Is stringent regulation stifling innovation in fintech?

India’s rapidly evolving digital financial industry has faced constant regulatory scrutiny in recent years, disrupting business across the board. The world's third-largest fintech ecosystem exists in India. So far, the Reserve Bank of India (RBI) has taken a balanced approach to regulating the fintech sector through its digital lending guidelines (DLG).

The regulatory body has attempted to find a middle ground by balancing between encouraging innovations in fintech, while also addressing the unique risk they bring to the table. But the sector disagrees.

“Most rules and laws are framed without much discussion and without any cost-benefit analysis,” says Sujeet Kumar, member of Parliament and chairman of Committee on Petitions (Rajya Sabha) at a round-table organised by a think-tank. He suggests policymakers must confer with industry experts before any major change is brought about to establish accountability.

“Innovation and (financial) inclusion should go hand-in-hand, innovation and data security should also go hand-in-hand. With the massive amount of data that will be generated and has already been generated, concerns about data privacy and security will prop up. So, any innovation in the fintech world has to take these factors into account,” says Kumar.

Why is regulation necessary?

The most apparent reason is the protection of consumers against unfair business practices by fintech companies. Data from the Reserve Bank of India’s (RBI) FY23 annual report shows the value and volume of digital fraud committed using cards and internet-based payment methods almost doubled in the last financial year. Many consumers become victims of debt traps.

Furthermore, regulation helps prevent fintech from creating monopolies that suppress innovation and kill competition as they have a tendency to leverage DNA (data, network effects, activity data) loopholes in order to grow aggressively. Lastly, to ensure a stable market, regulators need to step in considering the high probability of failures in the fintech startup world.

Hardeep Singh, head of the legal & policy team, CRED, while highlighting the regulator’s calibrated approach, says, “A key issue that the country was facing was fraud in digital payments, and the regulator after having looked at multiple options, took a step in the right direction in the form of tokenisation.”

“With the DLG guidelines, one of the best examples of great consultation work by the regulators, and eventually a regulation that looks at and understands the need of the hour from an innovation perspective; and the RBI eventually coming out and saying 5% FLDG (First Loss Default Guarantee) cap is permitted for non-regulated players, is effectively enabling non-regulated players to become a part of the lending ecosystem,” Singh adds.

However, the discussion brought other concerns to the fore: harmonisation of KYC (Know-Your-Customer) across the board, providing time for compliance, and lack of collaboration between policymakers and the companies.

Garima Prakash, deputy manager at NASSCOM, points out there is a need for the regulator to focus on minimising the negative impact on consumer services, while bringing out new regulations. Making suggestions, she says there is a need for “more collaboration with the industry before setting up implementation deadlines to ensure that the industry is prepared and that the implementation frameworks are structured, probably could have led to lower unintended consequences.”

Another fintech revolution trend she highlights was the way the RBI is regulating non-regulated entities through regulated entities. “The way the mandates are placed on regulated entities need a little more thinking and more collaboration with the industry,” she says.

Proportionate regulation

The adoption rate of fintech in India stands at 87%, a whopping 20% higher than the global average, according to a report by EY “The Winds of Change” in 2022. Amid the digital leap, the country needs a regulatory framework that can boost financial inclusion, protect consumers, foster stability in the financial system, and avoid the domination of business in the hands of a few.

Regulators' approach is slowly becoming sophisticated overtime, however, Astha Srivasata, principal associate, IKIGAI Law, suggested overall clearer regulations would enable efficacy. Citing the example of KYC norms, she says that vague and ambiguous regulations in that respect are leaving the industry and the consumers with a lot of unanswered questions. “Before we get to esoteric concepts of introducing new founded angles, first we need to clarify the doubts that regulated players have in mind. Over-compliance and under-compliance both are not good for financial inclusion and innovation,” she adds.