Finance is the lifeblood of an economy and technology is its carrier. It is time to convert fintech initiatives into a fintech revolution. - Prime Minister Narendra Modi
Kudos to PM Modi for recognizing the importance of fintech in India's growth story. We hope his call-to-action motivates regulators to build an enabling legal framework which ushers in a fintech revolution.
Welcome to another edition of FinTales - your monthly dose of all things fintech. And since you liked the previous FinTales menu, we repeat the three-course meal with a palate cleanser.
Appetizers: bite-sized snackable updates about recent fintech developments.
Main-Course: one big meaty story about the RBI working group's report on digital lending.
Palate Cleanser: a break from the fintech menu.
Dessert: sweeten your day reading about Niti Aayog's forward looking thoughts on neobanks.
Vamos!
Appetizers
Crypto Bill to land on Cabinet's table soon. The cryptocurrency regulation bill will reportedly be discussed by the Union Cabinet very soon. After this, the bill may be tabled in Parliament. Media reports relying on a Cabinet Note (on cryptocurrency regulation bill) indicate that the government does not intend to impose a blanket ban on cryptocurrencies. Instead, cryptocurrencies may be treated as assets which can be traded through crypto-exchanges regulated by SEBI. But the use of cryptocurrencies as a method of payment may be banned. For a deeper dive, hear our founding partner, Anirudh Rastogi, discuss what India's legal framework for cryptocurrencies should look like.
Unfair play through Rupay? Indian government left no stone unturned in promoting homegrown cards network, Rupay. Naturally, this is seen unfavourably by the bigger American competitors - Visa and Mastercard - who see this as protectionism. Both Visa and Mastercard reportedly complained to the United States government about this.
Adding G-secs to your portfolio? The RBI flagged off the retail direct scheme and launched a new portal where retail investors can directly purchase government securities (G-secs). Retail investors can now directly purchase and sell G-secs through the portal and save the commission which would otherwise be paid to intermediaries like stock exchanges and mutual fund houses.
Whatsapp's staircase climb to UPI peaks. The potential for UPI on Whatsapp is huge. But in a country with 400 million Whatsapp users, the NPCI rightly sees the risk in allowing all Whatsapp users to use UPI in one go. So, in the spirit of gradual increment, the NPCI increased Whatsapp's UPI user limit to 40 million users.
Unravel the mystery of Postpe's credit-based QR code payments. Postpe allows users to scan QR codes and pay merchants using a credit line.But NPCI hasn't enabled credit-based payments on UPI yet. So how is Postpe facilitating credit-based payments through QR code? This article by Captable unravels this mystery. Astha Srivastava, senior associate with our fintech team is also quoted in this article.
RBI charts out plan to boost UPI. The RBI's recent policy statement provides a sneak peek into how UPI may change in the near future. The RBI statement proposes a discussion paper on charges for digital payments. Other proposals include an increase in UPI transaction limits from Rs. 2 lakhs to Rs. 5 lakhs for IPOs and retail direct schemes. Most interesting is the plan to create an on-device wallet for UPI apps to process small ticket transactions.
Algo trading catches regulatory eye. SEBI has released a consultation paper on regulation of retail investors' participation in algorithmic trading. The paper recommends that all trading algorithms must be approved by the stock exchange and run on the servers of stock brokers. The deadline to send feedback is 15 January 2022.
Main-Course
RBI WG Report gives digital lending an opportunity to turn over a new leaf
Last month, the RBI released its much-awaited report on regulation of digital lending apps (DLAs). Much to the industry's relief, it steers clear of imposing any licensing requirements on digital lenders. But if the Report's recommendations are implemented, some digital lenders may have to change their existing business models and gear-up to bear increased compliance cost. Before we dive into the Report, let's recap. The RBI commissioned this Report in January 2021. Around this time, rogue digital lenders were making headlines. Alarmed by this, the RBI constituted a working group to suggest a regulatory framework for digital lending. Now, let's unpack the Report.
Ban on FLDG
WG Recommendation: The Report recommends a prohibition on unregulated DLAs bearing credit risk -including through first-loan-default guarantees (FLDG).
Current Market Practice: Regulated Entities (REs) want unregulated DLAs (as partners) to have enough skin-in-the-game so that they can trust DLAs' services for loan underwriting. So REs enter into FLDG arrangements with DLAs.
Impact: If unregulated DLAs cannot offer FLDG, REs will be reluctant to extend loans to borrowers referred by them. Risk-sharing arrangements like FLDG ensure that unregulated DLAs adopt rigorous standards while assisting REs with underwriting borrowers. As unregulated DLAs will have to compensate REs for any borrower defaults. If FLDG arrangements are prohibited, unregulated DLAs will be incentivized to chase volume at the cost of quality. This could lead to lax underwriting standards for loans and ballooning of NPAs.
Alternatives: RBI WG's concern that through FLDGs and other synthetic arrangements, unregulated DLAs may pose operational risk is valid. But prohibiting FLDG entirely may not be the most optimal way forward (because of the concerns highlighted above). Instead, FLDG should be capped at an appropriate level and monitoring mechanisms can be put in place.
Data Privacy and Security
WG Recommendations: The Report recommends that DLAs should seek prior, informed, explicit and auditable consent of the borrower for collecting her personal data. Borrowers should also be able to provide consent for use of specific data and its disclosure, retention and destruction. And DLAs should take separate consent for different types of data they access. All security breaches should also be reported to customers.
Current Market Practice: The core value proposition offered by DLAs is their ability to use alternative data sources for underwriting borrowers. DLAs rely on a large number of data points while evaluating the credit-worthiness of a borrower. A borrower's payments data, social media usage, contact lists, location etc. are all used to paint a picture of her education, employment, expenses and lifestyle. By leveraging these alternative data sources, DLAs can promote financial inclusion and extend loans to 'new-to-credit' and 'thin-file' borrowers.
Impact: If the recommendations are implemented, DLAs will have to send multiple notifications to seek consent for different types of data collected. If consent is required even for accessing publicly available information like social media posts, it may limit the range of alternative data available for underwriting and reduce the accuracy of credit risk assessment. From the borrowers' perspective, being bombarded with consent seeking notifications may lead to consent fatigue. And such information overload may prevent borrowers from developing a meaningful understanding of what is happening to their data. Further, reporting of all security breaches could cause unnecessary panic as many vulnerabilities are caused by minor errors or bugs which are routinely fixed by companies.
Alternatives: The WG's concern about safeguarding borrowers' data is legitimate. It is also backed by past experience of rogue DLAs misusing personal data to harass borrowers. However, to ensure regulatory consistency and prevent jurisdictional overlap, the Report's recommendations should be aligned with the Personal Data Protection Bill 2019 (PDP Bill). For instance, the PDP Bill recognizes 'credit scoring' as a reasonable purpose for which data can be collected and processed even without the consent of the data principal. Further, the PDP Bill requires reporting of security breaches only to the Data Protection Authority (DPA) and only if there is risk of harm. Once the PDP Bill is enacted, DPA as a specialized regulator will be best placed to address data privacy and security concerns raised by DLAs. In the interim, the proposed Self-Regulatory Organization can prescribe minimum standards for data collection, processing, sharing and storage by DLAs.
Artificial Intelligence
WG Recommendation: The Report recommends that any AI/ML systems used for credit risk assessment should be transparent, explainable, non-discriminatory and auditable.
Current Market Practice: As the volume of data for digital lending is too large for any human to handle, DLAs use proprietary AI/ML systems to process the data and assign a credit rating to the borrower. Indian fintech executives believe that the quality of credit underwriting algorithms will become a key differentiator in the industry. These technologies are still in their early days and they are not infallible. But the low NPAs achieved by fintech players like BharatPe and Cred give us reasons to be hopeful.
Impact: If the WG's recommendations are implemented in the form of prescriptive regulation, it could pull the brakes on development of emerging technologies like AI/ML for digital lending. Ensuring transparency, accountability and fairness of AI/ML systems are important goals but they may not be technically feasible yet. DLAs also invest heavily into developing proprietary AI/ML systems and they could lose their competitive edge if transparency obligations require disclosure of the raw code of these systems.
Alternatives: If AI/ML systems are not properly designed, they can perpetuate social inequalities and exclude creditworthy borrowers on arbitrary grounds. But, as the AI/ML technology is still emerging, it may be best to adopt a principle-based approach which grants adequate flexibility to DLAs about the specific features and design of their AI/ML systems. The regulations must not mandate disclosure of trade secrets like raw code. Instead, DLAs can be required to disclose relevant parameters based on which they assess a person's creditworthiness to check for discriminatory parameters like gender, caste, religion, race etc.
BNPL
WG Recommendation: The Report recommends that short-term unsecured loans like buy-now-pay-later (BNPL) products should be regulated as balance sheet lending.
Current Market Practice: BNPL comes in many avatars. Some BNPL providers help merchants accept deferred payments from their customers and they do not facilitate any loans from REs. They basically help customers open a khata with onboarded merchants. Then there are BNPL players which help customers avail loans from REs, which customers can use to pay merchants. These loans are sometimes not recorded as balance sheet lending because there is no interest payable on these loans.
Impact: Fintech players which merely enable merchants to offer operational credit without facilitating any loan from an RE will not fall within the ambit of this recommendation. But funds loaned by an RE to facilitate BNPL purchases will have to be recorded as balance sheet lending even if there is zero interest charged.
Alternatives: BNPL products which involve sourcing a loan from REs should be regulated as balance-sheet lending. These point-of-sale loans must be reported to credit bureaus to prevent over indebtedness. But at the same time, regulation of zero interest BNPL loans should be light-touch as they do not pose the same risks as interest bearing loans. BNPL players generate most of their revenue through commissions received from merchants and not through late charges paid by customers. So, they are incentivized to ensure timely repayment and it does not serve their interests to keep customers stuck in revolving debt. BNPL products also offer greater visibility about the end-use of the funds as they can only be spent to buy goods and services from onboarded merchants. Therefore, BNPL loans do not require the same kind of heavy-handed regulation as traditional interest carrying loans.
Keep the baby, throw the bathwater
DLAs and REs both bring unique advantages to the lending ecosystem. REs have earned consumer trust. And DLAs bring-in the tech stack and knack for distribution. They offer proprietary credit evaluation algorithms, which help REs underwrite borrowers more accurately, reduce NPAs and build their loan-book. DLAs have also set up large distribution channels. DLAs like Paytm, Mobikwik and Razorpay have helped REs disburse loans worth several hundred crores.
The Report lists technological neutrality, principle-based regulation and addressing regulatory arbitrage as its guiding principles. These principles set the right tone and if they are implemented while keeping sight of commercial realities, we could have a goldilocks moment in digital lending regulation. Which will allow DLAs to aid post-pandemic economic recovery by bridging the existing credit gap, reducing NPAs and creating bespoke credit products. And keep rogue players and predatory lending in check.
Palate Cleanser
Did you ever wish you could turn your random musings into a playlist? We haven't either.
But it's fun to create a playlist out of a random life situation. Check out our 'I am still hungry' playlist here. And create one for yourself using this 'weird' tool from our friends at Humit.
Dessert
Niti Aayog banks on digital banks
If I had a rupee for every time I heard the word 'neobank', I'd deposit all those rupees in a neobank. Despite being a fintech buzzword, neobanks have not made remarkable strides in India. As they operate in a regulatory vacuum. So, last month, Niti Aayog stepped-up as the bellwether for neobank regulations. And published a discussion paper on full-stack digital banks. Niti Aayog's proposed regulatory model would enable neobanks to operate as the utility layer as well as the engagement layer of financial services. The deadline for comments on the paper is 31 December 2021.
The discussion paper explains the value proposition of neobanks, and lays down an implementation plan to put the bank in 'neobank'. Here is all you need to know about the proposal and our take on it.
An idea whose time has come
An end-to-end digital bank model has not been green lit under Indian law. Which means neo-banks must partner with banks or other licensed entities to launch their platforms. As a result, most neo-banks end up acting as front-end technology layers. Traditional banks act as utility layer, and perform the core functions. So, neo-banks are not equipped with regulatory freedom to create ground-up innovative products. The Niti Aayog report highlights that neobanks have limited revenue potential (under current regulatory framework). They either earn fee-based revenue as partners or a fraction of interchange for processing payments. So, neobanks rely on equity capital to meet their operational costs, because unlike banks, they can't accept deposits. Low entry barriers (in absence of regulations) also aid entry of rogue players in the market.
As for financial inclusion, the report mentions that it is questionable how far traditional banks have been able to enable financial inclusion and bank the underbanked. India's small businesses continue to suffer from the same old malaise - lack of access to credit. As small businesses opt for informal credit, traditional banks find it difficult to assess their creditworthiness. And in cases where underwriting is simpler, the financial rewards (for banks) are not worth the risk.
Neobanks, armed with technological tools, offer high-cost efficiency. Operational costs for traditional players may be 10-20 times higher than that of neobanks. Neobanks with lower customer acquisition cost and cost-to-serve have the headroom to offer cheaper financial services at a faster pace. And they can be the be-all end-all for financial inclusion.
Blueprint for licensing
Niti Aayog's paper proposes implementation of full stack digital banks in three stages - (i) introduction of a digital business bank license with restrictions on asset sizes and deposits; (ii) enlistment and assessment of the licensee under the RBI's regulatory sandbox; and (iii) grant of a full-stack digital business bank license based on the performance of the licensee in the sandbox.
Niti Aayog's paper also proposes that RBI must allow digital banks to provide complementary non-financial services. Like payroll management, account receivables management and tax management. This can create seamless user experience and offer digital banks additional monetisation avenues. For this, the RBI will need to increase the remit of banking companies under the banking regulation law.
A utopian dream or an impending reality
A full stack digital bank in the hands of new age disruptors sounds utopian. A proof of concept is available in UPI, which enabled mass adoption of instant retail payments through participation of start-ups and tech giants. With their deep pockets to market and technical expertise, full stack digital banks could make banking as ubiquitous as UPI. Niti Aayog's proposal is tacit approval of the necessity of digital first neobanks. And may usher in the fintech revolution that our Prime Minister aspires for.
That's it from us, folks.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
