[Anoushka and Rishabh are students at NALSAR University of Law, Hyderabad.]
Recently, SEBI released a consultation paper proposing a framework for direct mutual fund (MF) investments through execution-only platforms (EOPs) offered by investment advisors (IAs) and stock brokers (SBs).
MF investments can be routed either through an intermediary, or in the form of direct investment without availing the advisory or brokerage services of IAs and SBs. Investors often prefer the latter to save the commission otherwise paid to intermediaries, which instead gets added to their investment returns.
Initially, when the prospect of providing direct plan through EOPs came to the forefront, firms required access to data feeds of registrar and transfer agents (RTAs), to access payment and transaction status’, maturity status and other information, and showcase them to the client to facilitate direct investments. These data feeds could be accessed only using a firm’s IA or SB code—this pre-condition mandated registration as either an IA, or a broker. Operational hurdles and compliances mandated of an IA made it more optimum for a firm to register itself as a broker, as shown by PayTM Money foregoing its IA registration in favour of becoming a broker.
Now, SEBI undertook various initiatives to promote MF investments, including allowing IAs to employ technological platforms for MF transactions. Accordingly, IAs and SBs would employ the use of digital and technological platforms for investors to simply “execute” these transactions, without availing the advisory or brokerage services provided by them. As per SEBI, several problems followed. First, entities would obtain registration as IAs only to provide execution services, and not advisory services. Second, IAs and SBs would use their registration codes to have “visibility of data feeds of [their] clients.” A key concern emerging from this was that clients (more like “non-clients”) opting only for execution-only services on EOPs, would not get benefit of the investor protection mechanisms in place for regular clients.
This paper seeks to analyze the consultation paper and the proposed regulatory framework, with a view to balance investor protection with ease of making direct investments.
Why Regulate?
SEBI has proposed that EOPs need to be regulated separately from IAs and SBs. SEBI proposes three possible ways to achieve the purpose: first, either by registering them as an intermediary that acts as the investor’s agent, governed by a separate regulatory framework; second, by registering them with the Association of Mutual Funds of India (AMFI) as an agent of the authority; third, by granting them limited membership with stock exchanges.
A key concern that SEBI rightly pointed out was that the investors availing the execution services to the exclusion of the advisory/brokerage services would not qualify as ‘clients.’ This is because EOPs do not satisfy the definitional criteria of “investment adviser” in Regulation 2(m) of the Investment Adviser Regulations, or of a “stock broker” in Regulation 2(gb) of the Stock Broker Regulations. Since these investors are not availing the services that IAs and SBs are meant to provide, and since EOPs are not covered under the aforesaid regulations (or the SEBI Intermediary Regulations), the investors availing these execution-only services have no legal recourse under any of the regulatory frameworks of IAs or SBs.
Another problem faced by current EOP platforms like PayTM or Zerodha, is the lack of a sustainable business model. Currently, EOPs do not charge any money from investors for providing their execution-only platforms. The current EOP revenue model, then, is based on the possibility of cross-selling other products to customers within the same platform. Following one of the three approaches laid down in the consultation paper would lead to a constant source of income, which will allow firms to function independently as an EOP.
Therefore, the need to iron out conflict of interest and competency issues warrants even EOPs to have an underlying regulatory framework.
Recommendations and Analysis
This leads us to the question of which of SEBI’s approaches would efficiently balance investor protection and easier access to MF investments. In the authors’ opinion, the second approach would be relatively more suitable, wherein an EOP would be the agent of the AMC.
The first or the third approach might impose a greater monetary burden on the investor themselves. The latter was visible when Zerodha charged INR 50 from the investor for using their platform, and the subsequent roll-back owing to a decrease in their user base. In any event, the premise of direct plan services is that investors spend less than they do with regular plan services. The only functionality of EOPs is providing customers with the underlying technological platform (and not any advice). Therefore, it making EOPs agents of the investor is not ideal, with the latter being forced to pay EOPs. Furthermore, EOPs would rake in higher profits in the second model by receiving commissions from AMCs for using their technological platform.
Nonetheless, the second approach poses two-fold practical difficulties: first, AMCs may be unwilling to spend money funding EOP platforms; and second, linking EOP profit to commissions received from AMCs can lead to manipulation.
As for the first point, the MF industry in July 2022 started providing financial services through the RTA backed “MF Central Private Limited”. Two possible scenarios emerge herein—with the SEBI MF EOP framework to include regulation of platforms such as MF central and MF utilities; and a scenario where this does not happen. A 2021 SEBI circular compelled RTAs, along with the MF industry, to form an interoperable platform to facilitate investment in MFs. The platform (MF Central) is supposed to comply with the SEBI Cyber Security and Cyber Resilience framework and the Guidelines for Business Continuity Plan and Disaster Recovery. However, the proposed SEBI framework is unclear on whether it will also regulate platforms such as MF Central, and others of its kind already in existence. Excluding it from the ambit of the EOP framework might result in arbitrage, consequently hampering the efficiency of EOPs. It would, thus, be advisable to include such platforms within the ambit of the EOP framework.
The subsequent problem, however, is that AMCs have no reason to invest in the functioning of EOPs such as PayTM, when there already exists the AMFI-sponsored MF utilities platform and previously mentioned MF Central platform. The second approach, from the perspective of the AMCs, does not make sense.
For the second point, while it is clear that EOPs currently do not charge investors to access their platforms, they can still be remunerated by AMCs. Linking EOP remuneration to commissions by AMCs might lead to a bidding system for more visibility. Similar to how the Google AdWords program functions, AMCs with a larger corpus would have more visibility, restricting the competitiveness of the MF industry. While admitting that the premise of the EOP system is to attract investors who believe they are capable of investing without advice, a “top funds” category does affect the subconscious of the average investor. This can be resolved by adopting a fixed fee-model, thereby preventing linkage of visibility with commissions. Another concern raised was that the display of “top funds” might be construed to be “advice”. It is of the opinion of the authors that the aforementioned delinking and fixed pay model would solve the possibility of EOPs being brought under the regulatory framework of IAs.
Therefore, while from an EOP perspective, the second approach seems ideal, SEBI would have to think outside the box to prevent linking visibility of funds with commissions paid and also provide some incentive for AMCs to get behind platforms such as PayTM Money and Zerodha Coin.
With respect to the possibility of providing both financial and non-financial services, SEBI has already allowed MF Central to do the same. EOPs providing both the services would make it easier on the investors, who had to contact the RTAs of all AMCs individually, if there was a need for changing something as simple as an email address. Therefore, there prima facie seems to be no reason to deny EOPs (and investors) these pre-existing benefits.
Additionally, while data-sharing between different departments was appropriate for EOPs’ sustenance, before such a proposed framework, through cross-selling of products, the authors argue that in any of the 3 approaches, it is essential to keep investment data confidential. Hence, criteria such as client segregation, and the need for robust cyber-security systems, need no debate—this is essential to the smooth and conflict-free functioning of EOPs.
Lastly, the consultation paper sought suggestions on whether any other minimum qualifications are required of promoters or key managerial personnel (KMPs). The essence of this requirement for intermediaries was to ensure that “advice” cannot be rendered by non-qualified persons—in line with the investor protection mandate of SEBI. However, EOPs have their foundation in the technological platform they provide. To that effect, SEBI’s proposed approaches stipulate basic infrastructural mandates. There seems to be no further need to have qualification requirements for promoters of KMPs in this field.
Conclusion
SEBI is trying to fill a gap in the regulatory framework, in line with its mandate of investor protection. It has rightly identified the need for aspects such as segregation at the AMC level, and the need for robust cyber-security mechanisms / data-sharing policies. However, all of SEBI’s proposed approaches suffer from certain deficiencies. Addressing these is key, as the model chosen by SEBI would not only delineate EOPs relationship with the investor, but also affect their business model. Lastly, in case SEBI choses the second approach, it needs to ensure that commissions do not lead to visibility only for bigger AMCs.