KAAND: The Regulatory Arbitrage Kaand TACTIC: Build in the gap between two regulators — RBI, SEBI, IRDAI, TRAI — where nobody is clearly in charge
THE TACTIC IN ONE PARAGRAPH The simplest form of regulatory arbitrage involves structuring a business or financial instrument so that it sits in the overlapping or undefined jurisdiction of two or more regulators. One regulator’s rules may permit an activity that another’s prohibit, or neither may have clear authority to scrutinize it. By design, the entity operates in this gap, exploiting the lack of coordination or conflicting mandates between agencies. The tactic relies on the fact that regulators move slower than markets, and their enforcement is often reactive rather than proactive. The instrument could be a hybrid debt-equity product, a cross-border payment mechanism, or a financial intermediary that blurs the line between banking and capital markets. The key is to ensure that no single regulator has full visibility or authority to intervene until the scale of the operation makes it impossible to ignore.
HOW IT WORKS IN INDIA SPECIFICALLY India’s regulatory architecture is uniquely vulnerable to this tactic because of its fragmented oversight, legacy laws, and the pace of financial innovation outstripping institutional capacity. The Reserve Bank of India (RBI) governs banks and non-banking financial companies (NBFCs), while the Securities and Exchange Board of India (SEBI) oversees listed entities and capital markets. The Insurance Regulatory and Development Authority of India (IRDAI) and the Telecom Regulatory Authority of India (TRAI) add further layers, each with distinct mandates and enforcement tools. The gaps emerge where definitions overlap or are absent: for instance, the distinction between a "loan" (RBI’s domain) and a "debt security" (SEBI’s domain) can be exploited by structuring instruments that straddle both. The Companies Act, 2013, and the RBI’s Master Directions on NBFCs provide some guardrails, but these are often interpreted narrowly, leaving room for creative compliance.
A critical enabler is the lack of a unified financial regulator. Unlike jurisdictions with a single prudential authority (e.g., the UK’s Financial Conduct Authority), India’s regulators operate in silos, with limited real-time data sharing. The Financial Stability and Development Council (FSDC), meant to coordinate between them, lacks enforcement teeth. Additionally, the judiciary’s slow pace in resolving regulatory disputes means that even when gaps are exposed, corrective action is delayed. Political economy factors—such as the state’s reluctance to stifle "financial innovation" or the lobbying power of regulated entities—further discourage proactive rulemaking. The result is a system where gaps are not just exploited but actively preserved until a crisis forces a belated response.
THE HISTORICAL RECORD One of the most documented instances of this tactic was the rise and fall of the Sahara Group’s optionally fully convertible debentures (OFCDs) in the early 2010s. Sahara issued these instruments to millions of investors, raising over ₹24,000 crore, by arguing that they were not "securities" under SEBI’s purview but "hybrid debt" under the Companies Act. SEBI, which regulates public issues of securities, initially had no jurisdiction. The Supreme Court later ruled that the OFCDs were indeed securities, but by then, the funds had been deployed across Sahara’s real estate and media ventures, with little recourse for investors. The case exposed the gap between SEBI’s oversight of listed securities and the Ministry of Corporate Affairs’ (MCA) regulation of private placements.
Another example is the 2018 collapse of Infrastructure Leasing & Financial Services (IL&FS), where the group exploited the ambiguity between RBI’s oversight of NBFCs and SEBI’s regulation of listed debt. IL&FS issued short-term commercial paper (CP) to mutual funds, which SEBI-regulated entities treated as low-risk liquid assets. However, IL&FS’s long-term infrastructure projects were funded by these short-term borrowings, creating a maturity mismatch that RBI’s NBFC norms should have flagged. The lack of coordination between SEBI and RBI meant neither regulator had a complete picture of IL&FS’s leverage until it defaulted on ₹91,000 crore of debt. The aftermath saw the government supersede the IL&FS board, but the systemic risk had already materialized.
A third case is the proliferation of peer-to-peer (P2P) lending platforms before RBI’s 2017 guidelines. These platforms operated in a regulatory vacuum, neither fully under RBI’s NBFC rules nor SEBI’s collective investment schemes. Some platforms raised funds from retail investors under the guise of "direct lending," while others structured loans as "investments" to bypass usury laws. The absence of clear oversight led to instances of fraud and mis-selling, with investors losing money in schemes that promised high returns but lacked transparency. RBI’s eventual intervention brought P2P lending under its ambit, but the damage to retail investors had already been done.
THE INSTITUTIONS THAT ENABLED IT No tactic thrives in isolation. In each of these cases, a network of institutions facilitated the arbitrage. Auditors, such as the Big Four firms, signed off on financial statements that obscured the true nature of the instruments, often by classifying them in ways that avoided regulatory scrutiny. Banks provided liquidity to these entities, either through direct lending or by accepting their debt as collateral, despite the lack of clear security. Rating agencies, such as CRISIL and ICRA, assigned investment-grade ratings to instruments that later defaulted, relying on narrow definitions of risk that ignored systemic vulnerabilities.
Boards of directors, often stacked with retired bureaucrats or industry insiders, asked few questions about the regulatory risks. In the IL&FS case, the board included former RBI and SEBI officials, yet the group’s leverage and asset-liability mismatches went unchallenged. The media, too, played a role by amplifying the narrative of "innovative financing" without probing the underlying structures. Parliamentary committees and investigative agencies, such as the Serious Fraud Investigation Office (SFIO), only stepped in after the damage was done, highlighting the reactive nature of India’s regulatory ecosystem.
THE CURRENT STATE The tactic remains alive, though its forms have evolved. Post-IL&FS, RBI has tightened NBFC regulations, requiring stricter asset-liability management and disclosure norms. SEBI has also expanded its oversight of debt instruments, including mandating credit ratings for all listed debt. However, new gaps have emerged. The rise of fintech platforms, for instance, has created overlaps between RBI’s payment system regulations and SEBI’s oversight of investment advisory services. Digital lending apps, some of which operate as NBFCs while others partner with banks, exploit the ambiguity between RBI’s lending norms and the Information Technology Act’s data privacy rules.
The introduction of the Insolvency and Bankruptcy Code (IBC) has improved creditor rights, but its effectiveness is limited by judicial delays and the lack of coordination between the National Company Law Tribunal (NCLT) and sectoral regulators. Meanwhile, the government’s push for "ease of doing business" has led to deregulation in certain sectors, such as real estate and infrastructure, where regulatory arbitrage is rife. Until India adopts a more unified approach to financial regulation—perhaps through a single prudential authority—this tactic will continue to find new avenues.
WHAT TO WATCH FOR Three red flags should alert you to this tactic in action. First, look for financial instruments with convoluted structures, such as "quasi-equity" or "hybrid debt," that seem designed to avoid classification under a single regulator’s rules. Second, be wary of entities that operate across multiple sectors (e.g., a "financial services" company that also runs a real estate or infrastructure business) without clear regulatory oversight. Third, scrutinize companies that rely heavily on short-term borrowings to fund long-term assets, especially if these borrowings are raised from retail investors or mutual funds. If the business model depends on regulatory ambiguity, it’s likely arbitrage at work.
This newsletter describes documented business tactics and systemic patterns based on public records, regulatory orders, and published financial journalism. It does not make allegations against any individual or entity. Readers are encouraged to consult primary sources and form their own conclusions.