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Financial Sector Regulations: Your Safety Net
April 5, 2010

'Financial inclusion' is officially on the cards. As the public and private sectors in India's banking and financial markets look at ways of mainstreaming and harnessing retail investors' voluminous (and low cost) money, protection of their interests and capital is rightly gaining focus. We take a quick look at the regulatory safety nets for retail investors in some other markets, and what has been unfolding in India.

Author : FSM Content Team

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For a novice investor, entering the capital markets can be very much like entering a maze blindfolded. And this is true anywhere in the world. The capital markets require superlative level of specialised information and knowledge to be able to completely understand the products and opportunities on offer – and therefore, one should be completely sure of the risks involved (a herculean task for an average retail investor at least!). But failing to attract the very capital it seeks to use and multiply would defeat the purpose. So to make the market more accessible to retail investors, at the entry level we have products with standard features, where investors can start to experience how things work with a level of risk/exposure they can handle. Mutual funds are probably the best example of this. To aid the accessibility and understanding of these products, the market allows for product distributors. These distributors, whether independent or affiliated with a product company, function as sales channels offering investment products on the one hand, and as advisers to retail investors on the other, helping them select products suited to their need and risk appetite.

This market structure has worked for over a decade now in India, with distributors functioning as the most important channel for retail investors investing in mutual funds, insurance policies, etc. However, as time has passed and retail investments in the market have increased, the risks inherent in this three-tier relationship have become obvious. This coupled with the investors’ inability to decipher products and related disclosures have caught the attention of regulators, and set the ball rolling on protectionist regulations.

We look at some of these risk areas, and review moves in international markets as well as India to correct the same, with a particular focus on mutual funds.


Suitability of Product

Product definition in terms of investment objective, asset class of underlying, investment style and tenure is what investors should depend on to choose a product’s suitability for their portfolio. However the following factors fuel confusion in the minds of investors, making them dependent on the “push” or “sell” techniques of issuers:

What shouldn’t confuse you?

  • broad and generic product definitions
  • features whose impact on cost and/or return is not very transparent; example, auto trigger concept, capital protection orientation, guaranteed returns in ULIPs, etc.
  • new fund offers (NFOs) with no unique proposition, but with an aim to churning investors’ funds; while distributors earn commissions every time funds move from an existing scheme to a new one, investors often face losses. This has also, wrongly, led to a short-term investment approach where mutual funds are concerned – which is not healthy for portfolios.  

Additionally, there is not much investors can do when the actual management of the fund is different than what was promised at the time of the offer. If, eventually, the underlying assets of a new scheme mimic other available schemes, investors can be overexposed to certain asset types.

Regulatory Thrust

The guiding principles that regulators world over are looking at with respect to product design are transparency on product features and risks and accountability for management of product.

The Financial Services Authority (FSA) in UK has initiated a Treating Customers Fairly (TCF) initiative that provides detailed regulatory guidelines for fair treatment of customers across all aspects of financial services, across product design, advisory and sales, and after-sales support.

Following are some of the guidelines it has set forth for product providers and distributors on product design:

  1. When undertaking product design, firms should stress-test the product to identify how it might perform in a range of market environments and how the customer could be affected.
  2. When providing information to customers, firms should take account of what information the customer needs to understand the product or service, its purpose and the risks, and communicate information in a way that is clear, fair and not misleading
  3. When providing post-sale support, should periodically review products whose performance may vary materially from the plan, evaluate whether it continues to meet the needs of the target audience and consider action to be taken (including ceasing to sell the product)

The Securities and Exchange Board of India (SEBI) has been focusing on controlling the glut of new fund offers flooding the market to ensure that only funds with a definite and clear value proposition are presented to investors. The over 5000 schemes (with plans) available in the market have drawn SEBI’s criticism for confusing the investors and misleading them with fancy names and marketing messages.

SEBI’s recent moves to change this trend:

  1. In early 2008, SEBI disallowed AMCs from charging up to 6% marketing fees on launch of new funds (closed-ended) over a period of 3-5 years. A similar fee for open-ended funds was disallowed in 2006. This took away a big incentive for AMCs to launch new funds.
  2. In August 2009, SEBI disallowed the charging of entry loads on any mutual fund scheme. Entry loads were used to pay upfront commissions to distributors as incentive to promote the new fund. With the ban on entry loads, there is no separate incentive for distributors to promote a new fund over an existing one.
  3. SEBI has made known its intention to scrutinize applications for launching new schemes more stringently and has asked the Trustee boards of AMCs to play a more active role in reviewing product design and objective before applications reach SEBI.

SEBI has also been focusing on mutual fund advertisements and has issued detailed notifications to ensure that the disclaimer statement is clearly and prominently conveyed to investors. It has also simplified the format of the mutual fund offer documents to make them more understandable.


Independence and Quality of Advice

Investors primarily depend on advisers to make their investment decisions. However, the following factors expose investors to a high degree of risk of mis-selling:

  • The ability of an adviser to perform the required due diligence with respect to investor needs, risk appetite, etc., is very subjective and not under any detailed control. Available certifications are product-specific and there are no defined qualification requirements for financial planning and advisory abilities. Advisers are also not subject to any ongoing assessments as to their awareness/understanding of new/alternate products that could meet investor needs better .
  • Advisers are not mandated to maintain any record of client profiling done at the time of selling, recommendations made or the reasoning for the same. This leaves investors with no recourse in cases of mis-selling.
  • Advisers earn sales commissions from the issuers of the products, while their advice and transaction services are not (so far) paid for by the investor. Thus, there is no direct relation for the advisers in the quality of advice and service they provide the investors and their earnings. This undermines the independence of the advice given by the adviser.

Regulatory Thrust

The past few years have especially seen a lot of regulations on these concerns. Markets across UK, the European Union, Singapore, Hong Kong, Australia, and of course, India have seen some definitive moves to bring transparency and accountability into the adviser-client relationship.

In the UK, the FSA undertook a Retail Distribution Review (RDR) to examine how products are distributed to retail consumers and has come out with recommendations to address the identified concerns. The key proposals are focused on:

  1. Independence: FSA has defined standards for “independence” that take into consideration the range of comparable products that the adviser is capable of advising on, the depth and fairness of market evaluation performed by the adviser and the assurance that the advice will be “unbiased” and “unrestricted”.
  2. Incentives and Charging: FSA has proposed that product issuers be banned from offering commissions on sales and that advisers will be required to agree with their clients on advisory fees. (Australia already requires investors to pay separately for advice.)
  3. Professional Standards for Advisers: FSA has proposed the setting up of a Professional Standards Board which will define the standards for qualifications required for this industry.

The European Union has been working to implement the Markets in Financial Instruments Directive (MiFID), one of whose aims is to “to ensure strong investor protection with a comprehensive set of rules governing the relationship which investment firms have with their clients.” MiFID requires that investment firms:

  • Categorise their clients as eligible counterparty, professional and retail, with eligible counterparty indicating the most sophisticated investors and retail the least. Under the provisions of MiFID, retail customers are eligible for the highest level of protection.
  • Follow a process of capturing all relevant information on a trade to ensure best possible execution and transparency during Client Order Handling, Pre-Trade and Post-Trade. This brings in a lot of accountability on the part of the service provider to ensure that the client’s best interests are always catered to.

Client focused advisory model

SEBI has focused on making the advisers’ business model into a client focused one, from a producer focused one to remove the bias in their advice and selling.
The following changes have been implemented in the past year:

  1. Entry loads charged to investors on all mutual funds, which were paid as commission to advisers, were banned. Advisers are being asked to work out fees directly with the clients for advisory, transaction and other value added services, to make the payment and accountability more direct and transparent between them.
  2. At the time of recommending a particular scheme, SEBI has mandated that the distributor disclose all commissions (trail commission or any other) that he is eligible for from competing products as well.
  3. In an indirect but progressive move SEBI has allowed buying and selling of mutual funds using the existing stock exchange trading infrastructure. This, along with the advent of online platforms in India, allows distributors to move to online transaction execution, reducing the costs and effort associated with physical transactions. This will help distributors move to an advisory and service oriented business from a transaction oriented one.
  4. From December 2009, investors no longer need a ‘No Objection Certificate’ to move their portfolio from one adviser to another. They just need to issue a letter to this effect to their new adviser and providing portfolio details. This brings in direct focus on the advisory and client retention capabilities of advisers.


Safeguarding Investor Interest

The following points briefly chronicle some of SEBI’s other regulations to ensure higher levels of protection for retail investors’ money and interest.

  1. To bring parity in the treatment of retail investors (as compared to institutional investors) by mutual fund companies, SEBI mandated that the exit loads charged to both classes of investors should be the same.
  2. To protect investors from potentially misleading information, SEBI disallowed the publication of indicative portfolios and yields on debt mutual funds in January 2009. In a follow up circular, it issued stringent guidelines on the valuation of debt securities to ensure a more accurate calculation of NAV.
  3. In another move to increase transparency and understanding of debt-oriented closed ended and interval schemes, SEBI mandated that AMCs disclose the portfolios of such schemes on a monthly basis.
  4. Liquid schemes would initially invest in instruments of maturity up to a year, thereby increasing the risk exposure of investors. Liquid schemes were banned from investing in instruments longer than 91 days maturity effective from May 2009.


Investor Capability to Understand Markets

In terms of ongoing activity on the regulatory front, SEBI has repeatedly drawn focus on the need for increased investor awareness and education. Because, the truth is, regulations can only help up to a point, and the investors have to become more capable of understanding information and disclosures provided to them, and look after their own rights.

To implement its vision of greater financial inclusion and understanding in the country, SEBI has established the National Institute of Securities Markets (NISM). One of the institute’s initiatives is the School for Investor Education and Financial Literacy (SIEFL) which is implementing investor education through the following three programmes:

  1. Financial education in schools: specialized modules for secondary school students
  2. A dedicated website for investor education ( with a focus on providing unbiased information for investor benefit. (This website is expected to go live soon.)
  3. Face to face investor workshops that are being conducted across cities and towns in India. 


Standardisation and Stability

The recent budget session also saw our Finance Minister, Mr. Pranab Mukherjee, announce the setting up of the Financial Stability Development Council (FSDC) to work as an inter-regulatory body to support collaboration on and resolution of over-arching issues.

Earlier in the article we have discussed the approach taken by regulators in countries like the UK and Europe in comparison with that in India. One striking difference is that we still do not have a comprehensive regulatory framework in place that covers the entire financial market and its participants. Therefore, we also do not have a comprehensive approach towards the retail investor as a customer of this market place. SEBI is limited in scope to mutual funds and stock market-related products, while IRDA manages insurance and its offshoots, and PFRDA looks after provident fund and pension products. This has also prevented the regulation of distributors and service providers in these various areas in a standardized manner.

With the setting up of the FSDC, we hope that this gap will be addressed and investors can look forward to uniform levels of service and protection across the financial market.



While it’s heartening to look at all the activity being undertaken to protect our rights as retail investors, it is also important to understand that overly protectionist policies or over-regulation can stifle growth and the ability of the market place to generate the best returns. Exhaustive disclosure norms, or very long and cumbersome investment processes can burden the market with additional costs and effort, which would eventually work against the investors. This can also stifle introduction of new and innovative products which could have worked with reasonably aware and selective investors.

As investors, therefore, we have to recognise the role we can play in improving the market. Money management, especially investments, have been an area we have been content to leave to “experts” or “advisers”. We have to take a more active interest in our investments, understand our own needs and limitations and take advantage of the easily available information and guidance to evaluate our options and make the best choice. Happy investing!



Disclaimer: iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's scheme information document including statement of additional information. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer on the website.Please read our disclaimer in the website.


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