SEBI’s October circular on the issuance and sale of Alternate Tier 1(AT1) bonds restricts the sale of these instruments to only Qualified Institutional Buyers (QIBs) and pegged the minimum allotment and trading lot size to Rs 1 crore. This was intended to exclude retail consumers from having any direct exposure to such instruments.
The underlying rationale for such exclusion has been that AT1 bonds are complex financial instruments with risk characteristics that might not be fully understood by the retail consumer. SEBI’s issuance of the circular was motivated by an incident earlier in 2020, wherein AT1 bonds issued by Yes Bank had to be written down, inflicting larges losses on retail investors.
SEBI has rightly pointed out that retail consumers do not have the sophisticated financial knowledge to make an informed decision on the purchase of AT1 bonds. However, a blanket ban on the sale of such products to retail consumers is at best a reactive regulatory measure, and at worst akin to searching for lost keys under a lamppost because that is where the light is.
The real and deeper issue that the AT1 bonds incident points to, and that SEBI should turn its attention to, is the lack of effective consumer protection in financial markets.
The fact that SEBI’s circular has misfired becomes evident when one considers that retail investors remain exposed to AT1 bonds via mutual funds. This is because mutual funds remain eligible to invest in AT1 bonds and nothing in the new restriction provides any safeguard against a mutual fund distributor mis-selling schemes with AT1 bond exposures to retail clients. Thus, SEBI’s inclination to reactively regulate the sale of this or that specific product to retail consumers needs to be replaced instead by an inclination to proactively prevent the sale of all unsuitable products to retail consumers. This would require a fundamental rethink of SEBI’s regulatory stance in two respects.
First, SEBI needs to clearly define who a retail consumer is and ensure that this definition is inclusive enough that it accounts for the universe of consumers that are susceptible to the mis-selling of financial products and services. Indeed, SEBI will need to coordinate with other regulators to arrive at an inclusive definition because investment products such as Pass-Through Certificates/securitised paper (PTC) and ULIPs, which are getting sold to retail investors and where mis-selling has been experienced, fall under the jurisdiction of other regulators.
The requirement that susceptibility to mis-selling be the key criterion for defining the retail consumer implies rather straightforwardly that a retail consumer is to be properly identified as an entity that lacks sophisticated financial knowledge, rather than as an entity with a certain kind of risk appetite or of a certain maximum size (of investment).
By this logic, SEBI’s current practices of allowing mutual fund distributors to sell ‘appropriate’ products to retail consumers, and of defining retail consumers as those with an absolute investment ceiling of Rs 2 lakh, are both misguided. In the first case, appropriateness has to do with risk appetite and not suitability, and, therefore, is not stringent enough to prevent mis-selling. In the second case, a ceiling of Rs 2 lakh will exclude a large number of non-HNI retail consumers and small businesses who remain susceptible to mis-selling, since they are unlikely to possess the required financial expertise to judge the suitability of investment products.
One way forward would be to define retail consumers as all legal persons and entities except regulated financial institutions, qualified institutional buyers, central, state or local governments and businesses above a certain size.
Second, SEBI should rationalise the differential burden of suitability assessments between advisers and distributors. All sale processes have some incidental advice embedded in them to influence the purchase decision, and the level of due diligence and suitability should be proportionate to the nature and complexity of products being sold by the distributors. To this end, SEBI should mandate distributors to put in place board-approved policies on suitability while taking a proportionate approach in designing these policies.
SEBI would also need to complement the above regulatory changes with supervisory and audit processes, including mystery shopping exercises to ensure effective implementation. To conclude, it is amply clear that banning the sale of select financial products to a subset of retail consumers is inadequate to achieve consumer protection. SEBI needs to take a more holistic approach and address the gaps in regulation and supervision if retail consumers are to be truly protected from potential harm.