SEBI and the impasse over 'unregulated' financial products
The debate is how can India's financial regulators plan to regulate innovation?
A lot has been written about the recent Securities and Exchange Board of India (SEBI) statement that bars investment advisers from marketing digital gold and "other unregulated products" to their clients.
The report preceded a missive from the National Stock Exchange (NSE) earlier to stockbrokers, asking them to discontinue the sale of digital gold on their platforms. In a market, awash with inventive products and services, these directions are no longer just about digital gold, but have rightly prompted a wider debate that has been a long time coming. The discussion is - how do India's financial regulators plan to regulate innovation?
New asset classes are either a methodical product of policy, such as real estate or infrastructure investment trusts, or the wild child of technological disruption – digital gold and crypto-currencies. Even binary options and 'contracts for differences' traded online are good examples.
While the former usually involve a syncretic, consultative process between the industry and the regulators to develop a framework into which such products are born, the nuts-and-bolts of the latter are often crowd-designed and industry-implemented before authorities pick up the baton.
A decade ago, a number of art funds in the market that was set up to invest high-net-worth individuals' funds into art and collectibles, ran into a similar regulatory gridlock. A number of such funds had petitioned SEBI asking to be regulated. They requested that the existing laws around collective investment schemes should not be retrofitted into a product, which warranted a more nuanced regulatory treatment.
However, that foray ended with SEBI initiating enforcement action for violation of the collective investment scheme regulations, with the Supreme Court eventually upholding SEBI's view in 2018.
Grey areas in the twilight zone
To date, the shadow of this regulatory twilight zone has not been cast on investment products alone. In fact, even the framework for investment in overseas securities and artificial intelligence-driven robot-advisory investment services remains unarticulated.
SEBI had issued informal guidelines recently. These disallowed portfolio managers from deploying the funds of their Indian clients overseas, since SEBI does not have jurisdiction over offshore securities.
Seamless access to overseas markets is a service being offered on a number of online broking platforms. It is unclear why the regulatory reflex on this service is negative. Incidentally, other than an observation years ago in a SEBI committee report, which highlighted the need for marketing guidelines for offshore financial products, India today has no substantive policy or literature on this.
Technology is changing the anatomy of financial markets, both in terms of creating new avenues for liquidity deployment as well as enabling better access; so what drives governmental agencies to airdrop abrupt, procedural barriers?
Even if we set aside crypto-assets and their kryptonite effect on regulators globally for the purposes of this analysis, what causes reactionary, dissuasive law-making across other asset classes or products?
Investor protection is the first exigency for every regulator to tackle effectively. And the market innovative products have a short lead-time and integrate rapidly into mainstream retail imagination due to their online outreach. Lack of product awareness when coupled with enthusiastic advertising and easy click-through execution, skews the risk-taking propensity of retail investors.
However, quick-yet-meaningful regulatory intervention during this phase is often limited by what current laws permit and the regulator's remit. The hybrid nature of products also requires turf-allocation to decide on the principal regulatory agency in that domain.
What also takes time is assessing the scale of the product and its accompanying risks. Whether it presents a broader systemic threat from money laundering, foreign exchange, or a leverage standpoint, must then be plumbed legislatively. Also, whether these are largely localized pockets of activity that can be reigned in through a tidy set of marketing or solicitation rules.
While there are enough reasons for agencies to wait for the dust to settle, the biggest loser in the short term, unfortunately, is the investor, whom the regulator seeks to protect. Not only does such an approach hamper investor confidence, but it is also not accommodative or encouraging of industry innovations.
In fact, taking such products away from the hands of the regulated entities like brokers or licensed advisers that owe systemic accountability, deepens the dilemma of the already exposed stakeholder. He is ultimately left to contend with unregulated intermediation platforms.
The Way Forward
A possible solution lies in implementing standardized marketing guidelines that cut across all asset classes, borrowing from some relevant International Organizations of Securities Commissions (IOSCO) guidelines on distribution and marketing. This ensures that even where the service or asset is unknown, there is regulatory introspection underway and retail investor impact is tempered in the interim.
To plan the next steps, consider a risk prioritization framework that scores on the two metrics:
To take further steps, consider a risk prioritization framework that scores on the two metrics. One, how faithful and aligned the product/service is to an existing body of law? Two, the degree of its investor outreach.
For instance, if the product patently flies in the face of existing rules (such as over-the-counter contracts, contract for differences, or running unlicensed order-matching exchange platforms), and it also has significant retail outreach, it should be called out immediately. Measures should be taken promptly to clip its wings.
Whether the product is not yet regulated, but it operates only within a certain investor subset by targeting sophisticated investors with a minimum ticket size, it must be considered if this mandates some market guidance, elaborate disclosures, and nuanced regulation that allows controlled beta testing, rather than an outright ban.
In fact, in such instances, the regulators can direct parties to file applications under the regulatory sandbox window and also deal with them in a time-bound manner, rather than track their impact from the outside.
Technological disruption in financial services should not be expected. It should rather be welcomed and planned for in a manner that provides flexibility for more predictive, supple market regulations and limits the latitude for reactionary market controls.
Shruti Rajan is a partner in the Mumbai office of Trilegal, and a regulatory and enforcement lawyer in the financial services space.