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Regulating Execution-Only Players

Sandeep Parekh

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Co-authored with Rahul Das, Senior Associate and Parker Karia and Navneeta Shankar, Associates, Finsec Law Advisors.

Over the last few years, SEBI has taken various initiatives to promote and facilitate investments into mutual fund (MF) schemes either directly or through distributors by using the stock exchange infrastructure and laying down a framework for the creation of an inter-operable platform among the registrars and share transfer agents of MFs and the depositories. One can either directly invest their money into a MF (direct plan) or take the help of a MF distributor to make the investments (regular plan). Due to distribution commission, regular plans are costlier. In 2016, SEBI also allowed registered investment advisers (RIAs) to use the MF transaction platforms of the stock exchanges to facilitate investments. As a result of the above as well as increased financial literacy,digitisation and technological and business innovations, investments in MFs has skyrocketed.

AfterSEBI allowed RIAs to facilitate direct purchase and sale units of MFs, it was observed that several entities obtained the IA license solely for the purpose of providing execution services in direct plans on their technology platforms.Functioning as execution-only platforms (EOPs), these entities allow investors to invest directly in an MF without the help of a distributor/agent, do not provide any advisory services, and typically use their IA registration code asa means to access their clients’ data feed to allow them to view their MF investment portfolio on technology platforms.

While EOPs may be a convenient and cheaper mode of investing into MFs, there is presently no SEBI regulatory framework governing entities providing such services. Thus, SEBI, in a recent consultation paper, has raised concerns that clients who avail execution-only services from entities including registeredIAs/stock brokers, may not have recourse to any regulatory framework to redress disputes and grievances. To strike a balance between convenience in making investments and investor protection as well as to fill in the void created by alack of a legal framework to govern EOPs, SEBI has proposed three alternate frameworks to regulate such platforms viz. (i) mandating EOPs to obtain registration from SEBI as an intermediary under separate regulations; (ii) mandating EOPs to register with the Association of Mutual Funds in India (AMFI)and act as an agent of an AMC; or (iii) mandating EOPs to obtain a limited purpose membership with stock exchanges, whereby the EOPs shall act as the investors’ agents through formal agreements with them.

Given that the intent is to ensure investor protection, it is possible that SEBI may require EOPs to register with the AMFI and act as an agent of an AMC by entering into contracts with them. This is akin to the established process of allowing MF distributors registered with AMFI and having contracts with AMCs to act as their agents to facilitate investment. Adopting this approach ensures that there is no direct impact on investors since EOPs will only act as agents of AMCs and merely facilitate the transaction between the investors and the AMCs. Regulation of EOPs will also provide greater clarity on the fees that they may charge from AMCs, and thereby ensure easier monetisation of these platforms, allowing them to sustain and grow in the long term. Currently, most EOPs do not seem to have a sustainable business model since they do not charge fees for execution services but rely on cross selling other products to investors.

Further,SEBI has proposed allowing EOPs to provide both financial and non-financial services. EOPs carrying out other activities may be required to maintain an arm’s length relationship between their activities as EOPs and other activities(including investment advisory services) by providing execution services through a separately identifiable department or division. To ensure better investor protection, SEBI should seek to mandate disclosure of potential conflicts of interest to clients in lieu of the multiple services provided by these platforms. Also, since EOPs operate through digital/technological platforms, SEBI has proposed a mandatory prescription of requirements related to cybersecurity and other relevant parameters for EOPs. Data protection rules must be put in place to ensure protection of clients’ personal information.Sharing of client data, if any, between the EOP and other divisions of the entity should be undertaken only after obtaining the client’s explicit consent.EOPs should mandatorily have contingency procedures in place to tackle probable data leaks and loss of information.

The proposed rules, if implemented, would require EOPs to comply with the minimum net worth requirements, standards for internal organisation and operational conduct, and the ‘fit and proper criteria’ prescribed under SEBI’s regulatory framework or devised by the AMFI and stock exchanges. SEBI has further suggested setting up of a grievance redressal mechanism to entertain complaints against EOPs, the exact structure of which would depend on the approach adopted to regulate these platforms.

While SEBI has come out with the said consultation paper with a view to govern the unregulated EOPs, the regulator recently issued an order against an investment adviser who was, inter alia, allegedly providing investment advisory services and execution services to investors of direct plans of MFs. In the order, SEBI concluded that the said entity was liable for violation its Investment Advisers Regulations, 2013 since it had failed to segregate its activities as an IA from its other business activities as the same were being undertaken under a common platform.

Numerous entities are presently providing execution services in direct plans of MF schemes through their digital platforms along with other services including advisory services. Even in the event where SEBI’s proposals are implemented andan arm’s length relationship between different activities of an EOP is mandated, it is likely that most EOPs would function similarly, wherein they would provide execution services on the same platform, broadly making use of the same infrastructure, as their advisory services. Therefore, in terms of the aforementioned order, the regulator might find itself at crossroads with these platforms and their intended way of functioning.

That being said, the proposed recommendations become increasingly relevant at a time when more and more investors are availing execution services for investment into direct plans of MFs. Keeping in mind the larger goal of investor protection and given that a number of these platforms also function as investment advisers, stock brokers and portfolio managers, SEBI would have to strike a balance between investor protection and business efficiency and innovation while attempting to come up with a suitable regulatory framework.Having a legal framework in place will reduce regulatory uncertainty and give legitimacy to such technology platforms, but a light touch approval will mean adequate investor protection without damaging the low cost business model most of them employ.

(This article was first published in Financial Express)