Home Business framework ERGO Analyzes Developments Impacting Businesses: SEBI Framework Facilitates Direct Mutual Fund Plans Invested Through Execution-Only Platforms

ERGO Analyzes Developments Impacting Businesses: SEBI Framework Facilitates Direct Mutual Fund Plans Invested Through Execution-Only Platforms

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Introduction

As of April 30, 2022, assets under management of the mutual fund (MF) industry in India stood at INR 38.04 lakh crore, with 45% of total assets channeled through direct plans. With increasing emphasis on financial literacy, digitalization, online banking, smartphones and MF awareness, investors can leverage technology and invest directly in MF, necessitating the need to regulate the field, in particular the digital/technology platforms through which the execution of MF investments are undertaken for a direct regime.

Background

Investment in mutual funds occurs via two mechanisms: (a) a regular plan which requires routing the investment through an intermediary (a mutual fund distributor (MFD)); and (b) a direct plan where the investment does not involve any distributor/agent. Naturally, investors prefer the direct plan having a lower expense ratio, with no commission paid to the distributor/agent, which adds to their returns. Investors who prefer direct plans have the following investment channels:

  • the office / website / mobile application of the wealth management company (AMC), in physical or digital mode;
  • the SEBI-registered stockbroker (SB) / investment adviser (IA) / portfolio manager (PM) digitally using the exchange-provided MF trading platform;
  • SEBI registered IA/PM directly with AMCs as clients; Where
  • platforms such as MF Utilities India Pvt. Ltd., MF Central, etc.

Several investors execute their investments in MFs via technology/digital platforms provided by exchanges/registrar and transfer agents of MFs (RTAs) and IAs/SBs/PMs. Some investors who use the platforms provided by IA/SB/PM do not use their advisory and brokerage services and only use the platforms for the execution of their MF trades. Investors generally prefer the platforms provided by IA/SB/PM over those provided by exchanges/RTAs, due to their convenience. However, there is no specific framework governing the use of IA/SB/PM platforms for investors seeking execution-only services.

Legal gaps and rationale

Under the existing SEBI, IAs/SBs/PMs that onboard an investor as a client are required to enter into an agreement or obtain the client’s signature under mandatory terms as prescribed by SEBI. Investors who use these platforms only for execution-related services, i.e. non-clients, without using IA/SB’s advisory/brokerage services may find it inconvenient to execute deals with mandatory provisions for IAs/SBs, as they may not be relevant to such non-clients. Generally, for investors, IA/SB/PM usually use their registration codes to get the data describing an overview of their investment transactions; however, this benefit is not available to non-customers and they have no remedy or protection available under any regulatory framework. In light of the above, on July 22, 2022, SEBI published a consultation paper proposing a new framework for execution-only platforms (EOPs), in order to maintain a balance between convenience and investor protection. Stakeholders are required to provide their comments no later than August 12, 2022.

Insight

EOPs can consider a variety of structural approaches, either – (a) registering with SEBI as an intermediary; or (b) register with the Association of Mutual Funds of India (AMFI); or (c) obtaining limited purpose membership from stock exchanges.

Main characteristics –

  • Scope of service – EOPs can provide both financial services, i.e. purchase and redemption of MF shares, etc., and non-financial services, i.e. change of email id, contact number, bank details, complaints, etc. Only a legal person can be registered as an EOP, and it must not exercise other activities. If the EOP also undertakes other activities, an arm’s length relationship must be maintained between its EOP activity and other activities. EOP services must be provided by a separately identifiable EOP department. Since EOPs are digital platforms, cybersecurity issues must also be considered.
  • EOP Registration Requirements / Limited Purpose Membership
    • adequate infrastructure
    • minimum net worth: (i) either secure capital commensurate with the required scale of operations, infrastructure and future growth projections; or (ii) as prescribed by AMFI and the Stock Exchanges.
    • Infrastructure and Workforce: (i) either for risk management and the establishment of checks and balances for cybersecurity, data processing and data privacy, including technological, operational, appropriate legal and financial; or (ii) in accordance with the minimum requirements prescribed by AMFI and the Stock Exchanges.
    • Fit and Proper Criteria – (i) either as prescribed in Schedule II of the SEBI (Intermediaries) Regulations 2008; or (ii) in accordance with the minimum requirements prescribed by AMFI and the Stock Exchanges.
  • General Duties and Responsibilities
    • Customer Transaction Visibility: EOPs should have visibility into customer transaction data streams from RTAs for transactions executed through their platform. The SEBI/AMFI registration number or limited use membership number provided by the exchanges can be used as a code to obtain this data from the RTAs/exchanges.
    • Use and sharing of customer data: in accordance with the agreement governing the customer relationship with the EOPs.
    • Agreements: EOPs may enter into a contractual agreement with (a) AMCs or RTAs/custodians (if authorized by an AMC); or (b) exchanges, to integrate their systems and provide execution services to direct MFS.
    • Client-level segregation: EOPs must ensure client-level segregation with reference to their activities as EOP, IA/SB/PM and MFD activities.
    • Fees: EOPs can only receive transaction-based fees either (a) from clients; or (b) from AMC, in the manner specified by AMFI.
  • Transparency and grievance resolution
    • Client onboarding: (a) EOPs will enter into a binding agreement with the client at the time of onboarding and ensure KYC compliance; or (b) Investors can be directly onboarded in accordance with the KYC process to be handled by AMCs.
    • Grievance Redress Mechanism – this may be either: (a) as prescribed for other SEBI Registered Intermediaries (through SCORES); or (b) as prescribed for MFDs where AMC must monitor EOP activities to ensure compliance with the Code of Conduct and other guidelines. The AMC must report to AMFI and SEBI any case of material breach of compliance with the applicable directives; or (c) as prescribed by the exchanges in consultation with SEBI.

comments

The various approaches recommended by SEBI should be considered with the intention of reducing any intermediary involvement, eliminating any stratification or superstructure in the implementation of EOPs and fully implementing the direct plan of MFs. . In the interests of investors, a robust cybersecurity and cyber resilience framework for PIOs is recommended, and their use of customer data should be in accordance with the signed customer agreement and data protection framework. The framework aims for an investor-centric mechanism to ensure that PIOs operate solely as agents of investors, and their fee structure is based on the investor compensation model.

The proposed framework will affect investment platforms such as Paytm Money, Zerodha and Groww, which offer direct MFIs requiring them to register as intermediaries. This decision aims to promote the ease of doing business in MF, combined with adequate investor protection and a grievance mechanism, by giving impetus to direct investment by investors in MF, thanks to the use of digital technology platforms.

The contents of this document do not necessarily reflect the views/positions of Khaitan & Co but remain solely those of the authors. For any other questions or follow-up, please contact Khaitan & Co at [email protected].