Wednesday, 08 May 2013
Challenges in capital market: The Indian experience
Sourajit Aiyer in the first of a two-part article
An evolving regulatory climate is part of every business sector, especially when the sectors themselves are in a developing
stage. Regulators need to ensure that business is conducted in a manner to achieve long-term client satisfaction and
The depth of the Indian capital markets has grown, but it is still lower than that in many countries worldwide. As India
seeks sustained GDP growth, the role of capital markets to mobilise investments is critical.
The purpose of this article is to highlight recent changes in the regulatory climate (enacted or proposed) in the Indian
capital markets, and what their possible objectives as well as potential impacts are. It covers segments like asset
management, retail and institutional broking, wealth management, investment banking and private equity.
The intent of recent regulatory changes is to (a) increase the flow of savings into capital markets, (b) ensure that
intermediaries keep the clients' interest as paramount, and (c) access to further participants and geographies.
The challenges are numerous, the players will need to adapt and bear the short-term pains in order to build sustainable
Asset management: Back in 2009, the Indian markets regulator - Securities & Exchange Board of India (SEBI) put a ban
on entry loads of mutual funds. This move led to distributor disinterest from selling mutual fund product since entry load
was a main incentive for them. This disinterest continued into 2012. While registrations of new distributors were reduced
during this year, a number of existing distributors did not renew their memberships. Active distributors declined to
~40,000 in 2012, from ~0.1 million back in 2007. They now comprise only about 50 per cent of the total. However, this
ban was imposed to limit its misuse as distributors often resorted to frequent churning of assets and product-pushing since
it earned them more, while investors lost opportunity for gains.
Nervous equity investors: Also, recent market volatility and poor fund performance rendered equity investors nervous.
Equity funds lost ~4 million folios in the 10 months of fiscal year 2012-13, and have not seen meaningful inflows in most
months of FY13. With the objective to enlarge the distribution network, the mutual funds trade association - Association of
Mutual Funds of India (AMFI), waived registration fees for first-time distributors from the period February to June 2013,
and reduced renewal fee for advisors, banks, non-banking financial companies (NBFCs) etc significantly. The Securities and
Exchange Board of India (SEBI) opened up new distributor channels like postal agents, retired government officials, retired
teachers, retired bank officers and bank correspondents. Following this, UTI Mutual Fund, a leading asset management
company, itself inducted ~500 new distributors. The recent months also saw money coming from distributors who had
registered earlier but did business for the first time.
Secondly, mutual funds will now offer a 'direct' plan of each scheme, apart from regular plans. Direct plan excludes
distributor commissions for investors who come directly to the asset management company (AMC) to invest. Mostly
institutions have shifted to the direct version as of now, as compared to retail investors. This is possibly because their need
for advice. With the introduction of the direct plan, AMCs fear that investors may take the distributor's advice and then buy
directly, or that experienced clients with large assets may use the direct route. Nevertheless, initial figures for difference in
NAV between direct and regular plans are estimated to be ~0.5-0.6% - which is a clear benefit to clients. However, a hitch
is that the shifts from regular to direct plan may attract capital gains tax.
Regarding Total Expense Ratio (TER) charged by funds, AMCs can charge an extra 30 bps if they attract assets from small
towns (higher of 30 per cent of gross new inflows or 15 per cent of average AUM. However, the dependence on larger cities
still continues due to the lack of investor awareness and also, the closure of retail operations in some smaller towns by
some of the smaller AMCs. AMCs would now be allowed to charge an extra 20 bps for exit load. This move is expected to
compensate for the loss in exit load collection, as this would now be credited back to schemes. SEBI would also allow
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fungibility in the expense ratio by removing internal sub-limits. Thus, AMCs would be free to spend the money it collects as
TER. Even the proportion of AMC fee within TER can be increased. Also, AMCs now have to pay upfront commissions from
their own pocket. There is discussion of banning upfront commission, as some mutual funds are luring distributors with
high commissions. The service tax charge on schemes that was borne by the AMC till now, would now be passed on to the
investors. Lastly, AMCs need to put 2 bps per annum from their assets for investor education and awareness initiatives.
Such awareness initiatives should help deepen the market.
With the aim to reduce multiple 'similar' products in the market and help clients choose the right product, SEBI has asked
AMCs to reduce the number of new launches or merge similar plans. Fund managers will need to ensure performance of
existing schemes before applying for new schemes. SEBI has asked AMCs to disclose detailed information regarding
performance to help investors assess the fund quality and caliber of fund managers. This should help them take more
informed decisions and make managers justify their fees.
However, regarding scheme mergers, AMCs are increasingly concerned over tax incentives for scheme mergers. This is
because investors are currently charged capital gains tax during merger of schemes as it is a withdrawal from one scheme
to another. SEBI has also brought the practice of mis-selling under the ambit of fraudulent practices, with the aim to avoid
product-pushing by making misleading statements or concealing facts. SEBI has also mandated informally that new
schemes need to raise a minimum threshold amount or else will need to refund within 20 days of the New Fund Offer's
(NFO) close. This will ensure that only serious NFOs are launched, although it may give advantage to large AMCs with
stronger distribution. SEBI has hiked the minimum investment limit in Portfolio Management Services (Managed Accounts)
to Rs 2.5mn, which may result in some incremental flow of retail money into mutual funds. While SEBI has allowed cash
transactions of upto Rs 20,000 in mutual funds, this has clearly not taken off due to the high cost of handling cash and the
inability to redeem units in cash.
SEBI's mandate: In terms of due diligence norms, SEBI has sent a lengthy mandate to AMCs for conducting distributors'
due-diligence. However, distributors find the requirements lengthy and duplicative. The in-person verification requires
investors to visit a branch physically to verify their physical presence, which may often be difficult. SEBI is also mulling
whether to increase the minimum share capital for AMCs as it may help to absorb shocks. Regarding the recent
introduction of guidelines for Qualified Foreign Investors (QFI), SEBI may not relax the Know Your Customer (KYC) norms
for QFIs investing in mutual funds. As a result, money may not flow in as anticipated as global investors may not be easily
willing to tweak their established operating mechanisms just to suit India's norms.
The recent Union Budget did try to address some concerns of the asset management industry. It expanded the scope of
the Rajiv Gandhi Equity Savings Scheme (RGESS), an equity savings scheme introduced for new investors, to include
mutual funds. These mutual funds would be schemes with RGESS eligible securities as underlyings. To help boost
institutional flows, it also allowed pension/provident funds to invest in Exchange Traded Funds (ETFs) and debt funds.
Retail broking: Shrinking participation from retail investors, relative high transaction costs, falling cash equities volumes
and yields, as well as risk management were some of the concerns which shaped the intent of regulators in this segment.
Following the cut in the Securities Transaction Tax (STT) charged in the equity cash delivery volume segment in last year's
Budget, the recent Budget also announced a STT cut in equity futures volume. A main objective was to address current
issues like the increasing shift of Nifty futures trading to the Singapore Exchange (SGX) which also offers Nifty futures
trading. SGX Nifty futures volumes are now ~50 per cent of the same segment in the National Stock Exchange (NSE).
While this move might be positive for traders & arbitrageurs, the post-cut trading costs are still lower in SGX due to other
advantages that Singapore offers.
The recent Budget also proposed a commodities transaction tax (CTT) of 0.01 per cent on non-farm commodity futures
(this excludes agricultural commodities). While this may ensure a level playing field between commodities and equities, it
may affect arbitrage returns and possibly might also impact food inflation. The RGESS was introduced as an equity savings
scheme for first-time investors, who have gross income <= Rs 1.2 million, with a maximum Rs 50,000 investment for
availing tax benefit and tax benefit extended to 3 years. The entry of first-time investors into equities will help increase
participation levels in the markets, although the lock-in norms remains a concern.
To simplify the registration process for brokers, a common registration certificate has been proposed for brokers across all
segments that they operate in. In terms of risk management, NSE (National Stock Exchange) asked brokers to pre-define
order limits (based on certain criteria) of each terminal they operate in both cash equities and equity futures and options
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Thursday, 09 May 2013
Challenges in capital market: The Indian experience-II
Sourajit Aiyer concluding his two-part article
The General Anti-Avoidance Rules (GAAR) proposals caused a lot of uncertainties to Foreign Institutional Investors
(FIIs/foreign portfolio investors) in 2012. Its subsequent deferment to 2016 gave a positive boost to FII inflows, and gives
ample time to them to review their investment structures. The Finance Ministry will soon announce new disclosures for
foreign investors related to source of funds and beneficial ownership while investing in sensitive sectors. Foreign investors
need to furnish these upfront to the Foreign Investment Promotion Board. This is expected to help identify the source of
funds as closely as possible, control the round-tripping of Indian money through the FII route and vet suspicious
investments at initial stage.
The new format of Mauritius' Tax Residency Certificate is expected to include disclosures from investors availing treaty
benefits - like address of assessee, tax identification number and entity status (individual, partnership, company). It should
help avoid investors from abusing tax treaties. Also, SEBI set up a committee to study a single route for all foreign
investments like QFIs, foreign financial investors, Venture Capital Funds, Non-Resident Indians. It should simplify the
investment process for overseas entities, though Permanent Account Number and taxation remain concerns.
SEBI announced a cap on execution charges earned by brokers from mutual funds (12 bps for cash equity and 5 bps for
F&O trades). This would have a negative impact on institutional broking revenues. FIIs can now participate in currency
derivatives, to the extent of its Indian Rupee exposure. This move should improve participation, liquidity & help cover
Wealth management: Wealth management as a segment is still largely unregulated in India, in terms of both distribution
and advisory. The Investment Advisor norms were an attempt on this front. SEBI recently announced these guidelines and
it is expected to be applicable by mid-2013. The Investment Advisor norms will make it mandatory for advisers to register
with SEBI and disclose (a) issues that could lead to conflict of interests, (b) risks associated with product, (c) fee received
for their advice, (d) records like KYC, risk profiling, record of advice and time of advice etc, as well as complying with net
worth and qualification requirements. This would help segregate investment advisory services from other activities of the
entity (including distribution).
Moreover, disallowing transactions on their own account contrary to the advice given by them (for up to 15 days from date
of advice) will ensure further transparency and accountability of the advisers.
Investment banking: The regulator's focus was to further the bankers' accountability in the Initial Public Offering (IPO)
process to bring back the confidence of the investors. SEBI plans to make the issue manager responsible for the end-use of
IPO proceeds. Companies cannot deploy more than 25 per cent of proceeds for general corporate purposes, and may not
be able to access the markets if the utilization plan is vague or does not create a tangible asset. This would help avoid
misuse and diversion of the issue proceeds. But it may also require the investment banker to submit periodic reports on
the usage for almost a year after the issue date.
Investment banking firms need to disclose the track record of price performance of the issues they handled previously. This
should help tighten the pricing process and avoid over-aggressive pricing during IPO issuances. SEBI may also ask
companies to compensate retail investors if prices crash within months of the IPO, even after factoring market movements.
But this would require a much more exhaustive due-diligence process. SEBI also relaxed the IPO norms for Small and
Medium Enterprises of achieving profits in 3 out of 5 years, which should enable such issuers to have easier access to
In order to comply with the 25 per cent minimum public shareholding rule for listed companies, SEBI created two new
ways by which firms can sell shares without public issue - Offer for Sale (OFS) and Institutional Placement Programme
(IPP). SEBI also amended the OFS rules to allow sale of up to 10 per cent stake to Alternate Investment Funds (AIFs). OFS
and IPP are faster and cheaper methods for promoters to raise money, and is expected to infuse ~Rs300 billion worth of
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shares in the markets. Among others, SEBI has allowed issuance and listing of preference shares on exchanges, which will
help companies improve net worth and debt-equity ratios. Fair trade regulator - Competition Commission of India - has
asked companies to clearly define their market and possible anti-competitive effects when seeking approvals for mergers
Private equity: The Alternate Investment Fund (AIF) Guidelines requires all Alternate Investment Funds to register with
SEBI. The SEBI (VCF) Regulations, which currently regulates Venture Capital funds, would be repealed. Existing VCFs
would continue to be regulated by VCF Regulations till they are wound up, though they may seek re-registration under AIF.
The AIF Regulations defines AIFs as Category 1 (VC, SME, Social Venture, Infrastructure funds), Category II (Private
Equity, Real Estate and Debt funds and Fund of Funds), Category III (Funds which employ diverse/complex strategies and
leverage). Thiis would require complying with the various requirements, like minimum investment of Rs 10 million from an
investor, minimum fund corpus of Rs 200 million, sponsor's interest of lower of 2.5 per cent of initial corpus or Rs 50
million, financial disclosures of portfolio companies as well as risk disclosures at fund level on various parameters within
180 days from year-end. Units of an AIF may be listed on the exchange subject to a minimum tradable lot of Rs 10 million,
which may impact traded volumes in the markets positively.
SEBI has also proposed to the government to allow foreign investments into AIFs under Foreign Direct Investment (FDI),
and has also clarified that it would not regulate fundraising from overseas markets done by the private equity (PE) players.
Inflows of those funds may get easier if they come under FDI. Foreign capital may also bridge the demand-supply gap as
domestic sources may not be able to match the requirement alone. SEBI is also looking at the control practices of PE
investors, whereby they often have powers over key decisions despite just a minority stake.
According to SEBI, PE investors will now be identified as promoters not only when they have a majority stake but also
when their holdings are actually higher than the original promoters. Being termed as promoters would require PE investors
to maintain a 3 year lock-in once the companies go public, which has led to some firms resorting to secondary deals. Given
the challenging conditions in the industry this year, PE firms are now widening the scope of the indemnity clause which
covers losses or liabilities, in order to safeguard their capital and make promoters more accountable for the funds.
Other segments: NSE's decision to allow brokers to use mutual funds as collateral for margin requirements, apart from
cash and bank guarantees, should widen the scope for investors. SEBI restricted dynamic price bands at 10 per cent of the
previous close for stocks on which F&O securities are available (can be relaxed in increments of 5 per cent if a trend is
observed in either direction). This should prevent acceptance of execution orders that are placed beyond the set limits and
help avoid flash-crash like situations. Securities lending and borrowing activities grew 3x in 2012 as regulations boosted
institutional interest, though this depends on available reverse arbitrage opportunities.
Also, lower client-level position limit is a challenge as there are only few active participants who are frequently trading in
limited counters. Introduction of inflation indexed bonds in the future would be a welcome step to protect the savers from
the impact of inflation.
The challenges that the capital market players face are immense - to replicate the risks and returns of physical assets to
capture that savings flow, educating investors about capital markets, increase opportunities for cross-selling and ensure an
incentive structure to intermediaries in order to increase inflows. But the intent of the regulators are in the right direction -
to ensure the clients' interests are kept paramount, achieve higher inflows and participation, increase market access to
participants, ensure a fair framework is in place for these segments and remove the scope for mis-selling and over-
aggressive pricing which can negatively impact long-term inflows into capital markets. Companies in the financial services
need to adapt to the changing regulatory climate and build their ability to showcase their role as value-creators for client
assets, which would bode well for flows into financial savings going forward.
Disclaimer: This article is meant for information purposes only and does not construe to be an investment advice. It is not
intended as an offer or solicitation for the purchase or sale of any financial instrument. Any action taken by you on the
basis of the information contained herein is your responsibility alone. We have exercised due diligence in checking the
correctness and authenticity of the information contained herein, but do not represent that it is accurate or complete. The
readers should rely on their own investigations.
The writer is Senior Manager, Investor Relations (corporate planning team), Motilal Oswal Financial Services
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