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MUMBAI : Even within the move-fast-and-break-things world of India’s fintech services industry, the penultimate weekend of October was particularly rocky. “We had to shut down our fledging digital gold business over the course of a weekend," said the chief executive of a Mumbai-based financial services platform. “The customers who had invested had to be refunded (within a few days)," he added, requesting anonymity.

The reason: a Securities and Exchange Board of India (Sebi) circular, issued on 21 October, barred registered investment advisers (RIAs) from undertaking unregulated activities, such as providing a platform for buying and selling unregulated products—including digital gold. The generic language leaves enough room to crack down on several other alternative assets, such as cryptocurrency.

With India unable to make up its mind about the legality of a variety of new, emerging financial instruments, the Sebi move, in effect, is a form of shadow regulation (until, that is, more well-thought-out rules are put in place supposedly). But since Sebi’s mandate is somewhat narrow, the new rules affect only those financial entities that have registered themselves with the market regulator.

“We are at a stage of total regulatory arbitrage. Entities regulated by the Reserve Bank of India (RBI) and other unregulated firms can continue to offer digital gold," the CEO quoted above said. “We had no choice but to shut down, while others are continuing to make money," he added.

The differential rules have understandably begun to cause much heartburn within the fintech industry. The new restrictions have come soon after an advisory was issued by the stock exchanges in August this year, which prohibited stockbrokers from distributing digital gold on their platforms after 10 September.

In effect, fintech companies such as Paytm or Groww, which hold a Sebi RIA registration, could earlier offer crypto or digital gold as part of financial plans to their clients. But that is no longer possible. If found doing so, the market regulator can impose monetary penalties, ask the firms to refund the invested money to clients along with interest and, in the worst case, even cancel their Sebi registration. The threat of license cancellation has already had a multiplier effect. On the one hand, there is a growing number of fintech companies that are rejigging their structures and hiving off their digital gold business into a separate entity. On the other hand, a few firms are planning to write to the regulator for greater legal clarity.

In response to all this confusion, Sebi has recommended to the government that digital gold offerings should be termed as securities in the upcoming Union budget, according to two people aware of the matter.

“The only way around this is if digital gold is termed as securities by an amendment to the Securities Contract Regulation Act (SCRA) and Sebi Act. Then, digital gold would become regulated and all RIAs, brokers and their connected entities would be able to offer digital gold," said the first of the two officials cited above.

“Essentially, all the gold trading on exchanges is anyway under us. So, digital gold is not much of a stretch," said the second person cited above. “Currently, digital gold is being offered in a regulatory vacuum. If something goes wrong, even the regulated environment will get impacted. Our circular is essentially aimed at ring-fencing regulated entities," the official added. An email query sent to Sebi is yet to be answered.

The twilight zone

Originally, digital gold was offered only by Metals and Minerals Trading Corporation of India (MMTC), a public sector undertaking. MMTC’s offering was a joint venture with PAMP, a Swiss gold refiner. It was marketed as a new-age investment instrument that allowed an investor to invest in 24 karat gold, which is then stored in MMTC-PAMP’s secure vaults.

However, five years after MMTC’s initial forays, the digital gold market now has dozens of private players. The total number of digital gold accounts across various platforms has already crossed the 120 million mark this year.

Gold is also a uniquely sensitive investment class in the Indian context. The country is the second-largest consumer of gold globally and the propensity to convert household savings into gold is rather high. Currently, investors are trading in digital gold at an average ticket size of 500-1,200, indicating the presence of small-time retail investors.

“Herein lies the question. What if the gold is not in their (fintech players’) custody? Who is monitoring these private players?" said the chief executive of one of the largest fintech firms in India.

For investment apps such as Upstox and Groww, digital gold was an avenue to get more users on to their platform. As compared to stocks, digital gold is fairly easy to understand and acted as a big draw for the bottom-of-the-pyramid investors. These investors then slowly graduated to more complex products.

So far so good. But the advent of private players also resulted in innovation, which increased complexity.

Take Oropocket, for example, a crypto firm founded in 2018 that allows Indians to invest in cryptocurrency tokens that are backed by gold and silver. Another company has created a cryptocurrency backed by digital gold and is issuing tokens against it without any regulatory oversight. Yet another one is offering to store the gold in Switzerland with scant regard for income tax laws or foreign exchange implications.

The regulator could not help but take cognizance of the growing market for digital gold and these alternate unregulated assets which are often marketed as financial innovations.

“I think digital gold was being hard sold and I think Sebi had to step in because of that," said Nithin Kamath, founder and chief executive officer of Zerodha Broking Ltd, a fintech firm. “Whenever it (Sebi) sees retail folks taking risks, that’s when the they typically jump in and issue clarifications," he added.

Sebi specifically mentioned digital gold because it was fairly visible on all the platforms. But there are other offerings that could potentially fall under this broad umbrella of ‘unregulated products’—such as international investing (allowing Indians to invest in US stocks), platforms offering investments in unlisted shares, pre-IPO orders and even cryptocurrency for that matter.

Pre-IPO orders work like this. If, say, Paytm’s public offer opens at 8 am on a particular day, then some intermediaries start collecting orders much before that time on behalf of their clients, which can potentially manipulate the sentiment around the initial public offering (IPO). Technically, the orders should be collected only during the IPO window. Then, everyone has equal information regarding the level of subscription.

“Sebi deliberately kept the term wide (in order) to ensure that all the unregulated so-called financial products are kept away from the regulated ecosystem," said the first official quoted earlier in the story.

“It should be noted that while products such as digital gold are unregulated and there are regulatory gaps as far as ensuring the quality of assaying and security of storage is concerned, the same could be plugged through appropriate standards. These could then be uniformly applicable to all market participants," said Sandeep Parekh, managing partner, FinSec Law Advisors.

Price of being regulated

FinSec Law’s Parekh believes that while concerns over the unregulated nature of digital gold is valid, a complete ban is not really a solution. “It may just erode investor confidence in the product," he said. Parekh also expressed doubts regarding the legality of the circulars.

For now, many fintech firms that are regulated by Sebi and that offer digital gold have started restructuring their business. For instance, Paytm Gold which was part of Paytm Money, a Sebi-regulated brokerage firm, has now been transferred to the parent company. “The company has removed digital gold from Paytm Money immediately and brought it back under One97 Communications Ltd’s Paytm app, which is not Sebi regulated. All non-regulated entities can continue to offer digital gold," said the co-founder of a digital gold platform who did not wish to be named.

A Paytm spokesperson in an emailed response said: “There has been no business transfer. Digital gold has always been a product of OCL (One97 Communications Ltd). The company’s draft red herring prospectus also states that digital gold is offered by OCL in collaboration with a partner. The accessibility for digital gold was earlier via Paytm and Paytm Money app. Currently, it is only accessible through the Paytm app."

Kuvera, an online platform offering financial products, in a tweet response to customer queries on 8 November, said: “Yes, we are regulated by Sebi and are working towards compliance with the circular. We will be issuing a communication to our users for a seamless transition."

“If there is an unregulated entity, then such entity could technically carry out the business of buying/selling and tracking of digital gold. However, ideally, such (a) company must be a separate legal entity and not under common control with the RIA company," said Vatsal Gaur, partner, Pier Counsel, a law firm.

In others words, common directorship will be a concern and the regulator can take action. Some other firms have completely stopped offering digital gold for the time being.

For the unregulated digital gold platforms, Sebi’s ban has turned into a boon and their traction has grown swiftly. But even they are being bombarded with questions on how the circular impacts them and their business.

“Two of our VCs (venture capital funds) reached out to us and asked whether we are impacted by this circular," said the co-founder of digital gold platform quoted above. “These questions are coming from well aware and educated folks and we had to explain to them that there is no impact on us."

The likes of Zerodha are planning to write to the regulator for some sort of informal guidance. “We are right now in the middle of putting up a request in terms of informal guidance on some of these products," said Kamath of Zerodha. “There is clearly some level of regulatory arbitrage. We have never sold digital gold because we thought it’s not a good product. But assuming we wanted to sell it and someone else sold it and we didn’t because of the regulations, then there is something (of a) regulatory arbitrage of sorts," he said.

“A similar scenario is playing out in the crypto space too. The crypto market is becoming bigger but we have to sit and watch. So, on these 2-3 products, we are putting up an informal guidance on whether it should be allowed or not," Kamath added.

“Being one of the larger players, if we start doing some of the unregulated things and if we get spotted for doing it, then the repercussions for us is going to be much higher than some of the small players. Regulators look at us almost like an MII (market infrastructure institutions or exchanges) today. So, we can’t really take these chances," said Kamath.

What next?

There is no denying that the regulator has kept the circular wide enough to cover as many alternate unregulated assets as possible. So, the confusion on what new innovative products Sebi regulated entities can or cannot offer will continue for some time at least.

There is one school of thought that says investors, in general, would understand the risks before punting their money and, hence, financial products should not be banned. However, the allure of owning gold in small denominations continues to sway the gold-obsessed Indian population.

The only way out is to bring digital gold into the well-regulated environment under one umbrella and avoid regulatory arbitrage.

When one product is regulated by two regulators—RBI and Sebi, in this instance—the odds of regulatory arbitrage only increases. This seldom results in any good.

The regulators and the government seem to be aware of this. Which is why digital gold may be brought under the Sebi Act sometime next fiscal. While that will fix some of the prevailing confusion, it will also inevitably raise compliance requirements for entities that are currently unregistered. However, as India embarks on the slow, unsteady path towards regulating a slew of new-age asset classes—from crypto to foreign stocks—some level of compliance and common rules might become a necessity.

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