Suyash Sharma and I have a piece in today's Financial Express linked here on SEBI's proposed performance validation process of investment advisors and RAs by an external agency. While useful, it would impose substantial costs on an already over-regulated arena:
In a bid to bolster the credibility of
various market players and protect investor interests, SEBI issued a
consultation paper to establish a ‘Performance Validation Agency’ (“PVA”).
The proposal comes in the backdrop of an increased demand by market players
including research analysts and investment advisers to advertise their
performance claims. An investor’s choice of an investment adviser is largely
dependent on the past performance capabilities demonstrated by the latter.
Therefore, from a business perspective, it is necessary for such investment
advisers to be able to showcase their performance to attract clients.
Presently, the regulations governing different intermediaries have imposed
varying restrictions in terms of what such intermediaries can advertise.
Entities like asset management companies and portfolio managers are permitted
to report their self-verified performance vis-à-vis certain benchmarks while stockbrokers,
IAs and RAs are not permitted to make any reference to past performances as per
the relevant advertisement codes. Thus, there is a lacuna in the market which
prevents intermediaries from showcasing their performances and thus prevents
them from advertising their services.
On the other hand, the regulator has also
noted an increase in untrue performance claims being made by various
intermediaries, notably in the form of doctored P&L statements on twitter
(X) and other social media platforms. These claims are mostly self-verified
which makes it easy to manipulate and mislead investors for the sake of
attracting clients. Thus, the proposed PVA has been devised by SEBI to serve
the dual purpose of addressing the demand by market players to showcase their
performance and to protect investors from being misled by false claims of
performances. The proposed agency will be an independent body, created as a
wholly owned subsidiary of a Market Infrastructure Institution (“MII”).
The paper has discussed that sufficient infrastructure requirements may be
specified by regulator but is silent on the specifics.
The proposed PVA, for a fee, will validate
claims of performance made by the registered intermediaries based on parameters
like returns, risk, volatility and other suitable parameters as may be decided
by industry forums in consultation with PVA and SEBI. The verification of
claims regarding performance of the different classes of financial instruments
have been described in the consultation paper. Broadly, the PVA would validate
claims by the registered intermediaries of the actual profits made by their
clients on the basis of advice/recommendations made. Such validation however
shall be carried out for all clients of the intermediary and not selective
clients to prevent cherry-picking and misleading claims. It will also validate
the claims regarding performance of trading algorithms by testing the algorithm
over a reasonable period of time to ensure a fair and accurate result. Claims
regarding any other performance metrics will be subject to the core principle
that there will be no cherry-picking of favourable events/strategies/client to
prevent statistically biased numbers.
To ensure confidentiality, the proposal
specifies that client specific recommendations by intermediaries would be
displayed on the intermediaries’ website only to the client as opposed to
generic recommendations whose performance metrics may be made available
publicly post verification. For claims of performance of stock/portfolios, the
performance of such stocks/portfolios shall be done for a reasonable period
before and after the recommendation, to ensure a realistic picture is
portrayed.
The intent behind this proposal is laudable
and there is a need to ensure that investors are not misled by false claims of
performance but the proposal may be a double-edged sword. There are two points
of concern which stem from the proposals (i) additional costs and time and (ii)
data privacy concerns. Primarily, the creation of an entirely new entity would
require a substantial capital input and time costs. Considering the PVA would
validate claims of performance for a fee, it imposes an additional burden on
the intermediaries in terms of compliances and costs. The fees which an
intermediary can charge has been capped by the various regulations which govern
them; therefore, it is an additional cost on the intermediaries for making
factual claims regarding their performance.
There is also an additional risk of data
privacy. The various intermediaries would be required to share data of their
clients with the PVA, including sensitive personal data, to get their
performance claims verified which invariably creates exposure to breach of data
privacy. For example, we take an investment adviser’s recommendation through
the proposed PVA mechanism. For an investment adviser to get his claims of
performance validated, it would have to collect the relevant data from the
client who in turn would have to extract the data from the stockbroker.
Thereafter, the data would be shared with the PVA for validation before it can
be displayed upon verification. The mere transfer of data through the various
intermediaries creates a risk of data leakage. The consultation paper seeks to
address this concern by proposing that the PVA would be owned by MIIs which
already process large amounts of data and as such it would ensure that the PVA
is capable of shouldering the burden of data privacy. However, even with a
robust internal mechanism to ensure data privacy, it is impossible for the PVA
to plug all the holes.
Another facet of this proposal is the lack of
discussion surrounding existing market infrastructure which may be used to
conduct validation of performance claims. ‘Zerodha’, a leading stockbroker,
recently launched its ‘Verified P&L’ initiative which enables users to
share their profit and loss report publicly through a link and the veracity of
the report is guaranteed by the broker itself. Similarly, other entities have
designed systems and mechanisms to verify claims of performances, albeit such
claims are self-verified and systems are devised internally. It does not take
away from the efficacy of such systems to conduct verification of performance
claims. It may be prudent to look into the systems developed by such market
intermediaries to create a holistic mechanism of verification which can
leverage the existing infrastructure and reduce both the regulators and
intermediaries’ burden in terms of costs while ensuring that the investors are
protected in the market.
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