In the evolving fintech or financial technology landscape, India sits at the intersection of innovation and regulation. What began as a quest for stability and oversight has transformed into a dystopian odyssey, where good intentions pave the way for chaos and unintended consequences lurk around every corner.
Our story today begins with a modest trigger: the RBI’s cautious instructions to Kotak Bank, halting the onboarding of new digital customers and suspending credit card issuances. Regulatory zeal, ostensibly intended to prevent potential failures, lacks a tangible basis for failures. This is reminiscent of regulatory crackdowns of the past, where rigid controls were imposed without a clear understanding of the underlying issues, such as that on HDFC a few years ago or on Pay recently. This knee-jerk reaction to largely hypothetical scenarios reflects a systemic inability to distinguish between proactive risk management and overreaction.
Now, cast your eye over the recent renewal of authorizations for new merchant onboarding for payment aggregators like PayU and Razorpay – a belated glimmer of hope in a sea of uncertainty. Even these restrictions were imposed earlier due to concerns over their KYC processes, which come with their own nuances. Yet this ray of light is quickly extinguished by the heavy hand of the RBI in other cases, exercising mandates on data localization and card storage with reckless abandon.
Is fintech regulation effective or disruptive?
The stated intention behind data localization is privacy and security. The question that needs to be asked is: was this the most efficient and least disruptive option?
The card storage guidelines were also poorly thought out: card data could only be stored at the network level or by banks, not by other entities, including payment aggregators and merchants. No bank has provided this facility. This caused a lot of disruption as merchants used to store these card numbers as stored card transactions are preferred to reduce friction in the transaction flow. Subscription services’ cumbersome protocols, requiring day-in-advance notifications and convoluted cancellation procedures, have only exacerbated disruptions, particularly in international payments. What was needed was simply to impose more transparency, not to add mandatory measures.
Merchants and users accustomed to seamless transactions via money orders and stored cards are wary of these changes. These are complex integrations between different entities, which require appropriate systemic thinking to develop good policies. We introduce several points of friction into the system without measuring their potential impact on the different transactional flows.
How OTPs complicate the situation
Stock brokerage and mutual fund firms also find themselves mired in a regulatory quagmire, with onerous OTP requirements for selling mutual fund units adding layers of friction to a process already complex. Additionally, this obsession with OTP-based two-factor authentication, without considering OTP delivery rates, will certainly lead to declines. Also, no one thought about the email and mobile data gap between different players in the ecosystem – brokers, RTAs, mutual fund companies, etc. This required a lot of frantic work behind the scenes to streamline the system.
Banning the use of wallets or mutual funds to purchase mutual funds only compounds the problem, unnecessarily complicating settlement processes, without considering the downstream impact on consumers and the market liquidity. Settlement processes became a bureaucratic nightmare, refunds remained in limbo and customers found themselves stuck in a maze of red tape.
Why not simplify the process?
The regulatory maze extends beyond that and even Aadhaar-PAN links and nominee declaration guidelines for mutual funds. While these measures may sound good in theory and are intended to protect customers, what about the readiness of back-end systems and customer discomfort? Wouldn’t it have been better to simplify the candidate verification process only for those who need it rather than requiring it for all redemptions and purchases?
Unintended consequences abound in this regulatory quagmire. Take, for example, the strict Know Your Customer (KYC) standards imposed on fintech companies. Ostensibly intended to combat money laundering and terrorist financing, these regulations have unintentionally erected barriers to financial inclusion, particularly for people in rural and remote areas. The imposition of arbitrary loan caps on peer-to-peer lending platforms, ostensibly to protect consumers from excessive debt, has effectively grounded a vital source of credit for small businesses and individuals and stifled innovation, choice and opportunity. Additionally, bureaucratic inertia and lack of regulatory clarity have created a climate of uncertainty, deterring investors and stifling startups and innovation.
The consumer pays the price
But perhaps the most glaring consequence of haphazard regulation is the disruption and inconvenience it inflicts on customers. Take for example the recent debacle surrounding digital lending apps, where unsuspecting borrowers faced harassment and exploitation due to lax regulatory oversight.
The lack of stakeholder consultation and cost-benefit analysis raises troubling questions about regulatory decision-making, highlighting a pervasive “act first, think later” culture that prioritizes compliance over ‘to innovation and consumer well-being. Additionally, the definition of cost in a cost-benefit analysis should be expanded to include customer discomfort, transaction abandonments, adding points of friction, increased work for different stakeholders, impact on innovation, etc.
Whenever regulators consider intervention, they must ask themselves: What is the optimal, least disruptive option? Doing nothing and letting markets act are also options, as each intervention has a significant opportunity cost, both for businesses and customers.
Behind the facade of regulatory vigilance lies a harsh reality: the sclerotic legacy systems of traditional banks, which have long resisted innovation, adaptation and competition. By imposing stifling regulations on fintech disruptors, regulators risk entrenching this status quo.
What effective regulation looks like
So where do we go from here? Separation of regulatory powers, transparency, consultative processes, greater proactivity and responsiveness in responding to consumer feedback – all noble ideals, in fact, necessary conditions, but mere band-aids on a gaping wound. For example, the RBI’s mandate is not really about fintech regulation: apart from separation of powers, it is also about capacity and expertise. So, calls for a separate fintech regulator are logical, but ignore the fact that despite the existence of a separate regulator, SEBI, for stock markets and mutual funds, we do not have not observed less disruption in this sector. What we need is to fundamentally rethink our approach to fintech regulation. It’s time to embrace innovation, develop expertise, build guardrails rather than obstacles, and think outside the box.
For example, OTPs are not the only method of two-factor authentication. Recognizing this opens the way to many innovations. Could we also modernize settlement and reconciliation processes, which are still file-based mechanisms and not API-based in today’s world? We need more private, agile entities running the foundations of our fintech system to drive scale and innovation. In a recent Bank for International Settlements (BIS) working paper, Nandan Nilekani and others propose the “concept of “Finternet” as a vision for the future financial system: multiple financial ecosystems interconnected to each other – much like Internet.”
If this is our vision, it cannot be accompanied by a regulatory system that is archaic in its rules and functioning.
In conclusion, the journey through the regulatory minefield is fraught with challenges, but it is not without hope. By embracing transparency, collaboration and innovation, India can chart a path to a better future.
(The author is a researcher at the Takshashila Institution, Bengaluru)