A Trillion-Dollar Opportunity: REITs and InvITs as equity instruments

I have a piece with Purva Mandale in today’s Economic Times that re-classifying REIT (Real Estate Investment Trusts) and InvITs instruments as equity would unlock a lot of capital to be directed towards real estate infrastructure.

We highlight how such a reform can:

• Remove outdated restrictions on MF investments;
• Recognise the economic similarities between REITs/InvITs and equity shares;
• Enable global best practices like index inclusion and performance-linked returns;
• Broaden investor participation, deepen liquidity, and mobilise capital for growth.

Below is the unedited copy of the piece:

In a pivotal move set to redefine India’s capital markets, the Securities and Exchange Board of India (“SEBI”) has proposed to reclassify units of Real Estate Investment Trusts (“REITs”) and Infrastructure Investment Trusts (“InvITs”) as ‘equity’ instruments. This proposal, detailed in SEBI’s April 2025 consultation paper, holds the potential to unlock significant capital flows into India’s foundational real estate and infrastructure sectors, crucial for driving the nation’s economic growth.  

Since their launch in 2014, REITs and InvITs have steadily gained momentum in India. As of March 2024, India has 5 registered REITs and 24 InvITs, out of which a majority are listed, collectively managing substantial net assets, what started as a trickle is now a substantial number. In the financial year 2024, InvITs have raised over ₹33,000 crore – a more than five-fold increase from the previous year – and REITs mobilized close to ₹6,000 crore in investments.

Despite this evident momentum, these instruments remain considerably underutilized. REITs currently constitute only 12% of India’s listed real estate market capitalization and a mere 0.35% of the global REIT index. This stands in stark contrast to mature markets like the U.S., Australia, and the U.K., where REITs account for over 90% of listed real estate market capitalization. With India's real estate sector projected to reach $1 trillion by 2030 and infrastructure requiring a staggering $4.5 trillion in investment over the same period, the question is no longer about the potential of REITs and InvITs, but rather, how best to unleash it further as a means of development and progress.

Under SEBI’s current regulations for Mutual Funds, REITs and InvITs are categorized as ‘hybrid’ instruments. This classification imposes significant limitations on mutual fund investments, capping exposure at 10% of a scheme’s Net Asset Value and 5% per issuer, thus limiting mutual fund inflows. While these restrictions were reasonable when introduced in 2017 to manage a nascent market liquidity and concentration risks, they are arguably outdated given the current maturity and scale of these markets.

Further, the ‘hybrid’ classification limits the inclusion of REITs and InvITs in benchmark indices and discourages passive investment. Thus, these factors collectively limit liquidity and stunt price discovery. Reclassifying these instruments as equity would dismantle these barriers, more accurately reflecting their true financial nature and unlocking their full market potential.

Economically and structurally, the units of REITs and InvITs bear similarities to equity shares. These units represent a proportional beneficial interest in the trust's assets and cash flows, fundamentally differing from fixed debt obligations. Further, the absence of fixed maturity date and requirement of principal repayment supports the cause. The mandatory distribution of at least 90% of net distributable income to unitholders is directly linked to the performance of the underlying assets, mirroring the nature of dividends, which are declared from a company’s profits, rather than contractual payments akin to debt interest.

Furthermore, REIT and InvIT units are publicly listed, traded, and settled on stock exchanges, leveraging the same infrastructure as equity shares, including identical mechanisms for price discovery and trading. Unitholders possess the right to vote on crucial decisions, including asset acquisitions, borrowings, and managerial appointments, directly paralleling the governance rights of equity shareholders. On the taxation front, the Income Tax Act, 1961, already aligns the tax treatment of long-term capital gains on REIT/InvIT units with that of equities. Notably, even SEBI, when establishing the original investment caps in 2017, explicitly acknowledged these inherent equity-like traits.

International experience consistently demonstrates that the equity classification of REITs is rooted in their economic substance, not merely their legal structure. Whether organized as corporations or trusts, listed REITs in major markets like the U.S., UK, Singapore, and Australia share core characteristics with traditional equity securities. These include robust market liquidity, residual risk-bearing by unitholders, and a direct alignment of returns with performance.

These global jurisdictions have seamlessly integrated REITs into mainstream equity indices. This integration has been vital in boosting institutional participation, significantly lowering the cost of capital, and enhancing secondary market liquidity. In the U.S., for instance, REITs are fully integrated into major equity benchmarks such as the S&P 500 and the MSCI US REIT Index, enabling over 150 million Americans to invest in REITs through retirement plans and mutual funds, underscoring their mainstream acceptance. In Singapore, S-REITs constitute 10% of the SGX market capitalization. Australia’s A-REITs, embedded in the S&P/ASX 200, represent a significant portion of the global REIT market. These examples demonstrate how equity classification enhances mainstream integration, fosters greater liquidity, and boosts investor confidence. These international experiences underscore that the equity classification of REITs is driven by economic substance and their functional role within capital markets, not merely by legal form.

To propel REITs and InvITs into India’s investment mainstream, a focused set of regulatory reforms is needed. The first and most foundational step is to formally recognize REITs and InvITs as equity instruments. This reclassification would align regulatory treatment with the true economic nature of these instruments, characterised by residual ownership, market-based valuation, and performance-linked returns, and harmonize India’s approach with international standards adopted in mature REIT markets like the U.S., U.K., Singapore, and Australia.

Secondly, equity recognition would enable the inclusion of REITs and InvITs in major equity benchmarks such as the Nifty and Sensex. This is not merely a technical adjustment but a market catalyst. Index inclusion would unlock automatic inflows from passive investment vehicles, such as Exchange Traded Funds (ETFs) and index-linked mutual funds, thereby deepening liquidity, improving price discovery, and strengthening investor confidence in these instruments. These inflows will automatically incentivise more people to monetise their real assets freeing up capital for further construction of projects.

Rationalising these limits will empower mutual funds to respond to market dynamics more effectively, facilitating broader participation and accelerating capital formation in the real estate and infrastructure sectors. SEBI’s proposed reclassification is a strategic pivot poised to shape the next decade of investment in India. With a compelling economic rationale, strong global precedents, and growing investor interest, the case for formal equity classification is a reform whose time has come.

 

RBI’s New Co-Lending Directions: Balancing Growth with Guardrails

I have a piece with Aniket Singh Charan and Pragya Garg in today’s Financial Express on the new RBI law on co-lending. 

On August 06, 2025, the Reserve Bank of India notified the RBI (Co-Lending Arrangements) Directions, 2025. At first glance, the Directions appear to be incremental changes to an existing framework. But a closer look reveals that they reshape the foundation of how banks, NBFCs, and fintechs will collaborate in extending credit. The new framework widens opportunities, imposes tighter risk-sharing obligations, and sets the tone for the next phase of India’s credit ecosystem.

Co-lending emerged in India as a hybrid model combining the best of both worlds. NBFCs and fintechs, agile in origination and distribution, could reach underserved borrowers in small towns, semi-urban centres, and niche segments. Banks, with their lower cost of funds, provided the balance sheet heft to finance these loans. In theory, both parties gained, NBFCs earned fee income and continued customer engagement, while banks got exposure to segments they struggled to reach.

RBI’s first attempt to formalise this model came in 2020, restricting it largely to priority sector lending or PSL. Soon, concerns were raised with respect to higher effective borrower rates, inadequate disclosures, and NBFCs acting mainly as originators with minimal balance sheet exposure. By 2023–24, the RBI was scrutinising whether such practices were resulting in regulatory arbitrage and systemic risk.

The  Directions are the regulator’s response, an attempt to mainstream co-lending arrangements (CLA) while curbing their excesses. .To begin with, co-lending is no longer confined to PSL. Any loan, secured or unsecured, can be originated under a CLA between regulated entities, not just banks and NBFCs. This opens the gates for broader participation, including housing finance companies.

Further, each co-lender must retain at least 10% of the loan exposure on its books. This “skin in the game” requirement ensures that lenders do not offload risks entirely to their partners. Additionally, the use of default loss guarantees or DLGs, where one party promises to absorb losses up to a cap, has been restricted to 5% of loans outstanding in respect of loans under CLA. This prevents an illusion of risk transfer and guards against hidden leverage.

The Directions mandate enhanced disclosures: quarterly and annual publication of co-lending partners, weighted average interest rates, fees charged and paid, and DLG details. Escrow accounts are compulsory for all collections, and tighter Know-Your-Customer rules have been prescribed. Loan transfer timelines are also specified, reducing scope for regulatory arbitrage. The originating regulated entity must ensure that any loan under a CLA is transferred only to the designated partner RE, as per the agreement and the Key Fact Statement at the time of sanction. If such transfer cannot be completed within 15 calendar days, the loan remains on the originating RE’s books and can only be transferred to other eligible lenders as per applicable directions. Moreover, any subsequent transfer of loan exposures originated under CLA, whether to third parties or between REs, must strictly comply with applicable directions and requires mutual consent of both the originating and partner REs. Collectively, these requirements signal that the days of opaque “back-to-back” loan originations are over.

The Directions will reshape the co-lending landscape, bringing both opportunities and challenges. On the positive side, they create a new growth avenue for NBFCs by allowing co-lending across all loan categories, helping them scale beyond the narrow PSL channel. This could unlock long-term growth potential while enhancing their credibility through greater transparency. Banks, in turn, benefit by leveraging the NBFC distribution network without having to build their own last-mile reach, which could expand access to formal credit in historically underserved regions. From a systemic perspective, the RBI’s insistence on risk retention and caps on DLGs ensures that no participant can fully distance itself from loan performance, thereby reducing moral hazard and encouraging a more balanced partnership.

The framework also introduces challenges: compliance with escrow accounts, IT upgrades, and detailed reporting which will raise costs, straining smaller NBFCs and driving industry consolidation. Additional costs may be passed on to borrowers thereby undermining the goal of financial inclusion. Further, operational frictions like system coordination and stricter timelines could erode the model’s fintech-driven efficiency by slowing down disbursements. .

Thus, while the framework strengthens resilience, it risks dampening the agility that gave co-lending its edge.

Globally, co-lending or collaborative lending models have taken diverse forms. In the United States, the Federal Deposit Insurance Corporation has promoted partnerships between large banks and Minority Depository Institutions to channel funds to underserved communities. These arrangements emphasise trust, governance, and community focus, elements RBI is now embedding through mandatory disclosures.

In Europe and East Asia, big techs often collaborate with banks wherein the latter provides low-cost funding while the former contributes towards underwriting models and distribution. The Bank for International Settlements has cautioned that such partnerships disproportionately benefit fintechs unless risk-sharing is properly designed. India’s insistence on a 10% retention echoes this learning, ensuring that originators cannot offload risk entirely.

The  Directions are neither overly liberal nor excessively restrictive. They represent a calibrated attempt to harness the promise of co-lending while putting guardrails around its risks. The framework’s success will depend on its execution particularly on whether lenders invest in technology to streamline compliance, whether costs are contained, and whether transparency indeed builds trust with investors and customers.

In the near term, smaller NBFCs may face pain, and credit costs could inch higher. But over the medium term, co-lending could evolve from a niche regulatory experiment into one of India’s primary channels of credit delivery, fuelled by banks’ balance sheets and NBFCs’ last-mile reach. The challenge for all participants will be to avoid viewing the new rules as a compliance burden alone. If treated instead as an opportunity to build transparent, resilient, and scalable lending partnerships, the Directions could mark the beginning of a more balanced, more credible era of joint lending in India.

How do Indian securities regulations and market infrastructure institutions compare to the US?

I have a podcast with Hansi Mehrotra (a Zerodha initiative on investor education), where we discuss the differences in approach of US and India with respect to investor protection and market infrastructure.  

How does India’s securities regulatory framework compare with the United States? The answer lies in their differing philosophies: proactive prevention vs. reactive correction. In the U.S., markets have historically been allowed to innovate freely, with regulation catching up only after systemic issues surface—subprime mortgages and crypto are prime examples. India, by contrast, cannot afford such shocks. Its framework is designed for pre-emption, prioritising investor protection and systemic stability from the outset. At the core stands SEBI (est. 1988/1992), empowered by statute to regulate markets, protect investors, and enforce compliance. Importantly, its toolkit includes both administrative penalties and criminal proceedings.

Supporting legislation:

• SCRA, 1956 – governs stock exchange integrity.

• Depositories Act, 1996 – enabled dematerialisation, ushering in transparency and efficiency.

In the U.S., investor recourse often takes the form of class-action lawsuits. India does not rely on this mechanism. Instead, SEBI directly steps into that role, acting as the primary enforcer of investor rights. Oversight is not unchecked. The Securities Appellate Tribunal provides an independent forum to review SEBI’s orders, ensuring due process and accountability. The result: India’s markets are governed by a preventive, statute-driven framework, while the U.S. leans on market-led innovation with corrective interventions. Each reflects its own economic context.

Access the podcast on:

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A Second Scheme, or a Second Guess?: Proposals to Broaden the Categorisation of Mutual Fund Schemes

I have a piece with Manas Dhagat and Pranjal Kinjawadekar in today’s Financial Express on SEBI’s proposed changes to the mutual fund regulatory architecture. It is a mixed bag with several positive recommendations. The full piece is as below:

In 2017, the Securities and Exchange Board of India (SEBI) introduced a scheme categorisation framework that transformed the mutual fund landscape. Prior to this, mutual fund houses operated with significant discretion in naming and structuring schemes. It was common to find multiple schemes within the same fund house following near-identical investment strategies but marketed under different names. For instance, titles like “Equity Growth Fund,” “Premier Equity,” or “Opportunity Fund” often masked portfolios heavily tilted toward large-cap stocks.

For retail investors, the result was a heightened sense of confusion. Many found it difficult to differentiate between schemes or evaluate their relative performance. Without clear parameters, comparison across AMCs became a challenge, and investors were often left to navigate a cluttered and inconsistent product universe, which incentivised old wine in new bottle.

SEBI’s 2017 circular sought to address this by introducing 36 distinct scheme categories. These were grouped under five broad heads: equity, debt, hybrid, solution-oriented, and others. Each AMC was permitted to offer only one open-ended scheme per category, with certain exceptions. This measure was aimed at eliminating duplication and improving comparability for investors.

SEBI has taken a step further in its regulatory efforts. On July 18, 2025, it released a Consultation Paper proposing a new round of reforms aimed at revisiting and rationalising mutual fund categorisation, through a Draft Circular. The Draft Circular introduces structural shifts in how AMCs design, govern, and differentiate their offerings.

India’s mutual fund industry today manages over ₹70 lakh crore in assets, underpinned by strong SIP flows and growing retail participation. Over time, this has led to a proliferation of schemes, some meaningfully different, others separated largely by branding. For example, a single AMC may have simultaneously run a “Growth Opportunities Fund” and a “Top 100 Equity Fund,” both tracking similar large-cap benchmarks and holding overlapping stocks.This proliferation has complicated investor choice and clouded comparability. The Draft Circular proposes to introduce clear limits to avoid similar portfolios.

A key proposal is the cap on portfolio overlap between schemes. For certain categories, particularly Value vs Contra funds, and thematic or sectoral equity schemes, the circular proposes a maximum overlap of 50%. The impact is not just procedural. Portfolio decisions can no longer be guided purely by investment logic; they must also pass through regulatory filters. If an AMC operates both a “Value Fund” and a “Contra Fund”, the two must now remain genuinely distinct in holdings. For instance, if both funds hold large stakes in PSU banks or IT companies, that may push overlap beyond permitted levels, requiring rebalancing even when investment rationale remains intact. This may require rebalancing purely for regulatory compliance, challenging traditional portfolio management processes. If these proposals are accepted, AMCs will need systems that detect and respond to such shifts proactively.

In parallel, SEBI is proposing a series of naming conventions to enhance investor understanding. Terms like “Low Duration Fund” would be replaced with clearer alternatives such as “Ultra Short to Short Term Fund.” Duration ranges like “1–3 years” or “4–7 years” would also be reflected directly in the scheme name. Further, SEBI suggests that all references to “Fund” be replaced with “Scheme”. 

While this might seem cosmetic, it goes to the heart of investor making sense of complexity.A retail investor may mistakenly believe that an “Income Fund” offers guaranteed returns. Calling it a “Debt Scheme – 3 to 4 Year Term” conveys a more accurate picture of risk and duration. AMCs will be expected to update marketing material, distributor communication, and investor disclosures accordingly.

However, one of the most contentious provisions in the draft circular is SEBI’s proposal to allow an AMC to launch a second scheme in the same category if the existing scheme is over five years old and has an AUM exceeding ₹50,000 crore. This proposal raises certainconcerns as it may dilute the clarity the framework seeks to uphold.

Investment limits for stocks and sectors apply strictly at the scheme level, not the AMC level, to ensure funds remain “true-to-label”. Therefore, a new scheme does not expand an AMC’s investible universe. Instead, the proposal introduces a parallel product that could potentially cannibalize the original scheme, as it requires the existing scheme to be closed to fresh subscriptions upon the launch of the new one. 

This raises operational questions. Would SIPs in the existing scheme continue? What happens to systematic transfer plans (STPs)? In practice, the original scheme could be reduced to a redemption-only vehicle, with little incentive for the AMC to maintain active management. The fear is that fund houses may shift focus and resources to the newer scheme, leaving the old scheme orphaned. Such duplication may thus return in a more formalised and sanctioned form under this clause.

On the operations side, AMCs will now need to build systems not just to track performance and compliance, but to assess portfolio similarity across schemes and flag breach risks. Investment ideation and security allocation will need to incorporate overlap considerations. For example, if an AMC’s Value Fund and Contra Fund are running close to the proposed 50% portfolio overlap limit, popular stock ideas like NTPC or telecom majors may need to be allocated preferentially to only one of them. Portfolio construction will increasingly require collaboration between fund managers, compliance teams, and investment committees.

To SEBI’s credit, the draft circular also opens the door to purposeful innovation. Lifecycle Funds with goal-based tenures for retirement, housing, or education are proposed, with glide-path investing models. Sectoral debt funds, REITs, and InvIT-linked exposures are being rationalised within hybrid funds and debt funds, subject to regulatory caps. These are progressive moves that cater to portfolio diversification needs. However, innovation must not come at the cost of governance. Sectoral debt funds must not have more than 60% overlap with other schemes, and sufficient availability of investment-grade securities in the chosen sector before launch. This prevents thematic debt schemes from becoming packaging gimmicks in thin markets.

As the industry reviews the draft and submits feedback, there is hope that the final outcome upholds the spirit of reform without reopening the door to old habits in new packaging.

  

SEBI’s Push for Governance: Are MIIs Being Over-Engineered?

I have a piece in today's Financial Express on SEBI's proposed amendment to stock exchanges and other MIIs governance with Navneeta Shankar and Purva Mandale. We argue that SEBI's micro-management is not a good idea and creates a moral hazard of 'SEBI certified' combined with a power vacuum at the top as the MD's powers are sought to be curtailed and who reports to whom is also prescribed. The full pieces is as below:

India’s capital markets regulator, SEBI, is once again in the spotlight with its latest consultation paper on the governance of Market Infrastructure Institutions (MIIs), released on June 24, 2025. While the paper aims to reinforce systemic accountability and operational transparency, it has triggered a strong resistance from within the very institutions it seeks to regulate. The proposed framework is a classic instance of regulatory overreach, one that risks undermining the foundational principles of effective governance, blurring the lines of accountability, and constraining the operational flexibility essential for market resilience and innovation. It has shadows of the erstwhile regime where senior SEBI officers sat on the board of MIIs, a practice which cannot adequately be condemned.

SEBI’s efforts to enhance governance within MII are not new. From the Kania Committee in 2002 to the Bimal Jalan and R. Gandhi Committees in 2010 and 2017 respectively, and more recently the Mahalingam Committee in 2022, there has been a steady evolution of oversight frameworks. However, a growing concern is that the regulator’s posture has shifted – from enabling strong, principle-based self-governance to imposing rigid, top-down structural mandates. A similar push last year, in the November 2024 consultation paper, proposed direct SEBI involvement in the appointment and termination of key managerial personnel (KMPs) of MIIs through an external agency-led process. That proposal was met with firm opposition and ultimately not taken up by SEBI in its subsequent board meetings.

One of the most controversial proposals in SEBI’s recent consultation paper is the mandatory appointment of two Executive Directors (EDs) to separately head Vertical 1 (critical operations) and Vertical 2 (regulatory compliance, risk, and investor grievance) of the MIIs, and further, to induct both into the Governing Board, when necessary. For MIIs, this not only blurs the fundamental distinction between management and oversight, but it also risks weakening the effectiveness of Public Interest Directors (PIDs), who are statutorily tasked with protecting market integrity and public interest. More importantly, introducing parallel power centres into an operationally complex environment could lead to confusion, overlapping authority, and weakened coordination. At the heart of this resistance is the belief that a single point of executive authority, i.e., the Managing Director (MD), is essential to ensure clarity, alignment, and accountability across the institution.

Another significant concern is SEBI’s attempt to prescribe in granular detail the roles and responsibilities of the MD, EDs, and specific KMPs like the Compliance Officer, Chief Risk Officer, Chief Technology Officer, and Chief Information Security Officer. SEBI’s proposals fail to consider that these functions are already embedded within the MIIs’ internal policy frameworks, are subject to extensive Board oversight, and regularly reviewed through SEBI’s inspection and audit processes. Codifying them at the regulatory level may inadvertently create rigidity, duplicate existing obligations, and reduce the institution’s ability to adapt. Many within the industry would argue that SEBI should focus on setting broad principles and let MIIs determine how best to implement them, through Board-approved structures suited to their specific scale and operating models. This is also in line with the Mahalingam Committee’s vision, which advocated a balance between rule-based and principle-based regulation.

On the global front, this prescriptive approach appears out of sync with the prevailing international standards. The Principles for Financial Market Infrastructures (PFMI), issued by the Committee on Payment and Market Infrastructures and the Technical Committee of the International Organization of Securities Commissions (IOSCO), stress the importance of clear and transparent governance structures. Importantly, they stop short of prescribing internal hierarchies. The PFMI framework leaves room for jurisdictions to shape governance in ways that reflect local conditions, so long as the end goals of safety, efficiency, and market stability are met. In most mature jurisdictions, MIIs are regulated through outcome-based principles and not organizational templates. By contrast, SEBI’s proposals risk binding all MIIs into a one-size-fits-all framework, regardless of whether the underlying risk justifies such intervention.

Another key proposal in the consultation paper is the treatment of external directorships held by senior MII leadership. In a welcome shift from its earlier restrictive stance, SEBI now proposes to allow MDs to hold directorships in government companies and not-for-profit entities, subject to prior approval and appropriate disclosures. This marks a more balanced and pragmatic approach. While restrictions on commercial board memberships are justified to avoid conflicts of interest, a complete ban would have been unnecessarily limiting. Senior executives often contribute to such bodies in non-remunerative capacities, and their involvement can support sector-wide coordination, knowledge-sharing, and policy alignment. SEBI’s revised position acknowledges the value of such engagements, and ensures that MIIs can continue to benefit from experienced leadership without disconnecting them from the broader market ecosystem.

What is perhaps most concerning to many MIIs is that the proposed reforms could unintentionally erode the authority of the Governing Board itself. By prescribing who must occupy key management positions, who reports to whom, and who must sit on the Board, the proposals effectively constrain the Board’s ability to shape the organization’s executive structure – a power that is fundamental to good corporate governance. There is little evidence to suggest that the absence of designated executive positions has led to any governance failures within MIIs. The objective that SEBI seeks to achieve from the appointment of EDs, particularly ensuring highest priority to public interest, technology and operations, and risk and compliance, over commercial considerations, are already being discharged under the supervision of KMPs, PIDs and the Board of the MIIs. This raises questions about whether the creation of additional executive roles is necessary or justified under the existing, functioning framework.

The issue at hand is not whether MII governance can be improved – it can and should evolve with time. However, governance reform must be based on proportionality, trust, and evidence rather than an assumption that regulatory micro-management is the only way to safeguard the public interest. By preserving the MD’s executive leadership, ensuring robust Board oversight, and allowing MIIs the freedom to design their internal frameworks, SEBI can achieve its goals without sacrificing the flexibility and responsiveness that are essential in a fast-moving market environment. 

Ultimately, the regulator’s challenge lies in finding the right balance, i.e., strengthening accountability while letting the MDs run the show, the Boards to effectively govern and the MIIs to breathe without stifling their autonomy. In fact, SEBI needs to travel in the other direction, relaxing the limits to compensation (currently at 0 beyond sitting fees) for independent directors and removal of such nomenclature as ‘public interest’  directors, as if the other directors are compromised acting in self interest. 

Regulating AI in the Securities Market

 I have a piece with Parker Karia and Varun Matlani on regulation on AI in securities markets in today's Financial Express today:

In one of the first measures undertaken by a regulator in India towards regulating the use of AI, last month, SEBI issued a consultation paper, seeking feedback on its proposals to regulate the use of AI / ML in the securities market. 

Broadly speaking, and as defined in the consultation paper, AI refers to technologies that allow machines to “mimic human decisions to solve problems”. ML is a sub-set of AI, and refers to the automatic learning of rules to perform a task by analysing relevant data. 

Currently, SEBI requires market infrastructure intermediaries such as stock exchanges, clearing corporations, depositories, etc., and intermediaries such as mutual funds, to report to SEBI on AI / ML systems employed by them, thereby giving SEBI an insight into its use-cases. 

Use cases of AI 

SEBI has identified that AI / ML is being used for various purposes. For instance, stock exchanges are leveraging AI for sophisticated surveillance and pattern recognition, and brokers are deploying it for product recommendations and algorithmic order execution. Further, AI is also used for customer support. 

Based on who is creating an AI / ML system, they can be classified into two categories viz. systems that are built in-house, or sourced from a third party. In this context, it is also important to remember that AI / ML systems can be integrated with each other, as well as with present systems. Further, the capabilities of AIs are expanding rapidly, with AIs making near-accurate predictions in finance and generating model portfolios that could, in not too long from now, give a fund manager a run for his money.

Proposed regulatory framework

In a forward-looking approach, SEBI’s consultation paper proposes guidelines to be framed with five core principles, which are a model governance framework, investor protection, testing mechanisms, fairness and bias, data and cyber security.  

Importantly, SEBI has proposed that the services provided by third parties would be deemed to be provided by the concerned intermediary, and thus, be liable for any violation of securities laws. Further, SEBI has extended the applicability of investor grievance mechanism in respect of AI / ML systems as well. 

Regulatory Lite Framework 

SEBI has proposed a ‘regulatory lite framework’ seeking to segregate between AI / ML systems that have an impact on the clients, and those which are used for internal business operations. Further, even if the AI ML system is outsourced, intermediaries will be liable. The real challenge for intermediaries lies in building the sophisticated internal teams, the robust audit trails, and the technical capacity to manage AI / ML systems. In this context, it is worth considering if SEBI should revisit this approach, and borrow a leaf out of its own playbook. 

Earlier this year, in February, SEBI introduced a revised framework for safer participation of retail investors in algo trading. In view of the fact that there were several entities providing various algo strategies to customers, and the consequent risk, SEBI decided to introduce a new class of regulated entities, viz. Algo Providers. While they aren’t directly regulated by SEBI, Algo Providers would have to become agents of stock brokers and be registered and empanelled with the stock exchange(s). 

A similar approach can be evaluated in respect of AI / ML systems, and a new class of persons, i.e., ‘AI Providers’ can be introduced. While it is not necessary that SEBI directly regulates such persons, it could result in better oversight and understanding of the evolving nature of the AI industry and its nexus and impact on the securities market. Further, liability can be affixed onto the person or entity actually responsible if a AI / ML system goes wrong, specially if the intermediary had no role in the violation. The alternative, results in a cascading round of litigation, as the investor would sue the intermediary, which in turn would seek to recover losses from the third party vendor (AI Provider). While the investor grievance mechanism is proposed to be extended to AI / ML systems, introducing a new class of semi-regulated players in the securities market could have a better impact on fostering growth in a transparent and accountable manner, with appropriate oversight. 

Leveraging the Regulatory Sandbox

SEBI’s proposal includes testing requirements at the time of commencement as well as on an ongoing basis, to ensure that the AI / ML systems are working in the expected manner. In this regard, a key reform which could further propel the growth of AI / ML systems is to allow players to access the regulatory sandbox framework to test their products and systems. This would result in a heightened scrutiny of key AI / ML systems, and allow SEBI to work with emerging players in the AI industry. This would also provide SEBI with key data points, thereby aiding in evolving best practices across the board. This kind of a framework would help SEBI become a proactive regulator as opposed to reacting to technological developments, and would be the first step in transforming SEBI into a regulator whose regulatory frameworks lay down the foundation for further innovation and advancement. This method will allow the regulator to be an enabler rather than impose roadblocks to new technology.

Risks of AI in the Securities Market

The paper highlights potential dangers of AI. The regulator explicitly flags the threat of generative AI being used for market manipulation through deepfakes and misinformation, the systemic concentration risk if the industry leans too heavily on a few dominant AI Providers. The identification of concentration risk is particularly salient, as there exists a danger of unregulated technology providers becoming systemic chokepoints for the industry. Further, since there are only a handful of foundational models, the risk emerges of synthetic data loops, wherein everyone uses the same AI model, trained on the same data, which may cause risk of collusive behaviour and herding.

There is much to applaud SEBI’s proposal of a principle based regulatory-lite framework, that reflects the regulator’s intention to adapt to innovation in technology that would shape the financial markets in the future. At the same time, there are steps it can take to not only regulate, but design a  regulatory framework that is ahead of the curve and supports growth and innovation.

Finsec Law Advisors completes 15 years

 Thank you everyone for your wishes and goodwill over the past 15 years.