Regulations have helped fintechs in governance

Fintechs in the country have grown in the last decade, both in the number of entities and scale. The key growth sectors have been payments, credit, insurance and wealth management, fuelled by angel investors, venture capital (VC) and private equity.

However, in the last couple of years, the access to risk capital for fintechs has dropped considerably, with total funds raised in 2023 ($1.2 billion) being less than a quarter of what was raised in 2021 ($5.1 billion). As they gained scale, fintechs’ heightened scrutiny has resulted in issuance of guidelines and regulatory expectations. Some of these have affected business models. Investors are playing the waiting game to see how the ecosystem adapts to the dynamic regulatory environment.

It has been empirically established that determinants for growth of fintech activity are customer demographics, digital infrastructure, financial services penetration and policy environment. India has a young demography of customers who are technologically savvy. The digital infrastructure is also reasonably well placed to support fintechs. There’s a negative correlation between fintech activity and financial services penetration. Under-penetrated financial service markets like ours offer more opportunities to fintechs. Therefore, with the three key growth drivers in place, government steps to strengthen innovation can spur fintech activity and employment in the sector.

Regulatory sandboxes: Typically, there’s significant information asymmetry between VC firms and early-stage fintechs. Resolving it requires time-intensive and costly upfront screening and post-investment monitoring. Sandboxes allow testing of products in a limited market environment under regulatory oversight. This provides assurance to investors that the participating firms meet regulatory needs. While financial sector regulators have set up regulatory sandboxes, an inter-operable regulatory sandbox (for fintechs which operate across financial services) participation has been limited.

Fintech ecosystem accelerators: These are fixed-term cohort-based programmes that offer startups cash incentives, shared office space and infrastructure and entrepreneurship coaching. While investor-backed accelerators are aimed at return on investment, those backed by the government seek to stimulate startup activity in the region and generate employment. Strategic location-based accelerators, which are backed by central or state governments, will enhance fintech activity and hasten the success of the better among them. Ecosystem accelerators can act as sort of a marketplace of fintechs; and enable cost and time-efficient discovery processes for VCs for identifying prospective investment candidates.

Self-regulatory organisations (SROs): Given that financial service is one of the most regulated sectors, navigating the regulatory landscape can be complex for young fintechs. The Reserve Bank of India has established guidelines for authorisation of SRO for fintechs, and other sectoral regulators could replicate the same. SROs can be instrumental in playing a developmental role for the ecosystem by setting standards on aspects of conduct, customer protection, corporate governance, technology best practices, operational resilience and cyber security. Additionally, there could be certifications that the SROs may undertake which provide assurance to incumbent firms, investors and regulators that baseline governance structures are in place for those certified. This will aid incumbent firms to make objective and comprehensive assessments of fintechs.

Regulatory posture and expectations have helped fintechs to align to higher standards of governance. The steps taken to ensure regulatory clarity, consistency, transparency and predictability for market participants are improving investor sentiment. There are already early signs of green shoots of recovery in funding for fintechs, and in some sense FY25 will prove to be the year of redemption.

This column first appeared in Business Standard on 11 August 2024.