P-Notes will go when economy opens up

The issue of money from stock markets being used for terrorist activities is being hugely exaggerated, says M Damodaran, chairman, Securities and Exchange Board of India (Sebi). In an exclusive interview with ET, Mr Damodaran said that the know-your-client norms being enforced by various regulators were effective in checking money laundering and round tripping of tax evaded money through stock exchanges. Here are some excerpts from the interview.

Private equity interest in the Indian market is on the rise. Globally, questions have been raised about the manner in which PE funds act at times. Is Sebi planning to regulate PE funds in India?

Private equity investors have become very important for the Indian market. The fact is, today we do not regulate private equity participants. We need to understand what increased private equity interest means for different markets. Clearly, there are positives. We have seen private equity investors get into small companies, build them into large companies and bring in better practices, better understanding of markets, and good governance.

At the same time, LBOs (leveraged buyouts) are taking place. Is that a concern in an emerging market? So far LBOs have been largely a developed market phenomenon. But India is now a large market, we have many large companies. These are issues that need to be addressed. There are no hard and ready answers at this stage. The IOSCO task force (of which India is a member) is looking into what we (regulators) need to do if at all there is anything to be done. The question is ‘do we need to do anything at all?’.

There are investors whose money goes into private equity funds. The securities market regulators’ task is to protect investors and if there is a category of investors who do not need protection, clearly our priority will be to guard those who need it. Few months down the line, there will be greater clarity on this issue (of regulating PE funds).

You have spoken about allowing hedge funds to invest in the Indian market directly. How do you plan to go about it?

Some funds have approached us saying, “We are hedge funds and we have very credible investors and there is a lock-in period for those investors.” Why are hedge funds feared? The traditional concern is that while hedge funds will bring in liquidity, they will also bring volatility as they have to perform better than everybody else. Their entry and exit are very quick compared with other funds, thus causing volatility. But some of these funds have told us that hedge funds are not one homogeneous category. There are some with a lock-in period for their investors.

Therefore, sudden investor redemption-led selling putting downward pressure on the market is unlikely in their case. These investors say the charge of volatility does not apply to them. “Look at who we are rather than grouping us in one large category called hedge funds,” they say. “In any event if we find India attractive, we are coming in through participatory notes,” they say.

Lock-in period for investors would reduce volatility to the extent that it is triggered only by unforeseen redemption pressures. But nothing rules out volatility. Today a retail investor can induce volatility by acting as a day trader. So, we thought of those category of funds that have a credible track record — with their top 10 investors being good, and are already present in the Indian market through P-Notes. Why not bring them in through a registration of their own. That is a possibility we are looking at.

Is there a conscious effort on the part of Sebi to phase out participatory notes?

I don’t think participatory notes will go away. It is not a tap that can be turned off one morning. What is the nature of the animal (P-Notes)? These are issued overseas to investors who are overseas. You are getting information on the basis of certification. There are no trades done in the market.

There is no STT (securities transaction tax). All these transactions are done outside the Indian exchanges. The intention of all markets over a period is that exchanges become the place where all trades take place. So if an entity is directly registered with us, all trades will take place through the exchange.

Our objective is to facilitate entry, except where there are concerns, and make participatory notes comparatively less attractive. You cannot wish them (P-Notes) away. They will disappear when the economy opens up completely and nobody needs to register anymore. But as long as there is restrictive access, those who do not find it attractive to invest directly, or are not eligible to do so, will invest through P-Notes. But over a period of time the proportion of investments through P-Notes will reduce.

Does not multi-layering of funds make it difficult for the regulator to curb instances of round tripping and money laundering? How is Sebi tackling these twin problems?

There are two sets of questions. One is can Sebi do it? Current regulations make it mandatory for the FII (issuing the P-Notes) to give a certfication to Sebi that he has the details of the entities to whom the P-Notes are issued. He provides the details to Sebi periodically. This should allay fears about the identity of the investors who are putting money into our stock market. If an FII gives the wrong certification, he may find himself out of the Indian market and that would be too high a price to pay.

If the concern is about round tripping — the tax escaped money from the country trying to find its way back — is it the securities market regulator that should look at it or is it some other regulator? We have other regulators within whose jurisdiction this falls (round tripping). Clearly, regulatory co-ordination is important to address this issue and that already exists in a large measure. The regulators in the financial services space regularly talk to each other, there is no issue at all on that front.

How serious is the issue of the Indian stock market being used as a conduit for financing terrorist activities?

All of this has its origin in a speech made by the National Security Advisor. The speech was not specific to India, it merely identified capital markets as one of the many sources for funding terrorist activities around the globe. We have KYC (know-your-client) norms in place. All the money that enters the securities market comes in through banking channels. There are no cash transactions. Now, banks have KYC norms. So they know which money is coming into the market.

Market intermediaries that bring people to the market, whether it is the broker or the DP, they also have KYC norms, they are supposed to know their clients. So whose is the money that comes into the market is supposed to be known. Now what seems to have been stated is that some people float companies, raise money in the market and use that money for terrorist activities.

Now, the application of the money made in the securities market is something that the securities market regulator cannot regulate and has not been asked to regulate. So money raised from the market being used for terrorism, or any other purpose, is beyond my regulatory turf and I cannot regulate it. That said, the issue of money from stock markets being used for terrorist activities is being hugely exaggerated. If it exists, it must be so minuscule as not to frighten us. And there are multiple regulatory bodies looking at it. I don’t think this is something that is to be unduly worried about.

So far Sebi has not passed any orders relating to insider trading? What has been the reason?

Insider trading exists in every market, it is not something that can be wished away. I am not saying it with any sense of satisfaction, but merely with a sense of realism. Markets operate on the asymmetry of information. If somebody takes advantage of information that is not in the public domain, we have to identify these, build iron clad cases and then take action against the entities involved.

We have a few cases in hand and I would not like to go into the specifics. Even if you look at a mature market like the US, recently the SEC has taken action against more than a dozen people from some of the very large intermediaries in a case that has been going on for years. It takes a lot of time to build up a solid case.

One way of reducing insider trading would be to reduce the asymmetry of information. Put as much information as is possible in the public domain, so that everybody who needs to know has access to that information. That is really the preventive side. On the punitive side, the task is to identify and punish, and I must confess that this is not an area where we have done extraordinary work, and this is clearly work in progress.

Companies often get away by making inadequate disclosures, especially denying developments though they eventually turn out to be true. Then there are also cases where the companies follow the disclosure norms in letter, but not in spirit. How do you plan to address this issue?

We have a regime of continuous disclosure, and companies have to disclose all material information to the stock exchange. Now who takes the call on what is material. Sometimes the company management may think that something is not material. It may turn out to be material. It is therefore for vigilant shareholders, for media, for stock exchanges and for Sebi to ensure that corrective action is taken. The other problem is the denials that come from the company. We don’t have a prescribed timeline as yet that says if a company denies something and that turns out to be true within x days..... we don’t have that yet. We are working on that.

The third problem, as much as I hate to say it, is the media. If you have two people from the same industry sitting together and having a cup of tea, you immediately sense that some day there could be a tie-up between those companies.... not tomorrow, not day after, maybe 1 or 2 years later.... you write a story with a few question marks, with sufficient hedges built in, so that should it happen a year or two years later, you can say that you were the first to spot it. That also puts pressure, and the companies come in to deny.

The key is really the market rewarding the companies that practice continuous disclosure and punishing those which don’t. If we (Sebi) had our way, we would like to incentivise the companies that practice continuous disclosure. For example when we introduced QIP (qualified institutional placements), we said that those companies which do not have a track record of continuous disclosures will not be allowed to take the QIP route.

Will the Sebi move to tighten disclosure norms for initial public offerings of real estate companies affect the launch of real estate mutual funds?

We have not said don’t come to the market. All we have said is that tell the market what you own and get it valued correctly. As far as real estate mutual funds are concerned, there are a couple of issues that are still being firmed up, we are working on the valuations and the accounting aspects.

Once these are sorted out, the product will be launched. We have been working on this, along with the members of the mutual fund industry and ICAI because there are some accounting issues involved as well. I am told that the valuations part is close to being addressed, it is the accounting part on which discussions are still going on.