Sebi’s bar on IDR redemption irks Standard Chartered’s IDR-holders

Standard Chartered Plc’s Indian Depositary Receipt fell by as much as by 20% on Monday on the BSE, on news that capital market regulator Sebi will not allow redemption of IDRs, except if they were illiquid.

Sebi’s decision appears to be in the context of the absence of 2-way fungibility, and the fear that wholesale redemption may result in an illiquid market for residual IDR-holders. An unstated fear could also be if all IDR-holders redeem, there would be no IDR left, which would mean one tick mark less in India’s claim to being a globally advanced capital market.
But this is an unnatural obstacle in the way of Standard Chartered’s IDR-holders. Their holdings anyway trade at a discount to the underlying share, which is listed in London and Hong Kong. On Friday, Standard Chartered share on the London Stock Exchange traded at 15.86 pounds, and is virtually at the same level it was a year ago. It had risen to a high of 19.59 pounds in October 2010.

Each IDR is equivalent to a tenth of an equity share of the bank. By that calculation, one IDR should have a value of Rs 116 and its closing value on Friday on the BSE was Rs 115. A year ago, it traded at Rs 103 a share a year ago, a discount of about 4% to the underlying. The rupee rates have been calculated based on the then prevailing exchange rates. The GBP has appreciated by 8% against the rupee in this period.

IDRs are similar to Global Depositary Receipts or American Depositary receipts that Indian companies such as Infosys and Wipro have issued. IDRs on the other hand are issued by foreign issuers, and represent underlying shares of a foreign-listed entity. Standard Chartered Bank is the only foreign issuer to have issued IDRs till date.

There are several restrictions on IDRs, stemming from India’s controls on inflows and outflows of foreign capital. Though Indian citizens are now allowed to own property and invest in overseas securities, these come with limits.
RBI’s regulations prevent 2-way fungibility of IDRs. Investors cannot convert their IDRs into shares at will and vice-versa. In the market, such an opportunity introduces the scope for arbitrage; investors can buy IDRs locally, convert and sell the underlying in London, and pocket the difference, or the other way around. But that would require freeing of capital controls, as this will mean money flowing in and out.

RBI regulations do permit redemption. An investor can convert his or her IDR holdings into shares, and subsequently sell them overseas. But this is allowed 1 year after the issue date, to ostensibly encourage long-term investors to hold IDRs.

Sebi has issued a circular now, because the 1-year deadline is drawing near. It says allowing redemption, when fungibility is not permitted, will mean a lowering in the IDRs under circulation, lowering liquidity. It has decided to allow redemption only when IDRs are infrequently traded, which it has defined.

The annualised trading turnover in the past 6 months should be at least 5% or more of the issued capital of the listed IDRs. The Standard Chartered IDR appears to meet this criterion comfortably, based on trading turnover available from the NSE.

The investors in the Standard Chartered IDR knew, when the initial offer was made, that the securities may trade at a discount to the underlying since there was no free fungibility. They also faced the risk of currency movements going against them. But they also knew they could redeem after a year, providing an incentive to hold on. A year down the line, being told they cannot redeem at will appears unfair.

Let’s examine Sebi’s logic of lower liquidity. The only reason that IDR-holders would redeem is if there was a sufficient arbitrage opportunity. If Sebi had freed redemption, this arbitrage would disappear as demand for IDRs would go up. This is what happened when the regulators allowed 2-way fungibility for ADR-holders: the discount at which the Infosys ADR traded to the domestic price narrowed considerably. Even now, with the IDR price hovering around the actual share price, why would anybody redeem? Sebi should have trusted the free markets to take care of this.

Sebi’s actions may well ensure that IDRs do not die a natural death, if that was indeed their fate. If the market had stabilised and arbitrage became insignificant, new IDR issues would have been met with enthusiasm (assuming other things were fine with the issue). But Sebi’s new regulation will ensure that there will be hardly any appetite for forthcoming IDRs.

Sebi may still be able to hold aloft its trophy IDR and lay claim to being a globally advanced capital market, but it comes at the cost of undermining investor confidence, and not just of those IDR-holders who saw their wealth erode. The IDR was down by about 16% at the time of posting.

Read the circular from the Securites Exchange Board of India here.

Updated: corrected for error in Friday’s closing price of the IDR.

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