The future is digital
We may not know what specific digital technologies and business models will win the day, but it is clear that the evolution of financial services around the world is now inextricably linked to the growth and development of digital products and processes.
Over the past three years, ISF and Mastercard Foundation Rural and Agricultural Finance Learning Lab (the Lab), among others, have conducted research on FSPs’ experiences and perspectives on digitization. In our survey of 47 Financial Service Providers (FSPs) around the world, 64% had already hired external consultants for digitization and 71% indicated that they probably or definitely will hire another specialist within the next two years. Those percentages were higher than any other category of business development services. Other FSPs indicated that they were building the capability in-house, choosing to develop systems internally.
And while the business case for digitization is preliminary, the Lab found positive impacts and perceptions in their own survey of 23 select FSPs in Africa. Though a small sample, their results showed a correlation between high levels of digitization and FSP profitability, and over 95% of the FSPs in their study indicated that they believed that digital tools would eventually increase their profitability.
But both surveys also indicated that FSPs considered the cost of digitization and data system development to be a primary barrier to uptake. Unsurprisingly, donors have stepped in with financial support to help extend the benefits of digitization to cost-constrained organizations that serve the rural poor.
Given the scale of attention and funding that is focused on digitization for FSPs in developing countries, we believe it is time to step back and consider how these investments should be structured to avoid distorting the market for digital services and make effective use of scarce donor funding. The question is no longer if digitization should be developed, but how it can be developed to have the greatest impact.
Build or buy: Understanding options for digitization
When an FSP decides to digitize, there are a range of options available, from building products and capabilities in-house, to hiring external digitization contractors to develop client-specific systems. These types of solutions can be mixed and matched to address a range of functional requirements—core banking, client registration and management, credit assessment, and more.
From an FSP’s perspective, the crucial considerations are strategic, financial and operational fit with the business. As in most markets, there is a general trade-off between affordability and customization. The more ‘bespoke’ a system, the higher the development and maintenance costs will be. From a functional perspective, building highly tailored systems internally will be required for organizations with a heavily tech-centric business model or operating in environments that have highly specific digital requirements (including strict privacy laws, regulations impacting FPS’ customer engagement processes, etc.). However, many FSPs could be better served by contracting with third-party providers, which can provider lower-cost options via standardized systems, with customizable modules and services a la carte when necessary.
So why does internally built digitization persist to such a high degree? In working with their partners, the Lab identified two main concerns that drive FSPs to rely on internal development of these systems. First, there is no ‘one size fits all’ system that will meet all FSPs’ needs to the same extent. There must be a minimum level of product customization and integration to successfully support an FSP’s digitization. Currently, many of the third-party providers are start-ups themselves, struggling to provide this necessary minimum support. Second, many FSPs simply don’t know where to look for third-party providers that meet their specific needs. And FSPs struggle with how to realistically assess their options given that providers’ track records are so limited—often there is no tangible proof of a product’s impact, just vague promises.
The fact is, the third-party provider market is not sufficiently developed to fulfill every FSP’s needs, and in-house systems will continue to play a crucial role for many organizations. But we suggest that the longer-term benefits of a robust service ecosystem for digitization deserve additional consideration, especially from donors that are impacting how this market develops around the world.
Donor objectives: FSP success and social return on investment
Imagine a world in which every company built their own email program. While early electronic communication may have been developed internally out of necessity, the maturation of the market clearly depended on a robust set of specialist providers. Lower marginal cost, specialized but widely available innovation, the development of skill nodes within the economy, and the ability to communicate between organizations were all bolstered by third-party providers meeting the needs of multiple organizations.
Digitization of FSPs is developing along a similar trajectory—though the need for strict privacy and security protocols adds an additional, and very challenging, dimension to the story. To date, many of these systems have been developed internally out of necessity. And currently, many donor-funded digitization projects focus on supporting the development of in-house systems and capabilities. As discussed above, there are benefits to this approach under specific conditions—digitization as part of the core business or specific digital requirements. However, is this approach to funding the right one if long-term impact and a vibrant digital ecosystem are the goals?
The case for considering two markets with digital investments
In this context, donors’ investments have the ability to shape the development of an FSP’s individual digitization service AND the digitization service market overall. In-house development contributes to an individual FSP’s capabilities and systems, but this type of internal, bespoke investment can present distinct downsides for the long-term impacts of digitization.
- First, when funding internal digitization projects on an individual basis, donors are foregoing economies of scale. Many of the systems currently being developed internally will be duplicative, meaning that donors are paying to develop the same or similar functionality multiple times. By directing funding towards third-party providers instead, donors have the potential to drastically increase the functionality that each dollar buys by avoiding scenarios in which each FSP is ‘reinventing the digital wheel’.
- Second, in-house development of digital systems results in ‘quarantined innovation’, where advances in digitization cannot easily spread through the market. There is also a paradoxical ‘downside of success’—when an individual FSP develops a highly successful product, the proprietary nature limits the impact of the innovation. And in the event that an individual FSP fails or abandons a system, the donor-funded digitization investment goes to waste. In contrast, if donors actively direct funding towards third-party providers they support a model of ‘distributed innovation’. The development of skill nodes and publicly available digital products broadens the scope of impact, and the rise of a robust service ecosystem offers the long-term potential for services at lower marginal cost.
- Finally, many donors actively profess an interest in data sharing and collaboration, which is hindered by the development of idiosyncratic systems. Widely adopted third-party systems offer the potential for interoperability and seamless data transfer that is unlikely with bespoke systems.
A call for a new donor mindset
Given donors’ active role in shaping the development of this market, ISF believes that there is call for proactive and careful consideration of how digitization funding is spent. At the core of this new mindset is a realization that, in supporting the move to digital, donors should be in the business of building two markets for long term impact – FSPs’ themselves AND a vibrant technology provider market. Practically, this approach requires a few additional steps in grant making to ask more specific questions, including:
- Does an in-house technology solution limit the potential impact relative to a more commercially available technology? [The economies of scale opportunity]
- Does this underlying technology have potential to support many FSPs throughout the ecosystem, to create new innovations over time, and what will be lost if the venture fails? [The quarantined innovation dilemma]
- Is there a broader data opportunity related to the technology that calls for a different ownership structure or access agreement? [The data opportunity]
While FSPs themselves will often push for an in-house solution to enhance their competitive advantage, donors have a broader opportunity to hedge against failure and open up more impact opportunities from replication, connected system innovation, and interoperable data.
Some donors and actors are already incorporating these opportunities into their granting and investment priorities.
Mojaloop (previously the Level One Project, funded by the Gates Foundation) is an open source software that offers an interoperable payments platform to anyone in financial services. The intent of the project is to level the playing field for companies seeking to enter or expand the digital payment space by reducing the need to ‘reinvent the digital wheel’ for payment processing and to facilitate a connected ecosystem that allows seamless transfers across many actors within the payments ecosystem—in other words, the economies of scale opportunity and the data opportunity.
LenddoEFL (an Omidyar Network investee) and First Access (a Mastercard Foundation Fund for Rural Prosperity Innovation Competition winner) both offer credit scoring platforms for financial institutions seeking to serve underbanked people at lower cost—addressing the quarantined innovation dilemma by developing services that actively seek to serve FSPs around the world.
Other initiatives are aimed at addressing FSPs’ concerns about finding a trusted service provider. FinForward, a partnership between FMO (the Dutch Development Bank) and FinConecta (a Fintech company), offers a proprietary market platform “dedicated to accelerate the digitization of the financial industry in Africa by connecting African Financial Institutions (FIs) and Mobile Money Providers (MMPs) with Fintech companies worldwide.” Similarly, the ASEAN Financial Innovation Network (AFIN), a collaboration between the Monetary Authority of Singapore (MAS), the International Finance Corporation (IFC), World Bank Group and the ASEAN Bankers Association (ABA), has launched APIX—an open-architecture API platform for collaboration between FinTechs and Financial Institutions. Both these initiatives offer financial institutions easy access to a pre-vetted community of Fintech service providers (“marketplace” functionality) and a low-cost, low-risk environment to prototype and test potential systems (“sandbox” functionality).
Learning from other markets
As donors and ecosystem actors shape this nascent market, it is helpful to remember that this is not completely new territory. Digitization and specialist third-party service providers have been developing in many other markets around the world, providing us with valuable sources of learning.
In the early days of microfinance, donors were quick to fund the development of bespoke core-banking systems to accommodate the unique requirements of this new form of lending. However, after a period of in-house replications of specialized software, a more sustainable and specialized vendor market emerged that built and maintained microfinance-specific core banking systems for the industry. Part of that shift was facilitated by CGAP, which in the mid-2000s created an Management Information Systems (MIS) fund, which paid for MFI needs assessments. CGAP also facilitated access to quality vendors via an online library of pre-reviewed core banking systems providers, thus addressing the same type of concerns that current FSPs have around finding trusted vendors.
The digital health sector, while highly diverse across countries, has started to coalesce around a core set of software solutions and third-party providers. In the private sector, the challenges of standardization, interoperability, and quality have been largely addressed. In the cost-constrained public sector, and developing country consumer-facing sector, many digital health data collection systems have been built off 2-3 foundation software builds. One such example is OpenMRS, an open source electronic medical records system developed by a non-profit collaborative network of universities, NGOs, and software companies, funded by USAID and the Rockefeller Foundation. And in the specific market for client-facing data collection, there are a set of third-party providers, both non-profit and for-profit, leading the field, including CommCare, Medic Mobile, Ona, and Aether/Gather.
Imagine a rural finance market where companies provide digital solutions to all players in the market with the sophistication of technology providers such as Salesforce, PayPal, or Oracle. Suddenly farmer registration, integrated payments solutions, credit scoring, and integrated insurance bundles would be a matter of integrating into value chains rather than spending years creating the technology from scratch.
These opportunities, at this crucial stage of product development, makes considering two markets such an important conversation to have. Rather than defaulting to siloed internal systems, is there an alternative that could spur the evolution of a supporting technology market to innovate solutions for longer-term, more systemic impact? Often, we think there is!