Mutual Funds: Why is SEBI mandating internal fraud detection mechanisms for AMCs? Here are 3 key reasons

The expansion of the mutual fund industry underscores the importance of robust internal controls and vigilant fraud detection measures. Given the involvement of people’s hard-earned money, it is crucial to protect their investments from possible misconduct. Strong controls reduce fraud risk and ensure funds are managed in compliance with regulations. Massive fraud in a mutual fund can undermine investor confidence and disrupt the stock market. Implementing rigorous internal checks can prevent such occurrences and uphold trust in the system.

SEBI’s updates to mutual fund regulations in April 2024 were a significant move towards enhancing investor protection. SEBI’s requirement for a structured approach ensures that asset management companies (AMCs) do not rely on fragmented methods for detecting fraud. This approach likely integrates the internal controls and fraud detection mechanisms of mutual fund houses.

The organization’s concentrated efforts on front-running and insider trading tackle some of the mutual fund industry’s prevalent and harmful types of fraud. This focused strategy allows AMCs to allocate resources effectively and customize their detection methods.

What do SEBI’s recent guidelines hint at?

SEBI’s recent initiative to mandate AMCs with robust internal fraud detection mechanisms in mutual funds marks a significant stride in investor protection. This shift in responsibility underscores the industry’s focus on proactive measures and accountability.

With reference to internal fraud detection measures, SEBI’s mandate aims to arm AMCs with essential instruments and procedures for proactive misconduct detection and prevention. This proactive strategy fortifies the legal framework and promotes a moral culture within the industry. This framework comprises three essential components:

Improved monitoring systems

SEBI aims to achieve with its emphasis on enhanced surveillance systems in mutual funds. Compared to manual examination, algorithmic analysis enables faster and more effective identification of red flags, which leads to the earlier detection of suspected fraud and the minimization of potential losses.

It is crucial to prioritize identifying patterns suggestive of potential fraudulent activities in the stock market. Advanced algorithms can detect unusual trading patterns that may elude human observation, aiding in uncovering cleverly disguised fraudulent activities. Continuous monitoring enables prompt intervention upon detecting suspicious activity, thereby preventing fraudulent transactions from being executed and safeguarding investor funds.

Internal control procedures

SEBI’s focus on robust internal control measures is crucial in combatting mutual fund fraud. Establishing clear and well-documented guidelines for every facet of mutual fund operations reduces uncertainty and promotes consistency, thereby lowering the likelihood of errors or deliberate manipulation.

Furthermore, one individual can’t supervise the entire investment process when responsibility is divided among several departments or individuals, which makes it more difficult for fraudulent activities to remain hidden.

Whether they are internal or external, independent audits are crucial for oversight. They locate potential mistakes, weak points in the control system, and instances of regulatory noncompliance. Promoting the use of anonymous channels such as whistleblower hotlines encourages employees to report suspicious activity promptly, enabling early detection of potential fraud. This approach cultivates transparency and empowers employees to actively contribute to resolving issues.

Processes for escalating issues

A clearly defined escalation process is essential for effectively preventing and addressing fraud in mutual funds. A well-defined framework ensures that red flags are promptly reported to the relevant individuals or departments, enabling swift investigation and possible mitigation of losses. Understanding whom to report to and the repercussions of not taking action promotes accountability among employees, discouraging them from disregarding or concealing suspicious activities. An open and clear escalation process fosters trust within the organization. It empowers employees to raise concerns without the fear of reprisal, which helps in detecting potential issues at an earlier stage.

Due to the higher risk involved with holding larger amounts of assets, SEBI is emphasizing the implementation by larger fund institutions (with assets exceeding ₹10,000 crore). Following SEBI’s finalization of the guidelines, these AMCs will have a three-month window for compliance. Smaller AMCs will be granted an extended period of three months, making it a total of six months to implement the new mechanisms. This phased approach is likely designed to strike a balance between the urgency of prompt action and allowing smaller AMCs adequate time for adaptation.

SEBI’s amendments, coupled with the internal controls and fraud detection systems adopted by AMCs, will help establish a robust framework to protect investor interests and foster a reliable and ethical mutual fund industry.