Investment Advisor Circular - lesson on way to draft a new circular

I have a piece in today's Economic Times where I argue that an innocuous circular, though well meaning will have huge adverse impact on investment advisors, a relatively new profession. I also argue that second order thinking and predicting unintended consequences is difficult for a small set of regulators, and before introducing any new law, it is good practice to put out a draft law for public comments. Below is the full article:

SEBI came out with an innocuous circular a few days back imposing some well-meaning reforms in investment advisor regulations. The circular is a good example of why a regulator should always expose any changes in the law with a proposal before making it final. There may be a few rare exceptions where it is important not to do so. For instance, where a new law would create massive lobbying efforts, it may be best to keep it as a surprise. Even then, public feedback should be accepted post publication. But in almost all other cases, the discipline of checking with the market would reduce both unintentional error and allow second order thinking.

The short two-page circular sounds so well intentioned. But the piece is an important message to the regulator about how to draft a new law and how a few words written without good process can have a seriously adverse impact on the industry.

The circular makes five changes to the law governing ‘investment advisors’. To recall, investment advisors are a new breed of professionals recognised less than a decade back. They are a subcategory of what was earlier captured under the portfolio manager regulations. Their work was seen as a contrast to distributors. While distributors pushed products as sales agents of manufacturers like mutual funds, investment advisors were seen as a agent of the investor. Thus, advisors can take no money from the mutual fund and are fiduciaries of the investor providing a low conflict model.

The five changes are, firstly, no free trial for services of advice. Second, that no part payment should be accepted from the client. Third, that service should be provided only after risk profiling i.e. not give advice without knowing the client’s risk tolerance. This profiling should be followed by a consent obtained through a registered email or physical document. Fourth, barring cash deposits and payment through payment gateways, while allowing only cheques/NEFT/RTGS/IMPS/UPI, as the latter category provides audit trails. Fifth, display of details of investor complaints on the advisor’s website. The circular is effective immediately.

It’s hard to quarrel with what are obviously reforms, but here is the list of problems these will generate on second order thinking. Regarding the first point, the mischief sought to be cured is that people are given free trial runs without doing an assessment of the investor’s profiling or measuring her risk appetite. A trial run is a great way for the investor to assess the quality of the advisor and thus banning it is counter-productive. To address the mischief, what ought to have been done was to say that trials cannot be offered without a full risk assessment. Barring a trial is a self-goal in investor protection and solves the mischief sought to be cured by going to the original cause rather than to the mischief. It’s a bit lit the movie terminator, going to the past to eliminate the then future president.

Similarly, not accepting part payment is prescribed, perhaps to avoid charging clients on the front side. But this is contrary to practice in nearly every profession. Few lawyers will charge fees only at the end of say a year, and few clients will agree to pay 100% upfront. It will also have the unintended consequence of the advisor charging the full annual fee upfront, thus disrupting the business model, which is already quite precarious. Clients would also end up being upset.

On the third prescription, seeking consent through email or physical form will drag the industry backward technologically. Today many if not most financial relationships start online without any email exchanged or paper being signed. With KYC happening across industries (not just within the securities industry), even the last vestige of paper will be eliminated early this decade. The rule will create pointless disruption for robo advisors, which offer a low cost and automated advice to clients, as they usually sign up clients online and complete their assessment in a few hundred rupees. Imagine if the law was to extend to Google or Microsoft software. Modern financial transactions like software purchase is done through click-through. In software, even the once dominant cling-wrap contracts, where unwrapping the clingy polythene was deemed to conclude the contract, have become obsolete.

The fourth mandate is somewhat strange. It seems to bar payment gateways, even banking ones or wallets like Paytm. It bars credit cards and debit cards and a host of highly regulated systems of payments with as good an audit trail as possible. This will be completely pointless disruption, besides being anti-competitive. This should be immediately revoked and if cash is the stated enemy, that alone should be barred.

Finally, asking the advisor to disclose investor complaints on their website may appear fair, but there is no requirement to have a website for advisors. This will be a whole new set of cost for small and rural oriented advisors who are not equipped to set up a website. SEBI should offer to host the information on their own site for such advisors.

Overall, while more regulations may appear to be fair, applying them across the board act as entry barriers and elitify what ought to be a grass roots profession. The regulator needs to adopt both cost-benefit analysis as also put up draft of circulars before implementing them. This is not just best practice, but also minimally good practice as can be seen from this circular and its effects.