Implications of Emerging Electronic Payment Systems in India: A Strategic Overview

Abstract

The purpose of this article is to study the implications of the development of electronic payment systems in the Indian markets. The electronic payment systems that emerged as a technological innovation, to provide customers with an efficient and secure means of payment, can have far-reaching implications for the country's banking system, the role of its central bank, its monetary policy, and its economy. This article identifies the policy issues that arise from the growth of these modern payment systems and discusses the possible policy responses by the Reserve Bank of India to mitigate such impacts. The article concludes that while we cannot slow down the pace of technological innovations, understanding these implications can contribute to finding policy responses and solutions, and building effective safeguards into the system.

Headnote

Abstract

The purpose of this article is to study the implications of the development of electronic payment systems in the Indian markets. The electronic payment systems that emerged as a technological innovation, to provide customers with an efficient and secure means of payment, can have far-reaching implications for the country's banking system, the role of its central bank, its monetary policy, and its economy. This article identifies the policy issues that arise from the growth of these modern payment systems and discusses the possible policy responses by the Reserve Bank of India to mitigate such impacts. The article concludes that while we cannot slow down the pace of technological innovations, understanding these implications can contribute to finding policy responses and solutions, and building effective safeguards into the system.

Keywords: electronic payment systems, paper based payments, cash usage, monetary policy, non-banks

JEL Categories: E41, E5, E52, E58.

Introduction

The last two decades have witnessed significant reforms in our payment and settlement system. Technology has driven far-reaching changes, slowly replacing older methods of payment with a number of innovative methods. These innovations - what people refer to as electronic payment systems - are reshaping the payment processes. They are influencing users in the choice of payment instruments, making retail transactions easier and cheaper for customers and challenging the lead role of physical cash in retail payments. However, there are other implications too. For the Reserve Bank of India (RBI), it raises several policy issues - it impacts seigniorage revenues of the RBI; implementation of monetary policy; and the reliability, soundness, and effectiveness of the retail payment mechanism. Although a number of studies have discussed the potential of electronic payments to replace traditional cash or paper based payments, there is little theoretical or empirical work on the implications and risks associated with electronic payments, especially in India. This article is an attempt to ascertain the implications that substitution of cash payments by different electronic payment media has on cash usage, monetary policy, and operational activities; systemic risk and security issues; and necessary technological and regulatory changes in the Indian context. It then provides possible policy responses to the challenges these systems pose. It contributes to the literature by relating a technological innovation to its practical implications for the nation's economy and its legal and regulatory system, and it sets an agenda for future research.

The article consists of four parts: The first part reviews the relevant literature and discusses the methodology. The second part describes electronic payment systems and trends in the growth of electronic payment systems, and it examines the policy issues and challenges arising due to development of such systems. The third part reviews the possible public policy responses to such implications by the RBI. The fourth part presents the conclusions and outlines areas requiring further research.

Recent Studies on Electronic Payment Systems

Hancock and Humphrey (1998), in their study, comprehensively discussed the steady and significant change from paper-based systems to e-payment systems and its impact on cash use, cash holdings, seigniorage, demand for money, risks in the payment system, payment system efficiency, and monetary policy issues. Bradford et al. (2009) discussed the changing risk profile of payment systems and their increased vulnerability due to the growing role and significance of non-banks in retail payments after the introduction of e-payments in the United States and Europe. A recent study on the impact of recent payment innovations on cash usage in Canada (Fung, Huynh, & Sabetti, 2011) found they do have a significant negative effect on cash usage in Canada. The Committee on Payment and Settlement Systems (2012) Report provides insights into innovations in retail payments and states that they cut processing costs and increase social welfare but also raise serious policy issues for Central Banks as they impinge on the responsibilities and tasks of central banks as catalysts and supervisors of payment systems.

Methodology

The article attempts to discuss conceptually the divergent impacts of the increasing substitution of cash payment systems by electronic payments systems in India. It then discusses the policy issues arising from such developments to understand the implications and decide on the necessary future action.

To study the emerging trends in payments, this research uses secondary data. The Websites of the Reserve Bank of India, the Bank of International Settlements, and reports of the Committee on Payments and Settlement Systems provide the data on the share of paper based vs. electronic transactions. The article uses statistical methods for analysis of this data and a multiple regression model to establish the relationship between value of currency in circulation and growth in electronic payments as well as the total number of transactions by non-banks.

Electronic Payment Systems

What constitutes electronic payment systems varies from country to country due to a variety of regulatory regimes and the growing number of innovative instruments, but they broadly constitute all payments that customers and payers make over the internet or by use of other electronic media and include internet payments; mobile payments; stylized prepaid, debit, and credit cards; EBPP (electronic bill presentment and payment systems); CTS (Cheque Truncation Systems); person-to-person electronic payments by NEFT (National Electronic Fund Transfer); retail payment options like ECS (Electronic Clearing Service); and large value payment options like RTGS (Real Time Gross Settlement).

These alternative payment technologies are slowly becoming a close substitute for cash and have led to an increase in the role of non-banks and non-cash payments in the payment process. The following sub-sections examine the implications of these developments in India.

Trends in Growth of Electronic Payment Systems

Figure 1 shows the slow and steady rise in volume of electronic transactions as compared to paper-based ones.

The graph shows a rise in the share of electronic transactions by 37.4 percent from 2005-06 to 2012-13.

Development of Electronic Payment Systems and Emerging Policy Issues

Impact on Cash Usage

The switch to electronic payments impacts cash usage. Since electronic payment systems are initially targeting small-value transactions, their major impact would be only on circulation volumes and values of coins and notes of small denominations. Table 1 and Table 2 show the value of banknotes in circulation as percent of total and as a percentage of GDP respectively.

A glance at Table 1 and Table 2 above shows the value of currency notes in circulation, both in terms of percentage of total and as a percentage of GDP, fell for small denomination notes viz., Rs. 2, 5, 10, 20, 50, and 100, in most of the period. The decrease in small denomination notes in circulation is due to the rise in electronic transactions by 37.4%, from 2005-06 to 2012-13.

Impact on Operational Activities

Development of electronic payment systems affects the operational activities and services banks offer. The change to faster payment processing may have a significant impact on liquidity. The slow but steady progress toward near-real-time and real-time processing in retail transactions might blur the distinctions between retail payment systems and large-value payments and may cause a shift in customer payment volumes away from the Real Time Gross Settlement Systems. This may lead to issues of cost recovery for the RBI. The RBI may need to reconsider incorporation of new technological developments in their own systems to support innovations; otherwise, better service provision by non-banks and private service providers may render the operational role of the RBI obsolete in the long run.

Table 3 shows increases in payment transactions by non-banks in total, in number per inhabitant, and in average value per inhabitant. Table 4 shows an increase in the number of branches of non-banks per million inhabitants (i.e., the increasing role of non-banks in payment systems each year).

The cumulative effect of the growth in electronic payments, and the increasing number of transactions by non-banks in India, will reduce cash usage, as is evident already from the decrease in value of currency in circulation as percentage of GDP. Table 5 presents the results of Ordinary Least Square Regression for the above variables.

The results show the two variables above explain about 95.21% of the reduction in cash in circulation, and the p-value shows the results are robust and significant.

Impact on Seigniorage Revenue

The responsibilities entrusted to the RBI include currency management function that focuses on issue of notes, which are accepted legal tender in India. The cause of concern is that electronic money used in electronic payments will impact the RBI's balance sheets to the extent it substitutes cash. The difference between production cost and face value of currency in circulation is the direct seigniorage revenue to the RBI. Besides this direct benefit, there is an interest benefit too. As cash in circulation is a non-interest bearing liability of the RBI, a substitution of cash payments by electronic payments would lead to corresponding reduction in asset holdings of the RBI and a loss in interest earned on these assets. Loss of seigniorage revenues could become a major cause of concern if the use of electronic payments becomes extensive and widespread, as the RBI would have to depend on other sources of revenue in such a case. At present, the RBI's seigniorage revenue is large, compared to its operating costs, and only a substantial fall will make it inadequate to cover its operating costs. But, a substantial rise in electronic payment transactions in India may not augur well for the RBI's revenues.

Impact on Monetary Policy

Another impact of substantial rise in electronic payments is its effect on the formulation and implementation of monetary policy. If the usage of e-payment systems expands massively to substantially substitute cash, it impacts the size of the Central Bank's balance sheets and its ability to influence short-term (money market) interest rates. This effect would result first from an impact on the demand for RBI reserves, and second, from the RBI's ability to supply these reserves. An impact on demand for reserves would result if there is substitution of e-payments to such an extent that it leads to a reduction in banks' demand for settlement balances from the RBI. The substitution of electronic money for reservable deposits with the RBI also would result in the same consequence. Table 5 shows that value of transferable balances held at the Central Bank as a percentage of GDP has shown steady decline. An impact on the RBI's capacity to supply these reserves would result if growth in electronic payments would be up to an extent that leads to shrinkage of the RBI's balance sheet due to reduction in its income-earning assets. In both these situations, it is conceivable that there would be an impact on the RBI's operating procedures and mechanisms used to set money market interest rates.

Legal and Regulatory Implications

These new payment systems mechanisms have brought to the fore many legal issues viz. whether existing banking regulations apply to e-payment arrangements, whether the electronic money issuers issue is an infringement on the monopolistic privilege of the RBI of issuing bank notes, and whether the RBI can itself issue electronic money for use in electronic-payment systems. A huge concern that arises is whether the legal rights and obligations of the involved parties - customers, issuers, system operators, and acceptors in an e-payment system - are welldefined and whether there is certainty regarding liability in the event of fraud, theft, accident, or default of any participant.

Security Implications

Other policy issues that are of great concern are issues relating to the security of electronic payment systems. First, all electronic payment systems are vulnerable to security breaches at any level - consumer, acceptor (i.e., merchant establishment), and issuer. These security breaches could involve attempts to disrupt the system, to steal devices or data stored onto devices, and to alter data stored on devices or being transmitted through the system. This vulnerability to security attacks is a direct cause of concern for the RBI as the issuers of electronic money generally bear losses resulting from such security breaches. Second, security breaches in electronic money transactions may be difficult to detect as such detection depends on maintenance of records in central databases of RBI and Directorate of Revenue Intelligence such that individual transactions are traced to individual devices. Many electronic payment systems allow direct transfers between users, and either the information on such transactions is not complete or the central database receives it with a significant lag of time. Third, electronic payment systems that allow cross-border payments over information systems networks, and in which customers can transfer electronic money balances directly without intervention of the issuer or systems operator, are very attractive for money laundering and other illegal activities.

Issues Relating to Oversight of Payment Systems

The Payment and Settlement Systems Act, 2007, and the Payment and Settlement Systems Regulations, 2008, provide statutory backing to the RBI to exercise oversight over the payment and settlement systems in India. The Reserve Bank of India Act, 1934 has entrusted RBI with the responsibility of development of payment systems that are safe, secure, sound, efficient, accessible, and authorized (RBI, 2010, 2012). For this purpose, the RBI needs to monitor closely innovations in payment systems and assess the risk profile of payment innovations through an understanding of the underlying technology and business processes. This necessitates technological expertise that is not a core competency of the RBI.

The growth of electronic payment systems has increased the role of non-banks in payment process and since the regulatory framework surrounding non-banks is lax in India, it poses a challenge to the exercise of oversight over payment systems. There is an imperative need to enact new regulations for monitoring non-banks involved in retail payments and to fill regulatory gaps with regard to security and fraud. There is also a need for additional resources to monitor and keep track of new developments.

Possible Policy Responses by the RBI

Regarding cash usage reduction, seigniorage revenue, and monetary policy impact, the RBI must consider the following:

The RBI should investigate how innovative electronic payment systems will affect cash usage in the Indian economy. If it anticipates or observes substantial cash usage reduction, the RBI should analyze the resulting impact on its seigniorage revenues, operations, and cash distribution.

The response to seigniorage revenue reduction and impact on monetary policy would depend on the extent to which electronic payments replace cash and the maximum size of open market sales of Government securities and bonds that RBI would have to make for monetary policy implementation in special circumstances. In case of substantial substitution, the RBI could consider taking some of the following steps to offset the loss of seigniorage and shrinkage of balance sheet size:

· Issuing e-money itself without operating e-money schemes.

· Expanding non-interest bearing reserve requirements to cover e-money.

· Encouraging Government entities, PSUs, and private sector banks to hold larger deposits at the RBI, by paying interest on reserve balances.

· While framing monetary policy, adapting its monetary aggregates to include electronic money that domestic and foreign institutions issue.

· Assessing the potential effects on liquidity due to faster processing of e-payments.

Regarding legal and regulatory implications, oversight function, and security aspects, the RBI must consider the following:

· Whether the same regulations that exist for traditional payments should govern electronic money and payments.

· Whether it should regard e-money balances as deposits and if deposit regulations are applicable to them.

· Whether it should extend specific banking regulations to specifically include non-banking financial institutions involved in electronic payment systems.

· If money laundering is a cause of concern, the RBI should regulate the type of payment instruments, the issuers of such instruments, and the maximum value that customers can hold on such instruments to prevent transfers of large amounts of money outside India without use of authorized banking channels.

· Evaluating changed risk profiles due to innovative products and filling regulatory gaps to ensure such payment systems are sufficiently secure to avoid possibility of any loss to customers due to fraud.

· Strengthening cooperation with other central banks and international oversight bodies to develop oversight standards (common minimum standards) for cross-border payment innovations, e.g., SecuRe Pay Standard at the European level that the Forum on Security of Retail Payments evolved.

Other Measures:

· Enhancing technological expertise to assess and oversee such technological innovations.

· Undertaking nationwide education campaigns to foster public awareness on innovative payment systems and their security aspects.

· Reassessing the adequacy of data collection methods and adapting them to match technological developments. It may require operators of payment systems to monitor and report transaction data.

Conclusion and Directions for Future Research

Fast and efficient payment systems are essential for smooth functioning and stability of the financial markets. The RBI has prepared the Payment System Vision Document (2012-15) "to proactively encourage electronic payment systems for ushering in a less-cash/less paper society in India" (RBI, 2012). The RBI's initiatives have resulted in deeper acceptance and penetration of retail electronic payments. Transactions using innovative electronic payment products are forming an increasing proportion of domestic and cross-border retail payments. Though technology can provide safe, efficient, accessible, and affordable payment systems, there are attendant risks they pose to customers, banks, the RBI, and the nation's economy. These are critical issues that can have far-reaching implications if the RBI and the Indian Government do not incorporate necessary safeguards into the system by amendment in the Banking Regulations Act, 1949, and the Information Technology (Amended) Act, 2008. The BIS and CPSS have been regularly surveying electronic payment systems around the globe to examine policy issues they raise for Central Banks and to recommend appropriate policy responses to Central Banks. Future research should focus on addressing these issues. Learning from the experiences of Central Banks in other countries where electronic payment systems are highly popular, the Reserve Bank of India and the Indian Government must adequately address all of these policy issues and challenges. Only then will it successfully meet the objective of empowering customers with the benefits of technology.

Sidebar

Discussion Questions

1. What other measures could Central Banks take to minimize risks due to growing use of electronic money and electronic payment systems?

2. Currency management is an important function of Central Banks. What would be the likely impact if we move to a cashless society, with non-banking entities outside the control of Central Banks issuing e-money? Is it desirable?

3. Should future studies examine the impact of e-payment systems internationally?

4. What changes are necessary in the organizational structures and personnel requirements of banks if e-money replaces physical cash?

To Cite this Article

Chelawat, H., & Trivedi, I. V. (2014, Fall). Implications of emerging electronic payment systems in India: A strategic overview. Journal of Multidisciplinary Research, 6(3), 53-65.

References

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