Introduction of Digital KYC

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Anita Baid (anita@vinodkothari.com)

The guidelines relating to KYC has been in headlines for quite some time now. Pursuant to the several amendments in the regulations, the KYC process of using Aadhaar through offline modes was resumed for fintech companies. The amendments in the KYC Master Directions[1] allowed verification of customers by offline modes and permitted NBFCs to take Aadhaar for verifying the identity of customers if provided voluntarily by them, after complying with the conditions of privacy to ensure that the interests of the customers are safeguarded.

Several amendments were made in the Prevention of Money laundering (Maintenance of Records) Rules, 2005, vide the notification of Prevention of Money laundering (Maintenance of Records) Amendment Rules, 20191 issued on February 13, 2019[2] (‘February Notification’) so as to allow use of Aadhaar as a proof of identity, however, in a manner that protected the private and confidential information of the borrowers.

The February Notification recognised proof of possession of Aadhaar number as an ‘officially valid document’. Further, it stated that whoever submits “proof of possession of Aadhaar number” as an officially valid document, has to do it in such a form as are issued by the Authority. However, the concern for most of the fintech companies lending through online mode was that the regulations did not specify acceptance of KYC documents electronically. This has been addressed by the recent notification on Prevention of Money-laundering (Maintenance of Records) Third Amendment Rules, 2019 issued on August 19, 2019[3] (“August Notification”).

Digital KYC Process

The August Notification has defined the term digital KYC as follows:

“digitial KYC” means the capturing live photo of the client and officially valid document or the proof of possession of Aadhaar, where offline verification cannot be carried out, along with the latitude and longitude of the location where such live photo is being taken by an authorised officer of the reporting entity as per the provisions contained in the Act;

Accordingly, fintech companies will be able to carry out the KYC of its customers via digital mode.

The detailed procedure for undertaking the digital KYC has also been laid down. The Digital KYC Process is a facility that will allow the reporting entities to undertake the KYC of customers via an authenticated application, specifically developed for this purpose (‘Application’). The access of the Application shall be controlled by the reporting entities and it should be ensured that the same is used only by authorized persons. To carry out the KYC, either the customer, along with its original OVD, will have to visit the location of the authorized official or vice-versa. Further, live photograph of the client will be taken by the authorized officer and the same photograph will be embedded in the Customer Application Form (CAF).

Further, the system Application shall have to enable the following features:

  1. It shall be able to put a water-mark in readable form having CAF number, GPS coordinates, authorized official’s name, unique employee Code (assigned by Reporting Entities) and Date (DD:MM:YYYY) and time stamp (HH:MM:SS) on the captured live photograph of the client;
  2. It shall have the feature that only live photograph of the client is captured and no printed or video-graphed photograph of the client is captured.

The live photograph of the original OVD or proof of possession of Aadhaar where offline verification cannot be carried out (placed horizontally), shall also be captured vertically from above and water-marking in readable form as mentioned above shall be done.

Further, in those documents where Quick Response (QR) code is available, such details can be auto-populated by scanning the QR code instead of manual filing the details. For example, in case of physical Aadhaar/e-Aadhaar downloaded from UIDAI where QR code is available, the details like name, gender, date of birth and address can be auto-populated by scanning the QR available on Aadhaar/e-Aadhaar.

Upon completion of the process, a One Time Password (OTP) message containing the text that ‘Please verify the details filled in form before sharing OTP’ shall be sent to client’s own mobile number. Upon successful validation of the OTP, it will be treated as client signature on CAF.

For the Digital KYC Process, it will be the responsibility of the authorized officer to check and verify that:-

  1. information available in the picture of document is matching with the information entered by authorized officer in CAF;
  2. live photograph of the client matches with the photo available in the document; and
  3. all of the necessary details in CAF including mandatory field are filled properly.

Electronic Documents

The most interesting amendment in the August Notification is the concept of “equivalent e-document”. This means an electronic equivalent of a document, issued by the issuing authority of such document with its valid digital signature including documents issued to the digital locker account of the client as per rule 9 of the Information Technology (Preservation and Retention of Information by Intermediaries Providing Digital Locker Facilities) Rules, 2016 shall be recognized as a KYC document. Provided that the digital signature will have to be verified by the reporting entity as per the provisions of the Information Technology Act, 2000.

The aforesaid amendment will facilitate a hassle free and convenient option for the customers to submit their KYC documents. The customer will be able to submit its KYC documents in electronic form stored in his/her digital locker account.

Further, pursuant to this amendment, at several places where Permanent Account Number (PAN) was required to be submitted mandatorily has now been replaced with the option to either submit PAN or equivalent e-document.

Submission of Aadhaar

With the substitution in rule 9, an individual will now have the following three option for submission of Aadhaar details:

  • the Aadhaar number where,
    1. he is desirous of receiving any benefit or subsidy under any scheme notified under section 7 of the Aadhaar (Targeted Delivery of Financial and Other subsidies, Benefits and Services) Act, 2016 or
    2. he decides to submit his Aadhaar number voluntarily
  • the proof of possession of Aadhaar number where offline verification can be carried out; or
  • the proof of possession of Aadhaar number where offline verification cannot be carried out or any officially valid document or the equivalent e-document thereof containing the details of his identity and address;

Further, along with any of the aforesaid options the following shall also be submitted:

  1. the Permanent Account Number or the equivalent e-document thereof or Form No. 60 as defined in Income-tax Rules, 1962; and
  2. such other documents including in respect of the nature of business and financial status of the client, or the equivalent e-documents thereof as may be required by the reporting entity

The KYC Master Directions were amended on the basis in the February Notification. As per the amendments proposed at that time, banking companies were allowed to verify the identity of the customers by authentication under the Aadhaar Act or by offline verification or by use of passport or any other officially valid documents. Further distinguishing the access, it permitted only banks to authenticate identities using Aadhaar. Other reporting entities, like NBFCs, were permitted to use the offline tools for verifying the identity of customers provided they comply with the prescribed standards of privacy and security.

The August Notification has now specified the following options:

  1. For a banking company, where the client submits his Aadhaar number, authentication of the client’s Aadhaar number shall be carried out using e-KYC authentication facility provided by the Unique Identification Authority of India;
  2. For all reporting entities,
    1. where proof of possession of Aadhaar is submitted and where offline verification can be carried out, the reporting entity shall carry out offline verification;
    2. where an equivalent e-document of any officially valid document is submitted, the reporting entity shall verify the digital signature as per the provisions of the IT Act and take a live photo
    3. any officially valid document or proof of possession of Aadhaar number is submitted and where offline verification cannot be carried out, the reporting entity shall carry out verification through digital KYC, as per the prescribed Digital KYC Process

It is also expected that the RBI shall notify for a class of reporting entity a period, beyond which instead of carrying out digital KYC, the reporting entity pertaining to such class may obtain a certified copy of the proof of possession of Aadhaar number or the officially valid document and a recent photograph where an equivalent e-document is not submitted.

The August Notification has also laid emphasis on the fact that certified copy of the KYC documents have to be obtained. This means the reporting entity shall have to compare the copy of the proof of possession of Aadhaar number where offline verification cannot be carried out or officially valid document so produced by the client with the original and record the same on the copy by the authorised officer of the reporting entity. Henceforth, this verification can also be carried out by way of Digital KYC Process.

[1] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11566#F4

[2] http://egazette.nic.in/WriteReadData/2019/197650.pdf

[3] http://egazette.nic.in/WriteReadData/2019/210818.pdf

Private virtual currencies out: India may soon see regulated virtual currency

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-Kanakprabha Jethani | executive

kanak@vinodkothari.com

Background

A high-level Inter-ministerial Committee (IMC) (‘Committee’) was constituted under the chairmanship of Secretary, Department of Economic Affairs (DEA) to study the issues related to Virtual Currencies (VCs) and propose specific action to be taken in this matter. The Committee came up with its recommendations[1] recently. These recommendations include, among other things, ban on private VCs, examination of technologies underlying VCs and their impact on financial system, viability of issue of  ‘Central Bank Digital Currency (CBDC)’ as  legal tender in India, and potential of digital currency in the near future.

The following write-up deals with an all-round study of the recommendations of the committee and their probable impacts on the financial systems and the economy as a whole.

Major recommendations of the Committee.

The report of the Committee focuses on Distributed Ledger Technologies (DLT) or blockchain technology and their use to facilitate transactions in VCs and their relation to financial system. Following are the major recommendations of the Committee.

  • DEA should identify uses of DLT and various regulators should focus on developing appropriate regulations regarding use of DLT in their respective areas.
  • All private cryptocurrencies should be banned in India.
  • Introduction of an official digital currency to be known as Central bank digital currency (CBDC) which shall be acceptable as legal tender in India.
  • Blockchain based systems may be considered by Ministry of Electronics and Information Technology (MEITY) for building low-cost KYC systems.
  • DLT may be used for collection of stamp duty in the existing e-stamping system.

Why were these recommendations needed?

  • DLT uses independent computers (called ‘nodes’), linked together through hash function, to record, share and synchronise transactions in their respective distributed ledgers. The detailed structure of DLTs and their functions and uses can be referred to in our other articles.[2]

Among its various benefits such as data security, privacy, permanent data retention, this system addresses one major issue linked to digital currency which is the problem of double-spend i.e. a digital currency can be spent more than once as digital data can be easily reproduced. In DLT, authenticity of a transaction can be verified by the user and only validated transactions form a block under this mechanism.

  • Many companies have been using Initial Coin Offerings (ICO) as a medium to raise money by issuing digital tokens in exchange of fiat money or a widely accepted cryptocurrency. This way of raising money has been bothering regulators as it has no regulatory backing and such system can collapse any time. The regulators also fail to reckon whether ICO can be even considered as a security or how it should be taxed.
  • Some countries allow use of VCs as a mode of payment but no country in the world accepts VCs as legal tender. In India, however, no such permissions are granted to VCs. Despite the non-acceptability of VCs in India, investors have been actively investing in VCs like bitcoin, which is a sign of danger for the economy as it is draining the financial systems of fiat money. Further, they pose a risk over the financial system as they are highly volatile, with no sovereign backing and no regulators to oversee. It has been witnessed in the recent years that there have been detrimental implications on the economy due to volatility of VCs such as bitcoins. the same has been dealt with in detail in our report[3] on Bitcoins. They are also suspected to have been facilitating criminal activities by providing anonymity to the transactions as well as to the persons involved.
  • The future is of digitisation. An economy with everything running on physical basis will not survive in the competitive world. A universally accepted system for digital payments would require digitisation of currency as well.

What is the regulatory philosophy in the world?

As a mode of payment: Countries like Switzerland, Thailand, Japan and Canada permit VCs as a mode of payment while New York requires persons using VCs to take prior registration with a specified authority. Russia allows only barter exchange through use of virtual currency which means that such exchange can only take place when routed through barter exchanges of Russia. China prohibits use of VCs as a mode of payment.

For investment purposes: Russia, Switzerland, Thailand, New York and Canada permit investment in VCs and have in place frameworks to regulate such investments. Further, countries like Russia, Thailand, japan, New York and Canada have also allowed setting up of crypto exchanges and have a framework for regulating the setting up and operations such exchange and subsequent trading of VCs on them. On the other hand, China altogether prohibits investments and trading in VCs and the law of Switzerland is silent as to allowing setting up of crypto exchanges.

Further, China has imposed a strict ban on any activity in cryptocurrencies and has also taken measures to prohibit crypto mining activities in its jurisdiction. No country in the world has allowed acceptance of virtual currency as legal tender. It is noteworthy that though Japan and Thailand allow transactions in VCs, such transactions are restricted to approved cryptocurrencies only.

Tunisia and Ecuador have issued their own blockchain based currency called eDinar and SISTEMA de Dinero Electronico respectively. Venezuela has also launched an oil-based cryptocurrency.

Issue of official digital currency

Sensing the keen inclination of financial systems towards technological innovation and witnessing declining use of physical currency in various countries, the Committee is of the view that a sovereign backed digital currency is required to be issued which will be treated at par with any other legal tender of the country.

Various legislations of the country need to be reviewed in this direction. This would include amendments to the definition of “Coin” as per Coinage Act for clarifying whether digital currency issued by RBI shall be included in the said definition. Further, on issue of such currency, it must be approved to be a “bank note” as per section 25 of RBI Act through notification in Gazette of India.

Various regulators would also be required to amend their respective regulations to align them in the direction of allowing use of such digital currency as an accepted form of currency.

Key features of CBDC are expected to be as follows:

  • The access to CBDC will be subject to time constraints as decided in the framework regulating the same.
  • CBDC will be designed to provide anonymity in the transaction. However, the extent of anonymity will depend on the decisions of the issuing authority.
  • Two models are under consideration for defining transfer mechanism for CBDC. One is account-based model which will be centralised and other one is value-based model which will be decentralised model. Hybrid variants may also be considered in this regard.
  • Contemplations as to have interest-bearing or non-interest-bearing CBDC are going on. An interest-bearing CBDC would allow value addition whereas non-interest bearing CBDC will operate as cash.

Why should DLT be used in financial systems?

  • Intermediation: Usually, in payment systems, there are layers of intermediation that add to cost of transaction. Through DLT, the transaction will be executed directly between the nodes with no intermediary which would then reduce the transaction costs. Further, in cross-border transactions through intermediaries, authorisations require a lot of time and result in slow down of transaction. This can also be done away through DLT.
  • KYC: Keeping KYC records and maintaining the same requires huge amounts of data to be stored and updated regularly. Various entities undergoing the same KYC processes, collecting the same proofs of identity from the same person for different transactions result in duplication of work. Through a blockchain based KYC record, the same record can be made available to various entities at once, while also ensuring privacy of data as no centralised entity will be involved. Loan appraisal: A blockchain technology can largely reduce the burden of due-diligence of loan applicant as the data of customers’ earlier loan transactions is readily available and their credit standing can be determined through that.
  • Trading: In trading, blockchain based systems can result in real-time settlement of transactions rather than T+2 settlement system as prevailing under the existing stock exchange mechanism. Since all the transactions are properly recorded, it provides an easier way of post-trade regulatory reporting.
  • Land registries and property titles: A robust land registry system can be established through use of blockchain mechanism which will have the complete history of ownership records and other rights relating to the property which would facilitate transfer of property as well as rights related to it.
  • E-stamping: A blockchain based system would ease out the process of updation of records across various authorities involved and would eliminate the need of having a central agency for keeping records of transaction.
  • Financial service providers: They can be benefited by the concept of ‘localisation of data’ due to which their data is protected from cyber-attacks and theft. Our article[4] studies implementation of blockchain technology in financial sector.

What will be the challenges?

  1. For implementation of DLT: Though a wide range of benefits can be reaped out of implementation of DLT in various aspects of financial systems, it has still not been implemented because there are a few hindrances that remain and are expected to continue even further. Some of the challenges that are slowing the pace of transition towards this technology are as follows:
  • Lack of technological equipment to handle volumes of transactions on blockchains and to ensure data security at the same time.
  • Absence of centralised infrastructure or central entity to regulate implementation of DLT in the financial system. Also, the existing regulators lack the expertise to oversee proper implementation.
  • First, a comprehensive regulatory framework needs to be in place that ensures governance in implementation. The framework will need to address concerns like jurisdiction in case of cross border ledgers, point of finality of transactions etc.
  1. For common digital currency: Decisions regarding validation function, settlement, transfer, value-addition etc. are of crucial importance and would require extensive study. Factors that might be hampering issue of such currency are as follows:
    • Having in place a safe and secure blockchain network and robust technology to handle the same will require significant investments.
    • High volumes of transactions may not be supported and might result in delays in processing.
    • In case an interest bearing CBDC is issued, it would pose great threat over the commercial banking system as the investors will be more inclined towards investing in CBDCs instead of bank deposits.
    • This is also likely to increase competition in the market and lower the profitability of commercial banks. Commercial banks may rely on overseas wholesale funding which might result in downturn of such banks in overseas market.
  2. For banning of private cryptocurrencies: A circular issued by the RBI has already banned its regulated entities from dealing in VCs. Many other countries have also banned dealing in VCs. Despite such restrictions, entities continue to deal in VCs because their speculative motives drive the dealing in VCs to a great extent.

Conclusion

The recommendations of the Committee intend to ensure safety of financial systems and simultaneously urge the growth of the system through innovation and technological advances. Rising above the glorious scenes of these recommendations, one realises that achieving this is a far-fetched reality. One needs to accept the fact that India still lacks in technology and systems sufficient to support innovations like blockchain. Various reports have already shown that operation of blockchains consumes huge volumes of energy, which can be the biggest issue for the energy-scarce India. India needs to work in order to strengthen its core before flapping its wings towards such sophisticated innovation.

[1] https://dea.gov.in/sites/default/files/Approved%20and%20Signed%20Report%20and%20Bill%20of%20IMC%20on%20VCs%2028%20Feb%202019.pdf

[2] http://vinodkothari.com/2019/06/blockchain-technology-its-applications-in-financial-sector/

http://vinodkothari.com/2019/06/an-introduction-to-smart-contracts-guest-post/

[3] http://vinodkothari.com/wp-content/uploads/2017/08/Bitcoints-India-Report.pdf

[4] http://vinodkothari.com/2019/07/blockchain-based-lending-a-peer-to-peer-approach/

BLOCKCHAIN-BASED LENDING – A PEER-TO-PEER APPROACH

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RBI to strengthen corporate governance for Core Investment Companies.

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Vinod Kothari

As a part of the Bi-monthly Monetary Policy on 6th June, 2019, the RBI’s review of Development and Regulatory Policies [https://rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=47226] proposed to set up a working group to strengthen the regulatory framework for core investment companies (CICs). The RBI states: “Over the years, corporate group structures have become more complex involving multiple layering and leveraging, which has led to greater inter-connectedness to the financial system through their access to public funds. Further, in light of recent developments, there is a need to strengthen the corporate governance framework of CICs. Accordingly, it has been decided to set up a Working Group to review the regulatory guidelines and supervisory framework applicable to CICs.”

Core investment companies are group holding vehicles, which hold equities of operating or financial companies in a business group. These companies also give financial support in form of loans to group companies. However, CICs are barred from dealing with companies outside the group or engaging in any other business operation.

Currently as per the data as on 30th April, 2019, there are only 58 registered CICs in the country. There may be some unregistered CICs as well, since those not having “public funds” do not require registration.

If a CIC is not holding “public funds” (a broad term that includes bank loans, inter-corporate deposits, NCDs, CP, etc.), the CIC is exempt from registration requirement. Presumably such CICs are also excluded from any regulatory sanctions of the RBI as well. However, it is quite common for CICs to access bank loans or have other forms of debt for funding their investments. Such CICs require registration and come under the regulatory framework of the RBI, if their assets are worth Rs 100 crores or more.

Corporate governance norms applicable to systemically important NBFCs are currently not applicable to CICs.

The RBI has observed that CICs are engaged in layering of leverage. This observation is correct, as very often, banks and other lenders might have lent to CICs. The CICs, with borrowed money, use the same for infusing capital at the operating level below, which, once again, becomes the basis for leveraging. Thus, leveraged funds become basis for leverage, thereby creating multiple layers of leverage.

While agreeing with the contention of the RBI, one would like to mention that currently, the regulatory definition of CICs is so stringent that many of the group holding companies qualify as “investment companies” (now, credit and investment companies) and not CICs. There is a need to reduce the qualifying criteria for definition of CICs to 50% of investments in equities of group companies. This would ensure that a large number of “investment companies” will qualify as CICs, based on predominance of their investments, and would be viewed and regulated as such.

Prominent among the registered CICs are entities like Tata Sons, L&T Finance Holdings, JSW Investments, etc. The extension of corporate governance norms to CICs is unlikely to benefit any, but impact all.

The Reserve Bank has accordingly constituted the Working Group to Review Regulatory and Supervisory Framework for Core Investment Companies on 3rd July, 2019 [https://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/PR43DDEE37027375423E989F2C08B3491F4F.PDF]. The Terms of Reference (ToR) of the Working Group are given below:

  • To examine the current regulatory framework for CICs in terms of adequacy, efficacy and effectiveness of every component thereof and suggest changes therein.
  • To assess the appropriateness of and suggest changes to the current approach of the Reserve Bank of India towards registration of CICs including the practice of multiple CICs being allowed within a group.
  • To suggest measures to strengthen corporate governance and disclosure requirements for CICs
  • To assess the adequacy of supervisory returns submitted by CICs and suggest changes therein
  • To suggest appropriate measures to enhance RBI’s off-sight surveillance and on-site supervision over CICs.
  • Any other matter incidental to the above.

As per the press release, the Working Group shall submit its report by October 31, 2019.

BLOCKCHAIN TECHNOLOGY & ITS APPLICATIONS IN FINANCIAL SECTOR

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Safe in sandbox: India provides cocoon to fintech start-ups

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-Kanakprabha Jethani

kanak@vinodkothari.com, finserv@vinodkothari.com

Published on April 22, 2019 | Updated as on April 22, 2020

Background

April 2019 marks the introduction of a structured proposal[1] on regulatory sandboxes (“Proposal”). ‘Sandboxes’ is a new term and has created a hustle in the market. What are these? What is the hustle all about? The following article gives a brief introduction to this new concept. With the rapidly evolving entities based on financial technology (Fintech) having innovative and complex technical model, the regulators have also been preparing themselves to respond and adapt with changing times. To harness such innovative business concepts, several developed countries and emerging economies have recognised the concept of ‘regulatory sandboxes’. Regulatory sandboxes or RS is a framework which allows an innovative startup involved in financial technologies to undergo live testing in a controlled environment where the regulator may or may not permit certain regulatory relaxations for the purpose of testing. The objective of proposing RS is to allow new and innovative projects to conduct live testing and enable learning by doing approach. The objective behind the framework is to facilitate development of potentially beneficial but risky innovations while ensuring the safety of end users and stability of the marketplace at large. Symbolically, RSs’ are a cocoon in which the startups stay for some time undergoing testing and growing simultaneously, and where it is determined whether they should be launched in the market. In furtherance to the recommendation of an inter-regulatory Working Group (WG) vide its Report on FinTech and Digital Banking1 , the Reserve Bank of India has released the draft ‘Enabling Framework for Regulatory Sandbox’ on April 18, 20192 . The final guidelines shall be released based on the comments of the stakeholders on the aforesaid draft.

Benefits and Limitations

Benefits:

  • Regulator can obtain a first-hand view of benefits and risks involved in the project and make future policies accordingly.
  • Product can be tested without an expensive launch and any shortcoming thereto can be rectified at initial stages.
  • Improvement in pace of innovation, financial inclusion and reach.
  • Firms working closely with RS’s garner a greater degree of legitimacy with investors and customers alike.

Limitations:

  • Applicant may tend to lose flexibility and time while undergoing testing.
  • Even after a successful testing, the applicant will require all the statutory approvals before its launch in the market.
  • They require time and skill of the regulator for assessing the complex innovation, which the regulator might not possess.
  • It demands additional manpower and resources on part of regulator so as to define RS plans and conduct proper assessment.

Emergence of concept of RS

The concept of RS emerged soon after the Global Financial Crisis (GFC) in 2007-08. It steadily gained prominence and in 2012, Project Catalyst introduced by US Consumer Financial Protection Bureau (CFPB) finally gave rise to the sandbox concept. In 2015, UK Government Office for Science exhibited the benefits of “close collaboration between regulator, institutions and FinTech companies from clinical environment or real people” through its FinTech Future report. In 2016, UK Financial Conduct Authority launched its regulatory sandbox. Emergence of RS in India In February 2018, RBI launched report of working group on FinTech and digital banking. It recommended Institute for Development and Research in Banking Technology (IDRBT) as the entity whose expertise could run RS in India in cooperation with RBI. After immense deliberations and research, RBI announced its detailed proposal on RS in April 2019. Some of the provisions of the proposal are described hereunder.

Who can apply?

A FinTech firm which fulfills criteria of a startup prescribed by the government can apply for an entry to RS. Few cohorts are to be run whereby there will be a limited number of entities in each cohort testing their products during a stipulated period. The RS must be based on thematic cohorts focusing on financial inclusion, payments and lending, digital KYC etc. Generally , 10-12 companies form part of each cohort which are selected by RBI through a selection process detailed in “Fit and Proper Criteria for Selection of Participants in RS”. Once approval is granted by RBI, the applicant becomes entity responsible for operating in RS. Focus of RBI while selecting the applicants for RS will be on following products/services or technologies:

Innovative Products/Services

  • Retail payments
  • Money transfer services
  • Marketplace lending
  • Digital KYC
  • Financial advisory services
  • Wealth management services
  • Digital identification services
  • Smart contracts
  • Financial inclusion products
  • Cyber security products Innovative Technology
  • Mobile technology applications (payments, digital identity, etc.)
  • Data Analytics
  • Application Program Interface (APIs) services
  • Applications under block chain technologies
  • Artificial Intelligence and Machine Learning applications

Who cannot apply?

Following product/services/technology shall not be considered for entry in RS:

  • Credit registry
  • Credit information
  • Crypto currency/Crypto assets services
  • Trading/investing/settling in crypto assets
  • Initial Coin Offerings, etc.
  • Chain marketing services
  • Any product/services which have been banned by the regulators/Government of India

For how long does a company stay in the cocoon?

A cohort generally operates for a period of 6 months. However, the period can be extended on application of the entity. Also, RBI may, at its discretion discontinue testing of certain entities which fails to achieve its intended purpose. RS operates in following stages:

S.No. Stage Time period Purpose
1 Preliminary screening 4 weeks The applicant is made aware of objectives and principles of RS.
2 Test design 3 weeks FinTech Unit finalises the test design of the entity.
3 Application assessment 3 weeks Vetting of test design and modification.
4 Testing 12 weeks Monitoring and generation of evidence to assess the testing.
5 Evaluation 4 weeks Viability of the project is confirmed by RBI

An alternative to RS

An alternative approach used in developing countries is known as the “test and learn” approach. It is a custom-made solution created by negotiations and dialogue between regulator and innovator for testing the innovation. M-PESA in Kenya emerged after the ‘test-and-learn’ approach was applied in 2005. The basic difference between RS and test-and-learn approach is that a RS is more transparent, standardized and published process. Also, various private, proprietary or industry led sandboxes are being operated in various countries on a commercial or non-commercial basis. They conduct testing and experimentation off the market and without involvement of any regulator. Asean Financial Innovation Network (AFIN) is an example of industry led sandbox.

Globalization in RS

A noteworthy RS in the Global context has been the UK’s Financial Conduct Authority (FCA) which has accepted 89 firms since its launch in 2016. It was one of the early propagators to lead the efforts for GFIN and a global regulatory sandbox. Global Financial Innovation Network (GFIN) is a network of 11 financial regulators mostly of developed countries and related organizations. The objective of GFIN is to establish a network of regulators, to frame joint policy and enable regulator collaboration as well as facilitate cross border testing for projects with an international market in view.

Final framework for RS

RBI introduced final framework[2] for the RS on August 13, 2019 which is almost on the same lines as the Proposal as mentioned above. However the RBI has relaxed the minimum capital requirement to Rs 25 lakhs in place of Rs. 50 lakhs as required under the draft framework with a view to expand the scope of eligible entities.

SEBI’s framework for RS

In May 2019, SEBI also came up with a discussion paper on RS for entities registered with SEBI under section 12 of SEBI Act. The framework was later on finalised in a board meeting of SEBI held in 2020. In line with the finalised framework, various SEBI regulations have also been amended to include a new chapter, allowing case-to-case based exemptions to entities operating in RS.

The SEBI framework is slightly different from the one prescribed by the RBI. SEBI has kept an open window for accepting applications under the RS framework, while the RBI will accept applications under theme-based cohorts. Further, RBI allows entities registered with it as well as other start-ups to apply for entry into RS. However, for the time being, SEBI has allowed only the entities registered under section 12 of SEBI Act to apply. Intermediaries that are registered under section 12 of SEBI Act are as follows:

  • stock broker
  • sub-broker
  • share transfer agent
  • banker to an issue
  • trustee of trust deed
  • registrar to an issue
  • merchant banker
  • underwriter
  • portfolio manager
  • investment adviser
  • depository
  • depository participant
  • custodian of securities
  • credit rating agencies
  • any other intermediary associated with the securities market

In the due course of time, SEBI may allow applications by other entities not registered with it.

Conclusion

Regulatory sandboxes were introduced with a motive to enhance the outreach and quality of FinTech services in the market and promote evolution of FinTech sector. Despite certain limitations, which can be overcome by using transparent procedures, developing well-defined principles and prescribing clear entry and exit criteria, the proposal is a promising one. It strives to strike a balance between financial stability and consumer protection along with beneficial innovation. It Is also likely to develop a market which supports a regulated environment for learning by doing in the scenario of emerging technologies.

 

 

[1] https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=46843

[2] https://www.rbi.org.in/scripts/PublicationReportDetails.aspx?ID=938

 

Ombudsman Scheme for PPI issuers

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By Simran Jalan (simran@vinodkothari.com)

Introduction

The payment technology has evolved and the number of digital transactions is increasing enormously. With this rapid adoption of digital mode of transactions, there was an emerging need for an expeditious grievance redressal mechanism for strengthening the consumer confidence in this channel. Consequently, the Reserve Bank of India (RBI) has issued an Ombudsman Scheme for Digital Transactions, 2019[1] (Ombudsman Scheme) to provide a mechanism for redressal of complaints against deficiency in services related to digital transactions.

In this article we shall discuss the important provisions of the scheme and their impact on Prepaid Payment Instrument (PPI) issuers.

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The arrival of digital empowerment

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By Rajeev Jhawar (finserv@vinodkothari.com)

During the past five years, the Government of India has been working stalwartly towards achieving the vision of Digital India, that aims to transform India through the power of technology and bridge the digital divide. Other programs like Start-up India, Stand-up India and Skill India were designed to become a significant adjunct to this larger narrative.

The Reserve Bank of India (RBI) has been playing a catalytic role in permeation of FinTech into the economy, propelled by its Payment and Settlement System Vision – 2018. FinTech or digital innovations have emerged as a potentially transformative force in the financial markets. With the rapid adoption of digital payments across the country, aided by the introduction of innovative products in the payment space, RBI is focused on strengthening infrastructure and ensuring safety and security of digital transactions.

Further to accentuate digitization of payments and enhance financial inclusion through digitization,RBI has decided to constitute a high level committee, appointing Infosys co-founder and former Chairman of Unique Identification Authority of India(UIDAI), Nandan Nilekani as the Chairman of five-member committee, which inter alia shall:

  • review the existing status of digitization of payments in the country, identify the current gaps in the ecosystem and suggest ways to bridge them;
  • assess the current levels of digital payments in financial inclusion;
  • undertake cross country analyses with a view to identify best practices that can be adopted in our country to accelerate digitization of the economy and financial inclusion through greater use of digital payments;
  • Suggest measures to strengthen the safety and security of digital payments;
  • provide a road map for increasing customer confidence and trust while accessing financial services through digital modes;
  • suggest a medium-term strategy for deepening of digital payments;

Lastly, the committee shall submit its report within a period of 90 days from its first meeting.

The road to digitization of payments

As per RBI’s annual report 2017-2018, the payment and settlement systems recorded robust growth in 2017-18, with volume and value growing at 44.6 per cent and 11.9 per cent, respectively, on top of an increase of 56.0 per cent and 24.8 per cent, respectively, in 2016-17. The share of electronic transactions in the total volume of retail payments increased to 92.6 per cent in 2017-18, up from 88.9 per cent in the previous year with a corresponding reduction in the share of paper based clearing instruments from 11.1 per cent in 2016-17 to 7.4 per cent in 2017-18[1].

Multiple factors and official & behavioral trends are fueling this shift towards economy. Improved internet connectivity and high rate of permeation of smartphones in the Indian market has altogether shaped India’s payments landscape in favor of digital payment.

Furthermore, flagship government initiatives such as ‘Digital India’ would act as key catalysts for this change.

[1] https://rbi.org.in/Scripts/AnnualReportPublications.aspx?year=2018

 

RBI’s Interoperability guidelines for PPIs- A move to promote Digitalization

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By Simran Jalan (simran@vinodkothari.com)

Introduction

Interoperability is the ability of customers to use a set of payment instruments seamlessly with other users within the segment. It enables a payment system to be used in conjunction with other payment systems. It allows Prepaid Payment Instruments (PPI) issuers and other service providers to undertake, clear and settle payment transactions across systems, without participating in multiple systems. All the service providers adopt common standards so as to make the PPIs interoperable. This interoperability shall facilitate payments among different wallets inter se and with banks. Paytm, Freecharge, Oxygen wallet, Airtel money, etc. are some of the digital wallets operating in India currently.

Last year, RBI issued Master Directions on Issuance and Operation of Prepaid Payment Instruments[1] (“Master Directions”) to regulate the prepaid payment instruments and to monitor the working of the PPI issuers. This was the much required legislative framework to supervise the prepaid payment industry. The Master Directions also provided for interoperability of the PPIs. It stated that the interoperability shall be enabled in the following phases for the PPIs:

The Master Directions mandated the first phase for all KYC compliant PPIs (bank and non-bank) issued in the form of wallets to have interoperability amongst themselves through UPI within 6 months from the issue of the Master Directions. This ensured fair competition between the different PPI providers as some providers used to spend exorbitantly to get merchants on-board and this would in turn eliminate competition.

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