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India's Fintech Success: UPI
India has definitely seen this third path approach of government-led centralization as a future. I find the Open Network for Digital Commerce setup pretty interesting. The idea of open sourcing a government-owned piece of infrastructure that everyone can access to run a private shop rather than using Shopify or some other thing is interesting.
In April 2022, Coinbase - the crypto exchange - announced support for payments made through the Unified Payments Interface or UPI in India.
Unfortunately, a few hours later, the National Payments Corporation of India or NPCI - the company maintaining UPI - said they were not aware of any such thing happening.
As of this writing, Coinbase still doesn't work in India. Maybe it will by the time you see this, who knows.
This kerfuffle aside, the incident has highlighted UPI's importance in India. This is a truly interesting piece of national fintech that the Western world should know about.
I have been interested in doing a video about the Indian UPI system for a while now. This opportunity is as good as any to start.
India has long been a cash-driven economy. A vast majority of its transactions are done in cash.
In the 2012-13 year, India's ratio of cash to GDP was nearly 13%, one of the highest in the world. To compare, the United States is 7.4% and Sweden is 1.8%.
People love using it, and that has long presented a challenge to the government. One sore point for the Indian government is that cash transactions help people evade income taxes - hiding their wealth from review.
So the Reserve Bank of India has long made it a focus goal to make the Indian economy less cash-dependent. Not totally eliminating the use of cash transactions but making it easier to use digital cash-less transactions.
Yet in 2015, Indians made an average of just 6 non-cash transactions for the entire year. Only a fraction of the country's 10 million plus retailers accept non-cash payments - despite having the capability to do so.
UPI had been in the works for a long time. The story begins in 2005, when the Reserve Bank released a vision document detailing their desire to set up an umbrella institution for all of India's retail payment systems.
Working with the Indian Banks Association or IBA, the Reserve Bank founded and incorporated the NPCI in December 2008. The following April, the company started operations with a mandate to consolidate all of the country's disparate systems together and create a uniform, affordable payment system.
In 2009, with the blessing of the Reserve Bank, the NPCI started by taking over the operations of the National Financial Switch or NFS - India's largest network of ATMs.
Banks have ATMs that help customers deposit and withdraw money. Having as many ATMs as possible around helps the bank better service its customers wherever they are.
But deploying so many of these expensive machines across a vast populace is costly. If a bank joins the Switch's shared network, their customers can use and be serviced by the network's other ATMs.
At that time, the network had about 50,000 machines and 37 banking members. Under the NPCI's overview, the network has grown to 256,000 machines and 1,200 members. Its ATMs are free to use for customers.
The idea to start off with the ATMs was quite astute. In order to join into its ATM-sharing scheme, the network's member banks had to adopt common digital standards to communicate with each other. This standard can then be leveraged and expanded into new services.
The NPCI thus introduced the Immediate Payment System or IMPS in 2010 - built on top of the NFS's financial infrastructure. With this, end users can instantly transfer funds between banks at any time. Banks seemed to have heavily marketed this 24-7 feature availability.
IMPS requires the sender to know certain personal and banking details about the person they are sending money to or requesting money from. This includes their phone number and a seven digit Mobile Money ID Number, which contains routing and account information.
If they are sending money to a business entity account, then they need to know the beneficiary's name, its bank account number, and its bank's Indian Financial System Code or IFS.
IMPS Adoption Challenges
The amount of money transacted through IMPS grew. In 2014, IMPS facilitated about 54 million transactions. That quickly grew and in 2020, Indians conducted nearly 3 billion transactions through IMPS.
With that being said, IMPS still had some usability flaws as a transfer service. While transactions can be initiated over the phone, there was still considerable payment friction. It reminds me of the way they send money in Taiwan. Taiwanese banking infrastructure is quite ancient.
To locally send a money to a person or company, you need to know their 3 digit Taiwan bank code - different from the SWIFT code - and their bank account number. This number is often very long and difficult to remember.
So NPCI still felt that improvements can be made. And Two major national developments helped pave the way to make them possible.
First, the Indian people rapidly started adapting smartphones as telecoms like Reliance Jio drastically bring down data prices. Indians enjoy some of the cheapest data rates in the world, and the vast majority now have smartphones.
Second, the Indian government completed a national identity ID service called Aadhaar. Having this opened the door for improved Know Your Customer security requirements and preventing fraud.
UPI is built on top of IMPS, but smooths out a lot of the friction that made the IMPS system difficult to use. With UPI, banks, financial institutions, mobile platforms, payment systems, and users can interact with one another using a single digital language.
UPI is a protocol - not an actual bank account or digital wallet like Venmo. There's no need to first pre-load anything with money from your bank account, which skips a frequently inconvenient step.
UPI gives each Indian with a bank account the ability to create a Virtual Payment Address - sometimes also called a UPI ID. It kind of looks like an email, like "jon@asianometry_bank".
You set it up - along with a pin code for authentication called MPIN - when you download a UPI app from your bank.
Once the address is set up, you can send or request payments from others without the need to awkwardly share bank account details or the like. QR codes are also available.
The person to person payments experience of UPI reminds me a lot of Zelle - an American payments network integrated into many big American banks. Like with an UPI-enabled app, Zelle lets you transfer money directly from one bank account to another without needing to know the gory banking details.
Unlike with UPI, however, Zelle doesn't let account holders create unique virtual private addresses - it works using email or mobile phone. And remember, Zelle - like Venmo and the like - is a service created by few private companies. UPI is a nationally-backed standard.
One critical improvement for merchants is the introduction of payment requests. With IMPS like the Taiwan bank account system, you can give your bank account details to the customer, but it is up to the customer to come through and start the transaction. With requests, a customer only needs to confirm details and accept for the transaction to happen.
For mobile e-commerce, UPI makes the payment part much smoother. Buy something on a website, and the merchant can send a payment request over to your mobile phone. The buyer can then authenticate and complete the transaction there.
## UPI the API
UPI is an API, which is short for "Application Programming Interface". An API turns a service traditionally seen as very complicated - like the Indian banking system - and simplifies it into something much easier for other parties to use.
Banks and third party banking softwares looking to provide UPI payment services are referred to in the documents as Payment Service Players or PSPs.
When someone wants to send money or request money from someone, they go through their banking app - the PSP. The PSP validates the transaction then fires an API transaction request in XML format to NPCI.
NPCI completes the transaction behind the scenes using the appropriate financial mechanism - something like IMPS or something else. Upon completion, it sends confirmation notices to both parties.
The standardized digital language of an API makes the service very scalable. Some of Silicon Valley's biggest startups started with APIs.
For instance, Stripe is the world's most valuable American FinTech startup, valued in the private markets at $95 billion. They started off with a set of simple APIs that allowed any company to accept electronic payments with a few lines of code.
NPCI cited Stripe - as well as Square, now named Block, I guess - as direct influences when designing how UPI would work.
The NPCI launched UPI in April 2016 with just 21 banks.
While PSPs like banks and Google Pay can integrate it into their third party apps in order to facilitate payments, the government also released an app of their own as a showcase of what the technology can do.
The BHIM app - BHIM stands for Bharat Interface for Money - is India's official national payments mobile app. The app uses UPI to help people send or receive money between different banks.
Shortly after UPI's launch, the government initiated another big national policy initiative to help move the Indian people's cash into the digital realm.
## The Demonetization Opportunity
In November 2016, the government announced that it would de-monetize the country's 500 and 1,000 rupee banknotes. Holders had until the end of the year to exchange them for new 500 and 2,000 rupee notes.
This effectively wiped out 86% of the country's paper currency value. The short deadline led to a mad scramble to deposit and exchange bank notes. People purchased long train tickets as a way to preserve the value of their cash. And some people even died in the rush.
The event was a massive shock to the economy, but eventually 99% of the demonetized currency was exchanged. Its macroeconomic merits were and remain questionable. But one thing it did do was open the door for new systems of payment.
To encourage the use of the cash-less payments, the Indian government heavily promoted UPI. When the BHIM app launched, they spent $65 million USD in cashback schemes for merchants and referral bonuses for end users.
Then in 2017, the Government waived merchant discount rates, or MDR, on transactions made using UPI and other similar type payments with values below 2,000 Indian Rupees. This initial scheme would last until 2020.
The MDR is a fee paid by merchants - something similar to those for credit cards - and is distributed to aggregators, banks, and the network. Removing the fee encourages people to use UPI for low-value transactions.
The government disbursed taxpayer money to compensate some players for the loss of these fees - at the time estimated to be about $140 million and $191 million respectively for the two years the scheme was estimated to last.
Then in December 2019, the government announced an extension of the zero-MDR policy. Now all businesses with over $6.5 million USD of annual revenue must offer UPI payment through a QR code or otherwise. This policy has been controversial with various industry players, who point out the potential long-term damage.
Then the pandemic happened. With Indians spending more time at home and on their phones, digital cash-less payments surged in both volume and value.
In October 2020, UPI facilitated over 2 billion transactions worth some $50 billion dollars. Year over year, that is 80% growth in transactions and 101.7% in value.
From its 2016 launch to October 2020, UPI facilitated nearly 30 billion transactions. Over a third of those - 11.8 billion - came in a single 8-month period after March 2020.
A year later, UPI transaction volume and value doubled once more to 4.2 billion transactions and $101 billion, astounding growth.
Considering the staggering transaction volume growth, the zero-MDR policy has been a double-edged sword. Networks cost money to upgrade and maintain, especially when scaling up as fast as UPI was during the pandemic.
Halfway through 2020, the NPCI told the Indian Government that the zero-MDR policy had resulted in some $700 million USD in lost revenue for the ecosystem as a whole.
NPCI has been in support of abolishing this zero-MDR policy. Thinking more longer term, MDR fees are the ecosystem's only revenue model.
Removing them commoditizes payment handling and forces those companies to make money in other ways - which is exactly the case to be seen in today's UPI-based super-apps.
## Third Party Apps
UPI's open, API-first nature allows it to support an ecosystem of third-party apps. The official UPI website lists the transaction and value statistics for some 65 such apps. The biggest four are PhonePe, Google Pay, Amazon Pay, and Paytm.
PhonePe is a Bengaluru-based fintech company owned by Walmart through its subsidiary Flipkart. They run the largest third party UPI app, with 47% market share of total transactions.
Google Pay is the second largest third-party app, handling 33% of total transactions in the ecosystem.
And the official national app BHIM is in only third place with 24% market share.
Interestingly enough. WhatsApp, India's dominant messenger, lags far behind those companies with less than a 1% transaction market share. However, they did not get bank approval to offer UPI payments until 2020 - perhaps for political reasons.
Many of these payment apps have expanded beyond simple payments into FinTech Super-apps - something reminiscent of what China's Ant Financial did with their AliPay app.
For instance, PhonePe has started offering mutual fund investments and insurance through their app.
Paytm also has stock investment services - along with movie ticket purchasing, flight booking, train ticket purchasing, and bill pay. Kind of reminds me of Meituan's focus on the online to offline industry.
The Indian government's zero MDR policy has kicked off a four-way competition between companies with deep pockets - trying to build up their FinTech super-app. Bloomberg estimated that the big four spent over a billion dollars to promote their payment apps in 2019.
Despite this, it is hard to imagine PhonePe, Google Pay, WhatsApp or Paytm growing to the same dominance of an AliPay. UPI is a public standard adopted by a wide variety of companies so you can't lock users in. Customers can always move to another payments app.
I think Indians are quite proud of UPI. And they should be. In March, UPI facilitated 5 billion transactions. Few pieces of national infrastructure have so many users and experienced such rapid growth.
As a validation of its competitiveness, NPCI has worked to take UPI abroad. In 2022, they announced that a payment system operator licensed by the Central Bank of Nepal will adopt the UPI technology standard as a way to tackle their own cash problem.
Countries like the United States are still struggling to unify and update their sprawling financial industry to allow the introduction of a UPI-like service.
Many years of legacy practices and legacy players - each with their own incentives - have made it challenging to simply launch a smooth experience from end to end.
Though the Federal Reserve’s FedNow service - scheduled for a 2023 launch - is kind of interesting.
It reminds me of the telecom experience in certain countries. Populations in Asia and Africa skipped the phone poles and went straight to cell towers - wiring up millions of people right off the bat.
India had the advantage of starting from more of a blank slate, leveraging other countries’ experiences to create something fresh from the ground up. Cash remains the dominant medium in India's society, but I expect things to rapidly change in the near-future.