Curbing Merchant Bankers

I have a piece with Aniket Singh Charan and Rishabh Jain in today's Financial Express where we argue that SEBI's proposal on curbing business of merchant bankers should be re-thought through. 

The securities market plays a role akin to the nervous system and arteries for the economy, facilitating price discovery in securities and allocating funds to companies that seem most promising. To ensure that this mechanism is not disturbed by information asymmetries favouring the issuer or its insiders, and to ensure liquidity and stability during and immediately following an issue of securities, a merchant banker is engaged to ‘manage’ the issue of securities. A merchant banker essentially oversees critical aspects such as undertaking due diligence of the issuer, undertaking valuation of the issuer’s securities and preparation of the prospectus, on top of its core job of marketing securities. Further, as an underwriter, a merchant banker may buy securities that have remained unsold at the end of an issue, thus ensuring adequate subscription. On August 28, 2024, SEBI released a consultation paper proposing changes to the Securities and Exchange Board of India (Merchant Bankers) Regulations, 1992.

Many key changes pertain to the eligibility and obligations of merchant bankers. Merchant bankers are proposed to be recategorized into Category-1 (possessing a net worth not less than Rs. 50 crores, and authorized to undertake all permitted activities) and Category-2 (possessing a net worth not less than Rs. 10 crores, and authorized to undertake all permitted activities except Main Board Issues). It is unclear why non-underwriting bankers require a networth.

SEBI further proposes to introduce the concept of liquid net worth, which for Category-1 merchant bankers would be not less than  Rs. 12.5 crores and for Category-2 merchant bankers would be Rs. 2.5 crores. The maximum underwriting obligations of merchant bankers, currently at 20 times their net worth, are proposed to be reduced to 20 times the liquid net worth for a merchant banker that has maintained 35% of its net worth as liquid, or otherwise the lesser of 7 times the net worth or 20 times the liquid net worth.

Another key set of changes pertains to the activities merchant bankers may undertake. Merchant bankers have traditionally performed a variety of roles, including providing advisory services for projects and syndication of rupee term loans. Further, upon obtaining appropriate registrations, merchant bankers also act in other regulated roles pertaining to the securities market, such as dealers of government securities or stockbrokers. Additionally, merchant bankers as a class have also been specifically recognized as providers of valuation services, both by SEBI for the purposes of acquisitions and share-based employee benefits and sweat equity, and by other authorities, particularly in respect of fair market value of unquoted securities for income tax purposes and pricing of non-debt instruments under foreign exchange rules.

SEBI has now proposed to specifically define the permitted activities for merchant bankers. These would include only activities related to the securities market that are under the jurisdiction of SEBI, and would not include any activity requiring a separate registration. To this effect, a list of permitted activities is provided, although it is not clear whether list is exhaustive. Apart from managing international offering of securities, which may not necessarily fall under the jurisdiction of SEBI, a perusal of the list of permitted activities indicates an intent to confine the activities of merchant bankers to those that are specifically permitted by SEBI under the relevant regulatory framework. What is truly concerning is that an adequate rationale has not been furnished for such a restrictive approach.

Firstly, prohibiting merchant bankers from carrying on activities regulated by other financial sector authorities is not consonant with SEBI’s own approach elsewhere. For instance, in its consultation paper reviewing the regulatory framework concerning Investment Advisers and Research Analysts, dated August 06, 2024, SEBI had proposed to permit investment advisers to advise on products regulated by other financial sector authorities. Further, where other financial sector authorities, such as the Reserve Bank of India, have found merchant bankers suitable to act as dealers of government securities, it is puzzling why SEBI adopts such a restrictive stance. Particularly in the case of valuation activities, as noted by SEBI, other authorities have recognized the validity of valuation by merchant bankers. SEBI has proposed to retain the permissibility of valuation activities by merchant bankers where specified under its own regulations. It is debatable that SEBI, being at most a co-equal authority, now prohibits merchant bankers from valuation activities that may be administered by other authorities. The idea that such activities may still be undertaken through separate divisions, could have been a better alternative to outright prohibition.

Moreover, no rationale has been furnished for prohibiting merchant bankers from carrying on activities that require separate registration with SEBI, nor does there appear to be international precedent for this. In fact, activities corresponding to merchant banking in India are usually carried on by broker-dealers in the United States, recognized as one of the most mature and well-regulated markets. Therefore, SEBI’s proposals, if brought into effect, would require the merchant banking industry in India to restructure its business in ways dissimilar to both existing practice and the rest of the world, for no perceptible regulatory benefit.

Further, SEBI has proposed to cancel the registration granted to a merchant banker if it fails to earn a minimum revenue from its activities. This too is an extreme step, given that revenue from permitted activities, unlike capital adequacy, does not impact the ability of a merchant banker to carry out its obligations. Moreover, there is no international precedent for such a requirement. Indeed, such a requirement may perversely incentivize merchant bankers to procure business by inappropriate means and would entrench existing players.

Another proposal that ought to be reconsidered is the confinement of underwriting activities of merchant bankers to those specifically permitted by SEBI. This proposal appears directed at least partly at curbing the market practice of underwriting private placements of debt securities by listed entities. Yet, this proposal misses the market reality that private placements of debt securities are often the first step to their introduction on the public market, akin to an initial public offering of equity shares in respect of the usual lack of a pre-existing liquid market in them. Absent underwriting by merchant bankers to make a market in such securities, private placements may often fall through. Therefore, we believe that merchant bankers ought to be allowed to underwrite private placements of debt securities.

It is also proposed that merchant bankers not act for an issuer, if the merchant banker’s directors, key personnel, compliance officer, and their relatives, individually or in aggregate hold, more than 0.1% of the issuer's paid up share capital or nominal value of Rs. 10,00,000, whichever is lower, save through mutual funds. Given that such personnel have significant financial expertise and experience, and are likely to hold large portfolios of investments, such a requirement may unnecessarily disqualify many suitable merchant bankers. Rather, it would be sufficient to require disclosure of such shareholding as conflict of interest.

By and large, it is commendable that SEBI has updated its regulatory framework on merchant bankers in line with the changing realities of the market and the regulatory framework. However, there is much to be reconsidered in order to ensure that unduly onerous restrictions that do not serve the interests of the market are not placed on merchant bankers.

Proposed Insider Trading Framework will criminalise the innocent

I have a piece with Manas Dhagat and Pranjal Kinjawdekar in today’s Economic Times on the proposed changes on insider trading regulations. These proposals with have the disadvantage of 100% false negatives AND 100% false positives. In other words it will only catch the innocent in a quasi-criminal proceeding. In fact, the deeming provisions in insider trading regulations should be completly abandoned. Here is the full piece:

“SEBI has recently proposed amendments to the SEBI (Prohibition of Insider Trading) Regulations, 2015 ("PIT Regulations") through a consultation paper. The proposed changes pose risks, not to wrongdoers, but rather to innocent people. Under the PIT Regulations, an "insider" is someone who has access to unpublished price-sensitive information ("UPSI") or is a "connected person." The proposal expands the current law, which already criminalizes certain conduct by creating a presumption, effectively overturning the principle of "innocent until proven guilty." The PIT Regulations currently identify specific categories of individuals presumed or deemed to be connected persons to the insider, including immediate dependent relatives (such as parents, siblings, and children) and certain corporate entities, based on their connection and presumed access to such information. SEBI's proposal aims to broaden this definition by adding new categories of deemed connected persons and replacing "immediate relatives" with the broader term "relative," aligning it with the Income Tax Act. Additionally, SEBI has proposed including six new categories of individuals as connected persons, referencing the definition of "related party" under the Companies Act, 2013. The expansion includes ‘material financial relationship …for reasons of …frequent financial transactions’. This could literally be thousands of vendors of a single public company.

 

The lack of clear justification for SEBI's proposed changes, particularly the shift from "immediate relatives" to the broader term "relatives," raises significant concerns. While SEBI suggests aligning definitions with those in the Income Tax Act and the Companies Act, the consultation paper fails to adequately explain the need for such changes. In fact, the definition of relatives in the Income Tax Act is used for providing benefits to taxpayers, not for criminalizing them. The current inclusion of "immediate relatives" in the PIT Regulations was a deliberate choice, made to address the specific nuances of insider trading, which even in its limited scope often inverts justice. Broadening this scope to include all relatives, risks implicating individuals who may have no direct or material connection to sensitive information, leading to a potential increase in the number of people subject to insider trading punishment without sufficient justification.

 

Under the current framework, connected persons are presumed to possess UPSI unless they can prove otherwise. This creates a rebuttable presumption, placing the burden of proof on the accused to demonstrate their innocence. While this may be somewhat logical for individuals reasonably assumed to have access to UPSI, expanding the definition of connected persons significantly increases the number of people unjustly burdened by this presumption. The proposed changes would require individuals, who might only be related to someone with UPSI, to prove a negative—that they did not have access to or act upon insider information. This shift in the burden of proof is not only unfair but also creates a potential for significant injustice, as it effectively presumes guilt rather than innocence. While one might argue that the presumption is rebuttable, in reality, proving innocence under these circumstances is nearly impossible without a camara on everyone’s head recording every breath. How does one prove that a distant relative did not pass on information? Under the current framework, a financially independent relative who lives separately and does not seek advice on trading decisions would not be classified as a deemed connected person. However, with the proposed change to "relative," such second-degree relatives would be included solely due to their familial connection, regardless of financial independence or involvement in trading decisions.

If one assumes this is a theoretical problem, one needs to look only at caselaw. In the Balram Garg case which went all the way to the Supreme Court of India, SEBI accused a person of insider trading merely because the two were residing in the same residential complex. In fact, the two did not get along and were quarreling. In addition, even the pattern of insider trading was the opposite of what was logical (sale before good news). Yet, SEBI charged the person with insider trading. It took the Supreme Court to say: “it is only through producing cogent materials (letters, emails, witnesses, etc.) that the said communication of UPSI could be proved and not by deeming the communication to have happened owing to the alleged proximity between the parties.”. After losing, SEBI choose to file a review petition instead of reviewing its actions. With the proposed law, the parties could be deemed criminals and it would be more difficult for even the Supreme Court to defend the innocent.

 

Instead of expanding the definition and increasing the burden on individuals, it would be more prudent for SEBI to focus on enhancing its investigative capabilities. This would enable SEBI to build stronger cases based on actual evidence rather than relying on presumptions that may not hold true. The proposed regulatory changes represent a significant shift in SEBI’s approach towards addressing insider trading, with far-reaching implications. The approach indicates a tendency to shift the burden of proof onto the accused rather than carrying it themselves. While improving SEBI's investigative capacity is crucial, granting the regulator unchecked power to label individuals as "connected persons" without concrete evidence risks regulatory overreach. It would not be an exaggeration to say that the new law would be the first which has a possible 100% false positives and 100% false negatives. How many criminally minded would trade through their uncles? The proposed law is designed to indict the innocent and perhaps the not very smart criminal (presumably a small class). In 1769 William Blackstone said that “the law holds that it is better that 10 guilty persons escape, than that 1 innocent suffer”. The proposed law would free the 1 guilty to use their artifice and imprison the 10 innocent. The proposal should be abandoned and even the current law on presumption needs to be rationalised.”

 

 

Striking the Balance: Salt and spice for investors

I have a piece with Navneeta Shankar in today’s Financial Express on the new Alt-Fund proposed by SEBI. It’s a good idea to permit a new category which allows higher risk taking than a classic mutual fund. The full piece is as below:

The current investment landscape in India is designed to cater to various investor categories. Retail investors typically have access to mutual fund schemes with a low entry point, while high net-worth individuals (HNIs) and institutional investors can opt for Portfolio Management Services (PMS) with a minimum investment of INR 50 lakhs and Alternative Investment Funds (AIFs) with a minimum investment value of Rs 1 crore. However, there exists a notable gap for retail investors who wish to invest, say, Rs. 20 lakhs in direct equityand who want to take a much higher risk. 

To address this issue, the Securities and Exchange Board of India (SEBI) issued a consultation Paper dated July 16, 2024, proposing a new asset class that will permit Asset Management Companies (AMCs) to offer new sets of investment products, including investment in derivatives or derivative strategies, to Indian investors. The proposed semi-alternate asset (Salt Asset class) is aimed at bridging this gap between mutual funds and PMS and is envisaged to provide investors with a regulated investment product with higher risk-taking capabilities.

In the absence of a favourable regulatory architecture, retail investors were becoming vulnerable to falling for unregistered and unauthorized investment products, which often promise unrealistically high returns and exploit the investors’ expectations for better yields.  The Salt Asset, with a return risk-profile positioned between mutual funds and PMS, is intended to provide investors with a secure and regulated option. This new class would serve as a customized investment product offering greater flexibility, higher risk-taking capability and a higher ticket size, catering specifically to this emerging category of investors. 

SEBI has proposed for this to operate under the mutual fund structure but with relaxed prudential norms. In order to enable existing and newly registered mutual funds/ AMCs to offer products, SEBI has proposed two routes of eligibility criteria. Existing mutual funds would be required to demonstrate a strong track record by being in operation for at least three years with an average Assets Under Management (AUM) of Rs. 10,000 crores over preceding three years, and no regulatory actions in the previous three years. For newly registered mutual funds or existing ones that are unable to show strong track record, requiring experienced fund manager and chief investment officer with demonstrable experience, and no regulatory actions against the sponsor/AMC in the last three years.

Since the products offered under the Salt Asset Class will be relatively riskier than the schemes offered by traditional mutual funds, there is a need to maintain a clear distinction between the branding of products under the Salt Asset and those under the traditional mutual funds. To achieve this, SEBI has proposed that the Salt Asset be branded and advertised as a product distinct from the traditional mutual funds. This, in SEBI’s view, will ensure that any potential misconduct/ failure in the performance does not negatively impact the confidence of retail investors in traditional mutual funds.  

Under the proposal, AMCs can offer ‘Investment Strategies’ with flexible redemption frequencies tailored to the nature of investments, allowing investment managers to adequately manage liquidity without imposing undue constraints on the investors. Importantly, no investment strategy under the Salt Asset class may be launched by an AMC unless the same is specified by SEBI and approved by the trustees, subject to final observations on the offer documents by SEBI. 

SEBI has proposed a minimum investment amount of Rs. 10 lakhs per investor, across one or more Investment Strategies under the Salt-y Assets offered by an AMC. This threshold, in SEBI’s view, will deter retail investors from investing in this product, while attracting investors with investible funds between Rs. 10 lakhs – Rs. 50 lakhs who are being drawn to unregistered PMS providers and those who perhaps cannot commit to an investment in an alternative investment fund (AIF) which requires a commitment of Rs. 1 crore per investment. 

It has also been proposed that all investments permissible to mutual funds under the current regulatory framework will also be available for the Salt Asset. Additionally, it will be permitted to take exposure in derivatives for purposes other than hedging and portfolio rebalancing to allow more flexibility and risk-taking in investments. Investors will also be given the option of systematic plans, including withdrawals and transfers, for investment strategies, though at no point in time the total invested amount of an investor should fall below Rs. 10 lakhs for reasons other than depletion in the value of the investments. 

SEBI’s proposal is a significant step towards democratizing the securities market and makingit more accessible to average Indians. With the proliferation of ‘finfluencers’ and the consequent rise in misinformation in the investment advisory space, the proposed Salt Assetoffers new avenues specifically for this emerging category of investors, who are likely to be propelled towards unregistered and unauthorized investment schemes while seeking flexibility in portfolio construction along with higher risks and returns. The initiative also paves the way for adopting thematic investment strategies like electric vehicles, water management, recycling, and renewable energy. The Salt Asset is likely to attract both the mass affluent and high net-worth individual investors by offering them new avenues for investment in emerging sectors. 

A Salt Asset coupled with the convenience provided by regulated mutual fund platforms will not only facilitate ease of investment but will also promote the concept of domestic mutual fund participation in sophisticated investment strategies, including in long-short equity and inverse ETF. That being said, SEBI is encouraged to not restrict the proposed investment product to only AMCs but consider permitting other registered intermediaries to offer products under the Salt Asset as well. Alternatively, SEBI may consider creating an altogether new category of a registered intermediary to provide this investment option, which could be regulated by a separate set of rules with much less compliance burden and restrictions than those on mutual funds/AMCs.

SEBI's introduction of Salt Assets reflects its commitment to fostering innovation and growth in the Indian financial markets, while also weening investors off spicier unregulated productsor unregulated offerings. While the success of this initiative remains to be seen, it promises to create a dynamic and inclusive financial market. This move will offer diverse investment opportunities, catering to the varied needs of Indian investors and contributing to the development of a more robust and resilient financial ecosystem. Similar to Mini-Reitsintroduced by SEBI, this move will bring in players and investors outside the margins of the securities market into a formal, regulated sphere of predictability and regulatory comfort.

New Delisting regulations of SEBI, 2024 - an important reform

I have a piece with Rashmi Birmole and Manas Dhagat in today's Financial Express on the newly introduced delisting regulations introduced by SEBI (not yet notified). These are long over-due and bring a 'right to exit' the public markets back into the Indian markets. Indian markets have long got the moniker of Hotel California - after the song, to mean that it's easy to list in India, nearly impossible to delist. Finally, reforms have arrived, which should not just make exits easier but also encourage more people to enter the markets. After all, how many would enter a room if the leaving the room were made into a maze? The full piece is produced below:  

Going public and getting listed on an exchange is, for the most part, considered a significant milestone for a company. However, due to factors beyond its control, such as sparse trading volumes or a minimum public float, a listed company may find itself at a crossroads, deciding whether to remain listed when the benefits of continued listing no longer justify the costs associated with being publicly traded. A company may also delist for strategic reasons, to do things which would not be possible with millions of shareholders to take care of. A reasonable next step is to pursue delisting, which is also an essential step in ‘take-private’ transactions. Since delisting is a crucial element in the mosaic of processes that shape the capital markets, it’s only logical that the mechanism by which a company can exit the public markets should be as efficient as other processes. However, instances of delisting in India are rather uncommon, so much so that the process is largely considered a hit and miss. Often what holds up the delisting is a small group of people who try to negotiate a price several times higher than the fair price. The resulting failure causes loss both to the company and the vast majority of shareholders.

On this precise issue, SEBI, in August 2023, proposed a review of the voluntary delisting norms under the SEBI (Delisting of Equity Shares) Regulations, 2021, to refine the delisting process and tackle hurdles faced by listed companies while exiting public markets, which included the introduction of fixed price mechanism as an alternate pricing method. SEBI, in the recent board meeting held on June 27, 2024, has approved these proposals, marking a pivotal moment in the evolution of the delisting framework.  Some of the noteworthy proposals related to eligibility thresholds for the counter-offer mechanism, use of the adjusted book value in determining the floor price and the setting of a reference date.

The delisting framework provided for the reverse book building process as the (nearly) sole price determination mechanism for voluntary delisting. In what has been hailed as a much-awaited move, SEBI has approved the introduction of a fixed price mechanism as an alternative to the reverse book building mechanism. The fixed price offered by an acquirer must include at least a 15% premium over the floor price and can only be availed for delisting of companies whose shares are frequently traded. The fixed price mechanism was proposed to allay concerns regarding the inherent price uncertainty associated with the reverse book building mechanism and the resultant increase in volatility and speculative activities in the scrip of the company. The proposal was premised on empowering shareholders to decide upfront whether to tender their shares at the given price and provide a transparent pricing strategy that is easily understood by all stakeholders.

The stringent conditions for making a counter-offer under the current delisting framework have often led to failed delisting attempts, even when a majority of shareholders are in favor. Acquirers are only eligible to make a counter-offer, if their post-offer shareholding amounts to 90% of the company’s total issued shares. It was noted that the high threshold deprived acquirers of the opportunity to make a counter-offer, even if a few shareholders who collectively hold major shareholding chose against bidding, while a majority of the shareholders favoured the proposal. SEBI proposed to lower the threshold for making a counter-offer to provide acquirers with more flexibility and increase the likelihood of successful delisting offers. The counter-offer price was proposed to be computed based on the volume-weighted average price (VWAP) of the shares tendered in the reverse book-building process or the initial floor price, whichever is higher. This approach was aimed at ensuring that the counter-offer reflects the general expectations of the shareholders. SEBI approved the proposal to lower the threshold to 75% in the case of delisting through the reverse book-building process, provided at least 50% of public shareholding is tendered. The lower threshold is designed to provide more flexibility in negotiating a price that is acceptable to both the acquirer and the public shareholders. However, pursuant to a counter-offer, the 90% threshold would still have to be met for the delisting to succeed.

Similarly, the determination of the floor price has also been a contentious issue, often resulting in disputes over fair valuation. SEBI had proposed that the adjusted book value be considered an additional parameter for determining the floor price. This metric considers the fair market value of the company's assets, ensuring that the floor price accurately reflects the intrinsic value of the shares. SEBI has approved this added parameter for both frequently and infrequently traded shares, with the exception of public sector undertakings (PSUs). 

The floor price is calculated based on a reference date, which was the date on which the exchanges are required to be notified of the board meeting in which the delisting proposal was approved. In its proposals, SEBI emphasized the importance of a clearly defined reference date for calculating the floor price to ensure consistency and fairness in the valuation process. The proposal was based on SEBI’s observation that the interval between the public announcement of the delisting proposal by the acquirer or prior intimation to exchanges in promoter-led delisting, and the date on which exchanges are notified, carried the risk of abnormal trading activity which may disturb the calculation of the floor price. To tackle this issue, SEBI proposed to calculate the floor price as on the date when information related to the proposed delisting is publicly disclosed for the first time, or based on an ‘undisturbed price’. Accordingly, SEBI has approved the modification of the reference date from the date of board approval to the date of the initial public announcement for voluntary delisting.

The changes approved by SEBI represent a significant enhancement in the delisting process. By incorporating a fixed price mechanism and lowering the counter-offer threshold, SEBI has addressed key issues that have historically hindered successful delisting. These modifications aim to reduce speculative trading activities, thus preserving the integrity of the delisting process and minimizing adverse influences. The updated methodologies for calculating the floor price and counter-offer price are particularly notable. The adjusted book value ensures the floor price is based on the actual value of the company's assets, ensuring shareholders receive a fair and reasonable exit and are not shortchanged. While specific amendments or circulars in relation to the above are yet to be notified, in summary, SEBI’s decision to streamline the process is expected to address the fault lines which have been exposed through past delisting attempts, without influencing the outcome, which ultimately depends on the shareholders and the company. By aligning the delisting process with market realities and investor expectations, SEBI’s reforms are poised to enhance market efficiency and foster a more robust investment environment in India. One is more likely to go to a movie theatre or a hotel in california where the exit door is not too small when one wants to leave. Similarly, easier exit is, counter-intuitively likely to make IPOs more common.

Regulations need a roadmap

I have a piece in today’s Financial Express with Parker Karia and Aniket Charan on the way forward for regulators to co-operate, not just for enforcement but also for development, not just within the financial sector, but across commercial, corporate and financial worlds. 

Over the last two to three decades, India has moved towards a multi-sectoral regulatory regime to handle the multitude of sector-specific issues. Today, we have the RBI, SEBI, CCI, IBBI, TRAI, IRDAI, PFRDA, CERC, and so many more, each of whom deal with the economic or industrial sector they are entrusted to regulate. Soon, India will have a regulator for data protection and privacy. Based on the nature, size, and business activities of a company, it interacts with one or more of these regulators. Naturally then, the company must structure its businesses, corporate governance, internal policies, practices, and procedures, etc. to ensure that it keeps all the concerned regulators satisfied. While this in itself has the potential for regulatory conflict, the real conflict starts to appear when someone wants to undertake an activity that requires the approval of more than one regulator.

An example helps explain this better. Consider a proposal of merger of conglomerates ‘A Ltd.’ and ‘B Ltd.’. Assume that they are in the business of providing, through their various listed and/or unlisted subsidiaries, banking, and financial services, including broking services and telecom services. This merger would then attract the scrutiny of the RBI, TRAI, CCI and SEBI. Each of these regulators would naturally be concerned with how the merger would be relevant to their field of regulation. For instance, the RBI would be primarily and broadly concerned with financial stability, impact on the (i) banking sector, (ii) depositors and borrowers, (iii)  banking operations, and customer protection. On the other hand, TRAI would be concerned with the impact on the telecom sector, and SEBI would examine the merger from the perspective of the effect on the broking arms of the merging entities and the interest of shareholders of the listed entities. The CCI would inter alia rule on the effect on competition in the relevant sectors, such as banking, financial services, telecom, etc, and whether any adverse effects on competition are there, and whether they are outweighed by the benefit to consumers, if any. In fact, regulators such as the RBI and TRAI, while examining the impact on their sectors, would have to take into consideration the impact on competition in those sectors. Based on the findings of each regulator, the companies would have to chart out their next steps. In some instances, what one regulator signs off on, is refused by the other, or the impact of the directions of one regulator are in conflict with another’s. To elucidate, the RBI may prioritise financial stability and risk management, arguing in favour of consolidation, as opposed to the CCI’s concerns on reduced competition, leading to higher consumer costs. On the other hand, jurisdictional conflicts may arise as well. Determination of which regulator has primary authority could lead to disputes and delays. All of this of course, does not even consider the application that would have to be made to the NCLT. Practically, it is a regulatory nightmare for a business to navigate.

Further, such regulatory tussles are not exclusive to corporate arrangements such as mergers, acquisitions, etc. It could very well apply to the launch of a particular product or service that has features regulated by more than one regulator. In the ever-evolving industry of financial services and cross-linking and tying of products and services, such a situation is no longer in the fictional realm. Diverse businesses being operated under one conglomerate with listed entities within it is also not unprecedented. Of course, this does not go to say that the due process is unwarranted, or not necessary. Assessing the consequences of an arrangement between entities that have an effect on the sector that is regulated is one of the functions of a vigilant regulator. But there remains significant room for improvement in harmonising the manner in which such assessment is carried out in instances where more than one regulator is required to apply its mind and issue necessary directions.

Regulatory conflict is not something that happens on a routine basis. But just because it isn’t frequent, does not mean it’s not necessary to address the issue. Further, each regulator would stand by its decision, as it is required to look at only the universe that falls under its regulatory purview. As stated above, each regulator has a specific mandate, which may not always align with the mandate of another, thereby giving rise to regulatory conflict, cause unusual second order impact on a company and invariably result in delays and pointless bureaucracy. It can get intractable when two regulators insist, probably rightly so, on following their respective statutes or regulations, causing an impossible impasse of the unmovable meeting the unstoppable.  

While regulators do liaise with each other, there exists no formal mechanism for regulators to act in cohesion. While Indian courts may not have tested the various issues that arise or may arise out of regulatory conflict yet, the prevailing judicial view in case two regulators having overlapping jurisdictions is that if a specialised regulator for the sector exists, it will take precedence over the general regulator, as was the case when the SC held the TRAI would have jurisdiction over the CCI while examining competition issues surrounding Reliance’s Jio.

Currently, the models that exist to tackle regulatory conflicts are (i) granting explicit and exclusive jurisdiction to regulators to remove ambiguity; (ii) regulators working jointly towards arriving at a decision by consulting each other; and (iii) mandatory consultation between regulators.

In the Indian context, the third approach seems to be appropriate. A standing committee, comprising of members nominated from each regulator, or the concerned ministry which supervises the regulator, could be created. The leadership of such committee could be on a rotational basis, and the members of such committee could perform a dual role, coming together when required to decide on an application. The decision of such committee, arrived at through a mandatory consultation among all regulators concerned with a particular arrangement or any matter that requires their consideration and/or approval, could be binding on all regulators. This results in a holistic view being taken, and a reasoned decision, even if it involves compromises on part of all parties involved. It serves as a single stop shop for businesses and would go a long way to ease the regulatory burden on such businesses. A forum does exist for discussing inter-regulatory issues in finance, but the Financial Sector Development Committee has had limited success till now on the ground. In fact, such an approach could be considered for enforcement purposes as well, wherein multiple regulators can act together as one, which will save time and costs on the regulator’s end as well as for the businesses. Indeed, the past few months have seen increasing cooperation between SEBI and RBI on enforcement.

 Laying the roadmap for companies and regulators to work with each other in an efficient manner is essential to ensure stable growth. In a growing economy such as India’s, where these issues are only starting to appear, we must take steps at this opportune moment to prevent irreparable harm or to avoid costly solutions later, and adopt a whole-of-government approach rather than working in silos.

Securing securities: Sebi’s steps are a paradigm shift with enhanced focus on clearing corporations

Under the current framework for settling a client’s buy transaction, the clearing corporation credits the securities to the broker’s pool demat account, after which the broker transfers them to the respective client’s demat account.

I have a piece with Manas Dhagat and Shivaang Maheshwari on SEBI's proposal to make direct payout of securities accounts without passing through the broker. The risks of a broker's negligence and given some past cases, even crooked behaviour, this will be a great step forward for both the efficiency, speed and safety of payment systems in the securities markets clearance and settlement. The full piece is as below:

 SEBI, in a recent consultation paper, has proposed to mandate direct payout of securities to clients’ demat account without any involvement of the stock broker’s pool account. Under the current framework for settling a client’s buy transaction, the clearing corporation credits the securities to the broker’s pool demat account, after which the broker transfers them to the respective client’s demat account. While the mechanism of direct payout of securities to clients was envisaged way back in 2001, the consultation paper has now proposed making it mandatory for all transactions with the objective of enhancing operational efficiency and reducing the risk to clients’ securities. 

The process would involve a clearing corporation or a clearing house reaching out to each clearing member (usually the stock broker) to obtain the beneficiary account details of the clients who are scheduled to receive a payout of securities. Once these details are obtained, the clearing member would send a payout instruction to the depositories, directing the credit of securities directly in the client’s demat account without any involvement of a broker’s pool account. The consultation paper also proposes that clearing corporations introduce a mechanism for clearing members to identify unpaid securities (i.e., securities that have not been paid for in full by the clients) or funded stocks under the margin trading facility, to provide clarity to stock brokers regarding the status of securities, ensuring they have up-to-date information on unpaid and funded stocks. 

The current process involves multiple entries, tracking, and reconciliation efforts on part of the stock broker while transferring securities from its pool account to the client’s demat account. With the direct credit of securities to the client’s demat account, the intermediary step of transferring from the pool account is eliminated, which significantly reduced the complexity of the brokers’ operational workflow. Handling transfers from the pool account to individual client accounts can be prone to discrepancies or potentially fraudulent activities by stock brokers. A number of cases have also been observed wherein the brokers were involved in misuse of clients’ securities kept in the pool account. Direct credit of securities reduces the touchpoints and hence the opportunities for errors and fraud, leading to more secure and accurate transactions. Additionally, brokers need robust IT systems to manage the complexities of transferring securities from pool accounts to individual client accounts, including handling exceptions and resolving issues. With a more straightforward process, the IT infrastructure can be simplified as well. Systems can be optimized for direct credit operations, reducing the need for complex transfer mechanisms and the associated support and maintenance.

This is not the first time SEBI has acted upon protecting an investor’s interest from a potential default by a stock broker. Last year, with a view to prevent misuse of clients’ funds, SEBI introduced a process for trading in the secondary market based on blocked funds in a client’s bank account. Under this process, funds would remain in the bank account of the client but will be blocked in favour of the clearing corporation, which will only be debited towards obligations arising out of the trading activity of the client. Thus, instead of transferring the funds upfront to the broker, funds are blocked in the bank account of the client itself, ensuring enhanced protection of cash collateral and preventing the misuse of clients’ funds by the broker. Similarly, the application supported by blocked amount (ASBA) method has been provided for retail individual investors for applying in an IPO. Under this process, funds are blocked in the bank account of the investor till the finalization of allotment, post which the amount equivalent to allotted shares would be debited or, in cases of no allotment or partial allotment, the balance amount will be unblocked.

A similar block mechanism has also been prescribed for undertaking sale of securities wherein clients’ securities lying in the demat account of a client are blocked in favour of the clearing corporation till such time a sell order is executed. If the sale transaction is not executed, securities would continue to remain in the client’s demat account and will be unblocked. This mechanism was introduced to do away with the movement of shares from client’s demat account for early pay-in and back to client’s demat account if the trade is not executed.

These steps taken by SEBI indicate a paradigm shift with less reliance on the broker for handling the securities and funds of its client and an enhanced focus on the clearing corporations to ensure smooth and transparent settlement processes. The direct crediting of securities to clients’ demat accounts represents a significant move towards increased market integrity and investor protection. Clearing corporations will now take on a more central role in the settlement ecosystem, overseeing the direct transfer of securities and ensuring that all transactions are accurately and efficiently processed. Clearing corporations will need to develop and implement robust systems to manage this increased responsibility. This includes upgrading technology to support real-time processing and direct crediting of securities, enhancing risk management frameworks to address any new risks associated with direct transfers and working closely with depositories to ensure seamless integration and synchronization of data, ensuring accurate and timely settlement.

Regulating AI in the securities markets

 I have a piece in today's Financial Express with Parker Karia on the impact of AI (artificial intelligence) on securities markets. The full piece is as follows:

Fast on the heels of development of AI, which has already resulted in transformations across various industries and professions, the European Union is the first jurisdiction to introduce legislation that regulates AI. Broadly, those AIs which pose an unacceptable risk would be prohibited, whereas minimal risk AI systems are unregulated. The former category would include AIs that affect people’s rights, biometric categorisation systems, scraping of facial images from sources to create a facial recognition database, social scoring, predictive policing, or such AI that manipulates human behaviour or exploits people’s vulnerabilities. Additionally, the EU’s AI Act establishes the EU AI Authority, which will be the nodal agency for implementation and enforcement of the AI Act, which, like the GDPR, has an element of extraterritorial jurisdiction.

What is actually regulated is AIs that fall into neither unacceptable risk, nor the minimal risk category. These are high-risk and limited risk AI systems. High-risk AI systems pose a threat as its uses include deployment in critical infrastructure, education, essential services, law enforcement, dispensation of justice, governance, etc. Such systems would inter alia be required to register with the relevant EU database, assess and mitigate risks, ensure transparency and accuracy, and more importantly, ensure human oversight. Moreover, people would have a right to submit complaints about AI systems and would be entitled to explanations about decisions in relation to high-risk AI systems that affects the right of the aggrieved person. Non-compliances with the AI Act will attract fines ranging from €7.5 million or 1.5 percent of revenue, up to €35 million or 7 percent of global revenue, depending on the violation and the entity.

GPAI

General-purpose AI systems, such as ChatGPT, Gemini, etc., would face new transparency requirements. Such software, including those that create manipulated images such as “deepfakes” would have to make clear that what people were seeing was generated by AI.

AI and the Securities Market

The securities market will not be, or rather, is not an exception to the infiltration of AI. Although recent breakthroughs have been largely in the space of generative AI, gigantic steps are being taken to equip AI with further abilities, as well as expand the data the AI has access to

To put the timeline and development in perspective, till three decades ago, activities related to trading in the securities market, such as research, placement of orders, etc., hardly incorporated technology. The focus on use of technology began with some seriousness upon the introduction of dematerialized shares. From then, to today, India has taken the lead in introducing a ‘T + 0’ settlement cycle. Today, any step or activity relating to trading in the securities market, cannot be imagined without the use of technology. Now, with the introduction of AI, the securities market is set to witness another transformation. Today, AI can analyze vast amounts of data, identify patterns, and make informed decisions in real-time, execute orders at lightning speed, create investment strategies by itself, etc., as a result of which, the manner in which trading is conducted, risk is managed, and investments are made, are rapidly evolving. One of the pertinent concerns in this regard would be around data privacy.

As AI and AI-generated algorithms permeate various sectors, including the securities market, regulators face the challenge of crafting laws that govern these technologies effectively. In the following paragraphs, AI’s impact on the securities market and its regulation, are discussed.

Algo Trading & Robo Advisory

Currently, algo trading is defined as trading carried out through automated means, i.e., order are placed without any human intervention. Recent suggestions by SEBI to regulate algo trading have received mixed reviews, while majority views agree with the need for regulating algo trading, SEBI’s approach towards meeting that end has been the subject of some criticism. It would also be required to be borne in mind that AI can effectively write codes based on instructions fed to it. Thus, creating an algo, in the near future, may not be the exclusive domain of a trained professional in the field of IT systems. In a situation where the deployment of an AI created algo results in a violation of securities laws, the question that arises out of this is on the extent of culpability to be fastened on the person who used AI to create the algo. The principle that the developer of an AI, or the human behind the ‘machine’ is responsible, exists, however, with the advancements in AI, which are unpredictable at this stage, the above principle may have to be revisited. As AI changes the landscape around us, our laws must keep pace to ensure that rights and obligations of the concerned parties are laid down in advance.

Additionally, robo advisory is presumably going to take the center-stage in the distant future. For instance, with the vast amounts of data points analysed in a few moments and investment strategies being created in seconds instead of weeks, it is not too far-fetched to presume a considerable shift in the manner in which investment advisory service is carried out today, which may warrant a revisit to the extant regulatory framework requiring both strengthening and rationalisation of regulations. Strengthening for the reasons described above, and rationalising because some of the restrictions may no longer be relevant with AI generated work product.

Grievance Redressal and Enforcement

AI may eventually be used for dispensation of justice by appropriately (and safely) integrating it in our judicial systems. In fact, it was recently suggested that AI may be used to resolve minor traffic challans, to begin with, upon adequately building up such capability. Similarly, the securities regulator may consider initiating the process to develop AI that can effectively monitor, supervise and assist in the enforcement of securities laws.

Additionally, with the recent focus on online alternative dispute resolution mechanisms for resolution of disputes in the securities market, minor issues, depending on the complexity, quantum of money/ assets and the nature of the dispute, AI can serve as an arbiter or mediator.

Pattern recognition and Predictive Analysis

In a potential game-changer for regulators, developing AI models are becoming increasingly efficient at recognizing patterns, and thus predicting the ‘future’, depending on the data points that the AI has access to, and how it is ‘coded’ to ‘think’. While algos are already deployed by financial sector regulators around the world to identify and/or track suspicious activity, AI can be of immeasurable assistance in this regard. For instance, SEBI has in the recent past issued circulars introducing the use of blockchain to verify information, and to ensure transparency amongst intermediaries and entities. The integration of AI in such systems can lead to predicting any defaults, or preventing violations, thus safeguarding investor interest. However, any such technology should be used with caution, and strict safeguards should be built around such systems to prevent any misuse.

To conclude, while the adoption of AI in the securities market would lead to increased efficiency, reduced costs, and enhanced decision-making capabilities for market participants, it raises significant concerns regarding market manipulation, algorithmic biases, data privacy and systemic risks, which warrants regulatory scrutiny and the need for comprehensive legal frameworks to address the issues emanating out of using AI. As AI continues to evolve and reshape the landscape of securities trading, regulatory authorities must remain vigilant, adaptive, and forward-thinking in their approach, and strike a balance between innovation and regulation, thereby navigating the complexities arising out of the intersection of AI and securities market. While this piece has focused more on the challenges posed, overwhelmingly, the use of AI will be a force for good, bringing speed, productivity, innovation and removal of human errors and biases. Thus, it would be better to delay introducing too many regulations till the dust has settled on the field.