Enhancing the Role of Islamic Finance Within the Digital Economy Era: Opportunities and Challenges

“FinTech, Islamic Finance and Regulatory Issues”

Mohd Sani IsmailSenior Financial Sector SpecialistAsian Development Bank

3rd Annual Islamic Finance Conference4-5 July 2018 | Makassar, Indonesia

Overview

Ø Growth of FinTechØ Benefits of FinTech and Financial Inclusion Ø Policies and Philosophical Approach to RegulationsØ Islamic FinTech and Regulatory ConsiderationsØ Case StudiesØ ADB and FinTech Support

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Leveraging digital platforms and mobile technologies to offer Inclusive financial services

Source: World Bank, Global Financial Inclusion Database and World Development Indicators.

1 billion adults have no

bank account in developing Asia

3.7 billion have a mobile

phone

Source: World Development Report: Digital Dividend, World Bank, 201620051995 2015

100%

50%

Mobile phone

Internet

Mobile broadband

”and nearly 70 percent of the bottom fifth of the population in developing countries own a mobile phone. World Development Report:Digital Dividend, World Bank, 2016

Unprecedented speed of spreading digital financial technologies

“More households in

developing countries

own a mobile phone

than have access to

electricity or clean water,

Benefits of digitalization

• provide access to financial services for 1.6 billion people

• increase the volume of loans by $2.1 trillion

• increase deposits by $4.2 trillion• reduce government leakage in

public spending and tax collection by $110 billion per year.

• boost annual GDP of all emerging economies by $3.7 trillion, that is 6% increase.

• generate 95 million new jobs across all sectors

Extending access to finance is the first building block for people to build a better life.

70% lower

Cost of servicing fully digital bank accounts is 70% lower per household than traditional accounts (JPMorgan Chase estimates)

digital bank

accounts

2025 the widespread use of digital finance can:

By

(McKinsey estimates)

Policies that harness the power of technology for financial inclusion

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Ensure access to basic digital infrastructure

Provide enabling environment for innovators and entrepreneurs

Improve the regulatory environment

Philosophical Approaches toFinTech Regulations

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Laissez-Faire (favored by FinTech companies)

- first to allow FinTech to grow, and then, only once it has developed, to put in place regulation.

- China (PRC) approach until 2015.

Uniform Regulations-The traditional financial services industry, arguably fearful of competition typically argues in favor of similar treatment for all. May kill innovation.

Balanced Approach- balance risk and potential innovation- similar activities should be regulated in similar ways in order to protect against regulatory arbitrage- multilevel approach which applies graduated regulatory requirements based upon level of risk and size (too small to matter can become too big to fail in short space of time).

Islamic FinTech

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ü Digital Delivery of Islamic Finance

ü Usage of Fintech utilities: KYC / AML, Blockchain and DLT, Cyber, Payments, Big Data & Machine Learning in Islamic Finance

ü Any FinTech in a Muslim market demography that delivers an unmet financial need and or financial inclusion objective

ü Any Shariah compliant FinTech fund investing in digital infrastructure or economic development.

Source: Ethiscrowd.com

Islamic FinTech

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ü Main types of services offered in Islamic Fintech are peer-to-peer (P2P) lending, crowdfunding, money transfer, mobile payments, trading platforms and wealth management.

ü Examples include: Singapore-based EthisCrowd.com & KapitalBoost.com, US-based Wahed Invest LLC in the segments of P2P lending, ALAMI Sharia facilitate small businesses to obtain Islamic financing from banks.

ü Prominent Islamic Fintech startup in Indonesia is Paytren, a payment app that allows Indonesians to make payments for utilities, mobile topups and donate to charity. Paytren is reported to process 700,000 transactions daily from its 1.7 million users.

ü Innovative financial solutions such as crowd or peer-to-peer funding is a good fit for Islamic finance, given the participatory character of their profit-and-loss sharing schemes

Regulatory Considerations

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ü Supervisors will have to ensure that financial institutions or firms have robust governance frameworks

ü From a risk management point of view, operational risk (reflecting cyber-security, fraud and theft, data privacy and legal issues) can be significant and capital requirements must be sufficient to restore operations if a financial institution suffers a cyber incident and to protect consumer

ü Regulators need to upgrade capacity and supervisory tools. For instance, in robo-advisory services, which rely on algorithms and portfolio management to analyze investors’ data and recommend investment portfolios.

Regulatory Considerations(Sandbox)

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Sandbox and its requirements: Limitations (on number of clients, risk exposure); -Time-limited testing, Set of predefined exemptions and testing under regulator’s supervision

Why sandbox? v Keeping regulation effective gets more difficultv Regulators have to become startups in a certain sensev Flexible approach allows to mitigate the risks while keeping it

conducive to innovations

Regulatory Considerations (Sandbox)

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Sandbox Requirements (UK FCA)

v The firm falls within the right scope: such that the plannednew solution is designed to support the financial services industry.

v Genuine Innovation: such that the new solution is novel orsignificantly different to existing offerings.

v Consumer Benefit: such that the innovation offers a good prospectof identifiable benefit to consumers.

v Need for Sandbox: such that the business in fact has a genuine needfor testing within a sandbox framework.

v Background Research: such that the business has investedappropriate resources in developing the new solution, understanding the applicable regulations and mitigating the risks.

Regulatory Considerations(Islamic FinTech)

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ü Need to consider how they can ensure that the end to end transactions are in line with Shariah, including the rights and ownership at each stage;

ü P2P platforms can operate based on Islamic contracts. In jurisdiction with established infrastructure, contracts based on Commodities Murabahah/Tawarruq can be used (Beehive in UAE). Alternatively, murabahah sale with deferred payment can be used.

ü In P2P platforms, does the investor/lender need to know the identity of the borrower and projects to conclude a contract? This requirement would prevent pooling of projects (2nd generation P2P)

ü Who has the responsibility to monitor continuous Syariah compliance of projects (activities, debt ratio…etc)? Is it the platform operator (higher cost) or the investors (higher risk)?

Case Studies (Malaysia)

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v Securities Commission Malaysia consider operators of equity crowdfunding and P2P platforms as financial service providers and subject to Guidelines on Recognized Markets.

v P2P operators must be locally incorporated and have a minimum paid up capital of RM 5 Million.

v Obligations of P2P operators include (i) having a transparent risk scoring system, (ii) ensure accurate disclosure, (iii) inform investors of any material changes; (iv) have policies to manage default and best endeavors to recover

v Investment limit: Operators to encourage retail investors to limit investment up to RM 50,000. No maximum limit for angel and sophisticated investors.

v Requirement to appoint Shariah advisor where Islamic capital market products are offered. Responsibility of advisor include (i) advising on compliance with Shariah principles; (ii) providing guidance on documentation, structure and investment instruments and (iii) applying Ijtihad to ensure compliance.

Case Studies (DFSA)

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v Operators to provide detailed disclosure of actual and expected default rates of borrowers.

v DFSA proposes to allow loan-based and investment-based platform operators to create a facility for the transfer (sale) of loans or securities to other lenders or investors who are already clients of the platform.

v DFSA proposed a limit of $50,000 per investment-based and loan-based platform per year for retail investors, and a limit of $5,000 per loan.

v a platform that wishes to be Shariah-compliant would need an Islamic endorsement (by the DFSA) and have Sharah governance arrangements usually including the appointment of a Shariah Supervisory Board.

v Innovation Testing Licence - restricted financial services licence to allow FinTech firms to develop and test innovative ways to deliver financialservices without being subject to the normal regulatory requirements

Case Studies (Bahrain)

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v The Central Bank of Bahrain (CBB) has announced new regulations to create a regulatory sandbox that will allow startups and fintech firms to test and experiment their banking ideas and solutions.

v The CBB issued the Regulatory Sandbox Framework directive, which includes the eligibility criteria, filing requirements and timeline for the process.

v The framework provides a virtual space for companies to test their technology-based innovative solutions, and is open to existing CBB licensees and other local and foreign firms. The testing duration is nine months, with a maximum extension of three months. In order to be eligible, companies need to demonstrate (i) innovation, (ii) customer benefit, (iii0 technical testing, and (iv) intention to be deployed in Bahrain after the sandbox period ends

ADB support for financial inclusion using fintech

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Potential Role of ADB• ADB can support the expansion of the digital financial services

industry by profiling champions in the private sector and identifying funding opportunities to promote financial inclusion.

• In the public sector, ADB can help conceptualize pilots for government-to-private sector projects, and crucially help governments craft fair and effective regulations that enable growth in the private sector.

• Through combined efforts of the Private Sector Operations Department and the Sustainable Development and Climate Change Department ADB is through a $700,000 TA (i) analyzing the impact of digital financial inclusion for three market segments—base-of-pyramid, MSMEs, and women; (ii) assessing regulatory frameworks for digital finance in each country to identify barriers to financial inclusion; and (iii) identifying private sector pilot projects involving digital finance to expand financial inclusion.

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SME financing: Technology enabled credit scoring system in

Greater Mekong SubregionADB supports KIU (an IT service company in Viet Nam) and partner banks to provide SME financing based on AI-enabled credit scoring.

• 8,000+ SME clients by end-March 2018, with loans up to $50,000 per client.

• ADB provided $100 million SME credit line to a KIU partner bank in Viet Nam. KIU also has partner banks in Cambodia, Myanmar, and Bangladesh. 19

FinTech Challenge Viet Nam• ADB and the State Bank of Viet Nam

(SBV) launched FinTech Challenge Viet Nam in November 2017 to spur innovation in financial services

• FCV attracted 140+ global FinTech solutions of which 16 were selected

• The SBV will allow regulatory sandbox piloting testing for selected FCV solutions

• ADB contributed $150,000 to organize it and will collaborate with partner banks to pilot-test the best solutions

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Thank you