Last year, under a partnership between the US Agency for International Development (USAID) and the ministry of finance to advance financial inclusion in India, we conducted research on digital payment acceptance among small merchants in rural, urban and semi-urban India.

In Kota (Rajasthan), we met Ram Babu, who runs a small roadside tea stall. Ram Babu had little contact with digital payments: he kept his debit card locked in a cupboard at home, and had never come across a point-of-sale (POS) device in his vicinity. But paradoxically, more than anyone we met, it was perhaps he who needed it the most. His customers often did not have exact change for their cup of tea. So, every morning, he would pay a beggar 10 extra and collect change for 100 (It was a common practice among many small merchants we met).

We heard such stories of the ‘cost of cash’ across four states where we conducted our quantitative and qualitative research. But despite these costs that cash imposes on small merchants, only ~6% of merchants in India accept digital payments.

As discussed in our first article in this series, payments banks have an opportunity to change this, and it is commercially important for them to do so. Their businesses model is heavily dependent on retail transaction revenue and digitizing spending at kirana, or neighbourhood grocery, stores will go a long way.

But to do this, they will have to do ‘better than cash’, something that financial service providers have struggled with over the past decade.

So, why does cash remains king in merchant payments in India? Our research threw up some answers. We found that most merchants who do not currently accept digital payments are simply unaware of them. Among those who were aware, interest was low. Contrast this with small merchants who accept digital payments—to our surprise, we found that most of them were highly satisfied with their experience—nearly half the merchants who accepted debit cards said they would actively recommend it to others, and only 11% were dissatisfied. They noted the benefits that Ram Babu intuitively understood, such as reduced hassle of finding change, safety and ease of use.

The foremost reason driving down interest in digital payments among small merchants did not seem to be tax concerns or high transaction costs, as many suspected; it was the sheer lack of relevance of digital payments in their lives. Small retailers are deeply embedded in a cash ecosystem, their customers rarely ask to pay digitally, and their suppliers want them to pay in cash. Getting out of the cash ecosystem seemed quite hard; we found that even those who were willing to try digital payments faced enormous barriers.

The current merchant acquisition process is fraught with red tape and high costs for merchants. It requires merchants to produce business registration documents (which many don’t have), to pay installation charges and monthly rentals for POS devices, and often to open new current accounts with the acquiring bank and maintain a minimum balance.

In addition, the fee structure is often complicated and varied. It is clear that the journey from ‘cash-only’ to accepting digital payments for the average kirana store is ridden with speed-breakers at every step of the way.

These findings suggest some clear ways in which payments banks can bring more small merchants onto payment platforms.

First, there is an opportunity to completely re-engineer the on-boarding of merchants onto digital payments to make it fast, low-cost and hassle-free, as Square has tried to do globally, and players such as Ezetap and mSwipe are trying in India. This could propel digital payments.

Second, there is a large opportunity to digitize retailer-to-distributor payments, especially for packaged consumer products, which are still largely cash-based. About 80% of the merchants in our sample who currently pay distributors in cash said they were willing to consider digital payments if their suppliers asked them to pay them digitally.

Third, provision of credit could be a critical hook to driving digitization of merchant payments. Here’s how: It is well-known that micro-enterprises in India have a large unmet credit need. The ‘data trails’ that are generated from digital transactions done by merchants can be used to provide them with loans.

So, we asked merchants in our sample to rank incentives that would encourage them to transact digitally, and ‘credit’ emerged as the undisputed winner. ‘Alternative lenders’, such as Capital Float, LendingKart and Neogrowth, which provide loans to small merchants based on their transaction data, including sources such as e-commerce sales and remittances, are already growing. Digital data on consumer-to-merchant payments would provide an additional rich data source for such lending.

With innovations such as IndiaStack, which have begun to provide seamless electronic authentication, eKYC and eSign services, digital data-based lending looks ready for take-off in India, and promises to incentivize merchant acceptance.

Finally, payments banks will need to develop more use-cases where digital clearly beats cash. Remote payments such as online payments and remittances are clearly such cases. Transport services such as Ola and Uber are another.

While the next “killer use-case" is anyone’s guess, our research does suggest some opportunities where cash can be beaten at the kirana store. Managing loose change is a clear one—it manifests itself in foregone earnings like in Ram Babu’s case, or in the form of candy/toffees that are a ubiquitous replacement for small change in India. Expenditure tracking and accounting systems that can be tagged on to digital payments are other potential services that merchants and consumers may value.

With payment companies locked in hot pursuit in their fight against cash, we look forward to a world in which Ram Babu can finally stop ‘paying for cash’ every morning.

Varad Pande is a partner at Dalberg, a global strategy and policy advisory firm focused on social impact, where he leads the financial inclusion practice. Manisha Pandita is a senior project manager at Dalberg. This is the last of a four-part series on what it would take for India’s payments banks to succeed.