India Strategy - P-Note proposals: less participation in the near term

India Strategy - P-Note proposals: less participation in the near term

P-note regulations and after

The Securities and Exchanges Board of India (SEBI) caused a furore in the stock market by imposing restrictions on money flowing in through participatory notes or P-notes, as they are more commonly called.

It is not news to anybody that the SEBI, the Reserve Bank of India and the Finance Ministry have been concerned about the opaqueness of these instruments and the quality of money that was flowing into the country through this route. Here is an assessm ent of the likely impact of these measures on liquidity flows into the country.

Ceiling on P-note issue

SEBI has ruled that FIIs holding P-notes that account for less than 40 per cent of their assets under custody (AUC) can issue further P-notes to increase the outstanding proportion to 40 per cent, but at an incremental rate of 5 per cent of AUC per year. However, FIIs with outstanding P-notes exceeding 40 per cent of AUC on September 30, can issue fresh P-notes only on a cancellation or redemption of existing instruments.

This clause effectively seeks to cap the money coming in through the P-note route. As per a recent report by securities firm CLSA, FII holdings in Indian equities were at $220 billion in August 2007. That suggests that the value of P-notes issued (not counting derivatives) by FIIs and their sub-accounts is currently at roughly 26 per cent of the assets managed by them in India. There could, thus, be room for a further 50 per cent increase in the value of these instruments over the next few years, but this increase would be gradual, as P-notes issuance can only be pegged up by 5 per cent every year.

This move appears welcome, given the heightened volatility that accompanied the deluge of funds hitting Indian stocks in August and September 2007.

Given the overall cap on P-notes, there are a couple of ways in which the gross number of P-notes issued can increase from current levels. If a large number of FIIs possessing the intent to issue P-notes enter the Indian equity market, then the P-notes issued each year may see a dramatic increase. However, given that, of the 1,125 FIIs and 3,450 sub-accounts registered with SEBI, only 34 FIIs/sub-accounts issue participatory notes, it is unlikely that there will be a large increase in FIIs that issue P-notes registering with SEBI in the near future.

Unwinding P-notes on derivatives

A sharp increase in the AUC of existing FIIs can also create room for increases in P-note issues, on a calibrated basis each year. However, SEBI has not clarified whether the date for determining the AUC will be frozen at September 30 this year or if it will be reviewed periodically and the limits modified accordingly.

The logic behind this enforcement is understandable since derivative positions held through P-notes could be partially responsible for the uncontrolled spiral in key pivotals in the stock market in recent weeks. P-notes on derivatives are also likely to be held with a more short-term perspective than the P-notes held on cash transactions. Another reason for banning the P-notes on derivatives could be to bar short-only funds that revel in downward-moving markets.

But one limitation of this move is that P-note holders in cash markets can no longer hedge their positions through futures and options. Speculative short positions will also become difficult to initiate since the mechanism for short-selling by FIIs is not yet in place.

Even if this is implemented, it is not clear if P-note holders will be allowed to use this facility. Forcing P-note holders to take only a long (optimistic) view of the market and preventing them from thinking or acting otherwise could be seen as setting limits on the natural functioning of the stock market. One consequence of this could be that some of these external investors may be forced to hedge Indian securities through overseas exchanges. This may cause loss to the exchequer and result in reduced liquidity in the market.

The unwinding of P-notes with derivatives as the underlying is not expected to cause any market upheavals in near term, given the 18-month window allowed for unwinding of such positions.

But extinguishing the $29 billion worth of ODIs on derivatives over the next 18 months, could more than offset any increase that can take place in P-notes by way of cash market purchases. The unwinding of derivatives-backed P-notes may thus balance out increases in further P-note issuances with cash markets as the underlying.

Hedge Fund Angle

The regulator’s stress on ‘regulated’ versus ‘registered’ entities has caused qualms in many quarters regarding the ebbing of hedge fund money from the market. The fears are justified since hedge funds have been using the participatory notes route for the convenience it provided in gaining exposure to the Indian market.

However, contrary to general perception, many hedge funds are regulated in the countries of incorporation and they have large institutional investors such as pension funds, university funds, charitable institutions, and so on, investing through them. There are more than a dozen hedge funds registered with SEBI and operating in India.

However, since these funds seek high returns through innovative strategies, not all the hedge funds investing through P-notes would want to disclose their strategies that regulation in a country such as India would entail. Their investment horizon would also be relatively short-term.

So, it is highly unlikely that they would go through the long-winded process of first getting themselves regulated in a country with which India has a double taxation agreement (such as Mauritius) and then registering as an FII in India, just to participate in the India growth story. It appears likely that a large chunk of the hedge fund money could turn away from Indian shores.

A wholly unsympathetic stance towards hedge funds may not be warranted. If a market was entirely devoid of short-term investors, there would be no one to sell the stock to long-term investors looking to buy, and vice-versa when they intend to sell.

In other words, short-term investors are essential for imparting liquidity to markets. Though pockets of disequilibrium occur from time to time, markets have a way of getting back to normalcy.

To sum up, it does appear as if liquidity flows into Indian stocks will be affected, with the flows through P-notes on cash transactions capped and P-notes with derivatives as underlying banned altogether.

One section of the investing community, hedge funds, might reduce its presence in the Indian market. However, the strong growth in the Indian economy could attract investors with a longer-term commitment that can make up for the temporary thinning-down of flows.

What if the capital inflows stop?

Here are some premature, and somewhat strange, cautionary observations. In the entire hullabaloo about capital inflows and the impact they are having on the domestic economy, is there any thought being given to what will happen when these inflows stop?

Simon Johnson, economic counsellor and director of the IMF’s research department, while releasing the analytical chapters of the Fund’s latest World Economic Outlook recently, said: "...What important lessons can be drawn from past episodes of surges in capital inflows (this is over the past twenty years), and particularly what kinds of macro policies could help ensure that growth remains robust after the capital flows stop (And the capital flows do, in our experience, always stop at some point)."

The crucial point is in the parentheses. What happens once the music stops? What kind of shape is the Indian economy in? Is it too dependent on capital inflows for its growth? These, and many other questions, must surely be exercising the minds of India’s central bank governors, who will be presenting their mid-term review of the annual monetary policy on October 30.

But these are long-term issues. The immediate concern is somewhat different. Like many other emerging economies in the region, and elsewhere in the world, India has been grappling with ways in which to tackle the wall of money that is washing up on Indian shores every day. Large sums of portfolio investments are finding their way into the equity markets, especially after the US Fed cut rates recently. This has put direct pressure on the rupee, which has been appreciating against the dollar.

A large section of exporters has been forced to shutter up. This has political ramifications, especially if the exporting units are labour-intensive, such as textiles. The central bank, to stem the appreciation of the rupee, has therefore been intervening in the forex market to buy dollars. This results in a surge of liquidity in the domestic system, which — acting through aggregate demand — could have implications for inflation management in the future. Thus, the central bank sells securities to soak up this excess liquidity, which also has a fiscal cost.

The Reserve Bank, in conjunction with the finance ministry, has tried repurposing policy contours to blunt the impact of capital inflows. First, the RBI imposed restrictions on inflows through the external commercial borrowings route.

It simultaneously also eased controls on fund outflows from the domestic economy. In addition, banks’ unremunerated reserve requirements were also raised to suck out liquidity. On the fiscal front, the government announced two packages of incentives for exporters, which even included lowering of interest rate for export credit. It might even be appropriate to view the recent controls on participatory notes, announced by the Securities and Exchange Board of India, as part of the same policy framework.

All this also brings into sharp focus what is known as the “impossible trinity” problem — the inability of central banks to simultaneously pursue an independent monetary policy, exchange rate stability and full capital mobility. Economists believe that it might be possible to achieve two of the three issues, but never all the three objectives.

The monetary policy regime in India follows a multiple-indicators approach, compared to some of the other countries, which either have an inflation target or currency value target. The RBI’s indicators focus on overall economic growth and the price stability, from which flow targets for credit growth and money supply growth. But, the central bank keeps a hawk-eye on one special variable — the price line.

Therefore, when the central bank governor’s meet on October 30, the policy language is likely to be influenced by what liquidity flows are doing to the current price line and their effect on future inflationary expectations.
There are two issues that allow the RBI and government to meet both the short-term as well medium-sterm objectives.

One is the larger and broader issue of the economy and its absorptive capacities. This has a direct bearing not only in tackling the current logjam but also for powering economic growth in the future. Governor Y V Reddy said as much in a recent speech: “...the absence of modern infrastructure and shortage of skilled manpower are the most critical barriers to growth. It is imperative to augment the existing infrastructure facilities, particularly roads, ports and power, to provide an enabling environment for industry to prosper.”

Secondly, the time might be just appropriate to introduce some more reforms in the money and foreign exchange markets, by allowing greater hedging flexibility. Specifically, the time might be right to allow a broader, exchange-traded, derivatives market in currency and interest rates, which offers the full suite of products (such as futures, options and swaps), while retaining an OTC market as well. This might give the central bank some breathing space.

India tightens rules on P-notes

India's stock market regulator on Thursday tightened rules regarding the use of participatory notes, which unregistered foreigners could use to gain exposure to Indian shares.

The curbs were in line with the proposals that the Securities and Exchange Board of India (SEBI) first floated last week and sought comment on. SEBI said the decision was about improving the transparency of inflows into India's financial markets by getting participants to register.

Chandan Desai, Director of Mauritius-based Silverstreak Management Services: "The biggest entities will take the front door to invest in India, but smaller entities which don't meet the criteria will probably stay out. For the short-term, money flow may get hampered for a while, but the country is on such a strong wicket, that investors will continue to come in. For the long term, these are definitely good measures."

Suraj Saraogi, Managing Director, Key Note Capitals: "All the decision were on expected lines and there are no surprises in the market. In a broker's language, I can say that all the poison is out of the market now and it will give a thumbs-up sign tomorrow."

Viral Doshi, an independent strategist, Mumbai : "Any measure which is more about transparency and less about capital flows control is always welcome ... the regulator always has a concern about the quality of the money coming into the system. There are many foreign funds with genuine money and genuine interest in India, and they will continue with their investments into the country."

Gurudatta Dhanokar, Derivatives Strategist, Almondz Global Securities: "Though this decision will create short-term panic in the market, overall it is a good one. The whole process will be now much more transparent once the unknown entities withdraw from it, and this will increase the comfort levels of existing players or the registered FIIs."

Nipun Mehta, Chief Executive, Unitis Tower Wealth Advisory, Mumbai: "I look at the measures in a very positive manner. This is something which should have happened much earlier, but better late than never. This is just about cleaning up the system, getting rid of the unregulated money in the market. Very clearly, there was some discomfort about foreign fund inflows which was excessive and one couldn't control it ... there should be transparency about who is investing in the system."

A Prasanna, Economist at ICICI Securities, Mumbai: "The broad measures are along expected lines and they seem to be keen on phasing out participatory notes on a gradual basis. This will have a moderating effect on the inflow of capital in the near term and in terms of the central bank's policy next week, they should maintain status quo on rates. There is no need to raise banks' reserve requirements immediately as they can monitor the impact of these moves on the inflows of money in the near term and also the festival season spending is due. There is no need to rush into a cash reserve ratio hike."

P-Notes regulations to stay

Sticking to the draft participatory notes (P-Note) regulations, Securities and Exchange Board of India (SEBI) on Thursday, announced that sub-accounts cannot issue participatory notes (PNs) and that FIIs have to unwind offshore derivative instruments (ODI) positions in 18 months. The regulator has also fixed September 30 as the date for calculating asset under custody for P-Notes. The rules approved by the board come into effect from October 25.

According to the new ruling, sub-accounts -- vehicles set up by registered FIIs to issue P-notes -- to wind up their positions altogether, although FIIs may apply to register proprietary sub-accounts. The Board has also approved the move wherein pension funds can register as FIIs, SEBI Chairman M. Damodaran told a news conference on Thursday.

Further issuance of P-notes by sub-accounts had been stopped with immediate effect, but proprietary, corporate sub-accounts could continue to do so till registration, he said. Those already registered as FIIs have been cleared, he added.

Indices ended on a firm note on Thursday ahead of the outcome of the crucial SEBI meet on the participatory note issue. Second rung stocks also participated in the rally. Metal shares were the biggest gainers among sectors.

According to SEBI, P-notes affect the transparency of inflows. It wants foreign portfolio investors to register so it knows the source of funds coming into the country. The finance minister has said India is also trying to moderate inflows to avoid a stock market bubble. India, the world's fastest-growing major economy after China, has battled a surge of foreign capital this year, which has pushed the rupee to its strongest against the dollar since 1998 and helped power the stock market to a series of record highs. SEBI wants FIIs to wind up existing P-notes on underlying derivatives over 18 months and restrict the issuance of new P-notes on cash positions.

No change in proposals on P-notes: Sebi

M Damodaran, chairman, Securities and Exchange Board of India (Sebi), today said there was no change in the draft regulations announced by the regulator last week on participatory notes (P-notes).

The draft, which said the current P-notes would have to be wound up in 18 months, was also cleared by the board of the regulator which met today.

Damodaran, while addressing the media a short while ago, said Sebi would review the position on the issue from time to time.

The reference date for the calculation of assets under custody (AUC) of foreign institutional investors (FIIs) for the issuance of P-notes has been set as September 30, 2007. The regulation on P-notes is effective October 25, Damodaran added.

P-notes can now be issued only to regulated entities in accordance with the FII regulation of 2004.

Pension funds, foundations, endowments, university funds, charitable societies, which may not strictly fit into the category currently, can now register as FIIs.

The board also cleared a proposal to have a separate exchange for the small and medium enterprise (SME) segment.

FIIs get a breather on P-Notes

Sebi to fast-track registration; proprietary sub-accounts have to register.

Securities and Exchange Board of India Chairman M Damodaran stood his ground on restricting the use of participatory notes (P-notes) by foreign institutional investors, but made two important announcements.

The first is to allow proprietary sub-accounts of foreign institutional investors (FIIs) — i.e. sub-accounts that are formed to invest their own money — to issue P-notes provided they apply to register themselves with Sebi in the next 24 hours.

The second is to put registration of FIIs on the fast track. Addressing FII representatives from all over the world through a video conference, Damodaran, however, said the issue of offshore derivative instruments by other sub-accounts of FIIs will not be possible after the changes it proposed last week come into force.

The Sebi board is scheduled to meet on October 25 to take a final decision.

“We will allow the sub-accounts of FIIs to apply for a full licence if they are used for their own trading, and will process the applications in about a week,” Damodaran said.

Other unregistered investors using derivatives to invest in stocks will have to unwind in 18 months, he added.

The Sebi chairman also said more than one entity from an FII can also be eligible for registration.

Unregistered investors, including hedge funds, have invested a cumulative $88 billion in Indian stocks. The government does not permit hedge funds to directly buy equities, so they use derivatives to invest.

Proprietary sub-accounts are different from other sub-accounts, which are largely corporate structures or special purpose vehicles formed in tax havens by unregistered investors, with FIIs investing the money on their behalf.

FIIs were of the view that they are already registered and hence there should not be any ban on P-notes issued by their own sub-accounts.

On the issue of speeding up the procedure for registering FIIs, Damodaran said Sebi had cleared 16 applications today, setting to rest the perception that the regulator delays registration of FIIs.

One of the proposals cleared was of Citibank’s application for a proprietary sub-account.

He also said that the Sebi board will review the registration procedures in its next board meeting and will consider broadening the list of various categories of investors that can come in as FIIs and invest here.

The regulator may also review the one-year track record period needed for getting FII registration.

Damodaran made it clear that P-notes are here to stay for long, but with limits. “We believe that the responses we have on board at this point of time are adequate for us to take the process forward,” Damodaran said.

In its proposal, Sebi had proposed limiting the issuance of additional P-notes, and capping the amount that can be issued by each broker.

The regulator proposes to set a limit of 40 per cent of assets under custody for issuing new notes. Brokers who exceed the limit will need to pare their outstanding notes. Brokers who have issued less than the limit may do so at an incremental rate of 5 per cent of their assets under custody.

The Sebi chairman, however, did not agree that the FII registration norms are slow and said clearance is pending in many cases as the applications are either incomplete or because the Sebi board has yet to take a decision on allowing that category of investors to register as an FII.

In many cases, it has been found that the custodians have not forwarded the applications to Sebi.

FIIs have bought a record $19 billion of Indian securities this year, more than double last year's $8.9 billion. More than half has been invested in the month since the US Federal Reserve cut interest rates.

ONE STEP BACK

Sub-accounts owned by FIIs to invest their own money, can issue proprietary notes provided they apply for registration with Sebi in the next 24 hours. FII registration put on the fast track Sebi cleared 16 applications on Monday

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’.

Cracking down on P-Notes, govt interference and more

India’s move against foreign speculators who exploit a loophole to buy domestic assets was clumsy, but not unexpected. Authorities cracked down on participatory notes (PNs), which have allowed foreigners to skirt investment curbs. PNs account for two-thirds of the country’s annual $75 billion (Rs2.99 trillion) capital inflows, which have caused the rupee to rise sharply. But India’s overheating problem is best solved by fiscal and monetary measures. Rather than tightening exchange controls, India should loosen them and allow its residents to invest freely abroad.

The problem of excessive capital inflows into an emerging market economy is serious. India’s response was measured. It removed a loophole that allowed anonymous foreign purchase of PNs, without the normal investor registration requirements. Foreign portfolio capital has driven the Indian stock markets to record levels and pushed the rupee up 12% against the dollar since January. With the country experiencing more than 7% inflation and significant real wage growth, competitiveness has suffered. Imports are up 31% from last year, against an 18% increase in exports.

The government controls foreign investment and traps domestic money within the local economy. Blocking Indians from investing abroad demonstrates that the local government still wants socialist-type controls over the lives and resources of its people. With reserves plentiful and the rupee strong, there is neither a moral nor an economic case for maintaining such restrictions.
India’s economy is clearly overheating. A rising rupee appears insufficient to lower inflation, yet it makes life difficult for India’s exporters. Inflation and excessive rupee rise are best fought through domestic policy measures. One is fiscal restraint; public spending in the current year is running 36% ahead of last year, a 29% real increase. The other is monetary tightening, forcing short-term interest rates above 10%—3% in real terms—from the current Reserve Bank repo rate of 7.75%.
That would deflate the Indian stock market, reduce the flow of hot money and alleviate the upward pressure on the rupee. That would solve India’s problems more effectively than putting more restrictions on foreign speculators.

P-Notes clampdown leads to more block deals

SEBI’s plan to curb participatory notes (P-notes) from the Indian stock market is sending institutional investors into an overdrive to restructure their shareholding pattern in companies.

The block deals counter on both exchanges saw hectic activity on Friday as entities holding shares in P-notes started to reverse their positions. Market experts said that shares are being transferred from parties holding shares in P-note form to FIIs registered with the market regulator.

Block deals were done in predominantly blue chip shares like Reliance Industries, Bharti Airtel, Hindalco and HDFC. Second line companies with large P-note holding as a percentage of total shares also witnessed hectic activity.

On Monday, SEBI had proposed measures to control anonymous foreign investments through P-notes in the futures and options market which make up about 30% of the money that has flowed into India recently. This had affected market sentiment earlier in the week resulting in market players selling off stocks across the board. The stocks with high P-note components were hit the most.

“If they sell shares in the open market, prices will tank further,” says the head of equities at a domestic brokerage. “The only option they have is transfer shares to a registered FII or some other entity and thus try to cap any more bleeding in share prices,” he says.

He feels that these players may be actually warehousing their shares with a friendly entity. Another investment expert pointed out that entities holding shares for some other players as proxies may have also have played a role in these block deals.

“Some of the players usually warehouse their stocks with obscure entities in the form of P-notes,” he explains. He says that this helps them as these shares remain out of regulator’s bound and can be held secretly for managing the movement in the index or some other purpose.

“However, as prices have fallen significantly, many such proxy players do not want to take the risk of further losses (as chances are that shares will fall further),” he adds. These players then shift the shares to other players who are willing to bear the risks of further losses or even stay invested.

FIIs can rollover PNs up to 18 months

In a bid to calm the investors, market regulator Securities and Exchange Board of India (Sebi) today said Foreign Institutional Investors would be allowed rollover Participatory Notes in derivatives market, provided it does not exceed the 18-month limit.
“It is made clear that there is no proposal to bar an Overseas Derivative Instrument (ODI) contract expiring this month or in the following months, being renewed provided the renewal does not go beyond 18 months,” Sebi said in a clarification to its draft discussion paper on ODI that includes Participatory Notes (PNs).
The Sebi clarification clears the air of uncertainty over the fate of renewal of PNs that are due to expire this month or will expire in the coming months.
SEBI had yesterday invited public comments on its proposal to restrict with immediate effect, issuance of PNs in derivative markets by FIIs and their agents.
As per the proposals, FIIs and their sub-accounts are required to wind up the current ODI position over 18 months, during which Sebi will review the position from time to time.
Sebi has sought comments from public by 20 October on its discussion paper, which Finance Minister P Chidambaram today said will become regulations “with or without some modifications.”
Sebi’s clarification came after the Sensex crashed by over 1,700 points within minutes of commence of trading, leading to closure of the markets for an hour. The markets, however, have recovered considerably after an assurance by the Finance Minister that there is no proposal to completely ban Participatory Notes.

Foreign inflow won't rely on P-notes

“There will be no change in the outlook of foreign investors. People were worried and took extreme steps,” Arun Kejriwal of Kejriwal Investment Securities said of Wednesday’s steep fall in equities.

Securities and Exchange Board of India’s discussion paper on participatory notes, seeking to clampdown on the foreign funds inflows into the country, saw the stock market buckle down early today.

The Sensex, which gained over 1,000 points in four sessions to scale 19,000, lost over 1,700 points in a few minutes of trade opening. The Nifty lost over 500 points from 5,600 levels.

However, the steep fall was on thin volumes. One shouldn’t read much in the fall and recovery as the fall, Kejriwal said.

Volumes were negligible due to lack of participation. Turnover in BSE cash market was Rs 122 crore before trade was suspended while that on NSE was Rs 48 crore.

The fall was more due to lack of clarity among investors over the future of foreign fund inflows which have been driving the Indian markets to new highs recently.

“Retail investors could not obviously quantify the effect of SEBI’s clampdown on P-notes but they knew that something adverse would happen. So they decided to book profits. FIIs, on the other hand, were going to be affected by the clampdown, so until they could get a good grasp of the effect, they would have sold a bit,” said Vinay Bhandari, options trader with trading firm Olam International.

“The crash in the morning would have been on very thin volumes, which is why it eventually recovered,” Bhandari said.

As the indices hit lower circuit filters, trading was suspended for an hour till 10:55 am. And as traders waited for the market to open fearing the worst, relief came from Finance Minister P Chidambaram, who said SEBI’s move was aimed at “moderating the copious capital inflows” into the country and had not banned participatory notes.

“Investors, through participatory notes are certainly welcome to invest in India, but for the present it is important to moderate these capital inflows. If some investor wishes to register in India as an FII and invest, he is most welcome,” the finance minister said.

Chairman M Damodaran also sought to allay fears of a ban on P-notes, saying that authorities did not want to ban foreign funds coming into the country, but wanted transparent flows through registration of investors.

“...there is no proposed bar on overseas derivatives instruments contracts, expiring this month or in the following months, being renewed provided the renewal does not go beyond 18 months,” SEBI said in a statement.

Damodaran said a disproportionate amount of participatory notes were being issued by a limited number of people.

These statements and the hour’s break helped control the damage done, and the indices rebounded with vengeance. The Sensex recovered nearly 1,400 points and Nifty rebounded 450 points.

Going ahead, experts said capital inflows won’t depend on P-notes but on the economy. As long as economy is strong inflows will continue.

“FIIs will not change their outlook on Indian markets since the regulatory framework for foreign investments will not affect the fundamentals of the growth story,” said Bhandari of Olam International.

Important Notes for the day!

Don't panic if Udayan tries to scare you :) .. Ooh Aaah, he will squeal

Remember

Don't watch CNBC, the more you see, the worse it is for your body :)

Sell on rises, not on dips

No doubt, its a huge negative looking at the amount of money invested through P-Notes

Funny situation for hedge funds, first they short, then they panic cover, now they have to panic sell

It's a Chidu induced correction, made enough money I suppose

It's only recommendations, Chidu may ask SEBI to reconsider

If you are a newbie who invested on tips, you will pay the market the 'fees' for doing so, you will come out a better investor

Don't PANIC seeing RED


PASS this on to friends who you think are at risk of a heart attack :)

Uday Kotak - Good for long term

Uday Kotak says

Short Term pain

Long term Gain

Wants all FIIs to register rather than invest through PNotes

Our notes

Terrorists investing in the stock market ?

SEBI clampdown because of this ?

Dubai based institutions linked to terrorist groups investing ?

Kotak seems to make sense

Once more, Don't PANIC!

P-Notes clampdown

The Securities and Exchange Board of India (Sebi) today proposed to tighten the rules for purchase of shares and bonds in Indian companies through the participatory note (PN) route.

The move is aimed at arresting the surge in foreign inflows through PNs, which are offshore derivative instruments that allow foreign investors to invest indirectly in a country’s stock market, which has seen the benchmark BSE Sensex zoom more than 5,000 points in two months.

The market regulator has proposed that foreign institutional investors (FIIs) and their sub-accounts cannot issue or renew PNs with underlying as derivatives with immediate effect. They have to unwind their current position within 18 months.

Sebi Chairman M Damodaran told Business Standard that the proposals were against PNs but not against FIIs. The procedures for registering FIIs were in fact being simplified, he said.

Sebi has also proposed a ban on all PN issuances by sub-accounts of FIIs with immediate effect. They also will be required to wind up the current position over 18 months, during which period the capital markets regulator will review the position from time to time.

Sebi has also proposed an incremental rate of 5 per cent for issue of PNs for FIIs with less than 40 per cent of assets in PNs. Those with over 40 per cent of assets in PNs can issue PNs only against redemptions or cancellations.

PNs are issued by Sebi-registered FIIs that do not want to disclose their identity, or those who are in a rush to buy stocks and derivatives without waiting for Sebi registration.

The proposals, which have been framed in consultation with the government, will be “implemented urgently”, after receiving comments from market participants within four days. The Sebi board is meeting on October 25 to take a final decision.

The big five FIIs — Morgan Stanley, Merrill Lynch Capital Markets Espana, Citigroup Global Markets, Goldman Sachs and CLSA Merchant Bankers — account for 60 per cent of PNs issued in India.

The Sebi release, issued late this evening said, “The year-on-year increase in PNs, the anonymity that they provide to investors and the copious inflows into the country from foreign investors have been engaging the attention of the government.”

“There is an unprecedented surge of liquidity in the emerging markets. And apart from Brazil, the Indian equity markets are favoured the most by foreign institutional investors. However, it would be too premature to make any judgments now,” said head of Korean mutual fund Mirae Asset Management Arindam Ghosh.

Market expects huge selloff; ADRs dip

The proposed restrictions on participatory notes (PNs) are expected to trigger a sell-off by hedge funds, and other short-term players, experts said. As a result, the Sensex, which has risen nearly 35 per cent in the last two months, may also feel the heat when the markets open on Wednesday morning.

Indications from the kerb (unofficial deals) and the fall in Indian share prices in the US markets suggest that the NSE’s Nifty Index may open at a discount of at least 150 points from today's closing of 5,668.05, said dealers.

At 9.45 pm, Dr Reddy's Lab ADR was down 5 per cent to $15.25, HDFC Bank was down 6 per cent to $111.34, ICICI Bank nearly 4 per cent to $53.32 and Infosys was down 5.8 per cent to $48.02.

Hedge funds, which account for at least 30 per cent of PN issuance, may be the first ones to exit, said dealers.

When restrictions were proposed on PNs on January 22, 2004, the Nifty closed 3 per cent lower to 1,770.

Former NSE Chairman R H Patil said, "The market is being manipulated right now and a bubble was growing rapidly. Although the Sebi proposals are late, they would help avoid a greater disaster. It is very important to know the identity of foreign investors, who have been manipulating this market."

Chidu was warning all of us that he was going short on the market 2-3 days ? How many of you did ?

IMPORTANT - SEBI recommendations on P-Notes issuance

Objective
This paper sets out the proposed policy measures on Offshore Derivative Instruments (Participatory Notes).

Background
With a view to monitoring the investment by FIIs through Offshore Derivative Instruments (ODIs) such as Participatory Notes (PNs), Equity Linked Notes, Capped Return Notes, Participating Return Notes etc., SEBI had prescribed reporting of issuance / renewal / cancellation / redemption of the ODIs on a monthly basis since October 2001. The figures submitted by the FIIs on a month to month basis showed an increasing trend.

In the latter half of 2003, a Technical Committee of SEBI Regulated Entities was constituted by the HLCCFM to examine the issues pertaining to P-Notes more closely. The Committee, comprising representatives of RBI, IRDA, SEBI and NSE met in October, 2003 and extensively discussed the issues like:

* Whether PNs should be allowed to be issued at all,

* Whether restrictive use of PNs is possible,

* Monitoring of compliance

* Phasing out of PNs that are non-compliant with new restrictions, etc.

The Committee, having examined the concerns raised by the participants, felt that while these issues and concerns would have to be addressed in the interest of the market, the measures taken should be practical, pragmatic, non-disruptive and enforceable without great difficulty. Recognizing that it may be difficult to enforce a complete ban on PNs, the Committee made certain recommendations which included issuance of PNs only to regulated entities subject to KYC requirements. The same was implemented through suitable amendment to FII regulations.

However, the year on year increase in ODIs, the anonymity that the ODI provides to the investors and the copious inflows into the country from foreign investors has been engaging the attention of the Government and the regulators such as the Reserve Bank of India and SEBI. This has been a topic for discussion in many fora such as HLCC and various committees set up by the Government/ regulators.

Current Scenario:
Currently 34 FIIs / Sub-accounts issue ODIs. This number was 14 in March 2004. The notional value of PNs outstanding which was at Rs.31,875 crores (20% of AUC [1]) in March 2004 has grown to Rs.3,53,484 crores (51.6% of AUC) by August 2007. The value of outstanding ODIs with underlying as derivatives currently stands at Rs1,17,071 crores, which is approximately 30% of total PNs outstanding. The notional value of outstanding PNs, excluding derivatives as underlying as a percentage of AUC is 34.5% at the end of August 2007.

Proposed Measures:
Following consultation with the Government, the following measures are proposed to be implemented urgently:

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.

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.

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.

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.

Long positions will get chopped tomorrow

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.