Financial technology (fintech) services are growing worldwide and reshaping the definition of money, financial services and economies. However, while the disruptions roil existing business models, companies and industries, increasing the choice of fintech services users while protecting their rights is a lodestone for regulators.
South African Reserve Bank (SARB) fintech head Dr Arif Ismail believes continued fintech innovation is vital in light of “South Africa’s huge, unmet needs” and reports that the bank, as a regulator, has “a strong desire” to support innovators to “be bold and challenge the status quo”.
The diversity of and improved access to financial services, afforded by developments and innovations, have increased the competition in the market and are helping to lower transaction and financial service costs, he says.
However, fintech services and platforms can expose users to financial risks, such as when fintech platforms fail or when peer-to-peer lending dries up during difficult economic times.
“Therefore, we call on fintech innovators and startups to talk to the SARB and our coregulators to get guidance on what regulations they must adhere to, what regulations may apply as they grow and how they should prepare.”
Guidance and Governance
The SARB’s core mandate, in line with most central banks and fiscal regulators worldwide, is to ensure the stability of the economy and the financial system. Most fintech offerings do not pose systemic risks – at least not yet, given the small portion of the economy they currently constitute, says Ismail.
The risks posed by fintech innovations and products are mainly borne by the users. Therefore, while the market size of fintech remains small, the SARB and its coregulators will focus their efforts on protecting the rights of fintech users.
“Improving overall social welfare may be one of fintech’s greatest promises. Novel solutions resulting from exploiting emerging exponential technologies can potentially reduce frictional costs, lower information asymmetries for users and providers, and decrease [fraud risks],” states the Intergovernmental FinTech Working Group (IFWG), which comprises the SARB, the National Treasury, the Financial Sector Conduct Authority and the Financial Intelligence Centre.
The SARB supports financial innovation, which it thinks can benefit market structures, reduce concentration and change the composition of the market, improve contestability, increase services and reduce prices, confirms Ismail.
Some fintech innovations – which have been likened to a form of shadow banking – present new consumer protection challenges, and will require a blend of existing regulation that can be amended or possibly supplemented by new regulation, according to the June 2018 report by the IFWG.
“The SARB is open to trials of exponential technologies, which include various fintech systems, but wants to ensure that the potential benefits are pursued in a responsible manner. This requires the bank to continuously reflect on what major policy questions need to be asked,” adds Ismail.
Requirements need to be proportional to the risks involved and more clarity must be provided for fintech firms on how they fit into the existing regulatory framework. Regulations must be principle-based, activity-based and technology neutral, according to the International Monetary Fund (IMF) and the World Bank Bali Fintech Agenda 2018.
Providing regulatory clarity supports the safe entry of new products, activities and intermediaries, as well as reduces regulatory uncertainty and the potential loss of confidence by users and investors linked to unsound practices and fraud, it states.
In a consultation paper issued last month, the IFWG and the Crypto Assets Regulatory Working Group noted that “regulatory action should not be delayed until the most appropriate regulatory approach has become clear, but regulators should rather act and amend as innovation evolves”.
Further, IMF MD Christine Lagarde wrote in the March 2018 edition the organisation’s Finance & Development magazine that regulators “must begin to consider the regulatory framework of the future”.
South African regulators will use policy instru- ments such as guidance notes or position papers to regulate fintech services and started with a cryptocurrency consultation paper released in January.
According to the IFWG consultation paper, additional fintech use cases will follow a simi- lar approach, including review and engagement with the industry.
In the consultation paper, two main regu- latory approaches are proposed. The first approach is a self-announcement mechanism for fintech firms to disclose their operations to regulators who can decide if they need to collect more information. However, fintech firms may need an incentive for self-reporting.
Alternatively, a base fintech licence with very low entry requirements might be effective, as several fintech firms are willing to comply with regulations. A basic licensing scheme would legitimise a fintech’s business and provide regulators with an easy channel of communication. However, this could create a risk of uneven playing fields and a false sense of compliance.
Regulators will need to strike the right balance between enabling financial innovation and addressing challenges to market and financial integrity, consumer protection and financial stability, the IMF and the World Bank state in the Bali Fintech Agenda 2018.
“This balance is critical to deliver the welfare benefits of financial innovation and avoid stalling the development of fintech with the risk of leaving the underserved behind,” the organisations warn.
Enablers and Barriers
While initial engagement with the industry is focused on blockchain and distributed ledger technology, regulators recognise that the focus will shift to consider other enabling technologies, such as digital identity, which have financial inclusion potential, but also financial stability outcomes, Ismail highlights.
“Human needs remain the same, which include keeping money safely, moving and paying, or borrowing and lending money, without the risk of fraud. The demand is for cheap, fast, seamless transactions and that clients are protected, receive goods and services and have regulatory guidance should a contract not be honoured,” he says.
The essential elements of a fintech ecosystem that can meet these protection requirements include digital identities and profiles, he stipulates.
Robust financial and data infrastructure is necessary to provide operational resilience and preserve confidence, the IMF and the World Bank’s Bali Fintech Agenda 2018 emphasises.
“Strong standards of operational resilience help market participants and infrastructures to withstand and rapidly recover from disruptions, thus supporting confidence in the continuity of services and preserving the safety, soundness and integrity of the financial system.”
Developing robust infrastructure, which is resilient to disruptions, including from cyberattacks, raises a broad spectrum of issues that are relevant to not only the financial sector but also the digital economy, including data ownership, protection and privacy, cybersecurity, operational and concentration risks, and consumer protection, the Bali Fintech Agenda states.
“Robust, resilient infrastructure supports trust and confidence in the financial system by protecting the integrity of data and financial services. Further, policy vigilance is needed to make economies resilient and inclusive to capture the full benefits of fintech and digital economies,” the IMF and the World Bank state.
Disrupting Central Banks
Ismail notes that the SARB has a working partnership with the central banks of Canada, Singapore and the European Central Bank, besides others, which are also running trials on fintech.
The SARB monitors central bank trials, including the joint blockchain research initia- tive, Project Stella, between the European and Japanese central banks, which explored blockchain systems for financial market infrastructures, including payment settlements. The initiative is exploring securities settlement as part of its second phase.
Canada has completed Phase 3 of its collaborative research initiative, Project Jasper, which explored the potential benefits of integrating ‘cash on ledger’ with other assets such as foreign exchange and securities.
The Monetary Authority of Singapore is working on its blockchain Project Ubin for the clearing and settlement of payments and securities. The authority is developing delivery- versus-payment capabilities for the settlement of tokenised assets across different blockchain platforms. The next phases of the project will focus on new methods to conduct cross-border payments using central bank digital currency.
Similarly, the SARB’s Project Khokha investigated the use of distributed ledger technology, also called blockchain, for daily, large-value payments and settlement between South African banks.
“Project Khokha proved that it could help reduce costs and improve efficiency. What we managed to demonstrate is that you do not need to depend on central bank market infrastructure to effect payments and, if the current South African Multiple Option Settlement (Samos) system were to go down, such a distributed ledger platform could facilitate transactions.
“Samos already performs the gross settle- ment, worth about R350-billion a day, in real-time. It has triple redundancy and is very effective. However, with Project Khokha, we wanted to see whether we could remove the dependence on the SARB. The answer is ‘yes’.”
The main barrier is that the comparative safety and efficiency benefits of such a system are yet to be empirically demonstrated for the entire financial ecosystem. However, the SARB is committed to experimenting with distributed ledger technology and is determining what Phase 2 of Project Khokha will look like, highlights Ismail.
Similarly, the Project Stella progress report of March 2018 states that “the distributed ledger technology experiments provided promising results and valuable insights into the functioning of distributed ledger technology. However, given the relative immaturity of the technology, it is not a solution for large-scale payment services at this stage of development.”
Fintech promises a far-reaching social and economic impact, particularly in low-income countries and small States, and for the underserved. Regulators must prepare to capture its possible wide-ranging benefits, including increasing access to financial services and financial inclusion, deepening financial markets and improving cross-border payments and remittance transfer systems, state the IMF and the World Bank.
“Although the benefits of technological change may take time to fully materialise, ongoing innovations and technological advances support broader economic development and inclusive growth, facilitate international payments and remittances, and simplify and strengthen regulatory compliance and supervisory processes.”
The World Bank’s initial focus will be on enabling reforms and capacity building to adopt fintech solutions to deepen financial markets, to enhance responsible access to financial services and to improve cross- border payments and remittance transfer systems, it says.
“The Fintech Agenda contributes to building the foundations of the digital economy, which is a key pillar in the World Bank Group’s larger disruptive technologies engagement.”