In simple terms, factoring is acquiring bills receivables from MSMEs and releasing money, or giving short-term loans, against these bills to the MSMEs
On July 26, the Lok Sabha passed the Factoring Regulation (Amendment) Bill, the main focus of which is to widen the scope of the factoring business in the country. Factoring is a form of the age-old bill discounting business for micro small and medium enterprises (MSMEs). Here’s what the move means.
What is factoring?
In simple terms, factoring is acquiring bills receivables from MSMEs and releasing money, or giving short-term loans, against these bills to the MSMEs. The MSMEs provide goods and services to corporate firms and the government, but the payment is not immediately made. Instead, the MSMEs raise bills, or receivables, against the payment due. The bills are given to the banks and factoring firms at a discount, and the acquirer of these bills, realising full amount against the due from the firm, earns a spread. If it is just a loan, or even commission, the factoring earns money, while the MSME gets the liquidity it needs. However, credit facilities provided by banks in the ordinary course of business against security of receivables or as commission agents for sale of agricultural produce or goods are excluded.
Why was the Factoring Bill introduced?
The recent Factoring Bill is an amendment of the original 2011 Bill, which allowed only specialised non-bank financial companies (NBFCs) and banks to engage in factoring. Such NBFCs had to have 75 per cent or more of their business coming from factoring income. As a result, only seven NBFCs have so far registered as factoring companies. This severely limited the scope of MSME financing. In order to mitigate that, an expert committee under U K Sinha, former chairman of the Securities Exchange Board of India, proposed on June 25, 2019, that the factoring space be opened to all NBFCs interested in such business. Incorporating the suggestion, the latest Bill was introduced in the Lok Sabha in September 2020, and cleared earlier this week. It will now go to the Rajya Sabha and if cleared, become a law.
What is the change in the new Bill?
The primary change is allowing more NBFCs into the factoring space. The Bill has also amended the definitions of “assignment”, “factoring business” and “receivables” to align them more with international standards. According to livelaw.in, a legal portal, the Bill has also amended some sections to reduce the time period for registration of invoice and satisfaction of charge upon it to avoid possible dual financing. The Bill also empowers the Reserve Bank of India (RBI) to make regulations with respect to the factoring business.
What is TReDS?
Trade Receivables Discounting System, or TReDS, is an online platform for factoring purposes. MSMEs can register here as providers of bills, and NBFCs and banks on the other side can bid for such bills. It is basically an online marketplace for bill discounting. The advantage of TReDS is that the discounting can be done online and in a completely transparent manner. “The TReDS platform specifically provides for free, trusted receivables payments to MSMEs within 48 hours, which helps smooth their working capital cycle,” according to Ketan Gaikwad, MD & CEO, Receivables Exchange of India (RXIL), one of the three TReDS platform providers in India.
How do MSMEs benefit?
This is a big relief for the MSMEs. The volume on the TReDS platform is very limited as of now. Just about Rs 2,000-3,000 crore are discounted every month across the three platforms. That is because there are not enough buyers for the bills. Once more participants come on board for factoring, the liquidity constraints faced by MSMEs will significantly reduce. “Now all the large financing NBFCs can come on board and compete for the bills. This will vastly increase competition, liquidity, and pricing for the MSMEs. There is absolutely no reason that such a vital field should remain restricted to just seven NBFCs,” said Raman Aggarwal, director of the Finance Industry Development Council (FIDC). FIDC, as a lobby group of financing NBFCs, had pushed for opening up the factoring business for all.
Will this change the game completely for MSMEs?
It should be able to achieve that. But there will also be the associated risk of rising bad debts for NBFCs and banks as more bills against various firms will come for discounting. This is a business risk the discounting party will have to take. It is worth mentioning here that most of the receivables are against government work. And while the government doesn’t default, it is also the slowest to release payment. Corporate receivables, on the other hand, have much shorter payment release cycles against their bills. But they are also susceptible to potential defaults. However, large NBFCs and banks have the means to recover the dues, which MSMEs don’t. And so, the MSMEs will crowd in for more instant discounting, and factoring should swell in the future.