A. Introduction

Most digital/IT related services have survived the negative economic impact of the ongoing COVID-19 pandemic. However, with a sharp drop in e-commerce and online travel and event booking transactions, the digital payments industry has been hit hard by the COVID-19 lockdown in the last 2 months. UPI transactions decreased from 1.3 million in December 2019 to 1.25 million in March 2020- a drop of 500,000 transactions1. Online transactions for PhonePe on the merchant side are down by 60%-70%; Razorpay's business is down by 40%-50%2. At the same time, however, the COVID-19 pandemic could also result in greater adoption of digital payments. For businesses and services to go remote, payments will also have to happen remotely. With bank notes considered to be potential carriers of the COVID-19 virus, both the RBI and NPCI have advised people to use digital payments3. This is an opportunity for fintech to do what it does best: innovate, scale and adapt.

However, unlike other products, digital payment products are a commodity. Some have better success rate. Others have better API integrations. But, in essence, they all offer the same service- enabling digital payment transactions. Without any fundamental difference between their products, digital payment players compete on margins i.e. the amount of money they make on each transaction, also known as 'merchant discount rate'. However, the earnings of digital payments players may be threatened by the government's zero MDR policy. Nandan Nilekani, who had chaired the RBI's committee on deepening digital payments, had said that MDR should not be subject to any kind of government intervention- it will automatically reduce to zero as a result of market forces4.

What is MDR?

The margin earned by digital payments service providers on each transaction is their 'rozi-roti', and in industry-speak it's called merchant discount rate or 'MDR'. Whenever you make a transaction at a point-of-sale ('PoS') (which can be a card machine, a PoS terminal at a shop, or an app like Paytm), the seller (or 'merchant') pays a fee to the payment gateway on every such transaction for transferring the money to the merchant's account. This fee is known as MDR. Depending on various factors (such as turnover of the merchant and the transaction amount), MDR can vary from 0.4% to 0.9% of the transaction amount5.

MDR is an important revenue component for most stakeholders in the digital payments ecosystem. This includes the payment gateway/aggregator, the acquiring bank (i.e. the bank which facilitates the transaction) and the PoS infrastructure providers. The various kinds of processing fees paid in a digital payment transaction (such as the interchange fee paid by the acquiring bank to the issuing bank i.e. the customer's bank, or any other processing fee) are paid from the revenue earned through MDR.

Thus, MDR acts as a financial incentive for banks and payment aggregators to acquire merchants, and it supports the entire chain of stakeholders in the digital payments ecosystem.

B. What is the government's zero MDR policy?

In her budget speech in July 20196, the Union Finance Minister announced that businesses with an annual turnover exceeding INR 50 crore must offer digital payments options such as BHIM UPI, UPI QR Code and Aadhaar Pay to their customers. She added that no MDR could be charged for providing these digital payments options.

To give effect to this announcement, the following legal amendments were introduced through the Finance Act, 20197:

  1. The Income Tax Act, 1961 made it compulsory for businesses with total sales, turnover or gross receipts exceeding INR 50 crore to provide their customers with RuPay debit cards, UPI and UPI QR code8 (as payment options).
  2. The Payment and Settlement Systems Act 2007 disallowed banks and system providers from charging (any person) for using the abovementioned digital payment modes9.

Thus, payment gateways/aggregators cannot charge MDR from merchants processing customer transactions using the aforementioned modes of payment.

C. Why does the government want to introduce the zero MDR policy?

The government introduced zero MDR to encourage merchants to adopt digital payments and reduce reliance on cash. But adoption of digital problems is affected by two problems. First, cash is always in high demand among merchants, as it is unaccounted, untaxed wealth. Second, merchants are required to pay a (somewhat nominal) fee on each digital payment transaction in the form of MDR, which is an annoyance for them. Merchants would earlier attempt to recover MDR charges from customers by charging them a 'convenience fee', but this practice was ultimately banned by the RBI10. However, in a post-COVID world with social distancing norms and reduced use of cash, merchants will have no option but to accept digital payments. They will be more amenable to paying MDR charges. Hence, instead of using a zero MDR policy, the government has to ensure that there is sufficient incentive for the various stakeholders in the digital payments ecosystem to invest money in setting up acceptance infrastructure (i.e. infrastructure for accepting payments, such as card networks, PoS terminals etc.).

A closer look also shows that the products which are currently subject to the zero MDR regime- RuPay debit cards, BHIM UPI, UPI QR code and Aadhaar Pay- belong to the National Payments Corporation of India ('NPCI'). Thus, through the zero MDR policy, the government wants to promote NPCI's products over other digital payment products in a highly competitive market. The government has taken steps in the past also to promote NPCI's products. In September 2019, NPCI's steering committee had proposed to introduce a 'market cap' of 33% on the volume/value of transactions for platforms enabling payments through UPI11. The government has also spent a large amount of taxpayers' money in promoting BHIM and UPI. For instance, it spent around INR 495 crore on giving cashbacks on the BHIM app between April and October 201712. But imposing zero MDR for NPCI products may result in large revenue losses for NPCI (to the tune of INR 200 crore annually)13. It will also disincentivize banks from adopting NPCI's payment instruments, who could then turn to companies like Visa and MasterCard14.

D. Why is the zero MDR policy an issue of concern for the digital payments industry?

A zero MDR policy will cause revenue losses to all players in the digital payments ecosystem. As discussed before, MDR contributes to the revenue of all stakeholders in the digital payments chain (either directly or indirectly). In 2016 the Watal Committee on digital payments (set up by the Ministry of Finance) observed that MDR incentivizes:15 (a) banks to issue cards and promote their usage; (b) card schemes to manage and grow the card network; and (c) banks and non-banks to acquire merchants. It recommended that MDR should be market driven, and capping MDR hinders growth of the digital payments industry.

Today the government's zero MDR policy is only for certain modes of digital payments, but it may be extended to other modes of digital payments. The State Bank of India and NPCI have already asked the government to extend the zero MDR policy to 'international card schemes' such as MasterCard and Visa16.

MDR is important for the financial sustainability of the entire digital payments ecosystem. A zero MDR policy could have a domino effect on the upstream revenue streams (like switching fee and interchange fee) of all these stakeholders. This will ultimately result in either the digital payments ecosystem becoming financially unstable, or force stakeholders to modify their business models to diversify their revenue model.

E. Is a zero MDR policy the correct approach to increase adoption of digital payments?

No, there are various flaws in the zero MDR policy which will actually harm the digital payments industry more than promoting adoption of digital payments:

  1. Zero MDR only benefits large merchants: At present, the zero MDR policy benefits large merchants (with annual turnover more than INR 50 crore), though it is actually the smaller merchants that need this relaxation to easily adopt digital payments17. This was also the RBI's rationale in introducing differential MDR based on merchant turnover in 2017: smaller merchants (with turnover up to INR 20 lakh during the previous financial year) were charged a lower MDR18.
  2. Zero MDR can only work if supported by government compensation models: Whenever the government has removed MDR for certain categories of transactions, it has always supported it with government reimbursement. In February 2017, when MDR charges were waived for debit card transactions for all payments made to the government, the MDR cost was absorbed by the central government19. When MDR was waived from 1 January 2018 to 31 December 2019 on transactions up to INR 2,000 for debit card, BHIM UPI and Aadhaar Pay transactions20, it was reimbursed by the government. Under the latest removal of MDR charges, the government has not indicated that it will absorb this cost. The NPCI has itself written to the government to devise a compensation method for banks to recover the lost revenue of MDR charges on UPI transactions21.
  3. Payments companies will pass on digital payments costs to customers: The RBI does not allow merchants to pass on the MDR charge (on debit cards) to customers22. However, the zero MDR policy could lead to banks passing on this cost to merchants (who would consequently pass them to customers), through various opaque and hidden charges. Passing the cost of digital payments to customers could hurt the adoption of digital payments and negate any possible benefit of the zero MDR policy. For instance, Axis Bank (after the first 20 free UPI transactions) charges its customers INR 2.5 for transactions below INR 1,000, and INR 5 for transactions above INR 1,00023.
  4. Zero MDR is a sustainable model only for large companies: The option to offset the MDR revenue loss by cross-selling other products (to merchants and customers) may be available only to relatively large and well-funded payment companies. These companies may be able to offer diverse product portfolios and absorb the MDR cost. However, small players or those that rely on MDR as a primary source of revenue, may not have this luxury. For instance, Paytm's CEO mentioned that companies like Paytm use their own investments to cover costs like MDR, whereas other intermediaries in the digital payments ecosystem rely on the revenue earned through a minor fraction of MDR24. By cutting off the MDR revenue stream, payments companies will have to diversify product portfolios to offer services like credit, insurance and wealth management.
  5. Privacy concerns with zero MDR: A zero MDR policy will also push payment players to look at other revenue models like using payments data (of merchants and customers), to cross-selling other products. But, the Personal Data Protection Bill, 2019 ("PDP Bill"), may make it difficult to use payment/ transaction data to cross-sell other products. The PDP Bill introduces principles of 'collection' and 'purpose' limitation25. So, payments companies can use data only for the purpose for which it was collected. For instance, if Paytm collects data from a merchant to set-up and offer a QR-code based point-of-settlement, it may not be able to use this data to sell the merchant an insurance product. To do this it may need to take separate consent from the merchant.
  6. Zero MDR policy will discourage investments for the Indian fintech ecosystem: Payment intermediaries and digital payment providers have attracted prominent Indian and foreign investments. A zero MDR policy significantly impacts the revenue stream of these players and fuels regulatory uncertainty about the future scope of such a policy. This could discourage investments in this sector and hurt the government's 'Startup India' initiative.

F. How will zero MDR play out in the times of COVID-19?

The COVID-19 pandemic has already hit the digital payments industry badly in terms of generating revenue. With no signs of transaction volumes increasing soon, the zero MDR policy will only add to the woes of an already stressed industry. And this is the worst time for the industry to suffer. With policies focusing on social distancing and possible decreased use of bank notes26, digital payments will emerge as an important alternative for conducting financial transactions. However, if the industry is already teetering from the impact of the zero MDR policy, it will not be able to develop innovative solutions for enabling digital payments remotely.

G. What are the alternatives to the zero MDR policy?

  1. The government could promote a capped-MDR regime (instead of zero MDR). In a capped-MDR regime, the government can introduce reduced MDR rates for small merchants, as the RBI had done in December 201727.
  2. The government could accelerate the 'Acceptance Development Fund' initiative. The Committee on deepening digital payments had proposed this fund to develop new merchants in poorly served areas28.
  3. Introducing benefits such as income tax incentives based on digital transactions for individuals, and Goods and Services Tax credits for merchants based on the volume of digital payments accepted, could help a large chunk of payments go digital[29].

Footnotes

1. Fintech boom falters as cash becomes king, Livemint, 28 April 2020, https://www.livemint.com/industry/banking/fintech-boom-falters-as-cash-becomes-king-11588001857344.html.

2. Clicks are down- a big shift in digital payments is being written in the confines of four walls, ET Prime, 16 April 2020, https://prime.economictimes.indiatimes.com/news/75168852/fintech-and-bfsi/clicks-are-down-a-big-shift-in-digital-payments-is-being-written-in-the-confines-of-four-walls.

3. Tweet by NPCI dated 17 March 2020, https://twitter.com/NPCI_NPCI/status/1239768901820571648.

4. Nandan Nilekani says MDR would have trended to zero even without government, The Economic Times, 04 February 2020, https://economictimes.indiatimes.com/industry/banking/finance/nandan-nilekani-says-mdr-would-have-trended-to-zero-even-without-government/articleshow/73930028.cms?from=mdr.

5. RBI had last fixed the MDR in December 2017. See Rationalisation of MDR for debit card transactions, RBI, 06 December 2017, https://rbidocs.rbi.org.in/rdocs/notification/PDFs/MDR06122017317CE333007D406A9002F5A119229563.PDF.

6. Pg. 28, Budget 2019-20: Speech of Nirmala Sitharaman, Minister of Finance, 05 July 2019, https://www.indiabudget.gov.in/doc/bspeech/bs201920.pdf.

7. Finance (No. 2) Act, 2019, http://egazette.nic.in/WriteReadData/2019/209695.pdf.

8. Section 269SU of the IT Act (https://bit.ly/3elVYNY), read with rule 119AA of Income Tax Rules, 1962. Rule 119AA, which gives the 'prescribed electric modes of payment' under Section 269SU, was inserted vide notification of Central Board of Direct Taxes dated 30 December 2019, https://www.incometaxindia.gov.in/communications/notification/notification_105_2019.pdf.

9. Section 10A of the Payment and Settlement Systems Act, 2007. This amendment came into effect on 1 November 2019.

10. [10] Paragraph 4, Pernicious practices of select banks deterring customer protection and accounting integrity, RBI, 17 September 2013, https://rbidocs.rbi.org.in/rdocs/notification/PDFs/CS172509113FS.pdf; Merchant Discount Rates (MDR) structure-unbundling of charges, RBI, 01 September 2016, https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NT599F9DCF396D45406A9F5D8A13446B7530.PDF

11. https://economictimes.indiatimes.com/industry/banking/finance/upi-entities-may-face-cap-on-market-share/articleshow/70986116.cms?from=mdr.

12. https://the-ken.com/story/bhim-cashbacks-digital-payments/?searchTerm=digital%20payment.

13. NPCI thought it was riding a tiger, but failed to see the leash called MDR tied to it, ET Prime, 14 February 2020, https://prime.economictimes.indiatimes.com/news/74124357/fintech-and-bfsi/npci-thought-it-was-riding-a-tiger-but-failed-to-see-the-leash-called-mdr-tied-to-it.

14. NPCI thought it was riding a tiger, but failed to see the leash called MDR tied to it, ET Prime, 14 February 2020, https://prime.economictimes.indiatimes.com/news/74124357/fintech-and-bfsi/npci-thought-it-was-riding-a-tiger-but-failed-to-see-the-leash-called-mdr-tied-to-it.

15. Pg. 76, Medium term recommendations to strengthen digital payments ecosystem, Committee on digital payments constituted by Ministry of Finance, Government of India, December 2016, http://finance.du.ac.in/du-finance/
uploads/pdf/Reports/watal_report271216.pdf/.

16. SBI, NPCI seek 'Visa power' for RuPay cards, The Economic Times, 04 January 2020, https://economictimes.
indiatimes.com/industry/banking/finance/banking/sbi-npci-seek-visa-power-for-rupay-cards/articleshow/
73092976.cms.

17. 'You are helping the rich get richer' the MDR waiver has a chilling message for card swipe, the Economic Times, 24 July 2019, https://prime.economictimes.indiatimes.com/news/70355253/fintech-and-bfsi/you-are-helping-the-rich-get-richer-the-mdr-waiver-has-a-chilling-message-for-card-swipes

18. Rationalisation of MDR for debit card transactions, RBI, 06 December 2017, https://rbidocs.rbi.org.in/rdocs/
notification/PDFs/MDR06122017317CE333007D406A9002F5A119229563.PDF.

19. Reimbursement of MDR, RBI, 16 February 2017, https://rbidocs.rbi.org.in/rdocs/notification/PDFs/
NOTI228457F1A9191D84367B65D2100A10360A3.PDF.

20. Subsidizing MDR charges on Debit Cards/BHIM UPI/AePS transactions of value less than or equal to Rs. 2000/-, Notification in the Gazette of India, 27 December 2017, https://meity.gov.in/writereaddata/files/gazette_notification
_on_subsidizing_mdr_charges.pdf.

21. NPCI thought it was riding a tiger, but failed to see the leash called MDR tied to it, ET Prime, 14 February 2020, https://prime.economictimes.indiatimes.com/news/74124357/fintech-and-bfsi/npci-thought-it-was-riding-a-tiger-but-failed-to-see-the-leash-called-mdr-tied-to-it.

22. Paragraph 4, Pernicious practices of select banks deterring customer protection and accounting integrity, RBI, 17 September 2013, https://rbidocs.rbi.org.in/rdocs/notification/PDFs/CS172509113FS.pdf; Merchant Discount Rates (MDR) structure-unbundling of charges, RBI, 01 September 2016, https://rbidocs.rbi.org.in/rdocs/notification/
PDFs/NT599F9DCF396D45406A9F5D8A13446B7530.PDF.

23. UPI slowdown incoming? Banks to charge up to INR 5 after 20 transactions, Inc42, 17 March 2020, https://inc42.com/buzz/upi-slowdown-incoming-banks-to-charge-up-to-inr-5-after-20-transactions/.

24. Zero MDR good, but govt reimbursements will help payment cos: Vijay Shekhar Sharma, The Economic Times, 09 Jan. 2020, https://economictimes.indiatimes.com/industry/banking/finance/banking/zero-mdr-good-but-govt-reimbursments-will-help-payment-cos-vijay-shekhar-sharma/articleshow/73164992.cms?from=mdr.

25. Clauses 5 and 6 of the PDP Bill.

26. Dirty money: Can coronavirus spread through bank notes, Scroll.in, 29 March 2020, https://scroll.in/article/957211/dirty-money-can-coronavirus-spread-through-bank-notes.

27. Rationalisation of MDR for debit card transactions, RBI, 06 December 2017, https://rbidocs.rbi.org.in/
rdocs/notification/PDFs/MDR06122017317CE333007D406A9002F5A119229563.PDF.

28. Pg. 16, Concept paper on card acceptance infrastructure, RBI, March 2016, https://rbidocs.rbi.org.in/
rdocs/PublicationReport/Pdfs/MDRDBEDA36AB77C4C81A3951C4679DAE68F.PDF.

29. Introduce incentives to widen digital payments in India, Moneycontrol, 11 March 2019, https://www.moneycontrol.com/news/business/personal-finance/introduce-incentives-to-widen-digital-payments-in-india-3626401.html.

Originally published 28 May, 2020

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.