Do SEBI Investment Advisers Regulations 2013 Encompass Robo-Advisors?
[Aditi is a Master of Laws student at Jindal Global Law School.]
The advent of robo-advisory services has given a new technological turn to the age-old business of managing other people’s money. This is a class of advisors that provides financial advice based on digital algorithms or artificial intelligence-driven inputs. It developed post-financial crisis in 2008 because of the decline in the trust in traditional banks and financial institutions. During that period, the retail investors felt the need for structured financial advice, which only sophisticated and high net-worth investors could afford. Consequently, the startups then leveraged technological advancement to present an algorithm-based solution to this investment problem. Presently, robo-advisors provide the services of portfolio management and tax-loss harvesting. This algorithm-driven financial service has been gaining tremendous popularity in recent years.
The service poses some regulatory complexities concerning transparency, record-keeping, data protection, and reliance on misleading data. Also, the determination of legal liability between the parties, i.e. the developers of the program, owners of the robo-advisors, and the person or team managing it, is a concern of legal interpretation. Because of these potential conflicts of interest between the client and the advisory business, countries envisioned regulatory inclusion. In India, the Securities Exchange Board of India (SEBI) took a view in a 2016 consultation paper that the use of the automated tool is not prohibited under SEBI (Investment Advisers) Regulations 2013. It categorised robo-advisors to be the same as investment advisors to keep the regulations technology-neutral to encourage innovations.
The approach taken by SEBI is highly relevant for the future availability of the technology in India. The scope of regulation depends upon the services extended by the service provider (distributor and advisor), technology incorporated, and human intervention.
Globally, robo-advisors enforcements are detecting frauds relating to lack of disclosure of trade data, reliance on misleading marketing materials, misleading performance data, and non-implementation of supervisory procedures. The Securities Exchange Commission of the US has charged robo-advisory giants Wealthford Advisers and Hedgeable Inc. with false disclosures. The fraud committed by algorithms is too complex to detect. The complexity emerges from the very point of origin, where the programmer develops a technology while the advisor entity owns it. Both could be the same person. The roles are important to understand for allocating responsibilities in case of fraud to the investors.
The varied elements of the recent developments in the advisory business have given a new tangent to the investor protection issue. To ascertain investor protection, the regulators promote the knowledge of the market and risks related to it; safety and avoidance of miscreants; and grievance redressal. The investor advisory business is now stringently regulated all around the globe. For continuous compliance, the online advisors need to comply with the respective rules on an ongoing basis, wherein they systematically track and incorporate regulatory changes into the platform.
To ascertain the safety and avoidance of miscreants, the identification and mitigation of risk are necessary. Robo-advisors are programmed to prepare a risk profile of the user based on a detailed questionnaire. The online advisors continuously monitor the investment assets to maintain specific allocation. The portfolio is then balanced in response to the changes in the market. This process is called portfolio rebalancing. It is significant for periodically aligning with the asset allocation mix. While rebalancing a portfolio, it is important to analyse the market changes continuously. However, an assessment of economic risk during unprecedented situations, such as an economic crisis, requires efficient market assessment and aggressive risk profiling. There could be limitations in the services of robo-advisors while maintaining portfolios in such situations. Human advisors, on the other hand, are deemed to mitigate the risk by rebalancing the portfolios in a personalised manner. This inadaptability of the robo-advisors can cause the regulatory risk of governing unsuitable advice.
To promote investor interest, global regulators always insist on transparency on investment advisors. Also, transparency with the client about the risk, limitations, and the process of portfolio making aids the investors in making informed decisions. The disclosures are fiduciary duties of the advisors to avoid misleading the clients. In the case of robo-advisors, the lack of human intervention makes the disclosures paramount. The disclosures regarding the algorithm must be made on its risk determination system, assumptions, the scope of services and limitations, mechanism to detect algorithmic failure, and rebalancing algorithm. Hence, provisions to impose ongoing compliance, continuous risk profiling, and disclosures on the client can be considered good regulatory practice in the case of robo-advisors.
The 2016 SEBI Consultation Paper was the first instance of extending the regulatory oversight of investment advisors to robo-advisors. The regulator imposed technology-neutral rules on the online advisors. It provided for mandatory risk profiling and investment advice based solely upon the risk profile. SEBI also extended the provisions for record-keeping of the risk assessment of the profile and suitability assessment of the advice for five years. Additionally, the regulator proposed a wide set of checks and balances, such as ensuring the fitness of the tools, disclosure on the technology used, and comprehensive system audit. These checks are, however, only suggestive. Other than the already established compulsions of risk profiling and record-keeping, the proposals of disclosures and audits have not been mandated upon the advisors. The lack of technological regulation can raise the risk of reliance on misleading marketing materials and behavioural bias. Hence, the design, performance, and security of the algorithms need to go through human oversight and audit, if not regulatory scrutiny.
The Regulator has brought certain qualifications for investment advisors through SEBI (Investment Advisers) (Amendment) Regulations 2020. The erstwhile requirement of graduation with five years of experience or a post-graduation has been replaced with the requirement of post-graduation in finance or related stream, a certificate in financial planning, along with five years of experience. In the case of a non-individual entity, the qualification is imposed upon the person at the managing position in the entity. This qualification has not been clarified concerning online advisors. In such entities, human intervention is kept at a minimum. It can be assumed that such requirements could be made necessary for the person managing the online advisor. This requirement can, however, defeat the purpose of establishing low-cost technology-based advisors, as hiring professionals with the abovementioned qualifications can be a costly affair. Additionally, a bar of the minimum net worth of INR 50,00,000 has been imposed on non-individual advisors. In India, most of the robo-advisory services are extended by body corporates or partnership firms, i.e. non-individuals. Therefore, these bars strike the reason for the popularity of robo-advisors, which are lower fees and lower minimum investment when compared with traditional wealth management entities.
In a guidance note to Paytm Money Limited on 9 April 2021, SEBI referred to a circular on investment advisor dated 23 September 2020 and emphasized the explicit consent of clients on the terms and conditions. Considering the same, the regulator stated that seeking electronic consent through a digital agreement and sharing the same on the client’s email cannot be considered as consent. Hence, it would not fulfil the requirement of mandatory agreement between the investment advisors and the client as required under Regulation 19(1)(d) of the SEBI (Investment Advisers) Regulations 2013. This is an area where the regulations can be relaxed if digital agreements are allowed, as in many other sectors, such as starting a mutual fund SIP and investing in other securities. These businesses mainly operate for the retail investment sector and clients who seek digitally viable and inexpensive investment advisory services. Therefore, imposing a physical agreement can render many businesses unfeasible. The relaxation of said regulations is desired as they encourage technological advancement, financial inclusiveness, and market penetration.
In India, the robo-advisory sector is at its nascent stage, which is expected to grow to the extent of $53.9 billion by the year 2025. The Indian regulator is yet to provide a coherent set of provisions in the SEBI (Investment Advisers) Regulations 2013 for robo-advisory services. Till now, SEBI has just extended pre-existing requirements of risk profiling, record-keeping and physical agreement to robo-advisory companies, but new legal complexities give rise to new regulatory requirements. Because of the new regulatory challenges posed by the automated advisors, it is pertinent for the regulator to tailor a new set of provisions to protect the interest of unsophisticated retail investors. Other than the compliance of data protection and anti-money laundering laws, the sector needs regulatory imposition of disclosure, auditing and mandatory licensing.