SEBI’s Shift Towards Financial Product Design: A Necessary Evolution or Risky Overreach?
Introduction: SEBI’s Expanding Role
SEBI, established in 1988 and given statutory powers in 1992, has always played a crucial role in India’s financial ecosystem. Initially, its focus was on regulating stock exchanges, ensuring market transparency, and protecting investors from fraud. Over time, as India’s financial markets evolved, so did SEBI’s responsibilities. However, a recent and somewhat controversial shift has been SEBI’s direct involvement in designing financial products, a role traditionally reserved for financial service providers.
This shift aims to attract a wider range of investors, particularly retail investors with limited financial knowledge, by offering structured investment products that promise safety and accessibility. SEBI has introduced micro-investments in mutual funds, specialised investment funds, fractional real estate investment trusts (REITs), and infrastructure investment trusts (InvITs). Additionally, it has proposed innovative hybrid products like securities-cum-insurance offerings.
While this intervention is meant to democratise investments and stabilise volatile markets, it raises a fundamental question: Should a financial regulator also act as a market architect? This essay explores the rationale behind SEBI’s shift, the potential risks and benefits, and whether such a move is sustainable in the long run.
SEBI’s Rationale: Why is the Regulator Designing Financial Products?
The core motivation behind SEBI’s intervention seems to be financial inclusion and risk mitigation. The Indian investment landscape is dominated by traditional savings instruments like fixed deposits and gold. Retail participation in equities is relatively low, with many people wary of stock market volatility. SEBI’s introduction of innovative investment products aims to:
- Increase Market Participation: SEBI hopes to draw in new investors who might otherwise avoid the stock market due to its perceived risks. By designing structured products like mutual fund sachets (small-value investments), even individuals with limited financial literacy can participate.
- Prevent Speculative Bubbles: SEBI has repeatedly warned about excessive speculation in the stock market, particularly in derivative trading, where uninformed retail investors often take high risks. Creating regulated investment products with built-in safeguards could help steer investors toward safer avenues.
- Compensate for a Lack of Private Innovation: The Indian financial sector has been slow in launching innovative investment products. Unlike the banking sector, where fintech startups and digital innovations have transformed services, capital market innovations have lagged. SEBI’s role in designing financial products may stem from a perceived innovation gap in the private sector.
- Align Investments with Developmental Goals: Some of SEBI’s interventions, like Infrastructure Investment Trusts (InvITs) and Real Estate Investment Trusts (REITs), support national economic objectives by channelling investments into infrastructure and housing projects.
While these motivations are valid, the shift toward product design also raises serious concerns.
The Risks of SEBI’s Financial Product Design Approach
- Market Distortion and Regulatory Conflicts
Financial products should emerge organically based on investor needs, market demand, and competitive forces. By designing products itself, SEBI risks distorting this natural market process. If regulators set the market direction, private firms may stop innovating, assuming that SEBI will do the work for them.
Additionally, SEBI’s involvement in product design creates regulatory conflicts with other financial bodies. For example, its proposal to introduce securities-cum-insurance products encroaches on the domain of the Insurance Regulatory and Development Authority of India (IRDAI). Past conflicts, such as the 2010 dispute over Unit Linked Insurance Plans (ULIPs) between SEBI and IRDAI, show how overlapping jurisdictions can create confusion and inefficiency.
- The Failure of Past Regulatory-Led Products
SEBI’s track record in designing financial products has seen both successes and failures, with the Rajiv Gandhi Equity Savings Scheme (RGESS) standing out as a notable misstep. Launched in 2012 to attract first-time equity investors through tax incentives, the scheme struggled due to overly complex eligibility criteria that confused potential investors, restrictive investment options that made it unattractive, and inadequate awareness caused by poor marketing efforts. As a result, participation remained low, and by 2017, the scheme was discontinued. This failure underscores a crucial issue with regulator-designed products—they often lack proper market validation. While SEBI’s intentions may be good, it cannot always predict investor behaviour, meaning that even well-intended schemes can fail despite their potential policy benefits.
- The Sandbox Conundrum: Why is SEBI Struggling with Innovation?
To encourage innovation, SEBI introduced a regulatory sandbox, allowing financial firms to test new products under supervision. However, participation has been disappointing. Between 2020 and 2024, only 13 applications were submitted—6 were withdrawn, 6 rejected, and just 1 approved. In contrast, the Reserve Bank of India’s (RBI) sandbox for fintech and digital payments has been far more successful, attracting significantly more participants. This stark difference suggests that SEBI’s eligibility criteria may be too rigid, discouraging firms from applying, or that capital market participants lack confidence in SEBI’s innovation framework. Unlike banking and insurance, where digital solutions have flourished, capital market innovations have lagged, possibly due to excessive regulation or unclear incentives. If SEBI aims to foster real innovation, it may need to rethink its approach, making the sandbox more accessible and attractive to market players willing to experiment with new financial products.
- Moral Hazard: The Risk of Perceived Safety
When SEBI designs financial products, investors may wrongly assume they are completely safe, creating a moral hazard. If a SEBI-backed product underperforms or fails, retail investors could face unexpected losses, believing it carried an implicit guarantee. For example, mutual funds developed under SEBI’s framework might be aggressively marketed by fund houses, leading investors to assume that “SEBI-approved” means risk-free. However, all investments carry risks, and such misconceptions could result in financial losses and disappointment. If this happens repeatedly, public confidence in SEBI’s regulatory role may weaken, as investors may feel misled into a false sense of security. A regulator’s primary role is to oversee and ensure fair practices, not to guarantee returns. To avoid this risk, SEBI must make it clear that its approval does not eliminate investment risks and ensure that products are transparently marketed with adequate risk disclosures.
The Case for SEBI’s Intervention: When is it Justified?
SEBI’s involvement in product design, despite its risks, is sometimes essential for market development and investor protection. One key area is underdeveloped sectors, where private firms hesitate to introduce new investment options. For instance, Infrastructure Investment Trusts (InvITs) initially struggled to attract investors, but SEBI’s regulatory support helped them gain traction, opening up new investment opportunities.
Another crucial role is protecting retail investors from high-risk financial products. The 2008 global financial crisis highlighted the dangers of unregulated innovation, where complex, unchecked instruments led to widespread market collapse. SEBI’s structured oversight ensures that financial products are carefully designed to minimise systemic risks and protect investors.
Lastly, SEBI’s intervention helps align capital markets with national economic goals. By promoting Social Stock Exchanges and investment avenues that support infrastructure and social welfare, SEBI plays a developmental role, guiding capital toward sectors that drive economic growth. In a rapidly evolving financial landscape, regulatory involvement can be necessary to ensure stability, inclusion, and long-term sustainability.
Conclusion: Balancing Innovation with Regulation
SEBI’s shift from a regulator to a product designer is a double-edged sword. While its goal of expanding market access and protecting investors is well-intended, its approach raises concerns about market distortion, regulatory overreach, and moral hazard. If SEBI takes on too much responsibility for product innovation, it may discourage private firms from developing their own solutions, ultimately stifling market-driven growth.
To strike the right balance, SEBI must ensure product development remains market-driven, intervening only when absolutely necessary. It should also enhance its regulatory sandbox, making it more accessible to encourage private-sector innovation. Additionally, SEBI must coordinate with other regulators to prevent jurisdictional conflicts, particularly in areas like insurance-linked products. Finally, it must educate investors, ensuring they do not assume SEBI-backed products are risk-free.
If SEBI carefully navigates these challenges, it can help create a more inclusive and stable financial market. However, overstepping its role could weaken investor confidence and hinder the very innovation it aims to promote.
