The tiered system RBI should consider for merchant discount rate charges on digital payments

Overall, it seems as if a tussle is brewing between India’s monetary and fiscal authorities. However, to objectively evaluate this debate on charges for P2M transactions, it is important to understand incentives and dynamics at play in the payments ecosystem.

Authors: Rohit Kumar and Aishwarya Viswanathan
Published: November 11, 2022 in The Economic Times

From debit and credit cards to e-wallets, India’s payments landscape has seen many waves of innovation and regulation over the years. Today, India’s latest home-grown innovation, the Unified Payments Interface (UPI), currently free of charge, is the subject of a fiery debate on whether levying charges will slow the adoption of digitisation or, worse, undo its gains and hasten a reversal to cash transactions.

In August 2022, the Reserve Bank of India released a discussion paper ( to elicit feedback on charges in the payments system. The paper approximated that, collectively, the various players enabling a UPI peer-to-merchant (P2M) transaction with an average value of ₹800 incur a charge of ₹2. A few days later, the finance ministry tweeted that UPI will continue to remain free of charge and cost concerns of service providers will have to be met through other means.

Overall, it seems as if a tussle is brewing between India’s monetary and fiscal authorities. However, to objectively evaluate this debate on charges for P2M transactions, it is important to understand incentives and dynamics at play in the payments ecosystem.

The ability to ensure frictionless and secure real-time payments via UPI is heavily dependent on banks and third-party app providers that perform a range of functions, including the acquisition of merchants, provision of infrastructure, fund transfers, and, as such, bear significant fixed and operating costs for facilitating transactions. While the finance ministry has already allocated two rounds of subsidies of ₹1,500 crore and ₹1,300 crore to boost digital transactions, continued subsidising of costs is likely going to be fiscally unsustainable.

And even if subsidies are an option, they can be an impractical offering that can lead to coordination difficulties with respect to allocation between payment players. For instance, in June, several payment companies wrote to the National Payments Corporation of India (NPCI) complaining that a large chunk of the money granted in the budget is being retained by banks, with very little flowing their way.

Here, it is important to note that much of UPI’s capture of India’s payments landscape has been enabled by payment companies operating third-party apps, who have invested heavily in designing user-friendly interfaces and instituting attractive cash back offers to drive adoption. But without adequate fiscal support, they are being incentivised to pursue other means of monetising their business.

What goes UPI, stays up

While some apps have chosen to directly pass on costs to consumers in the form of platform fees on services such as prepaid phone and direct-to-home (DTH) recharges, others are making up for lost revenue through cross-selling. A few others are indirectly imposing costs on users through data monetisation. In the absence of a comprehensive data protection legislation, the repercussions of some of these practices can be worrisome.

While the zero-charge framework for UPI transactions has certainly played a role in providing a fillip to the payments ecosystem, its role in incentivising adoption may be overestimated. In the digital payments space, the acquisition and maintenance of UPI’s QR (quick response) code infrastructure continues to be among the lowest for merchants. While it took over a decade to increase the number of point-of-sale (PoS) terminals from 5 lakh to 50 lakh, there are already over 10 crore QR code terminals in the country. By the time UPI completes a decade in existence, the number of QR codes is set to reach 170 crore.

Apart from the asset-light infrastructure, a steady proliferation of use-cases has been critical to merchant uptake. From recurring payments to FASTag recharges and ever-increasing acceptance of cross-border payments, continued innovation and development of UPI’s mandate promises to preserve UPI’s ubiquity and the expansion of its merchant base.

Against this background, instituting a merchant discount rate (MDR) may represent an important avenue of cost recovery for intermediaries. Rather than denting merchant acquisition or retention, MDR may help maintain uptake by making the system more resilient and sustainable, factor also critical in driving more users towards UPI. Also, the fact that UPI currently accounts for almost 50% of digital financial fraud and lacks a robust real-time dispute-resolution mechanism, also reflects the urgent need to create adequate financial incentives to enable robust systems for trust-building and longevity.

Since merchants have an option to choose between different service providers that offer the best rates, the market for merchant acquisition is generally competitive. So, ideally, the regulator should let MDR be market-determined. However, to ensure that the optics of levying MDR does not taint public perception or adversely impact acceptance of UPI, the regulator can consider instituting a tiered system of charges. UPI can be kept free of charge for low-value transactions, with higher-value transactions being charged a market-determined MDR. The threshold above which payments get charged can be decided by the regulator based on the funds required for sustainability as well as consumer price sensitivity.

Separate wheat from cost

For this, understanding the elasticity of demand to UPI transaction charges will be useful. Such research will help ascertain how usage of UPI is likely to be reduced if costs were to increase and, consequently, assist in identifying the threshold that balances costs and returns effectively.

This exercise can particularly help India’s monetary authorities proceed with a degree of certainty and assuage the concerns of the fiscal administration – which is actually pursuing the same objective: a safe and secure digital payments landscape.

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