Emergence and growth of fintech start-ups in India

The Financial Stability Board (FSB) defines 'fintech' as "technologically enabled financial innovation that could result in new business models, applications, processes, or products with an associated material effect on financial markets and institutions and the provision of financial services".

The 2015–2020 period has seen phenomenal growth in new start-ups across India in fintech, especially in digital payments, lending and wealth segments. According to the 'MEDICI India FinTech Report 2020', India had the second highest number of new fintech start-ups in the last three years after the US (data for China not considered).

At present there are more than 2,000 fintech companies in India. The Boston Consulting Group in its recent report has stated that there will be a $100 billion value creation opportunity and that India is strongly poised to realise a fintech sector valuation of $150–160 billion by 2025.

This article highlights the key enablers and role of the government in emergence and growth of fintech start-ups, key segments for fintechs and the roadmap for the scaling up of fintech start-ups.

The emergence and subsequent growth of fintech startups in India can be contributed to various factors. Some of the key drivers have been discussed below.

Various factors act as key enablers resulting in the success of fintech start-ups in India, including:

• Availability of capital and a vibrant investment ecosystem;

• Favourable demographic in India (more than 65% below the age of 35 years) having an appetite for innovative technology;

• Low penetration of financial services for a majority of population (unbanked, rural regions, as well as small and medium-sized enterprises (SMEs));

• Government initiatives and regulatory forbearance to fintech;

• Increased mobile and internet access;

• Reduced infrastructure and transaction cost through usage of cloud-based services and IndiaStack; and

• Advancement in technology.

A few of these key drivers are discussed below.

One of the most difficult tasks for any entrepreneur is to raise enough funding. There are many factors which affect the dynamics of investor behaviour such as diverse and innovative products, business model, the stage of development of a product, asset position, future earning potential and domain knowledge. As mentioned above, investments in fintech start-ups have risen dramatically in recent years. Ease of capital has helped fintechs to drive innovation as well as their business model.

In addition to private equity (PE) and venture capital (VC) investments, Indian fintechs have also benefitted from the support received from various sector focused incubators, accelerators and tech-hubs.

Most of the incubators and accelerators are either university-led, public sector-led, equity-led or financial institution-led. These incubators, accelerators and hubs perform several functions, and when combined, have had a synergetic effect on startups undergoing acceleration, and a positive impact on the fintech industry's overall growth.

Technology has been a fundamental enabler in the field of fintech. Innovations like blockchain, artificial intelligence, machine learning, biometric, robotic process automation, instant payments, internet of things, cloud computing has led to major transformations of the financial service industry.

The backbone of the infrastructure for fintech in India has been strengthened with the host of options available to market participants such as BBPS, Bharat QR, India Stack and UPI. According to BCG, India's public digital infrastructure – IndiaStack, has generated strong tailwinds for the fintechs in India. The open-API infrastructure has been leveraged heavily by fintechs to address diverse use-cases and has helped fintechs in significantly reducing costs of acquisition and servicing.

According to MEDICI, the Account Aggregation framework (being an interoperable and technology agnostic framework) is envisioned to bring in a new kind of digital data model wherein account aggregators (regulated by the special NBFC-AA license) will act as data access fiduciaries between users/entities who are the primary owners of data and banks/financial institutions that maintain and manage it. At present, the Reserve Bank of India (RBI) has issued four operating NBFC-AA licenses and two in-principle NBFC-AA licenses.

Given the fintech sector's competitive existence and overlap with other industries, effective policy and regulation are critical for the sector's growth and stability. India witnessed a phenomenal growth in cashless transactions with the introduction of demonetisation.

Some of the recent Indian government programmes towards creating a favourable business climate for fintech companies are Unified Payments Interface (UPI), Jan Dhan Yojna, Startup India, Digital India Programme, Recognition of P2P lenders such as non-banking financial companies (NBFCs) and National Common Mobility Card (NCMC).

“India is strongly poised to realise a fintech sector valuation of $150–160 billion by 2025.”

The RBI, to establish an effective structure for a Regulatory Sandbox (RS) for fintech products, announced its detailed framework on RS in 2019 including provisions for entry and exit of startups, duration and indicative list of innovative products, additional services available and technology which could be considered for testing under RS.

The insurance regulator (IRDA) introduced the IRDAI Regulatory Sandbox in 2019 to strike a balance between the insurance sector's orderly growth and the security of policyholder interests, while also promoting innovation in the insurtech space. Similarly, the securities regulator (SEBI) in 2020 has also released a framework for RS for entities registered with it to experiment fintech solutions.

In general, Indian regulatory authorities (including RBI, SEBI and IRDA) have adopted a consultative approach towards the fintech sector and have provided a broader framework and sandbox environment to encourage responsible innovation. Fintech start-ups have also benefitted from the government's pro start-up policies and accommodative regulatory conditions.

Initially, fintechs were mostly concentrated in payments and lending, however, growth of the fintech ecosystem has encouraged diversification of new fintech platforms in different segments. Set out below are the key segments and a few business models within such segments that have been adopted by the fintechs in India (see table).

S. No	Segment	Key sub-segment/business models	Key players (illustrative)
1	Digital payments (Electronic payment solutions covering both remittances and enterprise/ merchant payments)	• Payment gateways and payment Aggregators • Bill payments and money transfers • Payment infrastructure - POS/QR codes • Digital wallets  • P2P Payments	Paytm, PhonePe, BharatPe, Razorpay, Oxigen, Juspay, PayU, MobiKwik, Instamojo, Pine Labs, BillDesk, CCAvenue, Ezetap
2	Alternative lending	• Digital consumer lending • SME financing/invoice financing  • P2P lending • Aggregators • Credit scoring platforms	LazyPay, Zest, Lendingkart, InCred, CreditMate, EarlySalary
3	Wealthtech	• Personal finance management • Investment platforms • Robo-advisor • Digital discount brokers	Bankbazaar, Upstox, Zerodha, Scripbox, Paisabazaar, Groww
4	Insurtech	• Aggregators/policy management • Software/white label/infrastructure APIs • Online Insurance • Claims management • IoT/telematics • Bite-size insurance/ microinsurance	Policybazaar, Acko, Digit, Coverfox, Arvi, Toffee Insurance, Easypolicy, BeatO
5	Neobanking	• Retail neobanks • SME neobanks	Niyo, Jupiter, Finin, Neo, Kaleidofin
6	Enablingtech and Regtech	• B2B SaaS (including customer acquisition and service) • E-KYC, AML, fraud and compliance • Account aggregation • Data capture and integration • Risk management	CustomerXPs, SayPay, KhataBook, ClearTax, EaseMyGST

In order to ensure scaling up of fintech start-ups, some of the key challenges will need to be addressed.

Like with any sector, the Indian fintech sector also faces some challenges that could impact its growth. Some challenges are structural in nature which are likely to have an impact across most segments of fintech.

RBI and SEBI are yet to come out with comprehensive and separate guidelines for the fintech sector and it continues to be governed by banking and securities regulations. Increased regulation could hamper innovation – which is key attribute of fintech – and also drive up operational costs. However, regulatory coherence will support growth of the fintech sector in the long run and help in gaining customer trust – a key factor in attracting more capital. Like any other sector, as fintech sector matures and the start-ups scale-up, they are more likely to be subject to greater scrutiny from regulators.

The key challenge for the regulator is to create an ecosystem fostering innovation, while balancing issues relating to customer protection, data security and privacy. The accelerated rate of innovations in the fintech sector has at times led the regulators to play catch-up and have knee jerk responses to certain market activities, for instance its stand on cryptocurrency, payment regulations and capping of market share by the National Payments Corporation of India (NPCI).

According to RBSA Advisors, with the huge expansion of fintechs and the proliferation in underlying delinquencies due to the nature of the credit flow, it is imperative to have prudential regulation controlling and limiting the system wide risk proliferation. Traditional banks give advances sourced from deposits, whereas fintech start-ups lend from debt funds/equity investments. Thus, the risk can permeate to various categories of people including investors, consumers and enablers.

The fintech sector has benefited the most from unrestricted data flow. The fintech industry's biggest issue is the industry's hidden cybersecurity risks which include data breaches, third-party security threats, ransomware, application security threats, cloud-based security threats, and digital identity risks.

To combat the cyber threat and prevent hackers from gaining access to sensitive data, a balanced approach to innovation is needed to support the fintech industry's growth. A rapid digital transition has forced unprepared governments around the world to step up legislative efforts to protect citizens' data and rights.

To safeguard the interest of the users, as per Srikrishna committee's recommendation, the Personal Data Protection Bill 2019 was introduced in the Lok Sabha to make data localisation mandatory for all sensitive personal data (PDPB). Fintech startups' business models are highly reliant on outsourcing technical support and cloud services to low-cost, competitive service providers.

Due to data localisation standards proposed in PDPB, start-ups will be unable to choose the most cost-effective cloud service providers from a global supply pool. Data localisation would also require them to participate in product re-engineering in order to comply with complex regulations which will increase technological and operating costs.

Despite the growth in overall funding of fintech start-ups, proof of concept (PoC) and early-stage funds are still limited according to Yes Bank 'India Fintech Opportunities Review' (IFOR). As part of its study, IFOR has highlighted that:

• 71% of pre-revenue and 81% idea-stage fintech startups noted 'severe difficulty' in raising funds; and

• There is an even bigger challenge in PoC funding – only 11% report that they received funding and 19% stated that their industry partners paid for the PoCs.

KPMG in its 2020 report on fintech has also highlighted that fintech investors adjusted their strategies in H2'20, moving away from early stage companies and towards later stage companies; investors also focused more on profitability. Foreign investment restrictions on neighbouring countries (including China) introduced in April 2020 have also added uncertainty around startup funding.

Due to Covid-19 and the economic slowdown it resulted in, the fintech segments have seen a significant dip in terms of the number of start-ups being funded during the initial months of the pandemic. However, the year-end witnessed these numbers starting to rise and a positive traction was witnessed across all fintech segments.

With successful fintechs as well as financial institutions looking at adding new products/segments, the next few years are likely to see consolidation in the sector and an uptick in M&A activity wherein:

• Financial institutions will look acquire or invest in fintechs in corresponding segments for their technology and customer access;

• Larger and more successful fintechs will acquire smaller players across segments to bring width to their business, for access to larger customer base and higher customer engagement.

Moreover, few of the larger fintechs (such as Paytm and PhonePe) as well as large tech companies including Google, Apple, Facebook, Amazon, Microsoft (GAFAMs) and large Indian conglomerates (Reliance and Tata) are looking at an ecosystem orchestrator ('super app') approach that has been observed in the success of Chinese fintechs (Ant Financial and Ping An). This will also add to the M&A activity in the sector.

International expansion is another route that the fintech start-ups will look to adopt to pursue scale. This holds true for international start-ups foraying into India and for Indian startups going overseas. Indian start-ups will need to carefully identify pilot geographies/markets to test success before scaling up and foraying into other markets. One approach that may be adopted for choosing the pilot market is regulatory and cultural contiguity as well as business model portability.

The continuously increasing collaboration between traditional financial institutions and fintech start-ups in the form of supplementary offerings (integration and co-creation), partnerships/distributions, acquisitions, incubation and investment will remain to be one of the key drivers of India's fintech growth as well.

While fintechs bring technological innovation and agile execution capabilities to the fore, financial institutions bring the benefit of scale and customer reach to the table. Moreover, fintech start-ups can also learn and adopt best practices around operational excellence as well as risk, compliance and internal controls that most of the financial institutions in India have successfully put in place.

The above factors will play a major role in the scaling up of start-ups in India and would help transform the landscape of the fin tech sector.

The authors would like to thank Sumedha Kalra (Associate) and Pragya Pandey (Associate) for their assistance.

Click here to read all the chapters from the 6th IFLR Asia Fintech Special Focus 2021

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L Badri Narayanan

Executive partner

Lakshmikumaran & Sridharan

T: +91 11 4129 9800

E: badri.n@lakshmisri.com

L Badri Narayanan is an executive partner at Lakshmikumaran & Sridharan. He advises clients on various issues involving consortiums and joint ventures such as contract manufacturing scenarios, valuation, secondment, royalties and license fee arrangements.

Badri has advised and assisted various leading Indian and multinational corporations with transactions pertaining to joint ventures, acquisitions and restructurings. His broad experience also includes having represented parties before various fora in tax and commercial disputes.

Badri has a bachelor's degree in law from the University of London and a master's degree in law from Cornell Law School. He is qualified to practice as a lawyer in India and New York.

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Gaurav Dayal

Partner

Lakshmikumaran & Sridharan

T: +91 11 4129 9800

E: gaurav.dayal@lakshmisri.com

Gaurav Dayal is a corporate, M&A and PE partner at Lakshmikumaran & Sridharan.

Gaurav has advised investment and commercial banks, private equity funds, multilateral agencies and strategic corporate clients on a variety of domestic and cross-border transactions including acquisitions, joint ventures, foreign investments and corporate restructuring, involving extensive advice on general corporate law and foreign exchange laws as well as the attendant regulatory issues.

Gaurav has a bachelor's degree in law from the National Law School of India University, Bangalore.