#49 Virtual Accounts

Thoughts around Virtual Accounts and how they can power B2B Fintechs and Corporate Banking

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Introduction

The topic of virtual accounts has piqued my interest in the last couple of months and I’ve found myself in a rabbit hole trying to figure them out. Once largely figured out, the next question that immediately popped into my head was; “why aren’t they more widespread” at least in Africa. The use cases are seemingly endless and they solve a number of problems which to date have been bothersome to individuals and businesses alike. For the latter, businesses of all sizes can seemingly benefit from Virtual Account infrastructure. 

To begin with, it’s critical to define what virtual accounts are, their origins and how they are gaining traction. Virtual accounts are simply digital portions of a physical bank account. Virtual account infrastructure enables the creation of discrete digital sub-ledgers within your physical account that have the properties of a physical account, particularly the ability to record debits and credits as well as opening and closing balances. They are an information management framework within traditional accounts that enable data within the main account to be better organised. In practice, a physical account (think a normal bank account) is broken down into digital sub-ledgers. These sub-ledgers in turn have the ability to report an opening and closing balance and all aggregate to the balance of the physical account. This is all managed through software.

In essence, it’s a bit like what software has done to database technology. Modern software enables the provision of database capacity by virtualising storage and space. The same concept applies to physical accounts and is the idea behind virtualization of accounts.

Virtual accounts trace their origins to Asia and Europe and have traditionally been geared towards large multinational corporations with complex operations across multiple countries. Typically large company treasury departments have to maintain numerous demand deposit accounts, often across multiple banks. This is necessitated by the sheer complexity of commercial operations and the compounded complexity of managing many businesses within one account. For instance, a company can have different subsidiaries and business units. All these business units have their own bank accounts and the group entity’s treasury department manages group cash through bank transactions that pool cash within a few concentrated accounts.

Of course, managing group cash through this mechanism creates its own issues around reconciliation, costs and delays. This necessitates complex workflows and procedures to manage both cash and the associated risks. To make this clear, imagine an FMCG company called Kwaku Foods with operations in four countries and three business lines within each market; soft drinks, snacks and cooking oil for example. This means that in each market it may have to maintain at least 4 accounts, one for each business line and one for the subsidiary. In three markets, this will translate into 16 accounts, 4 in each market. Of course this is a generalisation. Managing 16 accounts across four different countries will have complications such as; different banks with different reporting capabilities, different internet banking platforms, potentially different closing hours and of course different currencies.

At a group level, you can clearly see how reconciliation problems at one subsidiary can compound into problems at group level. Not only is this framework expensive in terms of the costs of maintaining these accounts, it’s also cumbersome due to the issues reported above. One potential outcome is working capital problems as cash does not get to where it’s needed on time. 

Virtual accounts in this case can be introduced to solve a number of challenges. You could, for instance, open one physical account in each country and create a two-tier virtualisation architecture. The first layer of virtualisation would consider the business units and thus each unit would have its own virtual account identifier. The second layer could be created to enable each distributor to have his own unique identifier, thus when a payment is received from a specific distributor, it is recorded in a specific sub-ledger associated with that distributor. This way the entity can track receipts per product line and per distributor. This then enables accurate reconciliation and tracking of receivables.

What is more, some global banks are able to attach “clearing-recognised” account numbers to each virtual account. This means that instead of giving a distributor a reference number, Kwaku Foods can give their distributors an account number that works with existing rails but is actually attached to a virtual account. With this framework, the distributor does not have to include a unique reference number when making a payment. In essence, it doesn’t interrupt the distributor's existing payment processes. 

Virtual accounts thus confer the following advantages;

1. Reduction in accounts - a company doesn’t have to maintain multiple accounts leading to lower account maintenance costs. In essence, even a multi-country operation can maintain a single account with a virtual account hierarchy that handles subsidiaries, operating units and even large clients;

2. Reconciliation - One of the biggest advantages of virtual accounts is reconciliation as this is the bane of most CFOs in the corporate world. VA’s reduce unapplied cash and the number of open invoices;

3. Cash flow management - VA’s help CFOs or treasurers to centralise cash and allocate cash to where it’s needed the most thus improving group liquidity. In some instances, this can obviate the need for working capital facilities across subsidiaries;

4. Reporting - A well implemented VA framework can significantly improve financial reporting as balances can be tracked at an extremely granular level. This can further be designed in such a way that ERP integrations enable the matching of virtual accounts to actual accounting ledgers. For instance, cash and cash equivalents in the balance sheet can be broken down to a granular level through VAs;

5. On-Behalf of Structures - Virtual Accounts enable companies to manage On-Behalf of structures such as Payments on Behalf of (POBO) and Collections on Behalf Of (COBO). Simply, Virtual accounts are useful for both payables and receivables management. A group CFO can make payments on behalf of a business unit from a centralised demand deposit account. 

This article by Modern Treasury as well as this one by JP Morgan are decent primers on Virtual Accounts. Deloitte have also done a pretty good job at defining Virtual Accounts. 

Use Cases

Plenty of use-cases pop up for virtual accounts and specifically for a VA architecture;

In-House Banking

A virtual account infrastructure can enable a large corporation to provide In-House Banking (IHB) capabilities to its subsidiaries and business units. In Africa, an In-House Bank can provide the following services;

1. Centralised liquidity services;

2. Centralised FX management;

3. Centralised funding; &

4. Working capital management through both payables and receivables management;

Essentially, through a VA framework, a company can offer “banking” services to group units. For instance, through a payment factory (managed by a Payments on Behalf Of framework) can enable subsidiaries to make all their payments internally through an IHB structure created by the group.

The diagram below illustrates the functions of the IHB

Source: Goldman Sachs

Large corporations such as Dangote Group, SAB Miller in Africa, Lafarge, MTN, Vodacom and Massmart for instance have ample liquidity. However, in most instances, this liquidity is uneven across operating subsidiaries in the continent or even within specific regions. An IHB framework can then enable working capital provision to group companies where liquidity is pooled and opco’s that are short of cash borrow from the group at subsidised rates. Of course, companies with excess liquidity can benefit from a pool rate although this is at the discretion of group treasury policies. This is managed through a virtual accounting infrastructure with discrete sub-ledgers created for various accounting requirements such as accrued interest, interest payable and inter-company balances.

Marketplaces

Marketplaces, especially B2B marketplaces can benefit greatly from Virtual Accounts. A B2B marketplace brings about three participants, sellers, buyers and the marketplace provider. To succeed as a marketplace, it is expected that you should sit in between the flow of funds as this makes it easier to monetise and harder to get cut-off from the transaction. Payment operations thus become a critical element of a marketplace. 

Within a B2B marketplace, you should be able to provide the following core services;

1. A payments capability enabling both payments and collections;

2. Ledger services that enable escrow, store of value products or lending

A virtual account framework can enable all the above with a hierarchy created by the marketplace provider that enables POBO and COBO as well as balances. Companies such as Modern Treasury are helping marketplaces build their financial infrastructure. In Africa, companies such as Monnify provide such services. I’m also aware of a number of API fintechs that are building out these capabilities with launches expected soon. The marketplace provider just needs to connect to an API service that offers these capabilities; think Shopify and Stripe.

Budgeting Tools for SMEs and Solopreneurs

SME’s and Solo-preneurs or Gig Workers typically don’t have the resources to invest in accounting tools or even accounting staff. They therefore struggle with managing their books and keeping track of their spending. Virtual accounts can play a useful role in the provision of a holistic banking experience for these groups. Ultimately VA’s are discrete sub-ledgers. You can therefore imagine a bank or a neo-bank providing a physical account as well as the capabilities that can enable a small business owner to define his/her own VA hierarchy. These can then be augmented by the VA provider through a comprehensive VA capability. What this means is that, an SME can define sub-ledgers for different expenses as well as different revenue streams and thus manage his accounts solely through the bank account.

Tax expenses can be paid from the tax virtual account similarly to payroll being paid through a specific payroll VA. This can form the basis of a very useful financial service offering. You can imagine for instance, a bank offering the basic VA infrastructure even with “clearing identifiable” VAs. A Fintech company can then offer the front-end capabilities for accessing your accounts and orchestrating the VAs i.e. spinning up or shutting down VAs. The Fintech can then go further to integrate a service such as quickbooks that links these VAs to actual ledgers. An SME can then manage their business from a single app and a single bank account.

Of course, the VA architecture can scale with the business as the difference between an SME and a large corporate will simply be the hierarchy of VAs.

Property Management and Law Firms

Typically, Property Management Firms as well as Law-Firms manage complex payment operations as well as store-of value services. Property management firms, for instance, manage collections across numerous properties as well as numerous landlords. This can benefit from a VA hierarchy defined across numerous categories; landlord, property, unit and type of inflow be it rent or downpayment. 

A property management company can thus give visibility to tenants and landlords to rent collections as well as the balance on the lease down-payment. A VA architecture can then enable a property management firm to scale operations whilst maintaining a low cost base. This is particularly useful as Africa urbanises and the number of urban renters increases especially given the demographics of the continent where median ages hover at 19 and 20. This means that this will be a growing market with an increase in collections. Proptech start-ups would benefit the most from this and can actually become marketplaces starting with rentals and growing into property sales.

Of course for law-firms, this could be useful as an escrow mechanism for mediating transactions with improved visibility and reporting.

What Needs to be Done

A virtual account infrastructure needs two core ingredients, on one hand a bank that has Virtual Account Infrastructure either enabled directly at the Core Banking System level or through a middleware service as well as an orchestration layer. This orchestration layer defines the architecture and rules for the virtual account service enabling companies and individuals to build out hierarchies that work for them.

The bank is meant to provide tech as well as regulatory and legal air cover for its clients. In clearly regulated markets such as Europe and parts of Asia, the regulatory clarity is a defining reason for why Virtual Accounts have taken off in these markets. From the technology perspective, Virtual accounts need to be viewed by banks as part of a comprehensive BaaS proposition. Globally, Goldman Sachs is a clear leader in this space with ambitions of offering a world class BaaS service across North America and Europe. A defining feature of Goldman’s success in this field has been their ability to approach BaaS from first principles aided by a smaller global corporate banking service vis-a-vis the likes of JP Morgan and Citi. This first principles based approach has led them to the following key product principles;

1. The platform needs to be truly cloud native;

2. There needs to be one set of ledgers;

3. A single payments gateway;

4. A laser like focus on APIs and continuously improving them

These capabilities have enabled Goldman Sachs to offer a single API that covers KYC, money movement, ledgers, foreign exchange and regulatory guidance across Europe and North America. Additionally, a bank requires a big balance sheet to pull off a world class BaaS service thus making its VA proposition useful.

At the orchestration level, a bank can technically manage the orchestration layer for VA’s. However, I think the use cases will be quite numerous and complex and this may require a specialist Fintech specialist with a laser focus on building and managing use cases as well as serving clients. Of course, the bank will rightly focus on building out the entire experience for its key corporate clients.

Barriers to Widespread adoption of Virtual Accounts across the Continent;

Banks

Unfortunately across the continent, there are very few world class BaaS from the traditional large African Banks. This problem is significant across most markets even in Europe, Asia and North America; nonetheless the problem is acute in Africa. In the USA for example, different BaaS players serve different segments of the market. Cross River and Green Dot serve Fintechs pretty well particularly whilst Goldman does a good job with large clients such as Stripe, Apple and Shopify. In Europe, players such as Solaris have cropped up to specifically provide BaaS nonetheless lacking the balance sheet to be truly useful to large Fintechs and Corporate clients. 

In Africa, a number of reasons hinder the growth of BaaS ranging from technological to strategic;

1. Technologically, I’m yet to see a bank with the technological sophistication in terms of its existing tech stack as well as a general philosophical approach around providing BaaS. One issue could be around incumbent technology stacks as well as the costs to truly implement BaaS, especially given the uncertain conditions under which the latter is being evaluated;

2. Strategic - Banks in Africa are very profitable. The drivers for true innovation sadly aren’t there. In Kenya for instance, banks have come through the Covid period largely unscathed with most posting block-buster numbers for FY 2021 as well as Q1 2022. The same can be said of Nigerian banks particularly the larger ones. Within such an environment, there is hardly any real incentive to aggressively look for new revenue lines. This is rather unfortunate given that Banking as a Service product particularly with a sound Virtual Account proposition is a multi-year bet that will grow both funded and non-funded income whilst being incredibly sticky. Customers are unlikely to move and competitors won’t be able to prize them away on a pricing strategy. What is more, the bank that builds a reputation around BaaS will have a very strong brand position and first mover advantage;

3. Design and Incentives - Banks are yet to adjust their internal org structures to truly take advantage of new product paradigms such as BaaS and Virtual Accounts. Go-to market strategies are still built around commercial RMs who are incentivized on elements such as portfolio growth and non-funded income. There is barely any true alignment between commercial and technology teams meaning that novel solutions such as Virtual Accounts cannot be properly designed. Some banks are making progress towards a better go-to market strategy. Absa for instance now has commercial RM’s making customer calls with product and data teams. All the same, more needs to be done.

Regulation

African regulatory frameworks are as fragmented as their markets. There is barely any regional or Pan-African regulatory alignment around issues such as payments, monetary policy and bank supervision. In such an environment, the complexity of offering a single API across multiple markets in Africa is daunting. I make this argument because it’s expected that an investment in world class BaaS and thus VA’s would require a sizeable market to recoup the investment.

Another core challenge around regulations is the circular driven framework for bank supervision in Africa. The issue with this is the uncertainty that this would bring about for product management around Virtual Accounts and BaaS. This would be particularly cumbersome with the ever increasing scrutiny around KYC and account opening.

Having said this, the West African Economic and Monetary Union that comprises of 8 countries in West Africa could be an interesting testing point for a multi-market Virtual Account infrastructure. The same can arguably be said for the East African Community, in so far as it’s yet to be a monetary union with centralised bank supervision, there’s seemingly adequate coordination that banking supervision frameworks are largely albeit not entirely similar. 

Currency

Closely related to Regulation, the fragmentation of African currencies makes it difficult to provide an intuitive multi-market Virtual Account solution riding on BaaS. African currencies are not only fragmented, they also tend to be heavily regulated and controlled with barely any free floating currency still existing in the continent. This would weaken the value of any VA offering. For instance, if you have a multi-country operation and are running this through Virtual Accounts, you’d face the issue of currency conversion. VA’s don’t necessarily necessitate currency conversion as you can simply account for them using prevailing rates. Nonetheless, at the point of conversion, there will likely be a dislocation between the book exchange rate and the actual exchange rate you’re likely to get in the market. This would be quite a nuisance, leading many potential VA beneficiaries to revert to their old tried and tested methods.

Wrapping it Up

Virtual Accounts can be very useful for many market participants from marketplaces to large corporates, Fintechs, SMEs and property management companies. A well executed VA program sponsored by a tech-savvy bank with a large balance sheet and supported by an API Fintech player can unlock the potential of Virtual Accounts. Nonetheless, complex regulatory considerations, multiple currencies as well as the absence of a true BaaS bank in the continent are holding back the promise of VAs. 

As always thanks for reading and drop the comments below and let’s drive this conversation.

If you want a more detailed conversation on the above, kindly get in touch on samora.kariuki@frontierfintech.io or samora.kariuki@gmail.com