SEBI And The Impasse Over ‘Unregulated’ Financial Products

A lot has been written about the recent Securities and Exchange Board of India press release dated Oct. 21, 2021, that bars investment advisers from marketing digital gold and “other unregulated products” to their clients. This press release was preceded by a missive from the National Stock Exchange earlier in August 2021 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 – how do India’s financial regulators plan to regulate innovation?

New asset classes are either a methodical product of policy, such as real estate investment trusts or infrastructure investment trusts, or the wild child of technological disruption – digital gold, cryptocurrencies, even binary options and ‘contracts for differences’ traded online are good examples. While the former usually involves a syncretic, consultative process between industry and 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 or so ago, one would recall that a number of art funds in the market, which were set up to invest high-networth indivudals’ funds into art and collectibles, ran into a similar regulatory gridlock. A number of such funds had then in fact even petitioned SEBI asking to be regulated, requesting only that existing laws around collective investment schemes not be retrofitted into a product that, to their mind, 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 Twilight Zone

The shadow of this regulatory twilight zone is not cast on investment products alone – until date, the framework for investment in overseas securities or even artificial intelligence-driven robo-advisory investment services remains unarticulated. SEBI issued informal guidance last month that curiously disallows 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 today and 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?

Trouble While Playing Catch-Up

Investor protection is, rightly so, the first exigency for every regulator to effectively tackle. Market innovated 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 as well, i.e., whether it presents a broader systemic threat from a money laundering, foreign exchange, or a leverage standpoint that must then be plumbed legislatively or whether these are largely localised pockets of activity that can be reined in through a tidy set of marketing or solicitation rules.

And so while there are good reasons for agencies to wait for the dust to settle, the biggest loser in the short term unfortunately is the very investor that the regulator seeks to protect. Not only does such an approach hamper investor confidence it is also not accommodative or encouraging of industry innovation.

The Way Forward

A possible solution lies in implementing standardised marketing guidelines that cut across all asset classes, borrowing from some relevant IOSCO Guidance on distribution and marketing. This ensures that even where the service or asset is an unknown beast and there is regulatory introspection underway, retail investor impact is tempered in the interim.

To plan the next steps, consider a risk prioritisation framework that scores on the two metrics:

1. How faithful and aligned the product/service is, to an existing body of law; and

2. The degree of its investor outreach.

For instance, where 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 also has significant retail outreach, it should be called out immediately and urgent measures should be taken to clip its wings. Where the product is not yet regulated but operates only within a certain investor subset, for instance, by targeting sophisticated investors with a minimum ticket size, consider if this mandates some market guidance, elaborate disclosures, and nuanced regulation that will allow some kind of controlled beta testing, rather than an outright ban. In fact, in such instances, regulators can direct parties to file applications under the regulatory sandbox window as well and deal with it in a time-bound manner, rather than track their impact from the outside.

Technological disruption in financial services shouldn’t just be expected; it should be both welcomed and planned for in a manner that provides flexibility for more predictive, supple market regulations and limit 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.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.