Overview of Regulatory Framework of Payment and Settlement Systems in India by Anita Baid

Introduction

It has been a while that there has been a buzz around the emerging concept of financial technology (fintech), which seems to be evolving at an unimaginable speed. The technological development taking place globally, have compelled the traditionally cash-driven Indian economy to respond promptly to the fintech opportunities. The modern payment systems have overcome the shortcoming of the traditional mode of cash based payments where handing of cash was the most cumbersome part of all transaction. It is a known fact that the overall economic efficiency and stability of any country is dependent on the payment and settlement system in that country. As a result, the regulators in our country, including the central bank, have also been revisiting their operating model and policies regularly, to ensure and carry out the development of national payment systems. The regulators have to closely safeguard the sanctity of payment systems, primarily from the viewpoint of systemic risk, risk of fraud, etc. Specifically, it is the responsibility of the central bank of any country, that is to say the Reserve Bank of India (RBI) for our country, to ensure and carry out the development of national payment systems.

This article is intended to provide a panoramic view of the schematics of regulation over Indian payment and settlement systems.

Payment and settlement systems in India

The mission statement of RBI for payment and settlement system states that the endeavour would be “to ensure that all payment and settlement systems operating in the country are safe, secure, sound, efficient, accessible and authorised”. The Payment and Settlement Systems Act, 2007 (‘PSS Act, 2007’), legislated in December 2007, governs and regulates all the modes of payment systems used in India. Under the PSS Act, 2007 the RBI is given the power to direct and regulate the payment systems and the payment system participants in India. The PSS Act, 2007 has been enacted to govern and regulate the activities which involve payment and settlement of transaction in substitute of paying or settling a transaction by cash or other means of physical movement of payment instruments to settle a transaction.

Under the PSS Act, 2007, two Regulations have been made by the RBI, namely, the Board for Regulation and Supervision of Payment and Settlement Systems Regulations, 2008 (BPSS Regulations) and the Payment and Settlement Systems Regulations, 2008 (‘PPS Regulations, 2008’). Both these Regulations came into force along with the PSS Act, 2007 on 12th August 2008. They together provide the necessary statutory backing to the RBI for overviewing the payment and settlement systems in the country.

The Board for Regulation and Supervision of Payment and Settlement Systems (BPSS), a sub-committee of the Central Board of the RBI is the highest policy making body on payment systems. The BPSS is empowered for authorising, prescribing policies and setting standards for regulating and supervising all the payment and settlement systems in the country. The Department of Payment and Settlement Systems of the RBI serves as the Secretariat to the Board and executes its directions. The BPSS Regulations deals with the composition of the BPSS, its powers and functions, exercising of powers on behalf of BPSS, meetings of the BPSS and quorum, the constitution of Sub-Committees/Advisory Committees by BPSS, etc. The BPSS exercises the powers on behalf of the RBI, for regulation and supervision of the payment and settlement systems under the PSS Act, 2007.

The PPS Regulations, 2008 lays down the procedural requirements for commencing or carrying on a payment system.  It covers matters like form of application for authorization for commencing/ carrying on a payment system and grant of authorization, payment instructions and determination of standards of payment systems. It also further lays the regular compliance requirements, such as furnishing of returns/documents/other information, furnishing of accounts and balance sheets by system provider etc to the RBI.

RBI also has its FAQs on the aforesaid PSS Act, 2007 and Regulations (‘RBI FAQs on PSS’), with an intent to provide better understanding of the provisions contained therein.

Concept of payment system and settlement

Section 2(1) (i) of the PSS Act, 2007 defines a ‘payment system’ to mean a system that enables payment to be effected between a payer and a beneficiary, involving clearing, payment or settlement service or all of them, but does not include a stock exchange[1]. It is further stated by way of an explanation that a “payment system” includes the systems enabling credit card operations, debit card operations, smart card operations, money transfer operations or similar operations.

All systems (except stock exchanges and clearing corporations set up under stock exchanges) carrying out either clearing or settlement or payment operations or all of them are regarded as payment systems. To decide whether a particular entity operates the payment system, it must perform either the clearing or payment or settlement function or all of them.

Though the Indian payment systems have always been dominated by paper-based transactions, e-payments are not far behind. In the case of India, the RBI has played a pivotal role in facilitating e-payments by making it compulsory for banks to route high value transactions through Real Time Gross Settlement (RTGS) and also by introducing NEFT (National Electronic Funds Transfer) and NECS (National Electronic Clearing Services) which has encouraged individuals and businesses to switch to electronic methods of payment.

As per the PSS Act, 2007, ‘Settlement’ means the settlement of payment instructions received and these include settlement of securities, foreign exchange or derivatives or other transactions. Settlement can take place either on a net basis or on a gross basis. Further, the term ‘netting’  has been defined as the determination by the system provider of the amount of money or securities, due or payable or deliverable, as a result of setting off or adjusting, the payment obligations or delivery obligations among the system participants, including the claims and obligations arising out of the termination by the system provider, on the insolvency or dissolution or winding up of any system participant or such other circumstances as the system provider may specify in its rules or regulations or bye-laws (by whatever name called), of the transactions admitted for settlement at a future date so that only a net claim be demanded or a net obligation be owned.

The PSS Act, 2007 also legally recognizes settlement finality and the loss allocation among system participants and payment system, where the rules provide for this mechanism. It states that a settlement, whether gross or net, will be final and irrevocable as soon as the money, securities, foreign exchange or derivatives or other transactions payable as a result of such settlement is determined, whether or not such money, securities or foreign exchange or other transactions is actually paid. In case a system participant is declared insolvent, or is dissolved or is wound up, no other law can affect any settlement which has become final and irrevocable and the right of the system provider to appropriate the collaterals contributed by the system participants towards settlement or other obligations.

Ambiguity regarding issuance of Credit Cards

In India ‘plastics’ or ‘electronic payments’ have been fast replacing ‘paper based payments’. Card payments form an integral part of electronic payments in India because customers make many payments on their card-paying their bills, transferring funds and shopping. The issuance of Debit Card by banks have been growing in number however, Credit Cards have shown a relatively slower growth.

The term “credit card” usually/generally refers to a plastic card assigned to a cardholder, usually with a credit limit, that can be used to purchase goods and services on credit or obtain cash advances. Earlier, smart cards/ debit cards/ stored value cards/ value added cards etc. were issued only by banks and non-banking entities were not permitted to issue such cards. Prior approval of the RBI is not necessary for banks desirous of undertaking credit card business either independently or in tie-up arrangement with other card issuing banks. However, Non-Banking Financial Companies (NBFCs) are not allowed to undertake credit card business without prior approval of RBI. The instructions issued by RBI on credit card operations of banks are applicable, mutatis-mutandis, to NBFCs issuing credit cards.

Banking, including credit card operations, is a heavily regulated business, with high transaction and operating costs, and fairly constant business models. In recent times, fintech entities are also creating on-demand credit and currency markets, using self-learning models to analyse risk and making it easier for businesses and individuals to transact. Such retail fintech businesses, especially, have an advantage over traditional banking. Instead of relying on large transactions, they can process small transactions in large volumes. This makes them ideal vehicles to make banking services accessible to individuals and small businesses. However, though the credit card operations is covered under the definition of payment system, there are no further directions issued by the RBI for payment system providers, in this regard. Presently, under the PSS Act, 2007, American Express Banking Corp, USA; Diners Club International Ltd, USA; Mastercard Asia/ Pacific Pte. Ltd., Singapore; and Visa Worldwide Pte Ltd, Singapore, have been authorised to issue credit cards in India.

Further, since credit card operations are not covered under the purview of prepaid instrument, and in the absence of any specific regulatory framework under the PSS Act, 2007, it still remains a gray area for fintech entities. In the opinion of this article, in the absence of any enabling provisions, it can be inferred that the issuance of credit card is restricted for banks and permitted NBFCs only. In the meantime, the regulators must also come up with comprehensive regulation to keep check on the activities of such emerging fintech busines activities.

Entities authorized by RBI under PSS Act, 2007

As per the provisions of Section 4 of the PSS Act, no person other than the RBI (RBI) can commence or operate a payment system in India unless authorised by RBI. Accordingly, RBI has authorised payment system operators of pre-paid payment instruments, card schemes, cross-border in-bound money transfers, Automated Teller Machine (ATM) networks and centralised clearing arrangements.

All entities operating payment systems or desirous of setting up such systems are required to apply for authorization under the PSS Act, 2007. Any unauthorized operation of a payment system would be an offence under the PSS Act, 2007 and accordingly liable for penal action under that Act.

Further, the application for authorisation of a payment system operator is assessed by the RBI against the criteria specified for a particular payment system. For example, the application for issuance and operation of PPI is assessed against the Policy Guidelines on Issuance and Operation of Pre-paid Payment Instruments in India.

Upon registration, the payment system provider is required to operate the payment system in accordance with the provisions of the PSS Act, 2007 and the Regulations, the terms and conditions of authorization and the directions given by the RBI from time to time. Section 20 to 22 of the PSS Act, 2007 requires the system provider to disclose the terms and conditions including the charges, limitations of liability etc., under the payment system to the system participants. It further also requires the system provider to provide copies of all the rules and regulations governing the operation of the payment system and other relevant documents to the system participants. The system provider is required to keep the documents and its contents, provided to it by the system participants, as confidential and is prohibited from disclosing the same, except in accordance with the provisions of law.

Prepaid Payment Instruments

Under the PSS Act, the RBI has permitted the issuance of such instrument which can be used to access the prepaid amount to settle transaction, that is to say prepaid payment instruments, in the country and has also laid down the means to settle transactions (‘Policy Guidelines on Issuance and Operation of PPIs’)

The guidelines define the term ‘Pre-paid payment instruments’ as payment instruments that facilitate purchase of goods and services, including funds transfer, against the value stored on such instruments. The value stored on such instruments represents the value paid for by the holders by cash, by debit to a bank account, or by credit card. The pre-paid instruments can be issued as smart cards, magnetic stripe cards, internet accounts, internet wallets, mobile accounts, mobile wallets, paper vouchers and any such instrument which can be used to access the pre-paid amount (collectively called Prepaid Payment Instruments hereafter). The pre-paid payment instruments that can be issued in the country are classified under three categories viz. (i) Closed system payment instruments (ii) Semi-closed system payment instruments and (iii) Open system payment instruments.

RBI is in the process of revising the existing guidelines of pre-paid instruments and have prepared draft policy guidelines (‘Draft policy guidelines on PPIs’)[2] to facilitate the Prepaid Payment Instrument Issuers, System Providers, System Participants and all other Prospective Prepaid Payment Instrument Issuers to have all the extant instructions on the subject at one place.

Electronic Wallets

Prepaid instruments are a convenient cashless payment method and facilitate e-payment for goods or services purchased via the internet or mobile phone. Recently, electronic-based transactions are registering phenomenal growth in India. The limited accessibility and availability of bank accounts to a substantial population of the country has paved way for the growth of electronic payment instruments. Specifically, electronic wallets are becoming the preferred electronic payment mode for both consumers and retailers. The ease of using electronic wallets as a substitute to physical wallets have made electronic wallets as one of the most convenient ways of making payment through the use of mobile phones.

The market participants, including NBFCs and other companies apart from banks, who have availed the license for providing such services under the governing laws and provisions, are also finding the operation of electronic wallets as a lucrative business opportunity.

Under the PSS Act, 2007 prepaid payment instruments that can be issued in the country are classified under three categories viz. (i) Closed system payment instruments (ii) Semi-closed system payment instruments and (iii) Open system payment instruments.

Only the banks are allowed to issue open system payment instruments which can be used for purchase of goods and services, and also permit cash withdrawals from ATMs. These are payment instruments that can be used at any card-accepting merchant locations (point of sale terminals) and also permit cash withdrawal from ATMs. Example of these are credit cards, debit cards, etc.

Closed system payment instruments are used when the goods or services are acquired directly from the entity which issues this instrument. They do not allow cash withdrawal or redemption. Like in case of “Ola money” or “freecharge” wallet, where the amount so credited can be utilized only for either travelling or recharging of mobile respectively.

Mobile wallets are categorized under semi-closed system payment instruments. The definition of semi-closed system payment instruments, as per the guidelines, is as reproduced below:

“Semi-Closed System Payment Instruments: These are payment instruments which can be used for purchase of goods and services, including financial services at a group of clearly identified merchant locations/ establishments which have a specific contract with the issuer to accept the payment instruments. These instruments do not permit cash withdrawal or redemption by the holder.”

It can be inferred from the aforesaid definition that these are payment instruments that are redeemable at a group of clearly identified merchant locations/ establishments, which contract specifically with the issuer to accept the payment instruments. These instruments do not permit cash withdrawal or redemption by the holder.

As per the aforesaid definition, electronic wallets, in the nature of semi-closed payment instrument can be used for availing financial services also. A view can be taken that financial services includes services such as availing funding facility and the repayment of such facility, where the lender has a specific contract with the issuer of prepaid payment instrument.

The abovementioned guidelines further provides safeguard for the interests of customers using these payment instruments to ensure that their payments are duly accounted for by the issuers and intermediaries, so that transactions are completed in a safe and secured manner. The RBI stipulates that non-bank persons issuing payment instruments are required to maintain their outstanding balance in an escrow account with any scheduled commercial bank. The permitted debits and credits that can be effected in and from the said escrow account is also specifically mentioned in the guidelines, as reproduced below:

Credits:

1. Payments received towards sale / reload of PPIs, including at agent locations
2. Refunds received for failed / disputed / returned / cancelled transactions.

Debits:

1. Payments to various merchants/service providers towards reimbursement of claims received from them
2. Payment to sponsor bank for processing funds transfer instructions received from PPI holders as permitted by RBI from time to time.
3. Payment towards applicable Government taxes (received along with PPI sale/reload amount from the buyers)
4. Refunds towards cancellation of transactions in a PPI in case of PPIs loaded / reloaded erroneously or through fraudulent means (on establishment of erroneous transfer /fraud). The funds have to be credited back to the same source from where these were received. These funds are not to be forfeited till the disposal of the case.
5. Any other payment due to the PPI issuer in the normal course of operating the PPI business (for instance, service charges, forfeited amount, commissions)
6. Any other debit as directed by the regulator / courts / law enforcement agencies.

Settlement of payments for electronic payment instruments

As mentioned earlier, the use of electronic modes of payments to merchants for their goods and services has been gaining popularity. Banks and prepaid payment instrument issuers have also been facilitating the use of electronic modes by customers for payments to merchants. Here, the intermediaries such as aggregators and payment gateway service providers, including e-commerce and m-commerce service providers, are playing a major role for facilitating the use of electronic mode of payment. These intermediaries include all entities that collect monies received from customers for payment to merchants using any electronic/online payment mode, for goods and services availed by them and subsequently facilitate the transfer of these monies to the merchants in final settlement of the obligations of the paying customers.

The arrangement, involving such intermediaries, involves the flow of funds as mentioned herein below:

A lot of risk is involved in the aforesaid arrangement, for the customers and the merchants, as any delay in the transfer of the funds by the intermediaries to the merchants account will impact the payment system as a whole. It is vital to ensure that the interests of the customers are safeguarded and that the payments made by them are duly accounted for by the intermediaries receiving such payments and subsequently remitted to the accounts of the merchants who have supplied the goods and services without undue delay. Accordingly, the RBI has considered it necessary to frame specific guidelines and directions for the safe and orderly conduct of these transactions (Directions for opening and operation of Accounts and settlement of payments for electronic payment transactions involving intermediaries).

Intermediaries, like aggregators and payment gateways, which facilitate payment services, though not authorised by RBI under the PSS Act, 2007 are however required to route their transactions only through a nodal account opened with a bank under the aforesaid guidelines[3]. The RBI further stipulates that all accounts opened and maintained by banks for facilitating collection of payments by intermediaries from customers of merchants are to be treated as internal accounts of the banks. The permitted credits/debits in these accounts are provided herein below:

Credits

1. Payments from various persons towards purchase of goods/services.
2. Transfers from other banks as per pre-determined agreement into the account, if this account is the nodal bank account for the intermediary. 
3. Transfers representing refunds for failed/disputed transactions.

Debits

1. Payments to various merchants/service providers.
2. Transfers to other banks as per pre-determined agreement into the account, if that account is the nodal bank account for the intermediary.
3. Transfers representing refunds for failed/disputed transactions.
4. Commissions to the intermediaries. These amounts shall be at pre-determined rates/frequency.

The RBI has also further mandated that banks shall implement a settlement cycle for all final settlements to merchants. This settlement arrangement shall increase the efficiency of the payment process, accordingly, banks shall transfer funds to the ultimate beneficiaries with minimum time delay in the following manner-

1. All payments to merchants which do not involve transfer of funds to nodal banks shall be effected within a maximum of T+2 settlement cycle (where T is defined as the day of intimation regarding the completion of transaction).
2. All payments to merchants involving nodal banks shall be effected within a maximum of T+3 settlement cycle.

Conclusion

In all major global jurisdictions, the financial supervisor mostly maintains control over the payment and settlement systems. Hence, it is mandatory for RBI, as the apex financial and regulatory institution of the country, to ensure that the payments system in the country is as technologically advanced as possible and in view of the above, RBI has taken several initiatives to strengthen the electronic payments system in India and encourage people to adopt it. The PSS Act, 2007 was a major step in this direction. It enables the RBI to regulate, supervise and lay down policies involving payment and settlement space in India. The RBI is also regularly framing guidelines under the PSS Act, 2007 in respect of various payment systems to manage the steep rise in the usage of digital payment options, including e-wallets.

[1] Section 34 of the PSS Act, 2007 states that its provisions will not apply to stock exchanges or clearing corporations set up under stock exchanges

[2] Read our article on  Stringent norms ahead for the issuers of pre-paid payment instruments in Indiati

[3] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=40004

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By: Anita Baid: anita@vinodkothari.com