If it looks and walks like a duck, it’s a duck

Historically, the Indian regulatory regime, like several other jurisdictions including the United States, has followed what can be termed “unit-based” regulation. Thus, for example, the Act defines RBI’s regulatory authority in terms of 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 payment banks. There is also an ownership-based sub-classification into nationalized banks, private sector banks, cooperative 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 created for each type or even subtype of these entities, focusing on three key questions – who, what and how? The “Who” section of the regulations governs who can invest in or manage these regulated entities. For example, it will define who can own such entities, the “fit and proper” criteria for management and directors, etc. The “what” section provides a list of permitted activities for each of these entities; what they can and cannot do. Finally, the “how” section deals with how these entities will conduct their business, including compliance and disclosures, regulatory reporting requirements, etc.

The Indian regulatory experience has shown three problems with unit-based regulation. In an entity-based regulatory regime, if an entity does not meet the characteristics of a “regulated entity” as defined in the Act, its activities will not be regulated, even if they pose exactly the type of harm that the regulation is intended to address. Thus, for example, if Amazon starts offering an EMI service to its consumers or working capital loans to its sellers as part of its marketplace service, Amazon can technically do so, without being regulated by the RBI, since it does not meet the definition of a bank or an NBFC.

The regulatory disputes in early 2010 between SEBI, the securities regulator, and IRDA, the insurance regulator – with respect to the regulation of ULIPs offered by insurance companies – is an example of regulatory overlap. ULIPs bring together the features of an insurance and investment products linked to the securities market. Since IRDA regulates units which are insurance companies and SEBI regulates the “securities market”, this led to disagreement between the two regulators as to who would be more suited to regulate the sale of ULIPs, even though thousands of consumers were sold the product in the meantime.

The third problem with entity-based regulation is that it limits the kind of activities a financial company can carry out, and limits its potential and what is offered to consumers. For example, today, payment service providers (as well as digital applications, such as GooglePay, PhonePe, etc.) have possibly the best view of the cash flows and working capital cycles of the merchants using their services. They can also be the most effective service provider to small shops and merchants, who would otherwise have to jump through multiple hoops to get working capital loans from banks and NBFCs. Since payment service providers are not allowed to carry out lending activities on their balance sheet, this restriction either prevents these service providers from lending or forces them to tie up with entities registered with the RBI, namely banks or NBFCs.

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