BALANCING SAFETY AND FLEXIBILITY: ANALYSING SEBI’S CIRCULAR ON REGULATORY DEPOSITS

This post is authored by Divyansh Yadav, 3rd year B.A. LL.B. (Hons.) student at Hidayatullah National Law University.

INTRODUCTION

On 12 August 2025, the Securities and Exchange Board of India (“SEBI”) issued a circular (“the Circular”) permitting Investment Advisors (“IAs”) and Research Analysts (“RAs”) to meet their mandatory deposit requirements not only through fixed deposits with scheduled banks, but also via units of Liquid Mutual Funds (“LMFs”) and Overnight Mutual Funds (“OMFs”). The Circular has been issued with the aim of balancing investor protection and ease of doing business. This shows that SEBI is aware that smaller players in the market should not be strained in their regulatory compliance. The traditionally accepted form of deposits, which IAs and RAs had to comply with, was the parking of funds in fixed deposits of banks which although safe, were not very liquid and earned relatively low returns. By opening the eligible instruments to LMFs and OMFs, SEBI facilitates a way in which the instrument is safe, liquid, and offers better potential yields, which adds to the cash efficiency of the regulated entities. Since the Circular has a profound impact on the Indian financial landscape, it becomes imperative to analyse the same.

Through this article, the author delves into the intricacies of the Circular in three parts. Firstly, the article discusses the provisions laid down in the Circular, along with its potential impact. Secondly, it highlights the shortcomings of the Circular. Thirdly, it lays down plausible solutions to resolve these shortcomings. Lastly, the article concludes with a summary and a way forward for moving upward and ahead.

FROM LOCK-INS TO LIQUIDITY: ANALYSING THE PROVISIONS

SEBI has introduced the Circular to have a balance of investor protection and efficiency of regulations to the extent of providing IAs and RAs a flexibility in satisfying their mandatory deposit requirements.

Firstly, the expansion of the number of deposit instruments that IAs and RAs can use has changed. Previously, the compliance was limited to a Fixed Deposit (“FD”) with a scheduled commercial bank in case of Regulation 27 of the SEBI (Investment Advisers) Regulations, 2013 and Regulation 14 of the SEBI (Research Analysts) Regulations, 2014. Although legally sound, such FDs were attacked as tying up capital incomes at comparatively low rates, thus over-burdening the economy, particularly to the smaller advisory firms. The Circular permits the use of LMFs and OMFs, which are both low-risk instruments under SEBI Mutual Fund Regulations, 1996.

For years, regulatory deposits were confined to fixed deposits, while instruments such as LMFs and OMFs were sidelined despite their inherent liquidity and low-risk profile. The legal rationality of SEBI restricting permissible instruments only to these funds is underscored in Franklin Templeton Trustee Services v. SEBI, which exposed liquidity vulnerabilities in longer-tenure debt funds, making short-term, high-quality instruments a safer alternative. In contrast, LMFs and OMFs are invested in short-term high-quality securities and do not offer much volatility and are more liquid. This reform is therefore both legally and economically logical and increases the flexibility of compliance and protects the investor.

Secondly, the Circular has given a central role to the Bombay Stock Exchange (“BSE”), which will act as both the IAASB and the RAASB. The BSE has been mandated with the responsibility of ensuring that appropriate workflows are adopted with regard to lien marking, custody, and verification of deposits, which has institutionalised accountability.

Although the establishment of the BSE as IAASB and RAASB might be perceived as a procedural issue, it is pertinent to the smooth sailing of the Circular enforcement. The failure of regulatory reforms is not always due to flaws in the concept but rather the inefficiency of the implementation mechanism. SEBI will ease the risk of disjointed supervision by appointing a centralised facilitator and promoting efficiency in operational functions of lien marking, custody and verification. This institutionalizing makes the reform actual and practical so that the flexibility that is accorded to IAs and RAs does not come at the expense of investor protection. However, one needs to be cautious enough to not rely on one market institution.

To provide an orderly transition, SEBI has ordered that all IAs and RAs will have to switch to the revised deposit framework by September 30, 2025. The chronology shows that the regulator has been quite pragmatic in its approach of striking the right balance between reform and a suitable implementation period.

The reasoning is directly connected to the SEBI’s June 2025 Board meeting, which identified inefficiencies when it comes to mandating idle bank deposits. By enabling the deployment of liquid and overnight mutual funds, SEBI can achieve small returns with protection of the investors due to lien marking. The rationality of this reform is rooted in practical reasoning, as SEBI is developing a model of law, finance and governance that is trusted in the Indian capital markets.

BETWEEN LIQUIDITY AND LEGALITY: GAPS IN THE CIRCULAR AND SOLUTIONS

While the Circular is a watershed reform for the Indian financial landscape, concerns persist over potential risks that could challenge its effectiveness. The Circular, poses risks which this section elucidates on.

Firstly, though there are liquid and overnight mutual funds, which are classified as low-risk funds, they are still vulnerable to the market-linked risks. The closure of the Franklin Templeton debt fund demonstrated that even short-term funds might go under pressure during redemptions. In Morgan Stanley Mutual Fund v. Kartick Das, the SC was conscious of the unpredictability and instability of market-based instruments, and warned against assuming that they were risk-free.

Unlike the fixed deposits, which are insured under the Deposit Insurance and Credit Guarantee Corporation Act, 1961, mutual funds do not come with statutory insurance, thus putting regulatory deposits at the risk of being depleted. These risks compromise the SEBI investor-protection mandate contained in Section 11 of the Act, according to which the regulator is required to ensure stability. There is also international practice confirming this concern; the SEC reforms in the United States (“US”) in 2016 introduced liquidity risk management programs in mutual funds in order to avoid systemic shocks. The regulatory dependence on LMFs and OMFs may undermine investor confidence in times of crises because there are no parallel safeguards in India. SEBI thus, might require the imposition of liquidity stress-testing or regulatory haircuts to reduce volatility risks.

Secondly, the lien-marking requirement of the Circular is legally novel but procedurally complicated. Enforcement of lien over the mutual fund units requires coordination amongst the AMCs, RTAs and Depositories, whereas the enforcement of lien in the case of a bank is simple by virtue of the Indian Contract Act, 1872. Banking courts have always considered liens in banking to be valid. Without a codified enforcement system, lien-marked mutual funds units would face delays in the execution of processes, particularly redemptions or defaults. As SEBI is given supervisory powers under Section 11(2) (i) to regulate intermediaries, a binding Standard Operating Procedure (“SOP”) on invocation of lien is required. Unless this is done with precision, the lien condition can be mere symbolic as opposed to effective protection of investor interests.

Thirdly, one of the key impediments to the use of units of mutual funds to hold regulatory deposits is valuation. Unlike the fixed deposits which ensure a fixed amount of money plus interest after the end of the period, the units of the mutual funds vary daily with the Net Asset Value (“NAV”). This creates a question: is compliance to be evaluated at the moment of investment or on a continuous mark-to-market basis? In Bharat Petroleum Corp. Ltd. v. Petroleum Employees Union, it was observed that the valuation inconsistencies would create a dent in the market confidence and would cause regulatory arbitrage. With this application, when NAV is lower than the minimum amount of deposit, there is a risk that an adviser or an analyst may unwittingly become non-compliant without any malaise. Also, under the Companies Act, 2013, Ind AS 109, requires fair value accounting of financial assets and this principle should be applied uniformly when it comes to regulatory deposits. SEBI needs to prescribe a standardized methodology containing valuation buffers, to ensure uniformity and is in line with global regulatory best practices.

To address these shortcomings, a legally viable solution is to have SEBI mandate a statutory liquidity and valuation framework to regulatory deposits based on mutual funds. First, SEBI can require liquidity stress-tests and regulatory haircuts of LMFs and OMFs designated to be used in a deposit, following the 2016 reforms of the US SEC on liquidity risk management. This prevents the redemption pressure that occurred in the Simon Templeton crisis at the expense of the regulatory deposits. Second, SEBI should use mark-to-market regime with minimum buffer margins (say 10-15%) in line with Ind AS 109 as under the Companies Act 2013 that stipulates fair value accounting of financial instruments. SEBI stresses harmonisation of valuation in order to avoid regulatory arbitrage. SEBI can use the regulations to provide legally binding compliance certainty by incorporating these rules into the SEBI (Investment Advisers) Regulations, 2013 and SEBI (Research Analysts) Regulations, 2014. This kind of framework would not only reduce volatility risks, but also reinforce investor protection under Section 11 of the Act with predictable and transparent standards auguring well in terms of market confidence.

SEBI may also formulate a codified SOP under the provisions of Section 11(2) (i) of the SEBI Act 1992 which specifically addresses the issue of lien-marking and enforcement of mutual fund units. Currently, enforcement is done through AMCs, RTAs and Depositories, introducing a backlog in the process. Enforceability of liens as a security interest has always been stressed by the Courts as evidenced in ICICI Bank Ltd. v. Official Liquidator of APS Star Industries Ltd., where a pledgee was held to have prior rights to pledged securities. By requiring under the Depositories Act, 1996 that the lien-marking of regulatory deposits be done directly through the depositories, SEBI will be able to ensure that there is only one point of enforceability, eliminate potential jurisdictional clashes and simplify the timeline of invoking on such lien-marked regulatory deposits. Such codification would strengthen investor protection since regulatory deposits would be immune to the inefficiencies and conflicts of procedures.

CONCLUSION

The Circular marks a fundamental change in how securities are regulated shifting the hard and fast requirements on bank deposits to a more market aligned approach. By broadening the instruments that may be used, and by incorporating protections against liens, SEBI has become more protective of investors, but at the same time acknowledges that efficiency in the use of capital is essential. However, there are shortcomings such as the fluctuations in the mutual fund prices, enforceability of liens and liquidity mismatch may put intermediaries at risk as compared to the previous regime. The Circular is therefore, an intermediate step rather than a goal. Its effectiveness will depend on the speed at which SEBI formalises SOPs of operations and develops resiliency systems. When done right, this reform can establish a regulatory ecosystem in which innovation co-exists with uncompromised investor confidence.