Educate, don't micro-manage

The Securities and Exchange Board of India’s (Sebi's) proposal to restrict retail investors from taking large exposures in the stock market by setting trading limits based on income, or net worth, is ill-conceived. According to the proposal, which came from the Committee on Fair Market Conduct headed by T K Vishwanathan, Sebi should limit the trading activity of retail participants based on their net worth. The market regulator is now said to be asking brokers to set up systems where clients will submit a net worth certificate to the broker. Trading limits will be set accordingly. This is conceived as a risk-mitigation measure to prevent small investors from losing large sums. But there are several reasons why this proposal should be turned down. It is the market regulator's job to ensure that trading is conducted in a free, fair and transparent manner without manipulation. This includes overseeing brokers and ensuring that exchanges set and collect appropriate margins to guard against defaults. But it is outside the regulator's brief to attempt to limit the losses of any given participant in a transaction, so long as that investor has submitted the required margins to settle a trade. 

Beyond that basic principle, there are both practical and ethical difficulties in trying to run such a system of “risk mitigation”. An individual's net worth is private information unless she is standing for a political post where a declaration of net worth is necessary. Indians don’t pay taxes on net worth, and there is no necessity to disclose this detail otherwise. Enforced net worth declarations to brokers would put that private information out in the public domain, creating preconditions for the potential harassment of wealthy individuals. Such a system would also inflate costs and create compliance barriers against the entry of retail investors into the market. Every retail participant would have to pay a fee to get a valuation certificate before they could trade. Brokers would have to create the necessary infrastructure to verify such certificates, or risk the wrath of the regulator.

Moreover, net worth is hardly a reliable indicator of the capacity to invest, or to understand the risks inherent in a financial investment. A young professional may have extremely low, or even negative net worth, if she is paying off education loans. But such a person could be investment-savvy as well as cash-rich in the sense that she has a high savings rate. Any net worth based restriction would punish such an individual by excluding her from investing. Conversely, an elderly landowner could have high net worth, while being ignorant of the dynamics of financial markets. Such a person would be fleeced while still meeting the valuation criteria.