Regulation of Fintech in India – Explained, pointwise

Introduction

The RBI had come out with guidelines on Digitial Lending in September 2022. The guidelines were welcomed as they has been aimed at protecting customers from unethical business practices, such as mis-selling, breach of data privacy, unfair business conduct, charging of exorbitant interest rates, adopted by digital lenders. According to the the findings of an RBI Working Group, released in November 2021, as many as 600 out of 1100 lending apps available across 80 application stores were illegal apps. Even though RBI has issued guidelines, hundreds of illegal lending apps, which are not under the RBI ambit, are yet to be reined in by the State Governments. With the advent of Digital economy, a lot of digital financial service providers have come up in India and the landscape has only become complex with proliferation of numerous service providers and apps. This has necessitated regulation of the Fintech in India.

What is the meaning of Fintech?

The term “FinTech” is a contraction of the words “Finance” and “Technology”. It refers to the technology start-ups that are emerging to automate and enhance financial services and processes. These fintech firms are challenging traditional banking and financial players and cover a wide array of services, from crowd funding platforms and mobile payment solutions to online portfolio management tools and international money transfers.

According to Financial Stability Board (FSB), of the BIS, “FinTech is technologically enabled financial innovation that could result in new business models, applications, processes, or products with an associated material effect on financial markets and institutions and the provision of financial services”.

In India, Financial sector undertakings, including fintech businesses, are usually regulated by the RBI, SEBI, the Insurance Regulatory and Development Authority of India (IRDAI), and the Pension Fund Regulatory and Development Authority (PFRDA).

What are the benefits of the Fintech Sector?

Financial Inclusion: Innovation driven by Fintech has widened the access to financial services e.g., UPI has been adopted and proved to be beneficial to the small vendors.

Closed gender and access gaps in Financial Services: Fintech has assisted in overcoming obstacles caused by limits on the in-person mobility of women and the loss of job during a period of financial hardship due to COVID-19 pandemic. Fintech services have made it simple to sign up for accounts, complete transactions, and obtain credit. This is one of the many reasons why women made up a significant portion of the customer base.

Extensive Coverage: Fintech has allowed underserved and unbanked areas to be reached, which brick-and-mortar banks were unable to do. The majority of public and private sector banks have established their own fintech incubation centres. Banks have begun to see Fintech as a valuable partner in increasing their reach and connecting with consumers.

Simplified Processes: Fintech has reduced the layers to deliver financial services and have simplified the procedures e.g., many Fintech provide insurance services that are completely online in addition to offering wide range of insurance products.

Social Change: Fintech firms have brought a major change in the Global South by focusing on the social needs. People in developing nations have now been able to access microfinance and digital lending platforms. Regions in Africa, Asia and India, areas with large numbers of people who were disadvantaged by traditional banks, are now enabled to use payment services.

Crowdfunding: Many Fintech Platforms have enabled small businesses, entrepreneurs, charities and artists to receive support without raising money from conventional investors.

What is the need to regulate Fintech Sector?

Data Privacy: The rapid pace of digitization coupled with the decentralized nature of Fintech has posed unique challenges to the regulators. With the proliferation of fintech apps there are concerns related to misuse of consumer data. In addition, some firms have been accused of collecting sensitive user data without informing the consent or

Unethical Practices: A lot of apps have indulged in unethical practices including mis-selling of products, opaque lending practices, brutal collection methods and customer harassment etc. Predatory lending is regulated by the Usurious Loan Act (1918), however, many lending apps have remained under the radar.

Money Laundering: There are also possibilities of criminals indulging in money-laundering and other illegal practices through payments and transfers facilitated by fintech apps. Fintech companies must be required to comply with anti-money laundering (AML) regulations including undertaking measures to prevent and detect money laundering.

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.

What guidelines have been issued by the RBI so far for Regulation of Fintech?

The RBI has issued several guidelines like the Guidelines for Licensing of Payments Banks (2014), the Master Directions on Prepaid Payment Instruments (MD-PPIs, August 2021), Circular on Tokenisation – Card transactions (September 2022), Guidelines on Regulation of Payment Aggregators and Payment Gateways (August 2022) among others.

In 2019, the RBI came up with an Enabling Framework for Requlatory Sandbox. According to RBI, Regulatory Sandbox refers to live testing of new products or services in a controlled/test regulatory environment for which regulators may (or may not) permit certain regulatory relaxations for the limited purpose of the testing. The purpose is to foster innovation in developing new financial products and services. So far, multiple cohorts (phases) have been released dealing with multiple themes like ‘Retail Payments‘, ‘Cross-border Payments‘, ‘MSME Lending‘ and  ‘Prevention and Mitigation of Financial Frauds‘ etc.

Source: PwC. Benefits of Regulatory Sandbox.

In 2020, the RBI also announced the setting up of the Reserve Bank Innovation Hub (RBIH) to promote innovation across the financial sector, by leveraging technology and creating an environment that would facilitate and foster innovation.

The RBI issued Guidelines on Digital Lending (guidelines) in September 2022 that, among other aspects, create a comprehensive framework to protect consumers’ data. The guidelines bring unregulated digital lending players within the RBI’s ambit by requiring that regulated players (like Banks and Non-Banking Financial Institutions (NBFCs/NBFIs)), ensure that unregulated players with which they partner, such as Lending Service Providers and companies offering Digital Lending Apps, comply with them.

What are the Issues associated with Regulation of Fintech?

Pace of Innovation: The field of Fintech is evolving at a quick pace with rapid advancements in technology. It becomes difficult to regulate the evolving technology in advance.

Lack of Comprehensive Approach: RBI’s approach to Fintech Regulation has been criticized as being reactive rather than proactive e.g., the RBI issued guidelines regarding Digital Lending only after several incidents of fraud and coercive practices surfaced. RBI has been slow to respond to industry’s concerns e.g., Banks, NBFCs and fintech players are still awaiting clarity on many aspects of Digital Lending Guidelines, including the First Loss Default Guarantee (FLDG) system.

Arbitrary: Some Fintech players accuse RBI regulations as arbitrary e.g., RBI guidelines on Payment Aggregators (PA) require all companies applying for a PA licence from the RBI to have a minimum net-worth of INR 15 crore. Some start-ups call this clause arbitrary and violate Article 14 and Article 19 (1) (g), which guarantees the ‘freedom to trade’.

Data Localisation: The RBI has mandated data localization requirements which mandate storage of data only in India. Many international payment companies store their data on global servers. India based companies (including start-ups) also outsource technical support and data storage/cloud services. Localization requirement will prohibit these start-ups from opting for cost-effective cloud service providers abroad and forced to choose localized alternatives, which ends in high operational costs.

What steps can be taken ahead regarding Regulation of Fintech?

First, the RBI must adopt a comprehensive approach to Fintech Regulation. Fragmented and reactionary approach to regulation stifles development of innovation. RBI should consult all stakeholders while anticipating technology evolution to formulate supportive regulation.

Second, RBI should ensure that the regulatory framework does not end up stifling the innovation ecosystem. RBI should also be mindful of creating a level-playing field for small start-ups against established large banks. New players/Start-ups bring positive competition in the market along with the financial innovation that benefits the end consumer. Stability of the financial system should also be a top priority.

Third, The regulatory framework should take into consideration all concerns like cyber-security, data protection, anti-money laundering regulations etc.

Fourth, there is a need to bring-in more transparency like sharing key fact statements with customers, allowing them to make informed decision.

Fifth, Fintech players also need to be more prudent in their lending practices, minimize adverse outcomes and focus on customer experience. They should be aware of the risk, cultivate a culture of compliance and invest in regulatory technology.

Conclusion

The fintech ecosystem in India is rapidly evolving. Fintech has huge potential to facilitate financial inclusion and usher in a new era of digital economy in India. The regulation of Fintech sector is equally important in order to protect the consumers and their interests. The RBI must undertake a comprehensive review of the existing regulations and formulate a new comprehensive framework for Fintech Regulation after extensive consultations with all stakeholders.

Syllabus: GS III, Indian Economy

Source: Indian Express, Mint, The Hindu BusinessLine, PwC, Invest India