If It Looks And Walks Like A Duck, It Is A Duck

Historically, the Indian regulatory regime, like several other jurisdictions including the United States, has followed what could be termed as ‘entity based’ regulation. Thus, for instance, the law defines the RBI’s regulatory authority in terms of the categories of entities such as banks, non banking finance companies, payment system providers, etc. For some classes of these entities, there is a sub-classification. For example, banks are further divided into universal banks, small finance banks, and payments banks. There is also an ownership based sub classification into nationalised banks, private sector banks, co-operative banks, and foreign banks. Similarly, NBFCs are sub classified into deposit taking and non-deposit taking entities, core investment companies, loan companies, and so on. Regulations are then made for each type or even sub-type of these entities, focusing on three key questions—who, what, and how? The ‘who’ part of regulations governs who can invest in or manage these regulated entities. For instance, it will define who can own such entities, the ‘fit and proper’ criteria for its management and directors, etc. The ‘what’ part spells out a list of permitted activities for each of these entities; what they can and cannot do. Finally, the ‘how’ part deals with how these entities should conduct their business including compliance and disclosures, regulatory report requirements, etc.

The Indian regulatory experience has demonstrated three problems with entity-based regulation. In an entity-based regulatory regime, if an entity does not meet the characteristics of a ‘regulated entity’ as defined in the law, its activities will not be regulated, even though they pose exactly the sort of harm that regulation should deal with. Thus, for instance, if Amazon starts offering an EMI service to its consumers or working capital loans to the sellers as part of its marketplace service, Amazon may technically do so, without being regulated by the RBI, as it meets neither the definition of a bank nor a NBFC.

The regulatory disputes in early 2010 between SEBI, the securities market regulator and the IRDA, the insurance regulator—with regard to the regulation of ULIPs offered by insurance companies – is an example of a regulatory overlap. ULIPs bundle the features of an insurance policy and investment products linked to the securities market. Since the IRDA regulates entities which are insurance companies and SEBI regulates ‘the securities market’, this led to a disagreements between the two regulators on who would be more suited to regulate the sale of ULIPs, even as thousands of consumers were sold the product in the meanwhile.

The third problem with entity based regulation is that it limits the kinds of activities that a financial firm can undertake limiting its potential and what’s on offer to its consumers. For instance, today, payment service providers (as well as digital applications, such as GooglePay, PhonePe, etc.) possibly have the best visibility over the cash flows and working capital cycles of the merchants that use their services. They may also be the most efficient service provider to small sized shops and merchants, who would otherwise have to jump multiple hoops to get working capital loans from banks and NBFCs. However, since payment service providers are not allowed to undertake lending business on their balance sheet, this restriction either disincentivises these service providers to lend or compels them to tie up with entities registered with the RBI, namely, banks or NBFCs.

Technology related product innovation is exacerbating these problems. Take the example of crypto currencies. The regulation of crypto currencies depends on whether they are classified as payment instruments or securities. These definitional issues will decide whether these will be regulated by RBI or SEBI. As these definitional battles play out, selling (and mis-selling) of such financial products continues unabated and consumer grievances pile up without redress. As the industry matures, an ETF launched on a basket of crypto currencies will likely pose similar questions.