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Distributed Ledger Technology: a South African financial services perspective

22.11.2017Langelihle Mnyandu, Associate in Banking & Fin. Services Regulatory, Bowmans

This post was originally published on the Bowmans website.

The advent of Distributed Ledger Technology (DLT) has caught the attention of the global financial services industry, with many labelling it a technological revolution that is set to disrupt the financial services infrastructure. DLT is a type of digital ledger or database that is used for the recording, safe keeping and decentralised sharing of data relating to the ownership and possession of a wide range of assets. It uses consensus-based cryptographic methods to record and distribute information among participants of that ledger without the need for a middleman to facilitate this. Blockchain is an example of a very popular and well-known form of DLT.

There is no doubting that DLT, and generally financial technology (fintech), has huge potential to challenge and impact conventional ways of rendering financial services and possibly even extending services to new consumers. However, very limited actual ‘use cases’ have been introduced to demonstrate how DLT can help expedite financial inclusion. At present, most use cases pertain to how DLT can improve the efficiency of existing methods in order to make them more cost-effective and secure. These use cases have been, for example, on how blockchain can help reduce costs and improve payment settlement times in the deposit and peer-to-peer payment environments, and how it can help enhance data protection and data sharing between consumers, regulated institutions and regulators. Yet use cases are still lacking on how blockchain can be more effective than existing methods in expediting economic participation and use of financial services by unbanked people.

Obvious challenges

Perhaps one of the biggest challenges in achieving financial inclusion through DLT is that current DLT (blockchain) based products and services are aimed at improving existing methods of rendering financial services. In other words, the current use cases do not seem to introduce any new services that would be useful in the daily transactions that unbanked people ordinarily undertake.

It may be argued, however, that DLT is not meant to expedite financial inclusion directly by developing new products or services but rather indirectly through the introduction of cheaper and more efficient methods of rendering existing financial services and products, which in turn makes it easier for service providers to extend these services to new markets.

Another challenge is consumer education and awareness. Regulators will always want to be comfortable that the most vulnerable members of society know about and understand new products and services well enough to use them for basic transactions without their protection as consumers being compromised. The difficulty is determining who is better placed to lead this initiative - the service providers or regulators - while also ensuring that consumers do not bear the costs.

Despite these challenges, there is general industry consensus that with appropriate regulatory supervision, DLT-based products and services hold huge potential to improve financial inclusion - whether directly by developing new use cases or indirectly by making conventional methods cheaper and more efficient and thus more accessible to underbanked people.

Regulatory buy-in and the way forward

Financial services industry participants have also taken comfort from the fact that South African regulators are actively engaged in the conversation and creative process around fintech. This eases some concerns about a potential disjoint between fintech innovation and regulation.

In most cases there may not even be a need to drastically reform legislation to cater for new product innovations such as DLT. South African financial services legislation is largely sufficient to regulate DLT-based services and products, albeit in a fragmented manner. Consider the insurance landscape, for example. The insurance Acts already have broad deeming provisions that allow the regulator to deem a person’s conduct as insurance business conducted in South Africa and therefore requiring licensing by the insurance registrars.

The same can also be said for legislation regulating the credit lending environment. As with the insurance Acts, the National Credit Act 34 of 2005 (NCA) applies to credit transactions having an effect within South Africa. Because the NCA is activities-based and not entity-based, it means that provided a credit transaction has an effect within South Africa, it may be regulated by the NCA regardless of the medium used to provide that credit. However, this does not mean that the need for some level of regulatory reform is completely negated in other areas.

Regulatory reform will likely be required if, for example, we are to realise the potential of DLT to satisfy other types of regulatory requirements. For example, DLT-based products, such as cryptocurrencies (like bitcoin, ethereum and corda based currencies), may potentially be used by regulated institutions to satisfy their prudential capital requirements. In particular, certain cryptocurrencies have qualities of a ‘tier 1’ type asset for purposes of meeting minimum and solvency capital requirements under the Solvency Assessment and Management (SAM) framework. Cryptocurrencies such as bitcoin have been lauded as being immune to inflation and highly liquid, thus making them readily available to absorb losses as required for tier 1 assets under SAM.

However, cryptocurrencies are currently not recognised as securities in South Africa, let alone as securities that can be used for purposes of meeting the capital requirements of regulated institutions. Also, the current insurance framework (including the Insurance Bill) does not provide a clear position on whether such instruments can be regarded as eligible assets for purposes of meeting capital requirements. This is just one of the areas that may benefit from regulatory reform or clarification.

Although regulation may not be moving as fast as innovation, it is positive to see that the Financial Services Board, in particular, is adopting a more hands-on approach in keeping up with fintech innovations and has indicated that it will establish a regulatory sandbox to test new product developments. This will also allow it to leverage off the strides made by the UK’s Financial Conduct Authority in regulating fintech-based products, as our financial services regulatory framework is largely similar to that of the UK.

There are clearly a number of moving parts with regards to DLT and fintech innovations. Whether it is from the perspective of expediting financial inclusion, developing regulatory sandboxes to test new DLT use cases or grappling with whether or not these innovations will necessitate significant regulatory reforms, it is reassuring to see DLT, and generally fintech, receiving buy-in from South African regulators.

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About the Author

Langelihle Mnyandu is an associate in Bowmans' Johannesburg office, more precisely in Banking and Financial Services Regulatory practice area. He holds an LLB degree from the University of Kwa-Zulu Natal. He has expertise in banking regulation, financial services, financial technology regulation, securities, insurance, financial markets regulation, investment funds structuring and investment management.

Innovation doesn't have to be disruptive

21.11.2017H. Miller, Associate Consultant, Nathan Associates & G. Njoroge, Advisor, KPMG

In the previous blog, we looked at what technology meant in the context of innovation and problem-solving for rural customers. In this second of three blogs, we dig deeper into the idea of innovation and what it means for the Mastercard Foundation Fund for Rural Prosperity.

                     

It is clear that technology is changing the landscape of financial services in rural Africa. From the largest banks to the smallest fintechs, financial service providers are gearing up for a world in which finance is digital first and in which anyone with access to a mobile phone can also derive benefits from formal financial services.

The rapid uptake of mobile money in many countries has sowed the seed for a thousand new innovations that could further extend inclusive financial services. An outcome of this success has been that everybody in digital finance is looking for "the new M-Pesa", in the same way that elsewhere, entrepreneurs want to be "the Uber of..." An underlying assumption here is that change is generally linear until a special company comes along with an idea that creates non-linear change, which we often call disruption.

But when you map this idea on to the landscape of unbundling that financial services are currently going through, it is not so clear that disruption is what's needed. It used to be that a bank, or a microfinance institution, or an insurance company, would aim to provide a vertically integrated service to the customer, from initial acquisition to all aspects of relationship management and back end services. This is changing. Technology, and in particular the ability for different platforms to link with each other, opens up new opportunities for collaboration. Not everyone needs to develop the next big product or service - there may be much more value and impact for a fintech company to build a business- to-business solution that works at a specific pain point for a financial institution.

For example, the Fund is supporting a partnership between Juhudi Kilimo, an asset financing company, and the Entrepreneurial Finance Lab to develop a psychometric credit scoring tool for smallholder farmer borrowers with no or limited verifiable credit information. This is a tech-enabled solution for a specific challenge - how to estimate likelihood of repayment in a data-light environment - that could reduce costs and improve efficiency of Juhudi Kilimo's credit processes.

A similar partnership in the Fund portfolio is between First Access, a fintech company, and Esoko, an agricultural information and communications company. The two will develop a rural agricultural credit-scoring platform for lending institutions from disparate data sets, from soil and weather data to mobile phone usage and farmer profiles. The solution has the potential to impact a large number of farmers who do not have traditionally accepted banking histories.

These are great innovations, that could have a real impact on micro and small business finance, but they probably won't be putting other lenders out of business. And that's fine. Innovation can be highly effective without being disruptive.

There's nothing wrong with ambition, and there is certainly scope for massive changes in Africa's rural finance markets. But if you focus too hard on the next disruption you can lose sight of the great ideas that represent an evolution, not necessarily a revolution. At the Mastercard Foundation Fund for Rural Prosperity, we love big ideas. But the most important aspect of the big idea is the impact it has on the livelihoods of rural communities in Africa, not necessarily on how it disrupts the structure of the financial system.

So if you want to apply for support from the Fund, we're not so fussed about if you're the next big disruption to African financial markets. We want a credible plan that overcomes some of the many challenges of financing rural populations, and can have a real impact on the lives of people living in or close to poverty. We want ideas that work from the bottom up, which solve real problems. Maybe you'll be disruptive. If you're not, that's fine too.

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About the Authors

Howard Miller is a Senior Consultant with Nathan Associates London, and Principal, Nathan Associates India. He specializes in financial inclusion, challenge funds and the market systems approach to development. A trained economist, Howard has extensive experience in consultancy, public policy, and investment banking. Since joining Nathan Associates in 2011, he has worked on DFID financial sector development programs in Uganda, Mozambique, Bangladesh, and Rwanda, and on the FSD Africa Program. Before joining Nathan, Howard was a fellow at the Overseas Development Institute working on macroeconomic and financial sector policy for the Government of Uganda.

8 years ago, Grace Njoroge ventured into the corporate world under a graduate trainee program with one of the top regional banks in East Africa. She expected to be a classic banker but this according to her did not happen, at least not all of it. Her typical day involved riding a motorcycle to help micro-traders and assist small-holder farmers open savings account. In a surprising twist, she fell in love with the power simple financial products had to drastically change life and businesses potential for low-income clients. At KPMG IDAS, she works with donors and funders to support financial and non-financial institutions, to better serve the unbanked and under banked segments.

Are African leaders serious about using savings versus debt to better our African economies?

07.11.2017Nthabiseng Moleko, Economics & Statistics Lecturer, Stellenbosch Business School

According to the Nigerian, South African and Kenyan pension regulators we have seen significant growth of pension assets in the last decade. Kenyan assets have increased from 105 billion (Kshs) shillings in 2002 to 700 billion in 2013, the year on year growth remains buoyant with 0.8 percent growth to Kshs 807 billion (2015). The Nigerian economy has seen a similar rise from $7 billion (2008) to $19 billion in 2016, and South Africa's meteoric growth to $207 billion (2016) from $160 billion during the same period. South Africa's Financial Services Board (FSB), Kenyan Retirement Benefits Authority (RBA) and Nigeria's Pension Commission (PC) have established a strong regulatory framework, and asset consultants and managers continue to manage fast growing pension assets in relation to GDP. The Kenyan and Nigerian growth is similar to economies such as Mexico, Spain, France, Italy, China, Brazil and India who have asset to GDP ratios lower than 20%. In the last decade Towers Watson Global Pension Study has identified South Africa as the 11th biggest pension market globally and it has grown considerably over the last decade by 15% to significantly high level of assets at 74% in relation to GDP. The question is - - how is Africa using these funds more strategically to tackle inequality, underdevelopment and joblessness?

             
Source: Authors compilations from World Development Indicators (online), Financial Services Board Annual Reports, 1960-2013

                      
                           Source: Retirements Benefits Authority, 2017

                     
Source: Authors own work (Towers Watson, 2016 and OECD Pension Fund Indicators, 2016)

The increased size of pension assets has fared well for capital market development, showing both increased depth and liquidity of securities markets. The modernisation of infrastructure increased assets for bond and equities, particularly in the long run. Improved regulatory framework is also a consequence of pension asset growth with even some empirical studies attributing it to lowering of transaction costs. When the South African and Kenyan investment allocation by asset class are compared we see signs of large exposure to domestic equities (17.6% and 23%) and bonds (8.5% and 36%), including government securities. It is only in Eastern Africa a sizeable allocation in immovable property at 19% versus South Africa's lower 1.2%. Kenya has allocated an impressive Kshs 150 billion as at December 2015. Alternative investments, which include investments in infrastructure, are an asset class that require significant development for increased allocation in our capital markets. The African Equity Fund and Isibaya Fund, managed by the continent's largest pension fund manager (Public Investment Corporation), allocate a total 2% of the total assets of R37.1 billion into such investment products. Particular emphasis on the development of instrument, bonds and equities (listed and unlisted), project planning and packaging of such facilities is a key requirement in furthering such. The worsening condition of our West, East and Southern African economies must make use of all possible means to transform it, such as using capital markets in particular as an enabler to propelling economic development in greater proportions.

This is all against a backdrop of a slowed economy in the continent's two largest economies, both facing recession with Nigeria -1.5% growth and SA's lacklustre 0.29% growth in 2016. In the same period Kenya has experienced 5.8% growth, however, has the highest jobs crisis amongst the countries. The governments need to make deliberate efforts to put all these economies on higher growth paths. For instance, South Africa's growth has averaged 3% post democracy and at its peak, growth hasn't exceeded 5.6%. Kenya's growth and Nigerian economic growth has grown but neither of these economies have grown sufficiently to absorb unemployed labour, decrease widening inequalities and reduce significant poverty and infrastructure backlogs needed to boost sectorial development. The number of unemployed continue to worsen with the hardest hit being women and youth, ranging from 14.2% an estimated of 28 million people. South Africa's 26.6% with Kenya's staggering 39.1% unemployment levels signal a serious structural crisis. Despite significant growth, all these economies have been unable to match increased growth by absorbing new entrants into the labour market.

The total infrastructure backlog estimations made by the African Development Bank were projected at $93 billion per annum. With investment in productive investment and absorbing local labour we can begin to make a positive dent in poverty and unemployment. Public investment is inadequate to meet the financing requirements estimated at 10% of our economic output per annum. Labour intensive growth is what is required for our economies. However, we cannot be further indebted to Bretton Woods institutions in the process. Already soaring debt to GDP ratio's and heavily priced servicing costs places high levels of opportunity costs on the option of borrowing and servicing debt. The question is, where will the finance required to promote productive growth be drawn from? Increased investment must be in capital formation, making investment in machinery, equipment, and industrial infrastructure, logistics support through the construction of railways, ports, roads, and investment in other such infrastructure that will unlock the economy in regions that could be developed as economic hubs.

Is it true that investment in infrastructure is a risky investment?

The sole purpose of pension regulators is to ensure that there is a conducive environment to investments but limiting risky and reckless investments of pensioners. Curtailing the ability to act as a watchdog from looting and enforcing limitations on asset classes for optimal returns is crucial. This is to protect the pensioners' interest. However, is has been shown in countries such as Canada, the USA and Australia that have invested up to 15% of total public pension assets in infrastructure investments. These investments using non-traditional financing mechanisms have shown significant returns in other countries, whilst developing the economy has yielded positive returns. In a global pension assets study by Harith & Preqin, more than three quarters of infrastructure portfolio performance of infrastructure assets has met expectations. It exceeds 90% when including portfolios that have exceeded performance. The argument that targeted investment do not hold returns equivalent to other asset classes is unjustified as they do not perform differently from non-targeted investments.

The fears of weak state capacity, poor planning and weak governance of institutions and political meddling are seen as hindrances to securing not only foreign but even curtailing attempts to increase domestic savings as investment for domestic infrastructure. It must be stated though that infrastructure projects such as toll roads, power distribution and transmission facilities are able to generate operating cash flows. In order to ensure changes in investment behaviour and patterns, contract law and methods for recourse coupled with a strong regulatory capacity in infrastructure are required. The regulatory capacity in East African economies (including Kenya) and South Africa do not restrict investment, however in other countries pension fund regulation must reduce fragmentation and not be a constraint in diversifying assets. Secondly, governance concerns over agencies and their ability to collect payments for infrastructure services can only be quelled by building strong institutions and developing a track record of success. It has to be the state that quells the notion that there lack investable products, thus restricting investments. We have seen in South Africa how investment in institutional capacity from as far back as 1959 with the FSB's establishment has led to the development of a strong regulator, and one of the biggest pension market globally. It shows the state has to deliberately channel resources into development of project planning, project packaging and in the development of investable products using its institutions.

The task of improving the marginal productivity of capital requires innovation in our capital markets. Pension funds are a long term supply of funds to capital markets and offer the opportunity of diversifying risk and also heeding against investment risk as an asset class.

Economic estimations show that the size of the informal economy ranges from 10-50% of our African economies with a sizeable portion of our economy not contributing to formal pension schemes. Economic growth that is underpinned by increased labour productivity and employment will see the size of pension funds surely increase. But the strength of the relationship between pension funds and growth is strengthened if capital markets are developed with the intention of further driving growth.

Capital markets can also offer solutions that respond to the constraints of jobless growth, particularly in our emerging markets or developing economies. Life insurance companies, pension fund managers and the wider financial services sector should be encouraged to play a greater role in the provision of capital to drive continental growth. In time, the increased savings effect from pension funds will trickle in greater proportions through capital markets and grow the entire economy.

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About The Author

Nthabiseng Moleko is a Faculty member at the University of Stellenbosch Business School and teaches Economics and Statistics to postgraduate and Masters students. As a former Chief Executive Officer at JoGEDA, Project Manager and Researcher at ECSECC she has worked extensively in the economic development landscape.  At ECSECC she contributed to the development of various policies that contributed to the policy aspects of economic development in South Africa working with regulators, policy makers, national and regional government. The transition from a policy research think tank at ECSECC to a development agency in JoGEDA enabled her to be involved in several regional projects in South Africa. She started her career in the credit team at a highly rated specialist institutional fixed income boutique asset management firm, Futuregrowth Asset Management. Nthabiseng obtained her Bachelor of Business Science (Honours) degree in Economics at the University of Cape Town. Thereafter she obtained a Masters in Development Finance from the University of Stellenbosch Business School (USB). She is currently completing her PhD in Development Finance from the USB with the topic centred around pension funds, savings, capital market development, the Public Investment Corporation and growth.   Her research encompasses several time series analysis using econometrics to understand financial services, namely pension funds and capital markets contribution to economic growth.  She seeks to understand how financial development in Africa can be better used to aid economic development.

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LATEST POSTS

Can you save money while repaying debt?Stephen Davies, Financial Blogger
Distributed Ledger Technology: a South African financial...Langelihle Mnyandu, Associate in Banking & Fin. Services Regulatory, Bowmans
Innovation doesn't have to be disruptiveH. Miller, Associate Consultant, Nathan Associates & G. Njoroge, Advisor, KPMG

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