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It can be too easy to get caught up in fun innovative new product launches in digital finance in Kenya, probably the most robust and well-developed digital financial services (DFS) ecosystem in Africa, if not all frontier markets.

• Kenya‘s value of all mobile transactions surpassed GDP in June 2018
• Ghana is a close second with mobile transactions representing 75% of GNP.

Yet what about all the other markets? Especially Sub-Saharan African markets where financial inclusion and bancarisation rates are weak? What can their leaders and lobbyists do to help catalyze and enable DFS?

Creating the right environment and setting the stage for a digital financial ecosystem is a foundation for attracting new entrants and their innovative new products and business models.

Lucky for us, the brains at CGAP have taken stock of this and considered the regulatory frameworks in 10 frontier markets covering East and West Africa and South and South East Asia in their new report on the Basic Regulatory Enablers for Digital Financial Services. Also relevant to most of us in this domain is that their focus is on DFS models that specifically target excluded and underserved market segments.

A Critical Understanding of DFS Regulatory Needs

Over the past 10 years digital financial ecosystems have been developing, stalling, turning, growing, and diversifying in nature. The DFS developments and the conversations that happened  10 years ago are so starkly different than those of today

Given how much has been learned through experience and observation as well as the manic pace with which DFS technologies themselves have developed, we all need helpful, cohesive insights and frameworks for how we can understand the regulatory environment as a crucial enabler for digital finance and DFS start-ups.

4 Recommendations for DFS Enabling Environments

CGAP’s research shows patterns that help explain results and the focus note presents it in a structured way. Each of the enablers addresses a specific aspect of creating an enabling and safe regulatory framework for DFS.

• Nonbank E-Money Issuance: Clear definition, creating a specialized licensing window for nonbank providers to issue stored-value accounts, adapted prudential risk rules.
• Use of Agents: A key enabler is that DFS providers—both banks and nonbanks—are permitted to use third-party agents. The viability of DFS depends on providers’ ability to outsource functions to agents.
• Risk-Based Customer Due Diligence (CDD) and Know Your Customer (KYC): Adopting risk-based and proportionate due diligence and KYC as well as anti-money laundering requirements.
• Consumer Protection: A consumer protection approach that recognizes the nuance in the range of DFS providers and products, while providing an appropriately designed approach to the margin of safety (‘risk-based’ approach.)

The report emphasizes that local context is important and there is no single approach to an enabling regulatory environment, and different countries will have different priorities and may tackle elements in different sequences.

1. Nonbank e-Money

The e-money aspect of the regulatory environment is a real bedrock in helping ‘crowd-in’ new DFS players that can serve many different segments of the market, including the poorer, marginalized, and more informal, who still have financial needs to be met and often a basic willingness to pay.

The regulatory area of Nonbank E-Money Issuance is best described by presenting four main aspects that it governs, and why they are critical:

• A clear definition of the payment and deposit aspects of e-money (such as specialized licensing and stored-value accounts.)
• Separate and different prudential rules for e-Money licensed providers than for existing rules for commercial banks, need to be designed and defined.
• A ‘delimited’ range of permitted activities for e-Money providers; the goal to allow broad consumer activities to take place with a reduced risk.
• How customer funds are handled and dealt with when it becomes ‘e-float’

2. Third Party DFS Agents

Most of the important aspects of regulating Third Party Agents are in the name of protecting consumers from faulty businesses that avoid appropriate internal checks and monitoring systems, which could allow their business to get shaky and thus customer funds to be at risk. This enabler is best described in 3 areas.

DFS providers—both banks and nonbanks—need to be permitted to use third-party agents by law or by license.

Why it matters: Without this enabler, the potential reach and cost of DFS models is in question. The viability of DFS depends on providers’ ability to outsource functions to agents—thereby extending their reach and capturing efficiencies. This is a large reason we see so many MNO brands playing this role in developing nations; they already have an extensive agent network and extensive brand recognition across the country. On the other side, appropriate regulation safeguarding consumers from poor or risky providers is necessary for both customer protection and solvency.

Requiring safeguards, such as who has responsibility over agents and internal controls/agent monitoring.

Why it matters: For example, regulations can define the legal responsibility of the relationship as between provider and agent and make the principle (the DFS provider) liable for agent actions. CGAP notes “allocation of legal responsibility is considered essential so as not to overburden the regulator with directly supervising a huge number of agents.”

Who is eligible to become an agent: Must agents be registered formally as a business? Must they provide a minimum level of education? Or demonstrate level of experience?

Why it matters: An issue that affects every ecosystem and that relates equally to competition and outreach of agent networks, is whether agents operate on behalf of multiple providers. In most of the countries studied and in many countries today, agent exclusivity is prohibited. This is an evolution; it was not the norm or considered heavily when mobile money was taking off 10 years ago.

Interestingly, this is an issue related both to competition and to the impact of the outreach of agent networks which is a critical factor when we look at DFS through the lens of economic and financial inclusion of the marginalized and unbanked, as mentioned other places.

3. Risk-Based CDD and KYC

The challenge for financial inclusion is to ensure proportionate treatment using risk-based frameworks that protect the integrity of the system while imposing the least burden on DFS outreach.

Create a proportionate anti-money laundering and countering the financing of terrorism (AML/CFT) framework for PSPs

Without getting into too much technical jargon, overall this means lower risk should equal less rigor:  simpler CDD and KYC processes should be permitted for lower-risk accounts and lower-risk transactions, thus propelling business models to extend the reach to more unbanked, low-income and marginalized consumers.

This is rather than using an existing one-size-fits-all-transactions sort of CDD design which greatly increases the efforts, and thus costs of both money and time, which can lose customers. Or, having the same CDD requirements for PSPs as is for banks, which hold a completely different level of capital risk overall.

4. Consumer Protection.

Ensuring that DFS have the necessary reliability and public trust to become a pillar of inclusive finance means establishing effective consumer protection.

All three enablers mentioned above are only effective if customers trust the products and companies offering them. If customers don’t know how to reclaim money sent to a wrong number, or what to do in case of fraud, they won’t easily trust the system with their money and they won’t use it much, if at all. In terms of financially excluded populations, this is even more important as they have less money and disposable income and the risk to them is that much greater.

How will companies be held accountable to conduct good business and to not deceive or steal from consumers? To function as enablers and not to impede robust DFS ecosystem development, consumer protection rules should be fitted/customized enough to allow a full and robust range of DFS providers and products, while providing a necessary margin of safety.

Enablers are key to laying the foundation, not the end game

As the focus note is clear to say, these are key enablers but not sufficient to expect a flourishing DFS market and ecosystem itself; there are other aspects (ease of doing business; security; rule of law and enforcement, average literacy; connectivity rates; etc) and those aspects may look different and be prioritized differently among countries.

Having followed and analyzed trends and learned from different country experiences, we can agree with CGAP that these basic regulatory enablers are key in laying the foundation for a thriving DFS market/ecosystem.

Jo Ann Barefoot, one of the most dedicated and busiest advocates of the reg-tech space (and who is not related to CGAP) says in a very recent interview:

“Hundreds of millions of people are entering the global financial system as cell phones make it profitable to serve them — people for whom no one was ever going to build a bank branch. But as we approach full financial access, we know our archaic regulatory systems aren’t equipped to safeguard consumers and financial stability. Regulation and compliance have to digitize as finance does, to become faster, smarter, and cheaper. We need a transformation, and it’s coming.”

By Jill Shemin, consultant and advisor in digital financial services and business model development in emerging markets and ICT for development impact. She is currently based in Senegal.