Sebi’s 3rd consultation paper is work-in-progress

Regulations in the financial sector need to keep evolving as the market grows in depth, breadth and complexity. Think of this as the need for road rules and a traffic management system in a large metro—what worked 30 years ago cannot work today. It was possible to travel 5 km in Delhi without running into traffic lights or traffic cops 30 years ago as road traffic was thin. A malfunctioning traffic light today causes hours of traffic jams. As the traffic volume rises, cities resort to one-way traffic rules, higher parking fees and other measures to curb traffic in the city centre. Financial markets are similar; regulations need to keep moving to keep pace with the changing face of the market. Has the market changed? Yes, the size of the assets under management by the three large parts of the retail financial market—mutual funds (only retail), life insurance and the National Pension System (NPS)—crossed Rs34 trillion in FY 2017, up from Rs22 trillion just 3 years ago. Both the volume of money and the number of people on-boarding these products has risen sharply over the past few years. The share of household savings in financial products has been rising and now more than one-third of household savings find their way into financial products. In addition to the urban users of these products, a new category of investors are getting added through the Jan Dhan accounts. These are people who will be first-time users of many financial products as they move from cash, gold and real estate.

New road rules are needed when such a big shift happens in a market. One of the areas of work has been the distinction between an adviser and a distributor. The capital market regulator Securities and Exchange Board of India (Sebi) has been worrying about this for a few years now and has been keen to get a conceptual clarity between these roles. A distributor is a simple vendor of a product; think of a chemist who vends what is asked for. An adviser is a professional who recommends products that are suitable for clients and enhance their financial well-being; think of a doctor. Both distributor and adviser need to clear qualifying exams, but the threshold is lower for a distributor than an adviser. A distributor, just like a chemist, is responsible for the quality of products. For example, a chemist selling fake medicine or a distributor selling a non-regulated product is on the wrong side of the rules. A doctor has a higher level of responsibility towards the patient’s well-being and an adviser is held to a higher fiduciary standard that says the interest of the client comes ahead of his own interest. A chemist makes a margin on the medicine sold that is paid by the pharma company; a doctor gets a fee paid directly by the patient. A distributor is paid by the product manufacturer and an adviser is paid by the client.

The way the Indian retail finance market has evolved has seen the distributor of the product also advising clients on what to buy and being compensated by the product manufacturer through embedded commissions. The Securities and Exchange Board of India (Sebi) has been trying for some years to demarcate the two roles, wherein the distributor can only vend products, collect a transaction fee and a small trail commission, and an adviser can only recommend products but cannot vend them. The third consultation paper (read it here) takes the argument forward and says five things. One, the regulator wants a clear segregation of activities between advisory and distribution. Sebi is saying, decide who you are: a doctor or a chemist? Two, registered investment advisers (RIAs), or their relatives, cannot sell mutual funds; they can only advise clients. The only compensation an RIA can get is from the client. He, or his family, gets nothing from the asset management company (AMC)—directly or indirectly. This would mean that advisers take a fee from their clients, who could then buy direct plans. The cost of facilitating the buying can be built into the overall cost structure of the fee. Three, banks, non-banking financial companies (NBFCs) and other corporate bodies, who register as advisers, will not be able to sell products directly or indirectly. This means that banks will have to choose if they are distributors or advisers. Banks have been identified as institutional mis-sellers of retail financial products by various studies and mystery shopping exercises. A reluctant Reserve Bank of India (RBI) has dragged its feet on bringing accountability to the bankers selling third-party financial products. Sebi asking banks to decide who they are is a strong step forward. Four, existing RIAs who are providing distribution services through relatives need to wind it down by 31 March 2019. Distributors who are offering advice must also wind down their advisory service and only vend products. Five, distributors must ensure ‘appropriateness’ of the product to their clients. Sebi defines an appropriate product as one that belongs to a product category that is suitable for the client. For example, a first-time investor cannot be sold a sector fund. Or an income-seeking investor cannot be sold a growth plan without a linked systematic transfer plan.

Sebi’s struggle to get this piece of regulation in place is obvious when you see that this is the third consultation paper it has floated for public comments. Sebi is on the right track. It is operating from first principles in asking a basic question: who are you—adviser or distributor? The regulator then is trying to make this segregation without killing the market. The only problem in this paper sits in the fifth point where a distributor is being asked to sell only an ‘appropriate’ product. Sebi either needs to come out with very detailed guidelines on what is ‘appropriate’ or take away this requirement and allow a simple vending of the product. Clearly the trail fees in such a model for just distribution will go down drastically and we may see further regulation on that.

While Sebi is on the right path, all parts of the retail financial services need to move in the same direction. The pensions regulator is following Sebi’s footsteps and came out with adviser regulations in 2016. The outlier is the insurance regulator that is yet to move in this direction. With Rs28 trillion of retail assets under management, the insurance industry is in dire need of such a first principles regulatory approach. Unfortunately, the latest regulatory change in this space is muddled and seeks to carry forward a flawed understanding of the market where the agent is also the adviser and is compensated by the insurance company. In a January 2017 regulation, the Insurance Regulatory and Development Authority of India (Irdai) breaks up the market into three categories of distributors of life insurance products: agents, intermediaries with more than half their income coming from insurance, and intermediaries with less than half their income coming from insurance. Agents represent one company and are individuals. Intermediaries include corporate agents, insurance brokers, web aggregators and insurance marketing firms. Agents are paid a commission on the sale of insurance policies. Intermediaries’ sales commissions are called ‘remuneration’.

The Tarun Ramadorai Committee (you can read the report here) has also recommended a clear demarcation between the role of a distributor and an adviser for the entire retail financial services market. It has also recommended uniformity in the sector with the same rules for the same function, which means that insurance agents should only vend the product and a new category of insurance advisers must be put in place that put the interest of the client before their own and be held accountable to a fiduciary standard.

Sebi has clearly taken the lead to bring a first principles approach to solving a problem in the market. It is also good that the regulator is taking its time in getting the regulation right by floating consultation papers. The writing on the wall is clear—the market will get divided into distributors and advisers. Those afraid of the new world need to only look back at the very controversial abolition of front loads from mutual funds in 2009. Though drastic, the action weeded out the non-serious players from the distribution industry, leading to increased investor outreach, re-skilling the distribution chain and the rise of fintech. Other regulators need to follow this path.

Monika Halan works in the area of consumer protection in finance. She is consulting editor Mint and on the board of FPSB India. She can be reached at monika.h@livemint.com.