforms is that Freelance Genius would focus on building its unique user interface rather than the underlying plumbing. Unit, for example, provides you with modern docs, sandbox and dashboard access in minutes. We require one API call to approve an end-customer, whether they’re an individual or a business. We offer full programmatic access to all the concepts that matter: accounts, terms, transactions, payments and statements- along with every piece of relevant data. We handle fraud prevention, security, permissions, reconciliation and data protection in the background.
Compliance: platforms typically absorb the complexity and day-to-day work associated with compliance. Unit would allow Freelance Genius to operate a fully compliant product, but without dedicated compliance hires and with only a fraction of the compliance requirements that banks typically make. Our compliance team has the expertise and tools to handle manual account approvals, investigate suspicious activity as required by law, examine end-customer complaints and perform dozens of day-to-day activities as required by our partner banks.
Bank relationships: platforms have the bank relationship built into them. As Freelance Genius, you don’t have to start the process by shopping for a partner bank. Building on Unit means that you tap into our set of banking relationships, but without the need to work directly with them. Unit’s product is designed to give you access to multiple banks when needed, so you can easily expand into activities like cash advance or offer credit cards. As Freelance Genius grows to bank 100k end-customers, you may have reasons to split the deposits or activities across 2–3 banks, and Unit is designed to do this easily and without changes from your side.
We explained how the right platform can eliminate 90–95% of the enormous complexity and costs that Freelance Genius would face compared to working directly with a bank (option 1) or a bank + middleware (option 2). Is there a catch?
Possibly. While platforms are an enormous step forward for companies like Freelance Genius, they are a critical vendor that must be chosen carefully. Here are the areas you need to get right:
Tech: platforms are the ultimate single point of failure. If they rely on other vendors or bank systems, they are only as strong as their weakest vendor. We recommend vetting your platform’s technical leadership and making sure that its API design, availability and security are extremely well thought out. Unit recognizes the importance of these topics and openly shares its architecture, certifications, design choices and business continuity plans with its bank partners and clients.
Compliance: the experience and quality of the platform’s compliance team is critical. They will provide important guidance on the nuances of your financial features and help you reduce end-customer friction while staying fully compliant. As an important link between you and the banks, they play an important role in the stability of your own business.
Customer service: by offering financial services, you’re getting into a sensitive business. The platform’s customer service team is an important link between you, the underlying banks and the payment networks. Choosing right will ensure that your company- and your end-customers- never have to wait long for answers around the sensitive topic of money, whether they have simple questions or sensitive complaints.
Terms: as a link between you and the underlying bank, platforms create a longer “supply chain”. You will pay for transactions (e.g. ACH) as well as get paid (e.g. card interchange and interest) and there’s always the risk that platforms will make you overpay. Unit set out to give you a radically more affordable entry point (low minimums) while keeping your revenue potential high (high card interchange). However, many platforms have bad deals with their partner banks that would leave you with much less lucrative economics.
Flexibility: the nuances of your financial features will change over time, as you learn more about your end-customers. Unit, for example, lets you offer slightly different terms to different groups of end-customers, set custom rules for interchange or approve card spend in real-time. We recommend making sure that your platform gives you this level of flexibility so you can offer more products, and a smarter experience, over time.
Banks: when explaining the process of partner bank selection, we explained how banks differ around terms, product limitations and compliance. Banks are an important part of the equation even if you’re working with a platform. It’s very important to make sure that your platform has a strong and sustainable relationship with its underlying banks, that those banks have a good reputation and that their limitations don’t affect you. In particular, we recommend watching out for terms and culture that affect you and your end-customers.
When building on a platform, Freelance Genius’s bottom line is:
4–6 weeks and less than $50k to launch
Less than $50k / year from launch
Banking infrastructure is hard to navigate, and we hope that this post helped you make sense of the high level options that others have chosen:
Bank + middleware
We explained the heavy lifting and costs that go into the first two options: managing a bank relationship, investing in tech and investing in compliance. Platforms like Unit represent a modern and radically simplified option that removes 90–95% of the complexity. At the same time, it’s important to be thoughtful about comparing platforms and choosing the right one.