More info may not necessarily help investors

Regulations are blueprints used by the regulator while discharging its role as a referee to oversee the activities and behaviour of participants in the market. One of the important effects of regulation is signalling to the investors that they would be treated fairly.

Trust and confidence are crucial for financial transactions. Investors of the financial products will have confidence when they perceive that the suppliers of the financial products will keep their promises and not behave opportunistically.

Investors feel betrayed and become reluctant to invest in a system that seems rigged or where some parties enjoy unfair advantages over others. Whenever such perception arises it becomes the responsibility of the regulators to restore investor confidence.

On July 8 SEBI floated a consultation paper on applicability of the SEBI (Prohibition of Insider Trading PIT), Regulations, 2015 to mutual fund (MF) units, soliciting public views on the proposals. Some incidents in the past seem to have inspired the discussions on bringing mutual fund units under the definition of Securities under the PIT regulations.

It was observed that a Registrar and Transfer Agent of a mutual fund had redeemed all its units from a scheme, being privy to certain sensitive information pertaining to scheme of mutual fund, which was not yet communicated to the unit holders of a particular scheme. Similarly, in another instance, a few key personnel of a mutual fund were found to have redeemed their holdings in the schemes, while in possession of certain sensitive information not communicated to the unit holders of the schemes.

The reaction of the industry as expected is not favourable to these regulatory proposals. AMCs seem to be more in favour of greater disclosures and compliances as against regulating the conduct directly.

Disclosure-based regulations have many positive effects. Disclosures led public exposure will discourage misconduct and induce honest behaviour. It is also believed that disclosures will enable investors to make informed investment decisions. And thus disclosures of material information have become the primary tool for protecting investors and regulating the securities market. However, for a disclosure based regulatory framework to be effective, timely disclosures of accurate material information is a necessary but not sufficient condition. The information needs to be comprehended by the investor. And this is where disclosure based regulation becomes challenging. Disclosure-based regulation assumes that people are capable of making rational decisions for themselves after taking into consideration all the available information.

Information overload

However, there is substantial evidence that human minds have limits on the abilities to process information. Flooding an average investor with too much information by way of disclosures may backfire. More information is not necessarily better than less information.

Too long or complex disclosures can be counterproductive as it increases the cognitive load on an average person and hinders the optimal decision-making. The cognitive challenges on processing the information for decision making make investors more vulnerable than the lack of information. These concerns raise some fundamental questions about the purpose of securities market regulations — are the regulations designed to help the average, unsophisticated investor, or the sophisticated market professionals?

The very concept of investing through mutual funds is rested on the premise that mutual funds are vehicles to provide exposure to well managed portfolios to those investors who do not have the resources, both time and skill, to do it themselves. Hence the assumption above the investors in the mutual fund space is they have cognitive limitations.

Disclosures-based regulation is the most palatable form of regulation for a reason. It constitutes a compromise: requiring disclosures is better than doing nothing at all, and at the same time not prohibiting the conduct substantively. Regulating the conduct of the participants in the market requires more deliberations, analysis and fortitude. It is easier to demand reporting of conflicting interests than prohibiting conflict transactions and relationships outright.

Opting for regulatory disclosures shifts the onus on the investors to decide whether the conflict is sufficiently important to affect their investment decisions. However, it avoids the harder question of whether those conflicting interests are allowed to exist at all. So though disclosures have many positive effects in the market place, it needs to be appreciated that often more stringent measures are required to provide appropriate levels of investor protection.

Substantive regulations that shape the conduct of the participants directly may be more helpful especially in the mutual fund space where retail money is involved.

The writer is Professor & Dean (Academics), National Institute of Securities Markets

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