FinTechREGULATORY OVERREACH BY RBI: MISCLASSIFYING BPSPs AS PAYMENT SYSTEMS

In February 2024, the Reserve Bank of India (“RBI”) took decisive steps to limit the operations of certain fintech companies, particularly Business Payment Service Providers (“BPSPs”). The RBI classified their activities as unauthorized “payment systems” under the Payment and Settlement Systems Act, 2007 (“PSS Act”).

BPSPs have significantly enhanced the business-to-business(“B2B”) payments landscape by enabling transactions from commercial cards to vendors who lack card-accepting infrastructure. However, this regulatory move has sparked legal debates about whether BPSPs qualify as payment systems requiring licensing or if they should be treated as mere aggregators.

RBI’S CONCERNS: RISKS IN BPSP OPERATIONS

One major issue is that BPSPs aggregate payments and transfer funds via banking channels such as National Electronic Funds Transfer (“NEFT”), Real-Time Gross Settlement (“RTGS”), and Immediate Payment Service (“IMPS”) without necessary authorization. According to the RBI, this constitutes operating a “payment system” because it involves settling and transferring funds between businesses and vendors.

The central bank is also concerned about anti-money laundering (“AML”) and Know Your Customer (“KYC”) compliance. Given the high volume of payments processed by BPSPs, the RBI argues that current KYC measures are insufficient, exposing the system to potential risks of fraud and financial misuse. Moreover, pooling funds in accounts not authorized for payment system use raises significant concerns, as it creates vulnerabilities for misuse or misappropriation.

DEFINING THE ISSUE: ROLE AND OPERATIONS OF BPSPS

By December 2023, BPSP-facilitated transactions contributed to 12.5% of total credit spending, amounting to approximately ₹20,000 crore monthly. Despite their huge role in enhancing B2B transactions, the RBI classified these activities as an unauthorized payment system by citing the handling and settlement of funds.

This interpretation, however, fails to consider the distinct role of BPSPs. According to the PSS Act, a payment system directly facilitates the clearing, settlement, or transfer of funds between a payer and a beneficiary. In contrast, BPSPs act as intermediaries, enabling transactions without performing the fundamental clearing or settlement functions that define a payment system under the Act.

UNDERSTANDING PAYMENT SYSTEMS THROUGH LEGAL PRECEDENTS

The Delhi High Court’s ruling in PayPal Payments Private Limited v. Financial Intelligence Unit [CM APPL. 37179/2022] provides valuable clarity on the limits of what constitutes a payment system. The court held that while PayPal enabled international transactions, it did not engage in the clearing or settlement of funds itself. Instead, PayPal relied on other systems to complete fund transfers, which excluded it from being classified as a payment system operator under the PSS Act.

This legal reasoning applies similarly to BPSPs. Like PayPal, BPSPs merely provide a platform for transactions. The processing of payments through corporate cards occurs via established card networks, such as Visa or Mastercard, which handle the interaction with banking channels. Thus, BPSPs remain peripheral to the core clearing and settlement operations that define a payment system. Consequently, their classification as a payment system by the RBI appears misaligned with the statutory framework of the PSS Act.

The decision in Lotus Pay Solutions Pvt. Ltd. v. RBI [2021 (3) ILR Delhi 160] further elucidates the distinction between payment aggregators and payment systems. The court held that entities facilitating payments without directly engaging in the functions of clearing or settlement do not qualify as payment systems under the PSS Act. Lotus Pay, similar to BPSPs, acted as an intermediary, facilitating transactions without handling the core mechanisms of payment processing.

Both the Lotus Pay and PayPal cases emphasize that the determining factor for classifying an entity as a payment system is whether it engages in clearing and settlement functions. BPSPs, which operate as intermediaries enabling payments through licensed systems, clearly fall outside this definition. The RBI’s decision to label BPSPs as payment systems disregards this legal framework, stretching the Act’s intended scope.

REGULATORY OVERREACH: MISAPPLICATION OF THE PSS ACT

The RBI’s regulatory action under the PSS Act reflects an overreach, as the Act is designed to govern entities that perform essential clearing, settlement, or payment functions. BPSPs merely aggregate payments and rely on licensed channels like NEFT, RTGS, or IMPS for remittance. The core functions remain under the purview of authorized systems. By misclassifying BPSPs, the RBI imposes compliance burdens designed for full-scale payment systems on entities whose operations do not pose comparable risks.

This regulatory misstep threatens to stifle innovation in the fintech space. BPSPs have significantly supported SMEs by facilitating transactions totalling approximately ₹20,000 crore monthly, offering critical access to credit. With this lifeline disrupted, businesses may face hurdles in securing alternative credit sources, potentially undermining financial inclusion.

FINANCIAL INCLUSION AND THE IMPACT ON INNOVATION

BPSPs have played a pivotal role in expanding financial inclusion, particularly for vendors without POS infrastructure. By integrating these vendors into the formal financial ecosystem, BPSPs have bolstered digital transactions, contributing significantly to the country’s rising credit card spending, which reached ₹1.65 trillion in December 2023.

The stringent regulatory compliance under the PSS Act, including KYC norms and other requirements, is disproportionate for BPSPs. Unlike full-fledged payment systems, BPSPs lack control over transaction settlements. Imposing such burdens disproportionately affects smaller players, creating a regulatory environment that favors established financial institutions while sidelining innovators.

AMLEGALS REMARKS

The RBI’s current stance on BPSPs appears to reflect a broader trend of regulatory caution in the fintech ecosystem, potentially driven by concerns over systemic risks and operational transparency. While these concerns are valid, especially in light of rising financial frauds and AML/KYC lapses globally, the approach must be proportionate and tailored to the nature of the entities being regulated. BPSPs serve as bridges between businesses and established financial systems, enabling transactions in underserved markets and promoting credit accessibility for SMEs. Misclassifying such intermediaries as payment systems imposes compliance burdens that could cripple their operations, resulting in reduced competition and innovation in the sector.

Further, this regulatory overreach could deter global and domestic investors from engaging with India’s fintech sector, undermining its status as a global hub for financial technology. By creating an environment where only well-capitalized entities can thrive, the RBI risks concentrating market power in a few hands, stifling competition, and limiting choices for businesses.

Moving forward, a more nuanced regulatory framework is necessary—one that distinguishes between core payment systems and intermediaries while promoting transparency and security. This approach would enable the RBI to safeguard systemic stability without compromising the innovation and inclusivity that entities like BPSPs bring to the financial ecosystem.

– Team AMLEGALS 

For any queries or feedback, feel free to connect to mridusha.guha@amlegals.com or liza.vanjani@amlegals.com