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Moving to contactless lending, in a contact-less world

-Kanakprabha Jethani (kanak@vinodkothari.com)

Background

With the COVID-19 disruption taking a toll on the world, almost two billion people – close to a third of the world’s population being  restricted to their homes, businesses being locked-down and work-from home becoming a need of the hour; “contactless” business is what the world is looking forward to. The new business jargon “contactless” means that the entire transaction is being done digitally, without requiring any of the parties to the transaction interact physically. While it is not possible to completely digitise all business sectors, however, complete digitisation of certain financial services is well achievable.

With continuous innovations being brought up, financial market has already witnessed a shift from transactions involving huge amount of paper-work to paperless transactions. The next steps are headed towards contactless transactions.

The following write-up intends to provide an introduction to how financial market got digitised, what were the by-products of digitisation, impact of digitisation on financial markets, specifically FinTech lending segment and the way forward.

Journey of digitisation

Digitisation is preparing financial market for the future, where every transaction will be contactless. Financial entities and service providers have already taken steps to facilitate the entire transaction without any physical intervention. Needless to say, the benefits of digitisation to the financial market are evident in the form of cost-efficiency, time-saving, expanded outreach and innovation to name a few.

Before delving into how financial entities are turning contactless, let us understand the past and present of the financial entities. The process of digitisation leads to conversion of anything and everything into information i.e. digital signals. The entire process has been a long journey, having its roots way back in 1995, when the Internet was first operated in India followed by the first use of the mobile phones in 2002 and then in 2009 the first smartphones came into being used. It is each of these stages that has evolved into this all-pervasive concept called digitisation.

Milestones in process of digitisation

The process of digitization has seen various phases. The financial market, specifically, the NBFCs have gone through various phases before completely guzzling down digitization. The journey of NBFCs from over the table executions to providing completely contactless services has been shown in the figure below:

From physical to paperless to contactless: the basic difference

Before analysing the impact of digitisation on the financial market, it is important to understand the concept of ‘paperless’ and ‘contactless’ transactions. In layman terms, paperless transactions are those which do not involve execution of any physical documents but physical interaction of the parties for purposes such as identity verification is required. The documents are executed online via electronic or digital signature or through by way of click wrap agreements.

In case of contactless transactions, the documents are executed online and identity verification is also carried out through processes such as video based identification and verification. There is no physical interaction between parties involved in the transaction.

The following table analyses the impact of digitisation on financial transactions by demarcating the steps in a lending process through physical, paperless and contactless modes:

 

Stages Physical process Paperless process Contactless process
Sourcing the customer The officer of NBFC interacts with prospective applicants The website, app or platform (‘Platform’) reaches out to the public to attract customers or the AI based system may target just the prospective customers Same as paperless process
Understanding needs of the customer The authorised representative speaks to the prospects to understand their financial needs The Platform provides the prospects with information relating to various products or the AI system may track and identify the needs Same as paperless process
Suggesting a financial product Based on the needs the officer suggests a suitable product Based on the analysis of customer data, the system suggests suitable product Same as paperless process
Customer on-boarding Customer on-boarding is done upon issue of sanction letter The basic details of customer are obtained for on-boarding on the Platform Same as paperless process
Customer identification The customer details and documents are identified by the officer during initial meetings Customer Identification is done by matching the details provided by customer with the physical copy of documents Digital processes such as Video KYC are used carry out customer identification
Customer due-diligence Background check of customer is done based on the available information and that obtained from the customer and credit information bureaus Information from Credit Information Agencies, social profiles of customer, tracking of communications and other AI methods etc. are used to carry out due diligence Same as paperless process
Customer acceptance On signing of formal agreement By clicking acceptance buttons such as ‘I agree’ on the Platform or execution through digital/electronic signature Same as paperless process
Extending the loan The loan amount is deposited in the customer’s bank account The loan amount is credited to the wallet, bank account or prepaid cards etc., as the case may be Same as paperless process
Servicing the loan The authorised representatives ensures that the loan is serviced Recovery efforts are made through nudges on Platform. Physical interaction is the last resort Same as paperless process. However, physical interaction for recovery may not be desirable.
Customer data maintenance After the relationship is ended, physical files are maintained Cloud-based information systems are the common practice Same as paperless process

The manifold repercussions

The outcome of digitisation of the financial markets in India, was a land of opportunities for those operating in financial market, it has also wiped off those who couldn’t keep pace with technological growth. Survival, in financial market, is driven by the ability to cope with rapid technological advancements. The impact of digitisation on financial market, specifically lending related services, can be analysed in the following phases:

Payments coming to online platforms

With mobile density in India reaching to 88.90% in 2019[1], the adoption of digital payments have accelerated in India, showing a rapid growth at a CAGR of 42% in value of digital payments. The value of digital payments to GDP rose to 862% in the FY 2018-19.

Simultaneously, of the total payments made up to Nov 2018, in India, the value of cash payments stood at a mere 19%. The shift from cash payments to digital payments has opened new avenues for financial service providers.

Need for service providers

With everything coming online, and the demand for digital money rising, the need for service providers has also taken birth. Services for transitioning to digital business models and then for operating them are a basic need for FinTech entities and thus, there is a need for various kinds of service providers at different stages.

Deliberate and automatic generation of demand

When payments system came online, financial service providers looked for newer ways of expanding their business. But the market was already operating in its own comfortable state. To disrupt this market and bring in something new, the FinTech service providers introduced the idea of easy credit to the market. When the market got attracted to this idea, digital lending products were introduced. With time, add-ons such as backing by guarantee, indemnity, FLDG etc. were also introduced to these products.

Consequent to digital commercialization, the need for payment service providers also generated automatically and thus, leading to the demand for digital payment products.

Opportunities for service providers

With digitization of non-banking financial activities, many players have found a place for themselves in financial markets and around. While the NBFCs went digital, the advent of digitization also became the entry gate to other service providers such as:

Platform service providers:

In order to enable NBFCs to provide financial services digitally, platform service providers floated digital platforms wherein all the functions relating to a financial transaction, ranging from sourcing of the customer, obtaining KYC information, collating credit information to servicing of the customer etc.

Software as a Service (SaaS) providers:

Such service providers operate on a business model that offers software solutions over the internet, charging their customers based on the usage of the software. Many of the FinTech based NBFCs have turned to such software providers for operating their business on digital platforms. Such service providers also provide specific software for credit score analysis, loan process automation and fraud detection etc.

Payment service providers:

For facilitating transactions in digital mode, it is important that the flow of money is also digitized. Due to this, the demand for payment services such as payments through cards, UPI, e-cash, wallets, digital cash etc. has risen. This demand has created a new segment of service providers in the financial sector.

NBFCs usually enter into partnerships with platform service providers or purchase software from SaaS providers to digitize their business.

Heads-up from the regulator

The recent years have witnessed unimaginable developments in the FinTech sector. Innovations introduced in the recent times have given birth to newer models of business in India. The ability to undertake paperless and contactless transactions has urged NBFCs to achieve Pan India presence. The government has been keen in bringing about a digital revolution in the country and has been coming up with incentives in forms of various schemes for those who shift their business to digital platforms. Regulators have constantly been involved in recognising digital terminology and concepts legally.

In Indian context, innovation has moved forward hand-in-hand with regulation[2]. The Reserve Bank of India, being the regulator of financial market, has been a key enabler of the digital revolution. The RBI, in its endeavor to support digital transactions has introduced many reforms, the key pillars amongst which are – e-KYC (Know Your Customer), e-Signature, Unified Payment Interface (UPI), Electronic NACH facility and Central KYC Registry.

The regulators have also introduced the concept of Regulatory Sandbox[3] to provide innovative business models an opportunity to operate in real market situations without complying with the regulatory norms in order to establish viability of their innovation.

While these initiatives and providing legal recognition to electronic documents did bring in an era of paperless[4] financial transactions, the banking and non-banking segment of the market still involved physical interaction of the parties to a transaction for the purpose of identity verification. Even the digital KYC process specified by the regulator was also a physical process in disguise[5].

In January 2020, the RBI gave recognition to video KYC, transforming the paperless transactions to complete contactless space[6].

Further, the RBI is also considering a separate regime for regulation of FinTech entities, which would be based on risk-based regulation, ranging from “Disclosure” to “Light-Touch Regulation & Supervision” to a “Tight Regulation and Full-Fledged Supervision”.[7]

Way forward

2019 has seen major revolutions in the FinTech space. Automation of lending process, Video KYC, voice based verification for payments, identity verification using biometrics, social profiling (as a factor of credit check) etc. have been innovations that has entirely transformed the way NBFCs work.

With technological developments becoming a regular thing, the FinTech space is yet to see the best of its innovations. A few innovations that may bring a roundabout change in the FinTech space are in-line and will soon be operable. Some of these are:

  • AI-Driven Predictive Financing, which has the ability to find target customers, keep track on their activities and identify the accurate time for offering the product to the customer.
  • Enabling recognition of Indian languages in the voice recognition feature of verification.
  • Introduction of blockchain based KYC, making KYC data available on a permission based-decentralised platform. This would be a more secure version of data repository with end-to-end encryption of KYC information.
  • Introduction of Chatbots and Robo-advisors for interacting with customers, advising suitable financial products, on-boarding, servicing etc. Robots with vernacular capabilities to deal with rural and semi-urban India would also be a reality soon.

Conclusion

Digital business models have received whole-hearted acceptance from the financial market. Digitisation has also opened gates for different service providers to aid the financial market entities. Technology companies are engaged in constantly developing better tools to support such businesses and at the same time the regulators are providing legal recognition to technology and making contactless transactions an all-round success. This is just the foundation and the financial market is yet to see oodles of innovation.

 

 

[1] https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=19417

[2] https://www.bis.org/publ/bppdf/bispap106.htm

[3] Our write on Regulatory Sandboxes can be referred here- http://vinodkothari.com/2019/04/safe-in-sandbox-india-provides-cocoon-to-fintech-start-ups/

[4] Paperless here means paperless digital financial transactions

[5] Our write-up on digital KYC process may be read here- http://vinodkothari.com/2019/08/introduction-of-digital-kyc/

[6]Our write-up on amendments to KYC Directions may be read here: http://vinodkothari.com/2020/01/kyc-goes-live-rbi-promotes-seamless-real-time-secured-audiovisual-interaction-with-customers/

[7] https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/WGFR68AA1890D7334D8F8F72CC2399A27F4A.PDF

 

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

-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