Derived KYC

The cost of KYC is an impediment to lending below a certain ticket size. If we can permit lenders to use [[Derived KYC]] ensuring that it is only deployed in a digital context with all the required guardrails we will be able to radically reduce the cost of KYC opening up lending to the masses.

This article was first published in The Mint. You can read the original at this link.

Of the many transformative changes that India has made over the past few years, the way it’s overhauled its financial infrastructure has been the most impressive. Digital payments, over the rails of the UPI infrastructure, has completely transformed the way in which commerce is carried out in the country. Over the past few months, UPI has consistently clocked in excess of 2 billion transactions per month, and is today being offered by almost every type of commercial service—digital as well as brick-and-mortar. The infrastructure proved particularly useful in the pandemic, by facilitating contactless payments and enabling direct benefit transfers to the remotest corners of the country.

Digital Lending

Having solved payments, it’s now time to our focus to credit. We have millions of credit worthy borrowers, but lenders find it too expensive to reach all of them. Finding cost-effective solutions would not only benefit businesses whose growth is limited by the affordable capital they can access, it would uplift the entire Indian economy.

One of the natural constraints on credit is the cost of providing it. All amounts spent on acquiring a borrower as well as the costs incurred on the administration of a loan eat away at a lender’s profits. As a result, lenders don’t offer loans below a given ticket size, as it would be impossible for them to turn a profit. If we can systematically eliminate as many of these costs as possible, we should be able to create products that a larger number of people can afford.

The Cost of KYC

One such cost is KYC, the lender’s obligation to complete a ‘know-your-customer’ verification of each new borrower that it enrols. We all have experience of what this entails—reams of paperwork, physical in-person verification and other formalities that cost both in terms of paperwork as well as the man-hours of effort involved. The cost of completing the KYC verification of a single borrower can be significant. Unless the corresponding loan is large enough for interest earned to offset the cost of meeting KYC requirements, the lender has no reason to offer the loan.

Aadhaar-based eKYC was conceptualized as a solution to this problem. However, once the Supreme Court ruled out private-sector access to the Aadhaar infrastructure, its utility was greatly diminished. The central bank created a centralized KYC registry to address this problem. It required lenders to upload the KYC information of their customers to this registry, so that other regulated entities can rely on already-checked KYC data for subsequent transactions, without any duplication of effort. However, the CKYC registry has not been utilized to its full potential—thanks, in part, to the poor quality of the documents scanned into the registry, as well as the fact that CKYC standards have evolved so rapidly that older records are no longer compatible with the latest requirements. Both these mechanisms were built for the traditional lending paradigm, where lenders open accounts for borrowers in their own bank and deposit the loan amount in it. However, digital lending is not bound by these constraints.

Under the Open Credit Enablement Network (OCEN) framework, lenders simply evaluate the credit-worthiness of loan applicants using its account-aggregator systems and deposit the loan directly into the principal account of approved borrowers. The infrastructure automatically entraps borrower cash-flows to secure repayment programmatically through a tightly-closed loop. Payment flows are routed carefully to assure the lender that it will receive its funds soon after the borrower is paid for the goods and/or services that it provides. All this takes place without the need to open a fresh loan account for the borrower, thereby increasing the velocity of transactions while reducing their cost. By requiring such loans to only be provided to borrowers with valid PAN and Goods and Services Tax numbers, we can additionally ensure the traceability of transactions and enable easy audits.

Under this framework, all a lender needs to do is make sure the borrower has an account with a scheduled bank. Since it is reasonable to assume that the bank account of the borrower is legally valid, there should be no need for fresh KYC verification.

However, both the Prevention of Money Laundering Act and Reserve Bank of India master guidelines on KYC not only require lenders to conduct KYC checks of all new borrowers, they also make it clear that where third-party KYC is relied upon, the lender will ultimately be responsible for its veracity. While these guardrails might make sense in an offline context, they ignore the reality of digital lending. In the loan design described above, all necessary safeguards can be built into the closed-loop lending framework itself—thereby doing away with the necessity of regulatory restrictions that serve no purpose but slow things down.

Derived KYC

If we want to unlock all that digital lending has to offer, we need to make a start by letting lenders use derived KYC. They should not have to undertake KYC processes for new borrowers if all they’re doing is depositing loan amounts into the principal CASA accounts of borrowers. Those accounts are already KYC-compliant, and if funds only ever flow in and out of such accounts, there is no need for fresh KYC.

Apart from averting an unnecessary duplication of effort, derived KYC offers cost savings, and if we activate it, we could start opening up new worlds of opportunity for our credit-starved country.