Sebi draft proposal to rationalize Participatory-note issuance will rock stock markets

Indian ADRs dipped as global investors tried to assess the implications of Sebi’s draft proposals to restrict the participatory note (PN) factor in the stock market. On the NYSE, the HDFC Bank ADR was down 10.2%, Infosys was down 5.7%, Dr Reddy’s Laboratories was down 3.1%, Wipro was down 3.4%, and ICICI Bank was down 6.5%.

That gives an indication of what lies in store for Indian stock markets today. Today’s reaction would perhaps be the wrong way to assess the implications of the Sebi proposal. If the proposal is implemented its effect will be visible over the longer run on markets. After a very long time, the market regulator has done something about restricting entry into the Indian capital markets, through the participatory note route. The RBI has been perhaps the most visible opponent of this instrument but the government has been opposed to any move to do anything that could upset the applecart.

Sebi’s current proposal no doubt has the ministry’s silent approval. Perhaps, the steep run-up in the share markets in recent months, the effect of growing portfolio inflows on the exchange rate and the risk of what a scam (or an otherwise unexplained steel fall in equities) could do to the government’s image in the next general elections have influenced this decision. The measures that Sebi has proposed seem sure to be implemented, unless the market becomes so volatile that the government steps back.

There is time only till Oct 20 to submit comments on the draft proposals. The definition given by the “Report of the Expert Group on Encouraging FII flows and checking the vulnerability of Capital Markets to Speculative Flows” of participatory notes is a good one. “They are a derivative instrument issued against an underlying security which permits the holder to share in the capital appreciation/income from an underlying security. PNs are like contract notes and are issued by FIIs, registered in the country, to their overseas clients who may not be eligible to invest in the Indian stock markets”

PNs are used as an alternative to sub-accounts of FIIs. “A sub-account is generally the underlying fund on whose behalf the FII invests.” They came into being since FIIs also manage funds of their clients, and it is these client accounts that came to be known as sub-accounts. The regulations governing sub-accounts are less stringent compared to FIIs and those governing PNs are less stringent compared to sub-accounts.

There are two parties to this game, one are the real investors who stand behind the PN wall. If they are genuine investors there is no real reason why they should shy away from being visible in the Indian markets. One of the fears, though there has been no evidence as such, is that some of these FII inflows are round-tripping of money by Indian businessmen. If so, their bluff has been called. The second party is the FII who, having issued these PNs, holds the shares or derivative contracts that have been entered on behalf of their clients.

One does not know how these contracts are structured, but the FII is unlikely to give his client 18 months to decide what to do. The risk is if some of them decide to just close out these positions which results in pandemonium. The first reaction is almost likely to be widespread panic even in stocks where PNs do not make up for much. But since no one knows which stocks have a high exposure to PNs, investors are not likely to stop to ask questions. Coming at a time when the markets are soaring, such measures will be seen as killjoys.

That PNs could be conduits for hot money was known all along, and the government too did not deny that. To be fair, it did implement some know your client guidelines for PNs but too much was left to self-regulation by FIIs. Instead, the government could have set out a roadmap for a phase out in 2004-05 itself. In hindsight, the sharp economic growth over these years would have been enough to attract investors into the country, with or without PNs.

What the measures appear to do are:
1. FIIs and their sub-accounts shall not issue/renew ODIs with underlying as derivatives with immediate effect. They are required to wind up the current position over 18 months, during which period SEBI will review the position from time to time. FII participation in the derivatives market will be transparent. They have a 18 month window to wind up current positions, which may seem like an adequate window. But remember if no fresh inflows are coming through this window and flows do not come through the FII route, then the effect will be visibly harsh.
2. Further issuance of ODIs by the sub-accounts of FIIs will be discontinued with immediate effect. They will be required to wind up the current position over 18 months, during which period SEBI will review the position from time to time. Sub-accounts now will be banned from issuing PNs or any other form of derivative instruments. Again, the 18-month window seems long but whether anybody waits that long and will formal inflows pick up the stocks that are offloaded remains to be seen.
3) The FIIs who are currently issuing ODIs with notional value of PNs outstanding (excluding derivatives) as a percentage of their AUC in India of less than 40% shall be allowed to issue further ODIs only at the incremental rate of 5% of their AUC in India. This in a way caps PNs in the cash market to about 40% of outstanding FII investments. The current level is about 34.5%, so there is a small headroom that is left and the cash market will not get hit directly. But any unwinding in the derivatives market will likely hit the cash market too.
4) Those FIIs with notional value of PNs outstanding (excluding derivatives) as a percentage of their AUC in India of more than 40% shall issue PNs only against cancellation / redemption / closing out of the existing PNs of at least equivalent amount. This means that existing FIIs with PNs with underlying equities (cash market) do not have to unwind their positions. But their business has been capped. Only when existing positions come down will they be able to issue fresh PNs.

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