Tuesday, February 14, 2017

Regulating India’s FinTech

[The following guest post is contributed by Vaibhav Parikh, who is a business lawyer associated with the Aditya Birla Group]

“Disruption” is often used as a generic term to describe situations where smaller and newer companies with fewer resources are able to successfully challenge established incumbent businesses and upset status quo. Although a case has been made that it brings visibility to an enterprise, disruption is far more nuanced, and can result from a variety of factors ranging from technological innovation and disintermediation to regulatory arbitrage.

The distinction is, however, more than just academic, as knowing the nature of disruption can help assess its regulatory viability, sustainability and the ability of the underlying enterprise to retain value.

The Wave of FinTech Disruption

India’s resilient economy, along with a swelling middle class and recent governmental policies, has certainly increased the demand for financial services in the country. Traditional banks that were once sheltered by regulations are now sailing in unchartered waters. And it is the lack of innovation on their part that has resulted in the usage of FinTech as a tool, which is growing leaps and bounds. It is creating significant opportunities for innovators to take a leap of faith in the existing market.

Also, India’s FinTech firms are focusing more on untapped customer segments and are certainly fulfilling the needs of the customers. Businesses with unfavorable financing requirements from traditional banks have turned to unconventional lenders for funding. This under-developed consumer banking system has paved the way for FinTech firms to approach the unbanked population who are seeking better offerings elsewhere.

Further, the developing technology infrastructure in the country has also given FinTech firms an impetus to flourish. Ubiquitous connectivity in major cities and unprecedented changes in the government policies have translated to mature digital penetration in payment methods. With payment cards to digital wallets, FinTech firms have led the way in retail disruption.

Lastly, the readiness on the part of the bankable population in adopting these products has offered disruptors an opportunity to gain scale. India’s FinTech scenario is therefore at an inflection point in reshaping the financial landscape.

Why is there A Need for Regulating the Wave?

An emerging set of disruptors is seeking to operate in sectors not usually amenable to disruption by reason of their being heavily and actively regulated. Such regulation is often justifiable in the light of the systemic importance of these sectors, and the risks associated with them. This is proving to be a prominent disruption where FinTech firms are seeking to facilitate direct small and medium ticket loans to individuals and small-and-medium enterprises through third party lenders. They also seek to facilitate disbursements, repayments and contracting in consideration for service fees.

Their objective is to render payment services more efficiently and to drive loans which are not addressed by existing means. This would require participation by non-traditional lenders, simplified enrollments and lending procedures and unconventional lending and repayment mechanisms and terms. These FinTech platforms may be subject to limitations on interest rates chargeable, prudential and capital adequacy norms for participation in risk, reporting requirements, regulations governing KYC requirements and restrictions surrounding potential enforceability of electronic documentation for recovery. Again, proactive compliance and regulatory engagement will bring distinct advantages.

Also, investors investing into potentially disruptive businesses need to be mindful of the nature of the disruption, its long term sustainability, and how prepared their potential investee is for regulatory interventions. An analysis of trends from legal issues affecting investments into various sorts of disruptive businesses indicates that it is in the interest of the investors to future-proof business models and operations against emerging regulatory changes and trends.

One way this could be achieved is through conducting thorough due diligence (financial, legal and technical) on potential investees with special emphasis on the regulations governing their more entrenched competitors and investee compliance with such regulations. Investors must also analyze investee business operations and put in place suitable processes and documentation to comply not only with best practices but also at the very least with the spirit of applicable rules and regulations. Further, analyzing, estimating and classifying risks, and structuring businesses in such manner as to compartmentalize riskier, more regulated portions thereof from the remainder of the their operations will also go a long way in ensuring that the investment into a disruptive business is in the investors’ best interests.

Disruptive operations in highly regulated sectors like financial services are subject to very substantial and proximate regulatory risks. Last year, the Reserve Bank of India (RBI) set up an inter-regulatory Working Group to study the entire gamut of regulatory issues relating to FinTech and Digital Banking in India. One of the terms of reference of the working group is to chalk out appropriate regulatory response with a view to re-align/ re-orient regulatory guidelines and statutory provisions for enhancing FinTech associated opportunities while simultaneously managing the evolving challenges and risk dimensions.

The focus on this nature of investment has moved from risk mitigation to risk classification, with the intent being to mitigate the most serious risks as much as possible. Given the recommendations of Ratan Watal Panel mooting an independent payment regulator, expect disruptive behavior in the regulations for FinTech regulations in the form of sandbox regulations. Some level of regulatory crystal ball gazing is also called for by investors into these sectors.

Therefore, given the current strengths in terms of government policies, talent resource pool and the current contribution of the FinTech to the Indian economy, there is an opportunity to create best-in-class standards, practices, resources, regulation and technology in order to play a leading role in global as well as Indian development of FinTech.

- Vaibhav Parikh

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