MC EXPLAINER The real cost of UPI, missing revenue model, and a case for bringing back MDR

The MDR is paid by the merchant and is shared among the ecosystem partners. UPI had an MDR of 0.3 percent for every transaction until the government removed it to accelerate the adoption of digital payments.

And this has yielded results, and how! UPI has grown 15 times in the last five years. Out of the 18 billion UPI transactions every month, almost two-thirds are merchant transactions.

Despite cards being around for a long time, their adoption in the country was not considered good, mostly owing to the reluctance of small merchants to pay MDR. For instance, today, UPI spending is more than thrice that of credit card spending every month.

UPI was able to change that, with the ubiquitous QR code-based payments in all kinds of retail outlets, even in the remote corners of the country.

Subsidy instead of MDR

To compensate for the loss of income from MDR, the government proposed a subsidy for the industry. As per the government policy, it provides 15 basis points (bps) of subsidy for UPI transactions below Rs 2,000. One basis point is one-hundredth of a percentage point.

Transactions above Rs 2,000 are not subsidised, as such customers are considered to be people with higher purchasing power and it would be easier for banks to monetise.

However, it is important to note that this is not necessarily calculated on the basis of the cost of running UPI transactions, but as the opportunity cost of what it would have been if the government had continued to let banks levy MDR on UPI.

The logic behind the government’s subsidy was that it sees UPI as a digital public good that helps citizens to carry out money transfers and payments faster and more efficiently. The notion is that the digitisation of payments will also likely formalise the payments sector.

For the previous fiscal year, that is FY25, the government announced a subsidy of a Rs 1,500-crore incentive scheme aimed at promoting small-value UPI transactions. As per the government’s own formula, which it had stuck with in the previous financial years, the likely subsidy bill would have been around Rs 6,000 crore for FY 25.

So, the Rs 1,500 crore announced represented a huge shortfall of Rs 4,500 crore. In FY24, the government had disbursed more than Rs 3,600 crore as UPI subsidy.

As the UPI transactions have been rising rapidly and merchant transactions at an even higher pace, the increasing subsidy burden has come to sting the government.

In fact, its success has prompted a rethink even among government circles, and they have been receptive to the industry proposal of charging 25bps fee for large merchants with an annual turnover of above Rs 40 lakh.

The notion here is that large merchants like Amazon and Flipkart, or other large offline retailers which are paying 2 percent MDR for accepting card payments, should be able to pay 25bps for UPI transactions.

Debit cards have an average of 0.75 percent and credit cards have around 1.75 percent per transaction. Credit cards have a higher MDR since the platform offers the money as credit and even an interest-free period of 45-50 days.

Who gets what?

Earlier, the MDR was distributed among three major partners. If MDR comes back, this formula is likely to continue.

The issuer bank gets 50 percent of the MDR, while the acquirer gets 35 percent. The PSP bank gets 15 percent. The issuer is the bank from which the money is debited. The acquirer is the banker of the merchant. The PSP bank is the banking partner of the UPI app on both sides - sender as well as the receiver.

Stress on servers

The industry claims that it incurs expenses of around 30bps per transaction to run, maintain and expand the infrastructure in line with UPI's growth, and also to acquire new merchants.

Since UPI is a real-time payment settlement system, unlike cards, every single transaction has to be accounted for by the banks immediately. Hence, the huge volumes have been a stress on the banks’ servers as well as their core banking solution software, which were not designed to handle this many transactions.

Certain banks like SBI and HDFC Bank have a higher load simply because of the sheer number of customers they have. Many public sector banks, with relatively lower profits, have not been making enough investments in infrastructure, causing higher failure rates.

The argument for MDR is that if there were MDR on UPI, the banks would make more investments in technology infrastructure, and the higher reliability would ensure fewer bank outages and an even more seamless payment experience.

MDR on UPI will also help payment gateway firms, point of sale firms and other payment infrastructure companies to invest more in merchant acquisition, potentially accelerating the digitisation journey.

Is the cost static?

However, one aspect that not many discuss is that the fixed and variable costs of the UPI have been coming down. The economies of scale have been helping banks and other payment ecosystem partners to bring the cost down over the last few years.

The CBS (core banking solution) and bank data centre costs are core functions similar to building a branch or ATM network. Hence, to ascribe this cost to UPI does not make sense. Technology is an indirect cost at all levels of operation.

Multiple payment industry executives said that today, banks incur a cost of around 3-4 basis points for every UPI transaction, including the NPCI (National Payments Corporation of India) switching fees and the commission it pays to the technology service provider (TSP) for every UPI transaction. NPCI runs UPI.

Companies like Juspay, Mindgate, Sarvatra and Olive are the major TSPs for the UPI technology stack in the country. These players used to charge banks somewhere around 3-5bps per transaction in 2000, which has now dropped below 1bps.

“Banks incur a cost for everything from giving out fresh loans, servicing a savings account, maintaining ATMs, getting Fixed Deposits and so on. You cannot have a separate profit & loss account for everything. The standalone cost of running UPI is not as big as it used to be,” said a former digital banker.

While banks incur a cost for P2P transactions too, they do not worry about it as the account holders tend to keep money in a savings account rather than in cash. Thus, P2P transactions are seen as a service expense to keep customers happy.

Even an IMPS transaction incurs a cost, but most banks provide this for free for the same reason.

The quantum of subsidy

The government’s decision to lower subsidy was probably justified, given the changing dynamics within the payment ecosystem. Srinath Sridharan, policy researcher and corporate advisor, recently wrote in a Moneycontrol column that the government did not build UPI infrastructure for private profits.

Neither the banks nor the UPI apps ever planned to make money from the platform's transaction fees. Nor do the newer UPI apps plan to do that. UPI is a platform for customer acquisition and monetisation by cross-selling other financial services products and services.

For several banks, whether the PSP banks or the merchant acquirers, the revenue model comes from other services, such as selling them business loans.

Is MDR needed?

There are no questions about whether MDR will help the industry. In a free market where banks and payment companies decide on an MDR, even a price ceiling set by the regulator could work well for the ecosystem.

To be sure, even for the Visa and Mastercard debit cards, the MDR is capped by the RBI at 0.75 percent. Even a controlled market pricing of 0.25 percent MDR for UPI could do wonders for the ecosystem.

There is no denying the fact that PhonePe, Google Pay and Paytm played a key role in ensuring the success of UPI by investing millions of dollars in creating awareness, building trust, providing cashbacks and accelerating adoption. The companies’ investment in technology helped the platform provide a seamless customer experience, making UPI popular.

The current proposal of MDR for only large merchants could, in turn, subsidise the platform growth for smaller merchants, which could spur the next phase of growth.

The argument for a robust domestic system like UPI is becoming more important as nationalism in the US is forcing even its ally European Union, to create a UPI-like system for the economic union.

However, whether the platform should be free or not is a policy decision.