ROBOADVISORS IN MARKETS: WHERE DOES INDIAN REGULATOR STAND?

The big leap in technology and its application in the financial system has only been possible due to development in the "Fintech Industry." Fintech or "financial technology" implies a new sector that has emerged to support the introduction and implementation of digital technologies in the financial system, by adding value to its normal operations.[1]

In the last ten years, the Fintech Industry has changed drastically across the globe, with the emergence of Robo advisors as a better alternative for investors in the market. A Robo advisor is a broad term and is defined by various institutions according to the profession. For the purpose of our market and institution, it can be defined as the algorithm that can provide investment services to an investor.[2] This article aims to analyze the few existing legal, regulatory framework in India on the Robo advisors and to suggest some functioning guidelines.

EMERGENCE OF ROBO-ADVISORS

Investment for a lot of people can be challenging, marked by complexity on both the demand and supply sides of the market for financial assets.

An increase in the types of investment has made financial markets more complicated than they already were, particularly in the retail environment. Additionally, while understanding the growing array of financial products, the investors must evaluate risk, the effects, the tax implications of investment, and how to withdraw from their investment portfolio.

Since computers are considered good at both routine and highly complex tasks, and Robo advisors run by Artificial Intelligence in today's era can make it easier for clients to manage their investments. Robo-advisors designed based on an algorithm to interact with clients digitally, both to gather client information and to manage the client's investments.

 A client creates an account online by responding to a series of questions that may include risk preferences, assets, income, debt, and investment goals.

The Robo-advisor uses computer algorithms to offer investment selections deemed appropriate in terms of asset allocation and diversification based on the information supplied by the client. Robo invests the client's portfolio in accordance with the recommended asset allocation, which can typically be modified by the client. Robo advisors also manage their clients' portfolios on an ongoing basis, providing services that include automatically rebalancing the portfolio periodically to maintain the desired asset allocation and reinvesting dividends, redemptions, and interest payments. [3]

In addition to asset allocation and diversification, Robo-advisors generally rebalance clients' portfolios.

Moreover, Robo advisors have become increasingly popular after the 2008 global financial crisis. Although Robo Advisors originated in the form of fintech start-ups, they have gained popularity in recent years, particularly with large global financial institutions like Charles Schwab, Black Rock, Wells Fargo, and Bank of America bringing their own Robo Advisory services to the market.

THE INDIAN MARKET REGULATOR: SEBI AND BABY STEPS

As it stands today, Robo-advisory firms come under the ambit of SEBI (Investment Advisors) Regulations, 2013.[4] In October 2016, SEBI came out with a consultation paper with regard to compliance requirements for the same. It noted that the risk profiling of the investor is mandatory, and all investments on which investment advice is provided shall be appropriate to the risk profile of the client.

In India, SEBI needs to take steps to make the right regulations to make India stand along with the other developed countries with effective Regulations on Robo advisors and Artificial Intelligence. There are three different levels at which the Robo advisors operate —at the individual level, firm-level, and the system level.[5]

There are limited but certain compliance requirements suggested by the Consultation Paper issued by SEBI in 2016:

1. Mandatory Risk profiling and suitability of advice being given to the investors.
2. All investment advice should be appropriate to the risk profile of the client.
3. The records pertaining to risk profiling and risk assessment of the client and suitability assessment of the advice being provided to be maintained by the investment adviser for five years.
4. It should be ensured that the automated tools used are fit for the purpose.
5. Robust systems and controls should be in place to ensure that any advice made using the tool is in the best interest of the client and suitable for the clients.
6. There should be proper disclosures to the clients about how the tool works and its limitations of the outputs it generates, and the general obligations of the advisor are also given comprehensively.
7. There should be comprehensive clarity in the system for audit requirements in place.
8. The automated tools used by the advisers to be subject to audit and inspection.[6]

In December 2019, SEBI came out with a two-page circular, imposing some well-meaning reforms in investment advisor regulation. The Regulator intended to introduce some of the key changes in the functioning of Investment Advisors, including the Robo-advisors.

The key changes introduced by the SEBI Circular are:

1.     Restriction on a free trial for any product/service of the prospective client.

2.     Proper risk profiling and consent of the client on risk profiling and RIAs to give investment advice only after completing the risk profile of the client based on information provided by the client and obtaining the consent of the client on completed risk profile either through registered email or physical document.

3.     Receiving fees only through the banking channel and not in cash deposits.

4.     Display complaints status on the website in order to bring in more transparency.[7]

The prescription of seeking consent through email or physical form is a move to draw the industry backward, and this rule seems to create pointless burden and disruption for Robo advisors as they are designed to sign up online and complete their assessment in a few hundred bucks.

Moreover, most regulations appear to be fair, but applying them across the board may act as entry barriers. The Regulator needs to adopt cost-benefit analysis and also put updrafts of circulars before implementing them.

The Robo advisors in India are still in the nascent evolutionary phase and have a lot of shortcomings. Beginning with a lack of emotions and empathy. As investments are also a subdomain of behavioral finance, there are still major doubts about the viability of Robo advisors. Further, they are good for beginners in investment; still, Robo advisors are not effective for advanced advisory services like complicated tax planning, real estate investment planning, multiple stage retirement planning, etc.

And finally, they are not properly trained/equipped to deal with an unexpected crisis or extraordinary situations like the economic crisis of 2008. Whether they can perform better or worse than the traditional advisors in such situations- is still not tested.

Although the market in India is relatively small, given its massive growth potential and favorable external factors, Robo Advisors in India will thrive in times to come.

SUGGESTIONS FROM THE MIDDLE EAST

The Regulator of fastest-growing financial hubs in the middle east, i.e., The Financial Services Regulatory Authority (FSRA), has a regulatory framework for Digital Investment Managers, also known as 'Robo-advisors,' operating in Abu- Dhabi Global Market.

The guidelines by the FSRA states that FSRA will permit Digital Investment Managers to hold a lesser amount of prudential capital should they meet the criteria and requirements. By issuing this guidance the ADGM aims to make it easier for digital investment businesses to operate in ADGM.

The FSRA's requirements, with respect to algorithm governance, more precisely the Robo advisors, are closely aligned with international best practices. These include requirements for:

• ensuring that the algorithm model is not affected by possible behavioral biases;
• human oversight of the design, performance, and security of the algorithm model;
• ensuring the outcomes produced by the algorithm model is explainable, traceable, and repeatable; and
• adequate safeguards to be in place to protect the integrity of the algorithm model.[8]

The Middle East Region has been developing tremendously when it comes to Fintech, and it is quite evident from the fact that The Dubai Financial Services Authority announced in 2018 that Robo Advisory firm SARWA is the first firm to graduate from its regulatory sandbox after excessive testing and comprehensive guidelines.[9]

CONCLUSIVE REMARKS

After looking into the aspects of the legal framework for Robo advisors, this can be concluded that the existing market conditions are an optimistic opportunity for the introduction of Robo advisors in the present financial market. However, these technical developments require new, clear, and effective legal backing. The SEBI has not made clear and specific guidelines for the Robo-advisors and which is also a reason the Robo advisory technology in India is still at a budding stage since the investors are always under fear of conflict and lack of regulation about the subject. Also, it is necessary to distinguish that the current legal framework applies to which type of Robo advisor since there are types of them, and there are high chances of developing more types based on their function and needs.

 BY

Vijay Pal Dalmia, Advocate

Supreme Court of India & Delhi High Court

Email id: [email protected]

Mobile No.: +91 9810081079

Linkedin: https://www.dhirubhai.net/in/vpdalmia/

Facebook: https://www.facebook.com/vpdalmia  Twitter: @vpdalmia

AND

Kritika Singh

Maharashtra National Law University, Aurangabad.

Email: [email protected]

[1] Kakavand, H., Kost de Sevres, N. and Chilton, B. “The Blockchain Revolution: An Analysis of Regulation and Technology Related to Distributed Ledger Technologies.” (Apr. 26, 2020 18:49) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=284925

[2] STATISTA, Robo-Advisors, 2016: (Apr. 26, 2020 18:49) https://www.statista.com/out-look/337/100/robo-advisors/worldwide#.

[3] Berger, R. (2015). ‘7 Robo Advisers that Make Investing Effortless,’ Forbes, (Apr. 26, 2020 18:49) https://www.forbes.com/sites/robertberger/2015/02/05/7-robo-advisors-that-makeinvesting-effortless/#75eaae1f7e48.

[4] SEBI (Investment Advisers) Regulations, 2013.

[5] Vidhu Shekhar, Robo advisory platforms will take another 2-3 years to evolve into a mature industry. (Apr. 26, 2020 18:49) https://www.livemint.com/Money/gRpqlvGKLGzWmtCqR1ks3I/Robo-advisory-platforms-will-take-another-23-years-to-evolv.html

[6] Consultation Paper on Amendments/Clarifications to the SEBI (Investment Advisers) Regulations, 2013.

[7] SEBI, Circular vide Dec 27, 2019, Circular No.: SEBI/HO/IMD/DF1/CIR/P/2019/169.

[8] ADGM Releases Regulatory and Governance Regime for Robo-Advisors, (Apr. 26, 2020 18:49) https://www.adgm.com/media/announcements/adgm-releases-regulatory-and-governance-regime-for-robo-advisors.

[9] Robo-advisory firm Sarwa, First to Graduate from DFSA’s Regulatory Sandbox, (Apr. 26, 2020 18:49)

https://www.dfsa.ae/MediaRelease/News/Robo-advisory-Firm-Sarwa,-First-to-Graduate-from-D.