Embracing a Wider Scope for TReDS

Transfer of Factoring Units to come under the purview of TLE in lieu of the regulator’s move to enhance TReDs Platform

– Anita Baid, Vice President | finserv@vinodkothari.com

The concept of Trade Receivables Discounting System (TReDS) was introduced by RBI to enable discounting of invoices of MSME sellers against large corporates, including government departments and public sector undertakings, through an auction mechanism to ensure prompt realisation of trade receivables at competitive market rates. 

TReDS transactions fall under the umbrella of “factoring business.” Factoring is a financial practice where a company sells its trade receivables, or outstanding invoices, to a third party at a discount in exchange for immediate cash. TReDS platforms provide a digital infrastructure for facilitating such transactions, enabling efficient invoice discounting and promoting liquidity for MSMEs.(Our FAQs on TReDS and the India Factoring Report 2023 can be read here and here)

In a move to further strengthen the TReDS and promote smoother financial transactions, the RBI has announced significant enhancements to the TReDS guidelines. These enhancements are in line with the announcement made by RBI in the Statement on Developmental and Regulatory Policies dated February 8, 2023, to address certain challenges faced by financiers while bidding for low-rated buyers’ payables on TReDS platforms. (Our article on the same can be read here)

This article intends to discuss the RBI notification dated June 7, 2023 on Expanding the Scope of Trade Receivables Discounting System, introducing the said enhancements.

Insurance to hedge default risk

One of the key enhancements for transactions is the facilitation of insurance, which would provide financiers with a means to hedge default risks. RBI’s decision to enhance the TReDS guidelines by facilitating insurance for transactions shall move towards a robust and secure environment for trade receivables financing. Traditionally, financiers on TReDS platforms have been cautious about bidding for payables of low-rated buyers due to the increased risk of defaults. To overcome this challenge, the RBI has permitted insurance companies to participate as a “fourth participant” in TReDS, alongside MSME sellers, buyers, and financiers. This inclusion of insurance companies opens up new possibilities for mitigating default risks and protecting financiers’ interests. Now since insurance facilities will be available as an option, the financier would be more secure with respect to the underlying receivables. Eventually enabling them to take more risks in the form of offering higher interest rates. However, in case the cost of insurance is comparatively higher than the spread earned in these transactions, the additional cost of . insurance will further reduce the spread as well. The availment of insurance would of course be optional.

To implement this enhancement effectively, the RBI has given TReDS platform operators the flexibility to specify the stage at which insurance facilities can be availed. This allows the platform operators to tailor their business and operational rules to best suit the needs of the participants, by determining the appropriate stage for insurance coverage.

Moreover, the RBI has outlined guidelines for the collection of insurance premiums and related activities. The National Automated Clearing House (NACH) system, already used for settlement of TReDS transactions, will be leveraged to enable the collection of premiums. This integration streamlines the process and ensures that the insurance-related activities align with the existing framework of TReDS operations.

Further, to simplify the insurance claims process, TReDS platforms can, with the consent of financiers and insurance companies, facilitate automated processing of insurance claims. This automation, coupled with the settlement of claims through the NACH system, introduces efficiency and transparency into the system. By specifying timelines for claim settlement, TReDS platforms can ensure that participants receive timely reimbursements in case of defaults, thereby minimizing financial losses.

It is important to note that, as of now, credit insurance on TReDS transactions will not be treated as a Credit Risk Mitigant (CRM) to avail any prudential benefits. This means that credit insurance, although a valuable tool for financiers to hedge default risks, will not provide additional regulatory advantages, like capital treatment. The RBI has made this clarification to prevent any potential misuse of the credit insurance provisions.

Overall, by permitting insurance companies to participate as the “fourth participant” and providing flexibility in insurance coverage, the RBI aims to attract more financiers to bid on payables of low-rated buyers, thereby facilitating a more inclusive and efficient TReDS ecosystem. With streamlined processes and automated claim settlements, these enhancements will bring additional confidence to financiers and strengthen the overall framework of TReDS.

Enhanced pool of financiers

To enhance the accessibility and diversity of financing options, RBI has expanded the pool of financiers on TReDS. Earlier, to facilitate the smooth flow of credit to MSMEs through the discounting of trade receivables, participation was limited to banks, NBFC-Factors, and select financial institutions authorized by the RBI. However, the recent developments have allowed other entities and institutions permitted by the Factoring Regulation Act, 2011 (‘Factoring Act’) to partake as financiers in TReDS, thus opening new avenues for funding.

Entities eligible to carry out factoring activities: Entities identified under section 5 of the Factoring Act, viz. banks, and body corporates established under an Act of Parliament or State Legislature, or a Government Company NBFC-Factors registered under the Factoring Act NBFC-ICCs authorised to carry out factoring activities

Accordingly, any entity or institution, authorized to undertake factoring business under the provisions of the Factoring Act read along with its rules and regulations, is now eligible to participate as a financier in TReDS. The inclusion of a wider range of financiers on TReDS platforms creates a more competitive and vibrant financing marketplace. MSMEs gain access to a greater variety of funding options, allowing them to choose the most suitable financier based on their specific needs and requirements. The diverse pool of financiers is expected to bring in new perspectives and strategies, encouraging the development of tailored financial products and services that better serve the unique challenges faced by MSMEs. This enhanced competition can lead to improved pricing, reduced processing times, and greater transparency in the financing process, ultimately benefiting MSMEs.

Settlement of all Factoring Units, financed through TReDS or not

RBI has allowed TReDS platform to undertake the settlement of all uploaded Financing Units (FUs), whether financed/discounted or not, using the National Automated Clearing House (NACH) mechanism. Earlier, when FUs were not discounted or financed, buyers were required to make payments to sellers outside the system. This manual process often led to delays, difficulties in tracking payments, and increased reconciliation efforts. By enabling TReDS platform to undertake the settlement of all FUs, the inconvenience caused to MSME sellers and buyers is likely to be significantly reduced. With the settlement being integrated into the TReDS platform using the NACH mechanism, the entire process becomes more efficient and transparent, enhancing convenience for all stakeholders. Further, funds would be consolidated in one central system, enabling easier tracking, reconciliation, and allocation of payments

However, integrating settlement for all FUs, including those not discounted or financed, requires substantial technical and operational modifications to the TReDS platform. The seamless execution of the settlement process, while maintaining data privacy and security, necessitates careful planning and robust infrastructure. Platform operators must invest in system upgrades and thorough testing to ensure a smooth implementation and minimize any potential disruptions. Further, ensuring buyer compliance with this requirement might pose challenges, especially if there is resistance or reluctance to change established payment practices. Extensive communication and awareness campaigns may be necessary to educate buyers about the benefits and importance of adhering to the new settlement process.

TReDS platforms facilitate transparent and competitive bidding by the financiers. Further, to make the process more transparent, the platforms have been allowed to display details of bids placed for an FU to other bidders; the name of the bidder shall, however, not be revealed.

Applicability of TLE on the trading of FUs

The introduction of a secondary market for Factoring Units (FUs) on TReDS platforms, as mentioned in the TReDS guidelines, raises questions about its practical feasibility and implementation. The RBI has specified that such transfers shall be subject to the applicable provisions of RBI’s Master Direction – Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021 dated September 24, 2021 (as updated from time to time), including the eligibility of transferor/transferee as specified in paragraph 3 of the said Master Direction. While the concept of a secondary market for FUs could potentially enhance liquidity and promote efficient capital allocation, several critical factors need to be considered to ensure its successful execution.

The applicability of TLE would mean such factoring units are being treated akin to loan receivables. However, it is important to note that the minimum holding period requirement, as mandated by the TLE Directions, may present challenges to the facilitation of the secondary market on the TReDS platform. The purpose of establishing a secondary market is to provide liquidity and flexibility to participants, allowing them to buy and sell FUs as per their requirements. However, the minimum holding period requirement, which stipulates a certain duration for which the FUs must be held before they can be traded, might hinder the objective of facilitating an active and dynamic secondary market.

Conclusion

As TReDS continues to evolve, its efforts to enhance the availability of financiers will contribute to the growth and sustainability of MSMEs in India’s vibrant business landscape. Further, the decision to allow TReDS platform operators to undertake the settlement of all FUs simplifies fund management, enhances convenience, and ensures compliance with relevant statutes. However, challenges such as implementation complexity, timeline considerations, and buyer compliance need to be addressed effectively to maximize the advantages of this new settlement process. By proactively mitigating these challenges, TReDS platforms can further empower MSMEs and contribute to the growth and stability of India’s small business sector.

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Our related write-ups:

1. Ushering the new-age TReDS Platform
2. FAQs on TReDS