SEBI nervous about P-Notes

Markets have pronounced their judgment. After the mayhem in the stock markets last week, there’s no doubt they’ve condemned the Securities and Exchange Board of India’s (Sebi) move to regulate participatory notes (PNs). And they’ve done it in the way they know best, by voting with their feet to pull the Sensex down 7.83% (1,492 points) in just three trading sessions after the regulator made its draft proposal on regulating participatory notes public. But markets are fickle creatures. So while market reaction is important, it is seldom a good measure of long-term policy soundness. Hence it would be inadvisable to pay undue attention to it.

The more important question is, how will posterity judge the regulator. And here the consensus opinion, once the hullabaloo has died down, will be far more forgiving. The reason is that Sebi’s proposals are in the long-term interests of the market. To understand why it is necessary to look beyond and see why is the Indian stock market out of bounds to PN-holding investors. Is it cussedness on the part of the authorities? Red tape? No. Because if that were so, we would not have more than 1,500 FIIs and close to 3,500 sub accounts registered with FIIs. Rather, the reason why some investors resort to the PN route is because they are unwilling to comply with simple regulatory requirements.

Today, any entity regulated overseas can register as an FII in India. There are no onerous obligations. All it entails is some minimal disclosures about track record, top five investors and other such details that investors should normally not have any problems disclosing. The basic distinction between funds that come through the PN route and through FIIs, therefore, is that there is no audit trail in the case of the former. There is no knowing either the quality of the money or the ultimate beneficial interest. Which is why when FIIs and PNs come to dominate the market—75% of the floating stock is reportedly now in FII hands, with as much as 52% of the assets under custody of FIIs being in the form of PNs—there is reason for concern.

Like the dog that did not bark in Silver Blaze, Sherlock Holmes’ story of the racehorse that disappeared, the existence of a class of investors unwilling to comply with simple disclosure requirements is reason to doubt its motives. More so when the rise in the number and amount of PNs outstanding has gone in tandem with the ‘excessive’ rise in the Sensex. Admittedly, it is always difficult to say at what point a market is over-valued. But there’s no denying the Sensex has run up faster than warranted by historical trends.

In such a scenario, any regulator would have reason to be anxious and want to know more about the players in the market that is all. In this, SEBI is not unique. The US Securities and Exchange Commission is just as nervous of hedge funds. And if it has not acted as yet, it is only because US markets are highly developed and can deal with the large capital flows.

But as the subprime crisis has shown, even deep, well-developed markets can be laid low, especially when there is lack of transparency. So imagine how much more havoc could be caused by lack of transparency in the Indian context. Merely saying the market reflects underlying fundamentals does not make it so. The reality is that the best of markets is not immune to sudden surges of capital, inflows or outflows. Each extracts a price—inflows, in terms of a sharp appreciation of the domestic currency or if that is a no-no, of a surge in liquidity that can be as damaging. Sudden outflows, however, are far more destabilising. They can set economies back by years, as the East Asia experience showed. Do we want to go the same way? The answer must be an unequivocal ‘no’.