FINANCIAL TECHNOLOGY: WEATHERING THE RISKY STORMS IN THE NIGERIAN CAPITAL MARKET

FINANCIAL TECHNOLOGY: WEATHERING THE RISKY STORMS IN THE NIGERIAN CAPITAL MARKET

Abstract

The world is driven by innovation as every sector yearns for efficiency, reliability, and guaranteed results. However, every innovation effects systematic and revolutionizing changes. A copious example is Financial technology,¹ which guarantees ease in financial activities and tasks regulators to attempt the capturing of financial activities in the digital space. Importantly, Fin-Tech is a systemic risk to the financial sector, as it; creates a bubble, entails a cumbersome regulation, and has a contagious effect on the entire sector. Hence, the growing overreliance on this innovation has to be monitored, to avoid a repeat of the 2008 crisis. Of specific concern is the reaction of the capital market and its regulators to this innovation. Thus, this article discusses the risks posed by Fin-Tech, on the capital market and the regulatory response in different climes – fashioning out a road map for the Nigerian capital market to embrace Fin-Tech.

1. INTRODUCTION

The fragility of the global financial market, and by extension, the global economy was tested in 2008, by a devastating financial crisis. The crisis began in North America, specifically the United States, as a result of the deregulation of the financial sector to include non-traditional financial services companies or those dealing in “Over-the-Counter (OTC) derivatives”.² The highlight of the deregulation process was to grant banks the necessary permission to deal with “conduits”,³ such as hedge funds, and to trade in OTC and other forms of derivatives.⁴

Hence, banks, as “asset providers” bundled-up portfolios of certain income-producing assets, such as car leases, accounts receivable by way of securitization, sub-prime mortgages, visa card debts and other debt obligations with collaterals, and sold to those conduits who are “liquidity providers”.⁵ The process was facilitated by the issuance of Asset Bank Commercial Papers to the Conduits, including fellow banks, which served as a short-term investment and provided liquidity for financial institutions who required it for long-term investments.⁶ There was a lot of engagements and participation in the mortgage process, especially from those with no sources of income to offset such debts and because of the bubble created, there was a continuous demand for mortgages by asset providers to ensure that sale of derivatives was profitable – in the process creating interest-only loans which were affordable to sub-prime borrowers.⁷ The problem arose when the Federal Authorities raised the lending interest rates⁸ and the mortgagors, whose mortgages debts had grown, found it difficult to pay.⁹ Liquidity providers took the fall for this and the insurance arrangements could not still the troubled waters.¹⁰

For the American financial market, the effect was a devastating impact on some of its top financial institutions,¹¹ such as Lehman Brothers, Fannie Mae and Freddie Mac, Prudential, Bear Stearns and American International Group (AIG); some due to losses from investments in real estate and others due to the “runs” by investors who lost confidence in the financial system as a result of the contagion in the financial system.¹² Soon, the contagion spread to several markets including the United Kingdom, ¹³Canada,¹⁴ and Nigeria¹⁵ who took steps to minimize the devastation.

Interestingly, these facilities which were the architects of the financial meltdown served and currently serve as agents of ease in the financial sector. But the lack of regulatory foresight with respect to the ‘systemic risk’ created led to the catastrophic effects for the financial sector.

Systemic risks has been defined to mean “the possibility of financial meltdown”.¹⁶ However, the European Central Bank (ECB) in its 2009 Financial Stability Review explains the concept in more details, stating that systemic risk “refers to the risk that financial instability becomes so widespread that it impairs the functioning of a financial system to the point where economic growth and welfare suffer materially”.¹⁷ The fact remains that the concept is better understood from the perspective of interconnectedness of institutions which make up the financial sector.¹⁸ Thus, three forms of systemic risks exist, they are: the contagion risk between an institution experiencing difficulties and stable institutions; the risk of macro shocks causing simultaneous problems and lastly; and the risk of imbalances in the system which have built overtime being unraveled.¹⁹

With the financial crisis long resolved in many climes, it is logical that regulators should be on the look-out for similar risks, in a bid to avoid repeating the mistakes of the past. However, a new risk, which has long been in the making, has emerged in form of “Financial Technology”²⁰ – which is innovative in ensuring ease and less technicalities in financial dealings. Fin-Tech is the new gold, but regulators in various climes do not proactively anticipate the problems which abound. Hence, this article examines the risks posed by Fin-Tech to the capital market in Nigeria and how regulators have responded to this.

2. FINANCIAL TECHNOLOGY AS A RISK TO THE CAPITAL MARKET

Technology is indeed humanity’s big brother as it provides solutions to problems in every sphere of human existence. The proliferation of technology into the financial sector attests to this statement. Fin-Tech has emerged as an alternative to traditional financial practices, ensuring ease in financial dealings and creating modern sources of investment for its embracers. The term refers to “the synergy between finance and technology, which is used to enhance business operations and delivery of financial services”.²¹ Similarly, Sraders opines that Fin-Tech describes “any company that provides financial services through software or other technology and includes anything from mobile payment apps to cryptocurrency”.²² This can take the form of a business, service or a software which provides advanced solutions to make the financial processes more efficient by disrupting traditional methods.²³

The components of financial technology include: payment infrastructure, processing and issuance; stock trading applications; alternative lending marketplaces; cryptocurrencies and digital cash; blockchain technology; insurtech which seeks to modernize and simplify the insurance industry; money transfer and remittances; mortgage lending; robo investment advisors; neobanks; credit reporting; online business loan providers; small business credit cards, payments, and financing; financial cybersecurity companies seeking to protect institutions from money laundering, chargeback risk and cybercrimes; and infrastructure and software to power financial applications.²⁴ However, of importance to the capital market are; crowdfunding, robo-advisory services, digital asset management and custody services.²⁵

The financial sectors in various jurisdictions have embraced this revolutionary trend and it has been termed as the “the biggest disruptor of our time for financial institutions”, because “the myriad Fin-Tech solutions now available, or in development, are helping to rapidly reinvent the entire value chain of financial services”.²⁶ The worth of this industry is estimated to be $4.7 trillion in 2020, according to Goldman Sachs.²⁷ Interestingly, there are about 12,000 Fin-Tech startups have opened worldwide – the biggest of which is Ant Financial, with a net worth of over $60 billion and more than 10,000 employees.²⁸ The Fin-Tech industry will keep growing and will continually remain relevant. However, the question which this writer seeks to answer is, whether the risks created by Fin-Tech are bigger than the industry?

The fact remains that innovations such as this are disruptive and demand changes which accommodate its mode of operations. Fin-Tech poses a risk to the financial sector, and specifically, the capital market, despite the fact that the Fin-Tech companies that publicly trade in the stock markets are just over 550.²⁹ The concerns which emanate from the continuous growth of this trend with respect to the capital market, includes: the large Venture Capital investments in Fin-Tech startups; the interconnectedness created by Fin-tech in the financial sector and the likelihood of contagion; and the reliance of Fin-Tech in investment decisions by other financial players. These issues are discussed in detail.

1. 1. Increased Venture Capital Investments

Investors naturally cash-in on bubbling investment opportunities and emerging trends, such as Fin-Tech. This narrative is evident in the activities of venture capitalist with respect to Fin-Tech startups, which resulted in a $128 billion investment in 2018 and a predicted rise to $310 billion by 2022.³⁰ There are concerns that these startups are not immune to the threats in the financial market and are volatile,³¹ despite the belief in some corners that the Fin-Tech bubble is not as large as other market-quacking bubbles in the past.³²

1. 2. The Problem of Interconnectedness and Contagion

The Fin-Tech components creates a form of interconnectedness in the financial sector because the innovations associated to this are existent in all sub-sectors and traditional financial models rely Fin-Tech solutions. The International Monetary Fund has opined that the interconnectedness of traditional financial institutions – including nonbanks largely responsible for the global financial crisis – with lightly supervised Fin-Tech companies raises concerns.³³ This interconnectedness, although an agent of inclusion in the sector, raises risks of contagion where an institution has internal problems, thus spiraling such problems into an industry-borne one.³⁴

1. 3. How Safe and Reliable are Fin-Tech Solutions?

Interestingly, the Artificial Intelligence component of Fin-Tech is aiding in investment decisions. Investment technology firms now offer investment managers the necessary tools for monitoring markets and allowing better decisions based on robust data analysis.³⁵ The big question is thus, are these solutions safe and reliable? This is relevant, in light of the probability of such investment decisions being wrong and the likelihood of cyber-attacks, noting how large the industry is – a factor which encourages shadow operations.³⁶ Simply put, there is a high chance that with Fin-Tech solutions, everything can go wrong and the consequences on investors will likely be devastating.

3. RESPONSES OF GLOBAL CAPITAL MARKETS TO FINTECH AS AN EMERGING RISK

In terms of regulation of the financial sector, experience is indeed the best teacher as various climes are proactive in responding to any new kid in the financial bloc, capable of causing problems. The United States’ Security and Exchange Commission’s (US SEC) response to Fin-Tech regulation has been commendable, but not satisfying. This is because the Act which addresses systemic risks in general, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank),³⁷ only anticipated traditional financial institutions. The amendments to the Act under President Trump’s administration only increases the ‘Bank Systematically Important Financial Institutions’ threshold from $50 billion to $250 billion,³⁸ worsening the regulatory steps by leaving out some financial institutions – especially those in the Fin-Tech industry- out of the regulatory umbrella and crippling some who cannot secure mergers and acquisitions.

The US Securities sphere is governed by the Securities Act of 1933 and the Securities Exchange Act of 1934. Fin-Tech component, initial coin offerings (ICOs) sponsors are said to be under these Acts³⁹ based on the Howey Test established by the US Supreme Court in SEC v W.J. Howey Co⁴⁰ which states that “if there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived primarily from the entrepreneurial or managerial efforts of others”. However, such a token must represent an interest in an enterprise.⁴¹ The US SEC has however attempted to regulate Fin-Tech by referring to old rules. The first of these attempts was seen in a 2019 published framework which aims to build on a 2018 guidance, stating that the process of issuing an ICO is similar to the Initial Public Offering by public companies as both aims to raise funding.⁴²

Also, the SEC has made rules adopting the provisions of the Jumpstart Our Business Startups Act⁴³ which establish a regulatory structure for startups and small businesses to raise capital through issuing securities using internet-based crowdfunding.⁴⁴ Lastly, the SEC has issued guidance for robot advisors, which provide automated investment advice.⁴⁵ Both the SEC and the Commodity Futures Trading Commission (CFTC) are effectively regulating the Fin-Tech operators as the former has issued 48 cease and desist orders against defaulting digital asset-related companies since 2013⁴⁶ and the latter has issued more than 20 enforcement actions to enforce derivatives laws against firms related to Bitcoin and other cryptocurrency fraud schemes since 2018.⁴⁷

For the United Kingdom (UK), the overall regulatory goal has been to encourage solutions and new market players to Fin-Tech with the support of government measures.⁴⁸ The Financial Conduct Authority (FCA) – which regulates the capital market – established “Project Innovate” consisting of: “regulatory sandboxes” with the aim to create a ‘safe space’ for company innovation where companies could test new goods, services and delivery mechanisms; an innovation hub which supports innovative businesses by helping them understand the regulatory frameworks and how it applies to them, assisting them in getting the required authorization for qualifying firms and providing a dedicated contract for up to a year after the authorization; and an advice unit which provides regulatory feedback to firms developing automated models that seek to deliver low cost advice to consumers.⁴⁹ This initiative triggered interests in European Union states such as Denmark, Germany, Ireland, Netherlands and Sweden and globally in Hong Kong, Australia and Singapore.⁵⁰

Because it does not intend to impose crippling restrictions on the Fin-Tech industry, the UK has no specific laws to regulate the industry’s interaction with the capital market, but insists that the relevant laws and regulations in the capital market will apply on a case-by-case basis.⁵¹ However, policy guidelines will be issued when necessary. In line with this, the FCA published a Guidance Consultation Document (CP 19/3) in January 2019⁵² which highlighted the interaction between crypto-assets and the regulatory perimeter and the Policy Statement (PS 19/22) which cautions consumers to be careful with the purchase of unregulated crypto-assets such as Bitcoin.⁵³ Also, in April 2016, the FCA introduced the Innovative Finance ISA for loans arranged via P2P platforms in April 2016. In particular, crowdfunding platforms need to comply with Client Money regulations (CASS).

Fin-Tech regulation in Canada has not been proactive and the attitude of the Government towards this trend, for a long time, slowed its growth massively.⁵⁴ Whilst regulatory head-way has been made in capital market regulation at the federal level – with the Provincial Capital Markets Act (PCMA) and the Capital Markets Stability Act (CMSA) – since the global financial crisis, states led by Quebec and Alberta have opposed centralized regulation of systemic risk.⁵⁵

The regulation of Fin-Tech faces the same challenges. However, the Canadian Securities Administrators (CSA)⁵⁶ has implemented a regulatory sandbox programme to support Fin-Tech businesses seeking to offer innovative products and services in Canada by creating ease in registration and exemption from security law requirements.⁵⁷ This step has been adopted by states such as Ontario and British Columbia. Also, the CSA has been active with respect to guidelines and policies in this area. In August 2017, the CSA published the Staff Notice 46-307 on Cryptocurrency Offerings which highlights the application of existing securities laws and market rules to initial coin offerings, initial token offerings, cryptocurrency investment funds and cryptocurrency trading platforms. The CSA confirmed that many coins and tokens constitute investment contracts using the four-pronged test set out in Pacific Coast Coin Exchange v Ontario Securities Commission.⁵⁸ Also published, in June 2018, is Staff Notice 46-308 which provides guidance as to when an offering of tokens may or may not involve an offering of securities – giving examples of situations in which an offering of tokens may be subject to securities law.

A special mention to be made is Malta which has three major laws on the subject matter, including: the Malta Digital Innovation Authority Act (MDIA) setting up an authority which is to enhance the development of blockchain technology in the country – by certifying the DLT platform software and its mode of operations; the Innovative Technological Arrangement and Services Act (ITAS) which establishes criteria for defining innovative technological arrangements (ITAs) and maps out a registration process for those ITAs; and the Virtual Financial Assets Act (VFAA) which sets up a regulatory body to work with financial assets platforms such as: the ICO providers, custodian wallet providers, token exchanges, brokerages, nominee service providers, portfolio managers and different investment advisers. Notably, these regulations apply to banks and the capital market. ⁵⁹

4. NIGERIAN CAPITAL MARKET RESPONSE TO FINANCIAL TECHNOLOGY

Nigeria is undoubtedly one of Africa’s largest financial hubs.⁶⁰ The nation has a thriving financial services sector due to the giant strides in the banking sub-sector and a capital market with a N28.595 trillion ($73.9 billion) market capitalization as at July 2020.⁶¹ These facts have resulted in a booming Fin-Tech concentration in the nation as there are over 250 Fin-Tech startups in the country⁶² and the fintech revenue is expected to reach US$543.3 million in 2022 from US$153.1 million in 2017. ⁶³ Nigerian Fin-Tech firms such as Interswitch and Branch have received US$200m and US$170m respectively from Visa.⁶⁴ Other platforms such as; Cellutant, Paga, Flutterwave, Lidya, SureRemit, Farmcrowdy, Cowrywise, Piggyvest, Paystack, TeamApt, PayLater, O.Mobile, Mines I.O, Venture Garden have closed deals worth over $210 million from 2010 to 2019 from Venture Capitalists and other traditional financial institutions.⁶⁵

The boom in the sector has led to regulatory challenges, especially because Nigeria was also hit by the 2008 global financial crisis and such bubbles spur levels of concern on the part of regulators. Asides the Investment and Securities Act 2007, Banks and Other Financial Institutions Act (BOFIA) 2004, Companies and Allied Matters Act 2020, the Money Laundering (Prohibition) Act 2011, Cyber-Crime (Provibition, Prevention e.t.c) Act 2015 – all applicable to the financial sector- and Acts prohibiting fraud and corruption, there are no specific Fin-Tech Laws in Nigeria.⁶⁶ The bulwark of regulation has however been related to the banking sector than the capital market. This is because the Central Bank of Nigeria (CBN) is actively regulating Fin-Tech activities in the banking sector, through various regulations and guidelines on: Mobile Mobile Money Services 2015; Licensing and Regulation of Payment Services Banks 2018; Framework for the Use of Unstructured Service Data (USSD) 2018; Bill Payments in Nigeria 2018; Risk-Based Cyber-Security Framework and Guidelines for Deposit Money Banks and Payment Service Providers; for Finance Companies in Nigeria 2014; Operation of Electronic Payment Channels 2016; International Mobile Money Remittance Service 2015; International Mobile Transfer 2014 and the 2018 Financial Industry Sandbox. The CBN has however advised against the investment in crypto-currencies in separate circulars released in 2017 and 2018.⁶⁷

Regrettably, the Nigerian Securities and Exchange Commission has not been this proactive with respect to the regulation of Fin-Tech in the capital market. In 2018, the body set up a committee to draw up a roadmap for the regulation of this innovation and by 2019, the said road map was ready.⁶⁸ However, the implementation of this roadmap has only been paid lip service to – especially because the fourth quarter of 2020, which is the implementation deadline,⁶⁹ is already approaching and the gains are only a handful as SEC has only been able to register two (2) Fin-Tech service providers out of 50 which have come forward for registration.⁷⁰

However, this writer will not discredit or erode the steps already taken by SEC. The first step by the SEC was to adopt a Three-pronged Objective to Regulate Innovation in the Nigerian Capital Market, which includes; ensuring safety of innovations to investors, market/financial deepening to encourage innovation to serve investors’ needs and solving existing problems by providing tools to beef-up regulatory supervision and ensure regulatory compliance.⁷¹ A product of the latter is the Fintech and Innovation Office (FINO) which was established to facilitate engagement with innovators, provide guidance on requirements of existing regulations and monitor products and processes in the capital markets.⁷² Secondly, SEC has launched a regulatory sandbox – like several jurisdictions – to serve as a space to test innovative products, business models, services and delivery mechanisms which emerge in the capital market.⁷³

The third set of steps by the SEC relates to formal regulation of some aspects of the Fin-Tech industry. The SEC is working on amendments to the Investment Adviser Rules and Sub-broker Rules.⁷⁴ Also, the SEC has issued a rule to regulate Crowdfunding⁷⁵ despite the prohibition of private companies limited by shares from inviting the public to subscribe for any of its shares or debentures⁷⁶ and the fact that inviting the general public to provide finance in exchange for shares in the company without authorization of SEC is an offence.⁷⁷ This can partly be because Crowdfunding platforms which allow companies to raise equity capital from the general public will qualify as Capital Trade Points (CTPs) defined under section 315 of ISA 2007.⁷⁸ Section 25 of ISA 2007 also requires that CPTs register with SEC before carrying out operations.

The Crowdfunding Rules attempt to provide some form of clarity, by first defining the concept to mean “the process of raising funds to finance a project or business from the public through an online platform”.⁷⁹ Second, Rule 2 provides that all Small and Medium Scale Enterprises (MSMEs) incorporated as companies in Nigeria with less than 2 years operating track record can raise funds through a Crowdfunding Portal in exchange for the issuance of shares, debentures, or such other investment instrument as the SEC may determine. The rule also identifies the main players in Crowdfunding activities to include, Crowdfunding platforms and intermediaries, issuers and investors.⁸⁰ The Rule also incorporates various disclosure requirements.⁸¹

Noting the prohibition of private companies limited by shares from issuing securities, the recent Crowdfunding Rules have been argued to be unconstitutional,⁸² as it does not attempt to interpret, but amend a statutory provision,⁸³ contrary to the decision of Court of Appeal in Olanrewaju v. Oyeyemi & Ors,⁸⁴ that a subsidiary legislation cannot expand or curtail the provisions of the substantive statute. This writer agrees with this contention.

In light of the argued unconstitutionality of the most comprehensive Fin-Tech regulation, the trend remains under-regulated and the state of affairs clearly do not show readiness of SEC to ensure that the capital market reaps the fruits of Fin-Tech.

5. RECOMMENDATIONS

The aim of every regulator should be to encourage the prosperity of the Fin-Tech industry, by ensuring that the policies on ground are friendly. In suggesting the aforementioned, this author does not negate the necessity for proper regulation of the Fin-Tech industry. Notably, no nation -except Malta- is yet to get it right as what exists are regulatory patch-works in various climes. This writer thus provides certain recommendations:

• There needs to be an enactment of a law which governs Fin-Tech as a whole or laws relating to its components, empowering and giving guidance to regulators to tackle risks arising from this innovation. It is important that whilst Nigeria shops for a regulatory apparel from other jurisdictions, she must tailor the provisions to suit local peculiarities. This also helps resolve the unconstitutionality of they Crowdfunding Rules, as only the National Assembly can enact such changes.

• Continuous collaboration with stakeholders in the Fin-Tech industry to understand its structure and fashion out how regulations can properly capture the sector.

• Capacity building of staff of regulatory bodies to fully understand the workings of Fin-Tech.

• The regulatory approach must not be restrictive, but one that nurtures Fin-Tech startups and helps them raise capital from the money market.

• The SEC must be proactive in registering the Fin-Tech startups, in a bid to properly account for them.

• The regulations must specifically aim to reduce the systemic risks posed by Fin-Tech to the financial sector.

• Lastly and quite obviously, the SEC must fully implement its roadmap for regulation of Fin-Tech, so the document does not become a tool of decoration and a story with no ending.

6. CONCLUSION

The only venom to the poisonous consequences of new innovations is regulation. The emergence of Fin-Tech in the capital market was greeted with aspirations, owing to its ability to revolutionize the sector and even allow operators work remotely -a welcome feature in the Covid-19 era. However, understanding and regulating the sector is not, and might never be easy for regulators because it is a sector which is difficult to capture and control. The best approach remains adopting a friendly regulatory environment to encourage such businesses and deter shadow operations. Fin-Tech is here to stay and its risk threaten to blow up in our faces where the right regulations are not in place. Nigeria must be quick and calculative in regulating the sector.

About the Author

Nelson Iheanacho is a final year student of the Faculty of Law, University of Lagos. He is an avid writer, researcher and speaker with several accolades and publications to his name. Nelson’s interests include; Corporate Law, Securities, Energy and Taxation.
He currently serves as; Career Advancement Officer of the Oil and Gas Bar University of Lagos, Secretary General of the Lagos Model United Nations and Executive Editor of the University of Lagos Law Review.