INDIA: An Introduction to FinTech Legal

India: FinTech Legal 

The investment landscape and growth of the fintech sector

The FinTech sector in India is now one of the fastest growing globally, having attracted more than USD 10 billion in investments over the last five years. Business models and investments in this space have now diversified and expanded beyond back-end technologies and digital payments to cover more financial services such as lending, insurance, brokerage, mutual funds distribution, and wealth management. The expansion of the FinTech sector has, in large part, been fuelled by technology innovation, reducing data costs, higher smartphone penetration, better digital infrastructure and a generally FinTech-friendly regulatory environment in India. This has culminated in more than sixteen FinTech companies from India having attained unicorn status in the last two years. This sector is further maturing with a growing number of home-grown companies having filed or in the process of filing for their initial public offering, marking a new phase of growth where new-age, venture backed fintech companies will, for the first time, be tested by the public markets.

Regulatory steps taken to boost investments in the FinTech sector

The Indian Government has taken several steps over the years to encourage foreign investment into the FinTech sector and make the process of investments less tedious. One of the major steps was taken in 2016, wherein the Reserve Bank of India (RBI) and the Department for Promotion of Industry and Internal Trade (DPIIT) liberalised the Foreign Direct Investment (FDI) regime in relation to the financial services sector, allowing 100% FDI under the automatic route, i.e., not requiring any prior approval from the Indian Government, for the category of ‘other financial services’. This opened an avenue for all entities engaged in financial services and regulated by any financial regulator in India, to attract foreign investment. Subsequently, the minimum capitalisation norms for ‘other financial services’ activities were prescribed for ‘fund based’ and ‘non-fund based’ activities respectively (even if unregulated), that include stock broking, portfolio management, venture capital, and investment advisory. This development paved the way for FinTech entities to receive investments from across the globe.

Separately, the Indian Government has recently developed a regulatory framework for establishing International Financial Services Centres (IFSCs) in India (within the jurisdiction of a single regulator), to bring India at par with global financial hubs and to attract overseas investors. The IFSC has been envisioned as a special economic zone and a financial centre located within India, with entities registered therein legally deemed to be foreign entities, for the provisioning of various financial services to resident and non-resident participants in a foreign currency, i.e., not the Indian rupee. The Gujarat International Finance Tec-City (GIFT City), the first and only IFSC currently operational in India, enables foreign investors to set up a unit in the GIFT City to route investments into India seamlessly, without having to comply with the foreign exchange controls otherwise applicable in India. Regulated Indian FinTech entities can set up units in the GIFT City to attract foreign capital, subject to complying with the prescribed conditions.

Regulatory approach in India towards FinTech 

In addition to the FDI regime, the general regulatory approach in India has also been largely conducive to support the growth of fintech, with the underlying policy objectives of the Indian Government to attain a ‘less-cash’ economy and drive financial inclusion across cities and demographics. In the last decade, the government has played an important role to develop the underlying digital infrastructure that has supported the growth of fintech, obviating the need for private players to build this infrastructure of their own. This includes a wide-ranging technology stack comprising of the Aadhaar and e-KYC, the unified payments interface and other payment platforms of the National Payments Corporation of India, DigiLocker, eSign, the Open Credit Enablement Network and the account aggregator framework.

Further, multiple initiatives have been rolled out across regulatory domains for the financial, securities and insurance sectors, that include market studies, regulatory sandboxes, innovation schemes, incubation and funding support, to enable testing of new technology-driven products, services and business models for these markets in a controlled regulatory environment. This, together with the consultative process being generally adopted by regulators in this sector prior to the introduction of any new laws, has allowed industry players to play a more active role in the development of the regulatory framework for the FinTech sector in India.

Until recently, there were no specific regulations or licensing regimes in India for the FinTech sector. A large portion of this sector has been operating at the brink of or outside the regulatory regime applicable to banking and financial services, by virtue of positioning themselves as third-party technology enablers operating ‘over the top’ of licensed entities. With increasing FinTech penetration, together with the growing interplay between regulated and unregulated players (discussed below), Indian regulators have taken cognisance of the emerging risks and regulatory gaps, and accordingly been working towards effectively dealing with this dynamically evolving industry. In this backdrop, specific regulatory frameworks have evolved in the last three years to govern different FinTech activities, including for online payment intermediaries, digital wallets, small payment banks, peer-to-peer digital lending platforms and account aggregators. These new regulations broadly mimic the existing laws albeit aligned to the technological and industry changes being seen in the sector, and are indicative that the regulators increasingly blurring the distinction between traditional banks and non-bank FinTech entities; for instance, with non-bank entities now being permitted to issue full-KYC digital wallets and use the Aadhaar-based e-KYC facility for onboarding and authentication. These regulatory developments are in addition to the increased indirect regulatory governance of fintech entities through more onerous ‘outsourcing’ norms now applicable to regulated financial institutions and payment system operators.

The digital payments space is the most developed FinTech category in India, including in terms of the regulatory developments. With significant growth in digital payments adoption across India, there is now an increased regulatory focus on consumer protection, data security and anti-money laundering. This is alongside increased focus on consumer-centric initiatives through making online payments more affordable, mandating and incentivising interoperability in digital payment systems, enhancing the grievance redressal structures, and deployment of more digital payments acceptance infrastructure. The above is evident from recent regulatory developments and enforcement around the changes to the extant guidelines for online payment intermediaries and digital wallets, e-mandate framework containing safeguards relating to recurring online transactions, data localisation norms for payment-related data, prohibition on storage of card-on-file data, the expanding tokenisation framework, introduction of cyber security controls, and KYC, CFT and AML norms. These changes, although they are aimed at improving consumer welfare and are steps in the right direction over the long term, are inevitably increasing the compliance burden and costs for digital payment companies. This aspect may have to be reevaluated, given the already revenue-hit online payments space in India in the backdrop of the zero merchant discount rate (MDR) policy of the Indian Government.

Although the RBI is the key regulator for most FinTech activities in banking, payments and lending, there is jurisdictional overlap with the Securities and Exchange Board of India (SEBI) when dealing in or advising on securities, the Insurance Regulatory and Development Authority of India (IRDAI) for insurance products and services, as well as the rapidly growing Ministry of Electronics and Information Technology (MEITY) in relation to data protection.

In this backdrop, the Financial Stability and Development Council of India has recently constituted a new inter-regulator panel, including officials from the RBI, the SEBI, and the IRDAI, to seek better regulatory co-ordination to deal with FinTech companies. Additionally, frameworks for self-regulatory industry organisations that will be recognised by the RBI are also being developed, including for the Self-Regulatory Organisation (for payment system operators), the New Umbrella Entity (for retail payment systems) and ‘Sahamati’ (for account aggregators).

India’s evolving stance towards cryptocurrency 

The legal ecosystem in India for dealing with cryptocurrency continues to remain uncertain and an evolving one. There is no specific legal framework to regulate or recognise crypto transactions in India. The RBI, through its circular of April 06, 2018 (RBI Circular), had effectively imposed a ban on cryptocurrency trading in India, by shutting off formal banking and payment facilities for such transactions. However, on challenge, the said RBI Circular was set aside by the Supreme Court of India on the test of proportionality. Recently, the RBI has officially clarified that the RBI Circular cannot be cited by financial institutions to deny services related to cryptocurrencies, however, financial institutions can continue to carry out due diligence processes for crypto transactions relating to KYC, AML and CFT, as well as under the FEMA framework for overseas remittances. This RBI clarification appears to have become a key thrust for the recent regulatory action initiated by the Enforcement Directorate against digital exchange platforms that facilitate trading in cryptocurrency, and access denial to crypto platforms by banks and payment system operators. Separately, the Indian Government has previously proposed but withdrawn two draft legislations which, amongst other things, aimed to ban and criminalise activities connected with private cryptocurrencies (i.e., created by non-sovereigns and private enterprises), while purporting to promote blockchain technology. Further, the RBI has recently also indicated to a future roadmap for the creation of a Central Bank Digital Currency (CBDC) in India.

The shifting policy approach in India towards crypto has been a major cause of concern for players in this industry, who have had to constantly change and evolve their business models for the Indian market to manoeuvre through the regulatory developments in this space. This, alongside the unpredictable operating environment in India, largely on account of the recent regulatory enforcement against crypto exchanges and the shifting stance of banks for facilitating crypto-related transactions, has made it difficult for crypto players to invest and operate in India.

Given that the cryptocurrency and blockchain industry is, at present, driving substantial technological innovation globally across domains, it is important that the Indian Government creates an enabling regulatory environment for crypto and blockchain, in order to capitalise on the industry’s massive potential. This will also enable India to evolve at par with and integrate with other developed countries globally, which are establishing progressive frameworks to regulate crypto and blockchain, instead of a blanket prohibition.

Indications are that discussions within the Indian Government are taking place for the setting up of a new panel of experts to study the possibility of regulating cryptocurrency in India as ‘digital assets’ instead of currency, and in place of an outright ban. Media reports suggest that the Indian Government is planning to recognise cryptocurrencies as an ‘asset or commodity’ for all purposes, including taxation and as per use cases like payments, investment or utility. These developments come at a time when the Finance Minister has also indicated that a calibrated approach towards regulating crypto assets will be taken, including a window for experiments in blockchain, Bitcoin and cryptocurrency. If these reports are true, one can expect a more balanced regulatory approach towards crypto assets in India going forward instead of an outright ban. In fact, it is possible that the overall regulatory framework proposed to be adopted for crypto may be released in a phased manner and the recent regulatory actions may well be intended to cool the market rather than close it.

Recent trends in the FinTech sector 

As discussed above, FinTech innovation in India has now diversified beyond payments to cover other financial services. Neo-bank platforms that operate entirely online (i.e., without any physical branches) are a new category of FinTech start-ups growing in India at a fast pace. However, given that the RBI does not, at present, recognise ‘virtual’ banks and requires banks to have some physical infrastructure, neo-bank platforms in India typically offer banking services through an underlying partnership with a licensed bank. The FinTech sector is also experimenting with self-executing smart contracts (which currently operate in a regulatory grey area regarding their authenticity, admissibility and enforceability), blockchain-based use cases, and InsureTech. Further, artificial intelligence (AI) is one of the key technology enablers underlying the growth of FinTech in India, particularly to support data-focused analysis and services. Some common areas where AI is being deployed include virtual assistants to improve customer service and engagement, credit underwriting, automated tools and algorithms for aiding in analytics and investment decisions, algorithmic trading, and contract automation, as well as regulatory compliance, fraud detection and risk management.

FinTech and AI are playing a significant role to augment ‘financial inclusion’ across the underbanked and uninsured demographic in India, by improving access to financial services to children, lower-income groups, small businesses, and rural parts of India (especially tier-II and tier-III cities). For instance, industry stakeholders (including regulators and private players) have been working towards evolving the payments acceptance infrastructure to offer offline-transaction capabilities to cater to under-served rural areas and non-smartphone users. Similarly, based on data-driven underwriting and customer discovery processes, digital lending platforms have improved access to credit for many stakeholders such as small merchants and rural businesses that have limited credit history for traditional capital raising.

The growing significance of FinTech to the Indian financial sector is also evident from the evolving relationship between traditional institutions and FinTech entities, which is no longer competitive but focused on leveraging synergies. Traditional financial institutions in the banking, securities and insurance space are increasingly adopting technology and online delivery channels to develop new offerings and expand market reach, reduce operational friction and gain cost efficiencies, strengthen data analytics, and improve customer service. Similarly, FinTech entities are increasingly bundling their services with banks, non-banking finance companies and other licensed entities to rely on the latter’s licences and regulatory know-how, as well as their distribution infrastructure, large client base and strong networks. Different collaborative strategies are being used by traditional institutions for adopting FinTech, including investments and partnerships with fintech companies, acquisitions, as well as development of in-house technology capabilities. As a result, the FinTech sector in India is now no longer made up of only start-ups, but also includes seasoned companies and traditional financial institutions that have started offering a broad array of customer-focused and technology-driven product and service offerings.

Conclusion  

Demonetisation (the removal of INR 500 and 1000 denominated currency) in India in 2016 provided an initial push towards the adoption of digital payments. The recent COVID-19 pandemic has accelerated trends that were already occurring, including the shift towards digitisation and FinTech adoption among various stakeholders, including small and medium businesses, government bodies, banks and other financial institutions. A new cohort of users that were previously resistant to FinTech have come online for the first time as a result of the pandemic, and are likely to continue using FinTech products going forward. Related consumer behavioural changes are also contributing towards increased FinTech adoption, such as growth in e-commerce and discretionary spends on online platforms, telemedicine consultations, online streaming and distance learning activities. The above developments, coupled with continued interest from global investors in this space across FinTech business models, present further growth opportunities for this sector in India in the long run, and present a lucrative destination for foreign investment.

The expansion of the FinTech sector has raised valid policy concerns around data protection and privacy, data monopolisation, cyber-security risks, consumer protection against fraud, and money laundering, as well as the impact on financial stability and the wider systemic risk to the financial ecosystem in India.

A key policy question that Indian regulators are grappling with is to find the right balance between regulatory intervention to address the above concerns, whilst still allowing FinTech innovation and businesses to continue growing.

Authors: Avimukt Dar | Namita Viswanath| Shreya Suri | Shantanu Mukul | Aditya G Date: November 8, 2021