The age of building trust: Understanding the fundamental faultline of the Indian economy

Here’s the DocSend link to the full thesis

A phantom menace

As a VC for a few years now, I have had a vantage point from which to observe a number of sectors in the Indian economy. Of late though, I am starting to feel that whatever the industry maybe, whether it is fintech, proptech, kiranatech, what most startups are trying to solve for comes down to can be distilled down to one word – ​“trust” (or the lack of it thereof). 

It wouldn’t be hyperbole to say that the only dynamic that truly matters when analysing a sector in India is the degree / extent of trust/​distrust

There are two key factors that determine transactional trust , one is the extent of information asymmetry and the other is the effectiveness of dispute resolution / contract enforcement. The challenges that arise from information asymmetry are well documented especially by Prof. George Akerlof in his Nobel prize winning study popularly dubbed as the ​“Market for lemons”. Information asymmetry is a universal problem which is prevalent in all countries for certain types of transactions. 

Which brings us to the question of contract enforcement. While this is counter intuitive to many, India’s distrust problem is actually a downstream impact of our broken judicial system. By all measures, India’s dispute resolution / contract enforcement mechanism is — abysmal. There are a whopping 47 million pending cases in the Indian courts. According to the World Bank’s Doing Business Report 2020, India ranks 136^th out of 190 countries in the category of enforcing contracts. This ranking is significantly lower than China (46^th) and Brazil (128^th). Additionally, the average time to enforce a contract in India is 1,445 days, which is more than four times longer than the global average of 358 days. 

This leads to a situation wherein almost every market in India is a market for lemons. In every transaction, every transacting party has to constantly evaluate the trustworthiness of the counterparty. This results in three main types of issues. 

1. Friction / Transaction costs: Lack of trust creates additional cost and decreases the volume and velocity of transactions in many sectors of the economy. A simple example of this can be observed in the real estate rental market. Landlords in Bangalore often ask for obscenely high security deposits of 10 months (higher cost). Similarly a south Indian SME supplier might ask for a higher rate when supplying to a north Indian buyer to account for increased collection costs he might face as he supplies to buyers who are not geographically proximate 
   
2. Market breakdown: Using the same example above, some landlords might even choose not to let out their house causing a vacant housing problem ( as is the case in Mumbai). Similarly SME suppliers might choose to not engage with buyers are beyond their geographic zone for fear of non payment of dues, thus creating a market breakdown. 
3. Risk Premia: For every service transaction in India, the buyer is worried that the provider won’t complete the job and every service provider is worried that the buyer won’t pay them fully on the completion of the job. This trust deficit manifests in interesting ways. If you have ever tried to get your house painted, you will notice that for painters (and in most unorganised services in India), there is an extremely large price dispersion. The vendors who have an established track record of trust and service delivery price their services very high and are often contracted by those buyers who are prompt payers. This complicates the life of new service providers, for whom establishing trust would entail engaging with the next tier of buyers who might not be prompt payers. This results in a scenario where the established vendors are able to charge a premium permanently. It could be argued that at a macro level this ​“risk premia” for trust is a real economic price that consumers pay for an inefficient dispute resolution mechanism. 

The second-order impact of the issues outlined above can be observed in some of the largest markets in our country. Lets take the example of an SME supplier. 

The SME sector has two interlinked problems caused by a faulty dispute resolution and contract enforcement system. 

• Buyers tend to delay payment, especially when there is a power differential, because they know they can get away with it as contract enforcement is so weak that the sellers won’t be able to enforce contracts. As invoices are not paid in a timely manner, MSMEs tend to have erratic cashflows, 
• This makes MSMEs hard entities to lend to (a problem compounded further by the fact that even the loan contract is hard to enforce for the banks!). Therefore banks charge a higher interest rates to MSMEs (friction) or they don’t lend to the sector ( market breakdown, also known as a credit gap) 
• We finally end up in a place where delayed payments become a massive Rs 10 lakh crore rupee problem and that in turn leads to an even bigger, 25 lakh crore rupee credit gap problem for the MSME sector(!). 

The inefficiencies caused by a trust deficit is rife across many sectors in the economy, including the property market, the credit market and services markets. Amusingly, The highest margin sectors in India are those where there is significant mistrust in one time transactions ( house construction, wedding related vendors etc), perhaps precisely because of this reason. 

How the empire struck back 

Historically though, as a society we have coped with these problems for centuries in our own unique way. Over time, we have developed a shorthand for trust through some distinctive mechanisms including : 

• Community based enforcement: Many communities, particularly the ones engaged in trading, preferred to engage in transactions only with members of the same community. Even if legal enforcement is not possible, this allowed for quasi ​“social enforcement”. Incase someone reneged on a contract, one could impose a social cost to the party. Moreover, the network also helped to spread information of such instances quickly, which would then adversely impact the person’s ability to transact with other members of the community. This created a ​“social trust” mechanism in the goods / services market and then would extend to credit transactions within the community. Chit funds are an example of this phenomenon, as they often tend to be composed of people in the same community. 
• The primacy of collateral: The Indian credit system has been entirely based on collateral, As of 2021, the Reserve Bank of India (RBI) reported that secured loans accounted for around 75% of the total household credit disbursed by banks in India. This indicates that a significant majority of loans disbursed in India are backed by some form of collateral. 

The second order impact of this is that Indians overwhelmingly prefer gold as an investment avenue ( at least partly because of its value as a collateral for easy credit ) . This skews the role gold has in the asset allocation of a household. The per capita demand for gold in India is around 0.6 grams, compared to the global average of around 0.2 grams. Indian’ hold $10.7 trillion of household assets in India of which 15% is held as gold (which is 3x what is held as equity) . This is significantly higher than other countries, where the average percentage of household assets held as gold is around 2 – 3%. From a macroeconomic standpoint, unlike financial assets, an investment in gold leads to no investment multiplier effect and it is actually harmful to the economy at a macro scale ( Gold imports account for ~60% of India’s current account deficit) 

• The endurance of brands: In the early years of independent India, as a capital-starved society, an investment in building a brand was a powerful signal of your economic viability, which in turn signalled that you are likely to be a trustable party. Brands built in that era, evolved to become shorthand for trust and are independent of any product that they might have represented. Unlike in other countries, some brands in India are able to translate across disparate categories ( Tata Salt to Tata Trucks) precisely because of this context of operating a low trust society. Interestingly communities and social groups also have the ability to become brands. Agarwal packers, Shetty lunch homes and parsi owned cars ( in the second hand market) are examples of this phenomenon. 

While these ​“coping mechanisms” have helped, The traditional mechanisms that we have listed above are unable to scale to the needs of the economy today. Community enforcement becomes harder in a world of greater geographic mobility, the need for collateral continue to limit credit creation in our economy and brands have become much easier to build in the digital age that its diluting the trust signalling value of brands themselves ( so much so that even Tata has to try ​“Neu” ways to adapt). 

A new hope

We are living through a very interesting period in the evolution of trust in our economy. In a move with few parallels in other parts of the world, I would argue that the market is now forced to step into the role of contract enforcement that is being vacated by the state. Its doing so by leveraging technology and much of it is being built by many startups who are engaged in constructing a much needed ​“trust layer” for transactions in India. 

When viewed through this lens, one can observe each step in the evolution of the internet economy through the ​“Trust building strategy” that enabled that step 

Some of the significant examples include: 

1. Evolution of Ecommerce in India: Ecommerce websites evolved world over in the mid-2000s, the primary proposition was to solve for discovery / assortment by being able to provide a larger catalogue of goods to the consumer. In the Indian context however, these catalogue focused efforts did not create much interest. 

Trust building strategy: Various factors are associated with the growth of ecommerce in India, the demand for smartphones, the growth of 4g etc, but the moment when ecommerce in India truly started to take off was the moment when Flipkart popularised cash on delivery. An uniquely Indian solution to solve the trust problem amongst Indian consumers. I would argue that this was the first brick in the edifice of trust that is being built in the online economy in India. Ecommerce firms in that era also helped build the necessary infrastructure ( payments, logistics) and consumer behaviour needed for digital adoption. 

2. Evolution of second hand marketplace: The early internet ushered in an era where second hand goods transactions moved from newspaper classifieds to online platforms. Olx and Quikr are examples of this. They enabled better discovery by allowing users to search and filter listings, however they did not step into the domain of trust as the transaction occurred offline outside the platform. Today, we witness the emergence of verticalized players who solve for trust and therefore have been able to both scale and charge a premium. These platforms provide a superior full stack experience and even provide guarantees / assurances that help to alleviate the trust deificit. The success of startups such as Spinny and cashify are examples of this phenomenon. In India, the real value accrues to online platform when they are able to go beyond discovery and are able to assure quality / trust. 

Trust building strategy:  Solving for trust was even harder for these companies. Each had to build a sophisticated pricing algorithm to be able to buy inventory and price it at the right amount. This pricing algorithms were so sophisticated that they were far superior to traditional mechanisms of pricing the product, so much so that many traditional retailers use the prices on cashify website as a benchmark. They also had to build a complex operational capability to manage refurbishments. 

3. B2B market places: On last count, there seems to be atleast 100 B2B commerce companies that have emerged in India in the recent past. Alongside solving discovery, they also solve for the two of the most complex problems in the Indian landscape, delayed payments and credit. 

Trust building strategy: The B2B marketplaces are able to enforce good behaviour through ratings reviews and in some cases even ejecting bad actors from the platform. They often take on the role of guaranteeing the transaction or else will enable dispute resolution mechanisms to resolve disputes between buyers and sellers. Hence they are able to facilitate greater trust on the platform which leads to a virtuous cycle wherein lenders are now able to underwrite and lend to the sellers transacting on the platform with great ease. The emergence of OfBusiness and Oxyzo is an example of this phenomenon. 

A force awakens

Given this background, the interesting question or the participants of the Indian internet economy ( startups and VCs alike) is what is the next step in this evolution, there are a few interesting areas: 

1. Continued growth of verticalised marketplaces: As the ecommerce playbook continues to expand, we can expect marketplaces to emerge in some of the other large value chains in India. Unlike in the case of B2C platforms, the network effect is minimal in B2B platforms, therefore verticlaised platforms are likely to emerge in various sectors. One way to look at this is to analyse which are the large sectors in our economy which have high trust deficits ( characterised by high fragmentation, larger price dispersion, margins etc), these markets are likely to be well suited for a B2B platforms to emerge.

These marketplaces will need to enable discovery, facilitate trust with a feedback and rating mechanisms at their core that help to differentiate the good actors from the bad. They will often have take on the role of facilitating dispute resolution and sometimes provide escrow services and guarantees to ensure smooth function of the marketplaces.

2. Market Infrastructure: Much like payments and logisitics companies grew as B2C marketplaces grew, startups whoar leaning into the challenge of building market infrastructure to enable trust could grow on the back of the growth of B2B marketplaces. Examples are already emerging, Online dispute resolution has become an area where startups like PreSolv360 has shown great progress. Fintechs that offer purpose built solutions for marketplaces, including escrow services, embedded supply chain finance (Getbalance) are also starting to show promise. 
3. New mechanisms to solve for trust: One such example is Recordent which aggregates and tracks payment behaviour of buyers which could eventually lead to a payment score. The ONDC framework inbuilt. Rental companies in India were exploring the idea of building a shared rating system. Given the centrality of ratings as signals of past behaviour in a country with minimal legal recourse, it is rational to expect a meta rating to emerge. One that combines disparate databases of ratings such as credit ratings, rental rating, über rating etc at some point in India.

Conclusion

To use an analogy from the financial markets, many of the key transactions markets in india are in the process of moving from an OTC mechanism to an exchange mechanism. Where the burden of trust moves from the counterparty to the platform that is enabling the transaction.

From a public policy standpoint, the Indian trajectory points to an important question of whether this is in the best interest of the republic. The emergence of these market-led solutions means that it is very possible that over a really long term, these entities become the arbiters of trust in our society — a role that is typically played by the state. Would that really be a good thing for our society is an open question. 

While in the short term, these solutions are much needed, over the long term, the mechanisms that enable trust in a society are better kept in the public domain than in private hands. How this particular dynamic will play out in India will be the story that defines the Indian internet marketplace, in the decades to come. 

DocSend link to the full thesis