Has SEBI got PN regulations right?

K N Vaidyanathan CEO, Alchemy Capital Management

The Securities and Exchange Board of India banned badla in 1993 but brought it back in 1996 following strong lobbying by brokers. But when badla was banned again in 2001, it was coupled with a move to introduce 'futures and options' — albeit in limited measure — which alleviated some of the dent of the ban. SEBI's move to introduce demat in 1997 started with just eight stocks being made compulsory only for institutional investors. Today, the demat coverage extends to virtually the entire market.

Recent announcements regarding participatory notes (P-notes) have to be evaluated with this history in mind. Major changes are achieved through small steps — a state of prolonged 'work in progress'. It happens only in India! The restrictions on PNs are aimed at achieving twin objectives — of control (moderating capital flows) and regulation (more transparency). To evaluate these new rules, you do need to empathise with SEBI on the constraint of capital controls. It is a classic linear programming model of balancing multiple constraints to achieve an optimum solution. It will not please all. Every market regulator would want to have all activities relating to its market happen onshore — and directly under its surveillance. SEBI's intent to rein in offshore activity and bring it onshore is fully understandable.

But it is important to know how and why the P-notes market came about. The better known reason — part A of the problem — is the restriction on a certain category of investors to gain FII/sub accounts status. This made sophisticated market intermediaries provide that India exposure to such entities offshore. Once in place, other investors, who were otherwise eligible to be FII/sub accounts, took the more convenient route of dealing only through PN-notes.

The lesser known reason is that the derivatives market in India is still evolving — part B of the problem — and there are no OTC derivatives that synthesise a number of different individual exposures from both the cash and futures market. The large global brokerage houses have the wherewithal to write such swaps and the marketing edge to grow their books to large sizes that bring economies in transaction costs and reduce the India leg to hedge only a small net position. The genie is out of the bottle and it is now a US$90-billion problem.

The SEBI initiative to put FII registrations on the fast track, and lower the bar of eligibility, attempts to partially alleviate part A of the problem. There is still a premium put on 'regulated entities' to becoming a registered FII. This work-in-process should expeditiously result in encouraging all overseas investors to register in India by following globally accepted KYC norms used by banks. Over time, a big part of the offshore market will move back to India.

Part B of the problem will only be solved by establishing and encouraging an on-shore OTC market for a wide range of synthetic products. Such products add depth and breadth to the markets. Sophisticated investors desire such products both to gain and hedge exposures. Domestic institutional and individual investors too could participate and benefit — adding size and reducing transaction costs in the local markets. Over time, the off-shore markets could well become 'also ran' entities. Of course, care needs to be taken to put in place a regulatory framework that helps monitor risk and ensure market integrity.

Restrictions on PNs could reduce liquidity and increase volatility in the transition period — till markets adjust to the new rules of the game. But Indian markets remain attractive over the long term. And no player — including hedge funds — will want to miss the party. My faith in the temple of capitalism — markets — is strong enough to be confident that a solution will be found.

Susan Thomas Assistant Professor, IGIDR, Mumbai

The furore over the PN situation has been quite remarkable. For, there has been no discernable episode of market misconduct involving PNs. Yet, the regulators have gone on to try to block PNs. Insinuations are made about terrorists. Yet, there have not been any investigations where such relationships have been found.

Most people seem to approve of SEBI's actions despite there being no clear evidence of market misconduct. The recent regulatory actions have been praised for fixing a "non-transparent" mechanism for the flow of foreign capital into India. The argument is that the source of foreign funds coming into the country is non-transparent, and the current actions are undertaken to improve the transparency of the flows.

What is interesting is to observe that the situation today has an echo from the rather recent past. In 2003, there were similar fears that arose about the "sources of funds" coming into the equity market through PNs. There is a checklist of similarities that appear between 2003 and 2007:

(a) There was an unprecedented rise in the stock market index in 2003. This was the beginning of the global recognition of the India growth story, and the start of an increased FII participation in the equity markets. In 2007, there has been a similar rise in the index level, riding on a continued India growth story, layered with capital leaving the US.

(b) In 2003, despite the fact that the FII participation was at levels of 10% of daily trading volumes, the public perception was that "foreign investors were driving the market". In 2003, there were rumours about "manipulation using foreign funds". The jargon applied to the same inflows in 2007 is different, but the anxiety attack is the same.

(c) In both 2003 and 2007, the regulatory response to dealing with evidence that the Indian equity market is an attractive destination for global funds has been to clamp down on one of the more routine paths that global finance takes to investing in offshore markets — OTC derivatives contracts on equity.

Globally, it is perfectly normal and ordinary to have exchanges and an active OTC derivatives market trading side-by-side on the same underlyings. The exchanges have rigorous regulations and transparency; OTC markets are more relaxed on disclosures and regulations. The US treasury — a paranoid agency in the world when it comes to terrorist financing — works with the situation without calling on banning either market or participation in these markets. Does the Indian market deserve special action? In 2003, most people in India had little experience with large foreign portfolio flows. Perhaps a little anxiety attack was justified at the thought of the new liquidity surging in.

By 2007, we are veterans of some of the worst episodes of volatility, both domestic and international: the May 2004 election event was a six-sigma shock through which the equity market displayed stoic systemic stability. Volatility in April 2005 and 2006, associated with global liquidity shocks, was also weathered well. By now, one would have hoped for less anxiety from the regulators.

So are SEBI's actions today truly "merely an attempt to improve transparency of foreign funds inflow"? In 2003, SEBI asked FIIs to disclose the source and the destination of the foreign funds coming in on the back of participatory notes (P-notes).

This lead to new KYC norms between brokers and clients, more transparency on the PN market. These higher levels of information have led to no new or interesting prosecutions by SEBI since they were put in place. In which case, there is little justification for a renewed attack on "increasing transparency" in the PN market. Other than being a source for higher volatility, a rationale for the SEBI action remains to be clarified.

Rashesh Shah CEO, Edelweiss Capital

As with any regulatory change in India, there is considerable discussion on (a) if it was required at all, and (b) what are the implications? On the first question, there is now a growing consensus that this was required, had to be done. The two risks of not regulating P-notes were that of non-transparency and of exporting our capital markets. P-notes also made the cost of Indian investments higher as the additional cost of 'entry' into the market had to be tagged on.

The current time is maybe as convenient or inconvenient as any for a regulatory clean up. The need for a regulatory framework for PN has been prompted by the large inflows post September. As it is, portfolio investments in India account for a much larger share of inflows as compared to FDI. When a larger part of these portfolio investments were via P-notes, something had to be put in place quickly.

So what are the implications? Will hedge funds go away? The answer is obviously a thumping no. India is too important an investment opportunity for larger funds to stay away from. Fortunately, with the simplification of the FII approval process, hedge funds will now be able to invest in India by getting FII status, using FII sub-account structure, or via P-notes within the current cap.

Most larger hedge funds have one or two entities which are regulated — so they would be able to get FII status. They can also get FII sub-account from one of the FII accounts, most likely the current P-note providers. The only category of hedge funds which will not be able to invest at all are the completely unregulated ones. Currently, hedge funds operating from UK, Singapore and Hong Kong are anyway regulated. Only the funds from US may not be regulated (as this is still not mandatory there) but we feel this will change, and most hedge funds will be regulated in their home country. This will make them eligible to invest in India.

However, this could take time. For the P-note investors wanting to switch to direct FII status or FII sub-account status, the process could take 3-6 months. So we may see reduced flows from these investors in the next 3-6 months. We do expect the market volumes to go down temporarily — while this transition from P-note investing to direct investing happens. Once the new FIIs are underway, we expect volumes to move up as direct investing is cheaper, cleaner and hence conducive to higher volumes.

This is of course dependent on simplification and early FII approvals. One potential approach could be to do away with case-by-case FII approval and move to a transparent, score-based automatic approval. (The oxymoronic term 'automatic approval' is obviously the India way of killing two birds with one stone!) Of course, SEBI could obviously terminate/cancel any approval if the investor is found to be 'unworthy' or detrimental to our markets. The interjection should be more for rejection rather than for approval. This will ease the entry for regulated foreign investors without too much paperwork. The confidence in the India system will also be enhanced and will reduce workload for the regulatory authorities.

The difficulty in getting FII approvals in the past and the wide usage of P-notes had created an inefficient and non-transparent aspect of Indian capital markets. Correcting both together is a welcome move and over the medium term will benefit the markets. And some short term pain in terms of lower trading volumes will allow the market some breathing space.

Over a period of time, P-notes will become more marginal and will die a natural death. As stated earlier, direct investing is always a much better option for both the markets and the investors as long as the regulatory framework is simpler and transparent.