Retail investors can spur vibrant capital markets

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Photo source: Courtesy

By gatuyu j

This essay was first published in the Business Daily

Having deep capital markets is a reliable mechanism to unlock new pools of capital and ensure efficient allocation of resources in the economy. However, establishing vibrant capital markets is a drawn-out process requiring a mix of financial instruments, stable regulatory framework, market infrastructure, and a critical mass of market participants.

The Kenyan capital markets is underdeveloped relative to economy’s potential. The trading at the Nairobi Securities Exchange (NSE) is characterised by low liquidity in both equity and fixed incomes segments. The turnover ratio averages at five percent with some counters running for weeks without an activity.

Ordinarily, efficient markets should have well-balanced supply and demand sides of capital. In the past, policy measures have majorly focussed on the promoting demand side of the markets, on creating new instruments and encouraging issuers, without equivalent efforts to spur the supply side markets especially in relation to broadening the investor base.

A constant supply of capital is a critical pillar for securities market. A way of nurturing it is by ensuring every class of investors is able to get their desired outcome from the markets. Investors, both retail or institutional, are either “buy and hold investors”, “buy and trade investors”, “active investors”, and “private market investors”.

However, there has been a tendency to encourage the “buy and hold” investors and discourage active traders or speculators, on account of discouraging short termism approach to the markets. This view is unfortunate. Stable capital markets needs all groupings of investors irrespective of their anticipated outcome. The vilified speculators, for instance, provide liquidity to the markets and improve the quality of pricing.

Thus, the next frontier in deepening Kenya’s capital markets is widening the investor base. Currently, the main class of investors are institutional and foreign investors, and participation of retail investors is limited. Institutional and foreign investors bring in capital and skills to the market. However, in the case of foreign investors, their dominant participation in small markets may have de-stabilising effects. They pose a ‘sudden stop’ risk, where capital inflows are quickly reversed as a result of changes in the domestic or international risk environment, resulting into sell-offs and markets meltdown.

To broaden demand side of the markets, participation of local retail investors has to be encouraged. There have been reports of Kenyans recently being duped into sham investments. Sad, as these tales are, some lessons can be learnt. A number of citizens are on the lookout for attractive investments opportunities, a gap the capital markets should tap.

A hindrance for entry of retail investors in Kenya capital markets result from market illiquidity, high transaction costs and market power of brokers. These impediments need to be addressed.

Of these, a transactions cost is a major one. The brokerage fee for a trade transaction at NSE is two percent of amount involved. A buy and sell of equities results into transaction costs of four percent.

To this extent, for an investor to break even, a traded stock has to generate a return of about five percent, which is not easy to actualise in short runs. These transactions costs are detrimental.

This makes a case for introducing the direct market access mechanisms to enable retail investors directly interact with the order book of the exchange without having to pass through a broker-dealer. Stock brokerage is a disrupted practice. Trading has moved from traditional open outcry on trading floors to decentralised electronic, screen-based trading, where investors can trade for themselves rather than handing orders over to brokers for execution.

The law should not require it be mandatory that traders must access order book through brokers. Instead, stockbrokers should justify their continued relevance through value addition for traders to engage them.

Transaction costs

Adopting direct market access mechanism would certainly lower transaction costs, because only the technology is being paid for and not the usual order management. This would give traders more control over the final execution and the ability to exploit liquidity and price opportunities.

Another way to improve market liquidity is by reducing the trading cycle from the current settlement of three days (T+3) to same day settlement (T+0). Such will encourage more retail traders, especially the speculators, and increase trading volumes and facilitate more price discovery. The NSE should be able to demonstrate similar efficiency showcased by online sports betting firms.

Related, promoting margin trading would equally improve market liquidity to benefit of retail investors. Margin trading would enable investors increase their purchasing/selling power. The regulations to operationalize margin trading have been made, but the product is yet to be operationalized.

Lastly, the regulators must maintain a tempo of robust protection of investors by guarding against fraudulent practices which kill market confidence. A recent energised effort by Capital Markets Authority on allegations of insider trading in dealing with KenolKobil shares is encouraging.

Nevertheless, more is needed in legal reforms, especially in protecting minority investors especially against lock-in from protracted takeovers. To attract retail investors, above the liquidity of investments and attractiveness of returns, the safety of their invested money has to be assured. This combines with proactive investors’ education, especially on evidence-based, sensible investment strategy.

How Kenya Can Regulate Initial Coin Offerings

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Photo: courtesy

By gatuyu t.j

The Capital Markets Authority (CMA) has in numerous occasions issued public cautions to warn the public against investing in initial coin offerings (ICO) that have floated by various start-ups, citing the unregulated nature of the offering and the risk of investors losing their money.These cautions comes on a background of continued surge of ICOs as a new model of fundraising, with parallels to initial public offerings (IPO), venture capital, and crowd funding.

ICOs allow Blockchain-based ventures to raise money by creating and selling digital assets usually known as “tokens”. Even though ICOs continue to be a prominent source of fundraising, some have turned out to be speculative ventures without underlying utility, triggering regulatory actions.

New ideas facilitate market efficiency, spurring improvements to services and products and promote market competition. In guiding new innovations, regulations should address and potentially mitigate negative externalities.

In a rapidly changing world of finance, regulators ought to recognise the unique dynamics of emerging technologies and discourage regulatory environment with largely binary outcomes, of either approval or disapproval, which lacks flexibility and often torpedoes innovations.

IPO versus ICO

A company issuing tokens to the public in return for funds is a setting that strongly resembles an IPO used for traditional securities. However, there are visible distinctions. Whereas an ICO leads to the creation of digital tokens on Blockchain, an IPO leads to the distribution of shareholdings to the public, often through underwriters.

Only well-established private companies with profitability record are allowed to carry out IPOs, while ICOs are floated by start-ups on basis of proof of concept outlined in a whitepaper. Lastly, IPOs offer dividends from company profit as a form of return while ICOs offer tokens which have prospects of value increase after a project launch.

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Paul Muthaura, CEO, Capital Market Authority. Photo source: CMA

The ICOs have been able to gain huge popularity because they have certain merits. First, unlike the IPOs, an ICO enables the compensation of initial developers without giving them more control of the network than other token holders.

For in IPOs, founder shareholders often reserve certain controlling rights in the management of a corporate entity. Second, ICOs permit a venture to finance from future users, similar to the pre-sale of goods or forward contracts, and this provides issuers with an early signal about consumer demand, enabling better informed investments in building.

Further, ICOs tokens have high liquidity, which triggers instances of temporary overvaluation (phenomenon that also exists in IPO markets), leading to huge gains for investors. Lastly, tokens can hasten network effects, which are often central to the marketplaces that ICO issuers seek to build. This is experienced where token price appreciation leads more users to join the platform, even though this may have an offside of facilitating market bubble creation.

Criteria for a security

In exploring the regulatory status of ICOs, interrogation usually centres on whether an ICO meet the definition of a security. The Kenyan Capital Markets Act provides a broad definition of security and includes a phraseany instruments commonly known as securities.”

There are no clear guidelines in Kenya or court decision that has clarified when an investment contract becomes a security. In other jurisdictions,a criterion popular as the “Howey Test”, which originated from a US Supreme Court decision, is often applied to determine whether an investment scheme qualifies as a security.

The Howey Test postulates that an investment will be deemed to be a security if it meets four conditions. An offering will be a security where an investment of money is made by the purchaser, the investment is part of a common enterprise among numerous investors, the success of the enterprise depends on the efforts of a third-party promoter, and the investor has an expectation of a financial return, such as capital gains.

Applying Howey Test for ICO in Kenya will end with a conclusion they are an offer of securities, hence subjecting the offer to a slew of capital markets regulations, and eventually killing it.

Rules are necessary for proper functioning markets in order ensure market fairness and integrity, protect investors and facilitate systemic stability. However, it is impossible to regulate new innovations like traditional securities.

Many statutes in the financial sector in Kenya date back decades. As a result, the regulatory framework is not optimally suited to address new business models and products that continue to evolve in financial services. This has the potential negative consequence of limiting innovation to the detriment of consumers and small businesses.

If it not for regulatory restraints expended by former CBK governor Njuguna Ndung’u, perhaps M-Pesa similar payment systems may not have been allowed to operate. By the CBK allowing M-Pesa to operate, without unduly alarming the public with public cautions, it fast-tracked the development of this product to the giant it is today.

Agile Regulations

The mix of technology and its applications to financial services has increased dramatically. It is important for financial regulators to adopt appropriate regulatory approaches without stifling innovations that require time to mature, or create unnecessary barriers to innovation.

Agile regulations and mechanisms such as regulatory sandboxes programs ought to be encouraged, for they facilitate controlled disruption. Further, there need to spearhead proactive amendments of the laws to ensure they keep pace with development in the financial sector.

For every new innovation presents its inherent risks. The regulatory environment should instead be flexible so that firms can experiment without the threat of enforcement actions that would imperil the existence of a firm. Innovating is an iterative process, and regulator feedback can play a helpful role while upholding safeguards and standards.

The regulators should been seen to encourage innovation. They should strive to acquire and understand existing and emerging technologies, to engage with developers and first-movers. Otherwise, the country will lose its repute as a centre of financial innovation. Instead of always issuing warning, CMA should work with innovators and ensure services such as ICO are rolled out successfully. That is the way to foster vibrant financial markets and promote growth through responsible innovation.

The author is the Managing Editor with the Gatuyuriana and a financial markets specialist.

How Kenya can Avoid Tax Evasion Practices by Mining Companies

BE AFRAID, dear countrymen. All the oil prospecting companies operating in the country, such as Tullow oil, are subsidiaries of holding companies incorporated in shadowy tax havens. When mining firms employ harmful tax practices, such as use of tax havens, it portends a Potential tax leakage. Consequently, when the mineral resource is depleted, these multinationals will easily vacate the country to explore elsewhere. Like President Maghufuli has done with Acacia, Kenya must stop these vultures.

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President Kenyatta flagging off early export of Kenya oil from Turkana county. Photo: Courtesy

By gatuyu t.j

In mid-2017, Pombe Magufuli, President of Tanzania, threatened to close mining companies operating in Tanzania. He accused them of not being truthful with their tax obligations on gains accruing from their mining activities. Acacia, a global mining company, bore more of presidential wrath and was issued with a huge assessment of backdated tax liabilities. The case is pending.

Kenya is revamping her extractive industry. The country needs to early on learn from Tanzania to deter tax evasion practices in the sector. This will prevent revenue leakages and ensure the country gains from her resources.

Tax evasion practices by multinationals in extractive industry are a rampant in Africa, making the continent to be unable to benefit from her vast natural resources. A report by a joint team of AU and the United Nations, chaired by Thabo Mbeki, found out that in 2015 alone, African countries lost up to USD 50 billion through tax avoidance schemes.

The extractives industry in Kenya has not been spared from such schemes. A study dated May 2016 by Oxfam, “the Use of Tax Havens in the Ownership of Kenyan Petroleum Rights,”found out that various mining companies in Kenya use intricate corporate structures to hold petroleum rights in order to minimise tax liabilities. This includes owning mining blocks through offshore subsidiaries registered in tax havens. These are all tactics that create room for the companies to erode their Kenyan taxable base and shift profits to affiliates located in offshore low tax jurisdictions.

The study gives examples of mining companies that use offshore entities. These include British Tullow Oil (Netherlands), Africa Oil (Barbados), ERHC Energy (Virgin Island) Octant Energy Corp, Ophir Energy (Bermuda), Swiss Oil (Mauritius), Total (Netherlands), among others.

Kenyans should be worried to have her mining sector dominated by companies employing aggressive tax planning practices. It is an indicator the government may not be able to collect sufficient taxes from the mining industry. The same concern was raised by the Ministry of Energy and Petroleum, in December 2016 in report, titled Social Assessment of the Petroleum Sector in Kenya, which called for raising accountability bar in mining sector.

When mining firms employ harmful tax practices, such as use of tax havens, it portends a Potential tax leakage. Consequently, when the mineral resource is depleted, these multinationals will easily vacate the country to explore elsewhere.

Whenever tax consultancies are accused of facilitating these harmful tax avoidance practices by multinationals, they turn militant and unleash clever sounding clinches’ of how tax avoidance is different from tax evasion, and how tax payers are entitled to arrange their affairs to prevent a large shovel of a taxman into their stores. It does not sink. Exploiting the tax system to prevent the country from accruing appropriate benefit from her resources is immoral.

Silicon Valley giants have perfected the art of notorious and aggressive tax planning. However, such firms are present in the long run and a solution on how to curb these practices may be found. The same leisure cannot be accorded to the extractive industry. Minerals are finite. They can only be extracted once.

It is vital that a country accrues maximum benefit from the windfall. The government should therefore do all is possible to protect the revenue base from the country’s mining wealth. We cannot afford a rat race the countries are doing with tax evading tech firms with extractive industry.

It therefore does not matter whether tax havens are legal or otherwise. They are toxic non-value adding jurisdictions that facilitate harmful and immoral tax practices. They facilitate the creation of shadow long-winded corporate structures, which are nothing but smokescreens to avoid accountability. Entities registered in tax havens should not be allowed to own mining blocks in the country.

Kenya needs to pre-empt a predicament facing President Magufuli. The country should aggressively streamline the regime of taxation in the extractive industry to deter possibilities of tax leakages.The companies operating in the sector should be required to maintain high disclosure requirements in line with international best practices.

This would include requiring them to lift veils of their corporate structures and reveal their ultimate beneficial owners.Increasing transparency is a step to deter potential profit shifting. It will also ensure the country benefits from her mineral resources fully for the benefit of her citizens.

The author the Managing editor of the Gatuyuriana

Why the world can do without America

At the dawn of 2019, the United States and Isreal quit UNESCO. This is a continued surge of American carnage, where United States is drowning the established global order. The World should ignore the American theatrics and move on. The World can do without the United States.

On 1st January 2019, the United States and Israel officially quit the United Nations Educational, Scientific and Cultural Organization (UNESCO). This was a culmination of a process that was triggered more than a year ago.

It is not the first time the US is pulling out of UNESCO. It did so in 1984, during the Reagan administration, under the pretense that UNESCO was mismanaged, corrupt, and used to advance Soviet interests.

The US will later rejoin the body in 2003. Only to quit again in 2019, now in order to side with Middle East bully Israel, and as a protest for UNESCO having (almost) unanimously voted to admit Palestine as a member. They wrongly accused this UN body for anti-Semitism.

President Donald Trump, during his inaugural address as president, promised the end of American Carnage. Seemly, what we are now witnessing is the surge of American carnage, with president Trump as the god of carnage.

President Trump has been on warpath against multilateral global order. One of the lows of his ignoble presidency, is when he withdrew United States membership from the Paris Agreement, an ambitious deal aiming at combating climate change, a phenomena that has an existential threat humanity.

America, now join other two states, Syria and Nicaragua, who are outsiders to Paris Agreement. Fears, and these are not misplaced, American indifference to global affairs may result to a collapse global order.

But digging history shows the world has shown resilience on various fronts in absence of American leadership. The World can in fact do without America and should call a bluff to US tantrums. We illustrate.

US, through the warlord and perpetrator of crimes against humanity, President Bush, withdrew from the Statute of Rome, a treaty that creates International Criminal Court. Yet, even though with flips and bumps, the world has marched on and brought various crimes against humanity perpetrators to account.

United States is yet to ratify United Nations Convention on the Law of the Oceans. Yet the world oceans are being managed well, demarcated, and highs seas protected.

In the 1920s, America refused to be a member of the League of Nations, during its moments of ill advised isolationism. The League kicked off, deterred world wars for a period, and laid the ground for United Nations, which US has now hijacked.

United States refused to ratify the Kyoto Protocol, the predecessor to Paris Agreement, and yet world made some steps in reducing greenhouse gas emissions and combating climate change.

United States (and Somalia) are the only two countries yet to ratify Convention on the Rights of the Child and optional protocols under it. Yet, progress has been made by world states in guaranteeing children rights.

United States is yet to ratify the Convention on the Elimination of All Forms of Discrimination Against Women, which would guarantee women equal rights in various facets. Yet, progress has been made, women are making strides, even in Saudi Arabia, the hell on earth for women.

United States is yet to ratify treaty on nuclear weapons test ban, popular as Ottawa treaty banning landmines. Yet, it is the only country that has used nuclear weapons in war to effect a massacre.

The country has not ratified the Moon treaty that prohibits abuse of celestial bodies, yet progress has been made.

The crux of our contention is the world can still surge forward on various fronts of mutual concern, with or without the United States, a crumbling giant which is becoming an impediment to global order. The Paris Agreement, the the UNESCO, and other beacons of global order, can be implemented, with or without the United States.