Baba’s Explainer – Fintech Regulation in India

Over the last two years, there has been a massive adoption of digital payment systems in India, making it a lot more convenient to go about with basic financial services. This growth and expansion of the FinTech ecosystem in India have been aided by a number of factors, including the growing availability of smartphones, increased internet access, and high-speed connectivity.

In recent years, India’s payments infrastructure has seen substantial improvements, particularly with the introduction of new payment mechanisms and interfaces such as Immediate Payments Service (IMPS), Unified Payments Interface (UPI), Bharat Interface for Money (BHIM), and others. The government’s “Make in India” and “Digital India” projects also played a significant role in accelerating the adoption of Fintech. It is commendable that the Reserve Bank of India (RBI) has also pushed the growing use of electronic payments to establish a truly cashless society in recent years.

India’s emergence as a fintech ecosystem has been spectacular where fintech’s financial institutions, regulators and Governments have followed a collaborative approach to provide a comprehensive and continuous impetus to the growth of this sector. While transformational digital initiatives by the government have helped fintechs to enhance the social and economic well-being of millions of people around the world, the next stage of the digital revolution lies in moving beyond fragmented digital solutions to digital Infrastructures that will spur digitalization across economies and societies.

With the advent of breakthrough platforms such as PayTM, PhonePe, MobiKwik, etc., digital payment systems have undeniably been the flag bearers of the Indian FinTech market.

The government has demonstrated to the world a unique model of public-private partnership by building a strong public infrastructure in the India stack – that facilitates and enables private-sector innovation. The India stack is based on a four-pronged approach.

1. Biometric identity in the form of Aadhar for identification
2. Getting everyone a bank account through Pradhan Mantri Jan Dhan Yojana (PMJDY) and building financial inclusion
3. Building scalable platforms to transfer money [Immediate Payment Service (IMPS), Unified Payment Interface (UPI), Bharat Bill Payment System (BBPS), etc.,
4. Allowing Banks and fintech also to access platforms like UPI, Goods and Service Tax Network (GSTIN), and Digi locker to innovate.

This open-API infrastructure has been leveraged heavily by fintech to address diverse use-cases and will continue to act as the core pillar for powering the next wave of growth.

• Enabled the penetration of under-banked and unserved segments of our vast market that brick-and-mortar banks failed to reach.
• Provided transparency, thanks to its adaptability, multilingual options of access and robust interface, leading to an expansion of the country’s consumer base.
• Eased friction between financial institutions and retail customers
• Drawn capital flows into the Indian economy
• Bridged the gender and accessibility gap in financial services:
  • Helped meet challenges arising from restrictions on the in-person mobility of women and loss of employment at a time of financial distress owing to covid.
  • The ease of signing up, making transactions and obtaining credit offered by fintech services only added to the many reasons that their cash-free model resonated with a consumer base of women.
• The Indian market has witnessed an upward trend in fintech unicorn and soonicorn valuations. This is an outcome of the regulatory sandbox regime introduced by the Reserve Bank of India (RBI) in 2019 that has helped pave the way to the El Dorado of a $5 trillion economy.

India Post Payments Bank launches ‘Fincluvation’

India Post Payments Bank (IPPB), a 100% government-owned entity under the Department of Posts (DoP) announced the launch of Fincluvation– a joint initiative to collaborate with the Fintech Startup community to co-create and innovate solutions for financial inclusion.

• Startups are encouraged to develop solutions aligned with any of the following tracks-
  • Creditization – Develop Innovative & Inclusive credit products aligned with the use cases of target customers and take them to their doorsteps through the Postal network.
  • Digitization – Bring convenience through the convergence of traditional services with Digital Payment Technologies such as making the traditional Money Order service an Interoperable Banking service.
  • Any Market-led solutions that can help solve any other problem relevant to IPPB and/or DoP in serving the target customers

The intersection of technology with financial services coupled with traditional distribution networks is opening up a new set of business opportunities.

• Blockchain technology, that maintains records on a network of computers, but has no central ledger.
• Smart contracts, which utilize computer programs (often utilizing the blockchain) to automatically execute contracts between buyers and sellers.
• Open banking, a concept that leans on the blockchain and posits that third-parties should have access to bank data to build applications that create a connected network of financial institutions and third-party providers.
• Insurtech, which seeks to use technology to simplify and streamline the insurance industry.
• Regtech, which seeks to help financial service firms meet industry compliance rules, especially those covering Anti-Money Laundering and KYC protocols which fight fraud.
• Cybersecurity, given the proliferation of cybercrime and the decentralized storage of data, cybersecurity and fintech are intertwined.

The future of fintech looks promising. However, it also brings greater exposure to regulatory requirements, sanctions and legal actions. For example, fintech companies tend to be less regulated than traditional financial institutions. In addition, fintech firms may be more vulnerable to cyberattacks since they often hold consumers’ sensitive financial information.

1. Data Privacy

• Data privacy is one of the most important legal issues in the fintech industry. Fintech companies collect and use large amounts of customer data. This raises concerns about how this data will be used and protected.
• One of the most critical issues in developing financial technology is risk assessment and data breach prevention. When regulatory bodies uncover a data leak, they may be able to identify the perpetrator due to noncompliance with anti-data-leak regulations.
• In countries that are members of the European Union, noncompliance with anti-data-leak financial technology regulations may result in hefty fines.

2. Money Laundering

• Money laundering is a process whereby the proceeds of criminal activity are transformed into legitimate funds. Money laundering costs firms and governments more than $2 trillion per year.
• This legal issue is particularly relevant for the regulation of the fintech industry because of the way fintech companies facilitate payments and transfers. Fintech companies are required to comply with anti-money laundering (AML) regulations. These require financial institutions to take measures to prevent and detect money laundering.
• AML laws and programs for fintech regulation should include customer identification and screening, transaction monitoring and reporting of suspicious activity.

3. Cyberattacks

• Financial institutions are a common target for cyberattacks.
• Fintech companies hold large amounts of data. This makes them attractive targets for cybercriminals. Also, fintech firms may be less prepared to defend against cyberattacks than traditional financial firms.
• All financial firms need to have robust cybersecurity programs in place to ensure proper protection. These programs should include data encryption, firewalls and intrusion detection systems.

There is a challenge to fintech coming from Bigtechs, which have enormous customer networks and primary businesses in social media, telecommunications, Internet search and e-commerce, with significant global presence. Bigtechs use the new technologies that enabled fintech start-ups to unbundle financial services to ‘reverse’ the unbundling.

• They benefit from cross-subsidisation and economies of scale because of their worldwide user base of non-financial products. As a result, they are well-positioned to acquire a major part of the financial services sector and take control over the market.
• Bigtechs’ penetration may pose new and complex trade-offs between financial stability, competition, and data protection. It is time that the regulator focuses on Bigtechs as well and ensures a level-playing field between Bigtechs and banks, considering the former’s wide customer base, access to information and broad-ranging business models.
• The network effects and concentration of Bigtech in supplying some financial services such as cloud computing highlight the financial sector’s reliance on Bigtech services and their systemic significance. Breakdown of any one of these firms, or failure of a service, would lead to severe consequences for markets, customers and financial stability.

Some lacunae and loopholes in regulating fintech undeniably exist. The multifold disruption of technology makes it hard for policymakers to keep up with the curation of laws. It is thus imperative for the regulator to put in place reasonable restrictions where data protection, privacy and security may be at threat.

So far, the regulations have been ‘light touch’, aimed at reducing risks arising from the fintech industry. Key examples would be licensing of payment aggregators and the regulation of payments data and digital lending. It is important for the regulator to strike a balance between product innovation and consumer protection.

Broadly, the fintech sector is regulated under five regulations:

• The Payments and Settlement Systems Act of 2007
• Peer-to-peer lending guidelines of 2017
• National Payments Corporation of India regulations for payments via the Unified Payments Interface (UPI)
• Regulations governing NBFCs under the RBI Act of 1934
• Regulations governing payment banks under the Banking Regulations Act of 1949.

Additionally,

• RBI set up an internal fintech department in January 2022: Constituted in a bid to promote orderly growth in the country’s digital financial services sector, identify issues and challenges, facilitate constructive innovation, boost incubation, and regulate the fintech industry for its smooth working.
• The regulator has rolled out a number of favourable policies for credit facilitators like small finance banks and payment banks. This has fast-tracked the usage of UPI, internet-based banking and mobile banking.

Along with the deepening of technology and digital services, there’s been a rise in digital fraud and consumer dissatisfaction. This has triggered the regulator to take a closer look at the operation of the fintechs, resulting in the introduction of certain supervisory steps to address the risks emanating from their activities.

Worldwide, fintech firms are subject to three types of regulations.

• Activity-based regulation, in which identical actions are regulated equally regardless of the legal status or type of the entity doing the activity.
• Entity-based regulation, which requires laws to be applied to licenced firms engaged in comparable and specified activities, such as deposit taking, payment facilitation, lending, and securities underwriting, among others.
• Outcome-based regulation, where firms are required to ensure certain fundamental, common, and technology related aspects.

Steps being taken by India

• The zero-MDR (merchant discount rate) guidelines for promoting small ticket debit card merchant transactions
• The most recent move by the RBI in barring prepaid instruments with credit lines in connection to Buy Now Pay Later (BNPL) is criticised as a deterrent to fintech growth and innovation in India. Razorpay report, ‘The (Covid) Era of Rising Fintech’, shows that the Indian BNPL industry has grown by a whopping 569 percent in 2020 and 637 per cent in 2021 to achieve the market size of $3.7 billion. However, recently, Harvard Professor Marshall Lux claims that BNPL is a bubble, not a boom.
• The tough stance of the RBI regarding cryptocurrency transactions is also criticised among participating fintechs. Fintechs operating as P2P lenders, alternative credit scoring platforms and crowd sourcing platforms are being slowly brought under the regulatory ambit.

As fintech firms grow in size, they may encounter increased regulatory scrutiny. A sensible regulation with transparency will strengthen the sector in the long run and facilitate the Indian economy in growing at its potential rate by allowing its growth drivers to fuel the engine of economic advancement.

Fintech has the ability to transform the way financial services are delivered completely. It has already disrupted the financial world and changed the way we bank, make payments and invest, and greater changes are yet to come.

• Financial institutions should prepare for the future with the tools and technology needed to stay up with fintech regulation. This will help them be aware of the risk, cultivate a culture of compliance and invest in regulatory technology.
• Fintech regulation is important to protect users and ensure the safety of payments. In order to provide secure services and protect their users, all fintech financial institutions must adhere to fintech laws and regulations. Only then can the full potential of fintech be realized.

Fintech has the potential to transform other financial services like insurance, investment, remittances. With right cyber security and internet penetration approach India should move forward to recognize the emerging virtual banking system in future.