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.

Sunlight Is The Best Disinfectant

To say that Securities and Exchange Board of India chairman M Damodaran is a busy man is to put it lightly. Back from London for just a day, en route to China, he met us in his office in Mumbai. As we sat outside his cabin, our eyes spotted an article in a foreign daily on China considering having a new “super regulator” and financial watchdog for it banking and finance industries.

When we asked him if there was anything coincidental about the article and his trip, he laughed and brushed it off and said he was going to sign an agreement on exchange of information. Though hard pressed for time, he showed no signs for stress or jet lag as he chatted about his views and plans for the fund industry.

Mutual funds have become powerful players over the past few years with fund managers having much more money at their disposal than Ketan Parekh or Harshad Mehta. This should trigger a proactive tightening of the regulations surrounding their market actions. What is SEBI's gearing towards this?
The first issue is: Who can manage funds? To distribute funds you need qualifications but to manage them you don't seem to need any. Almost anyone can be a fund manager since there is no regulation specifying any qualifications. We are addressing that. Interestingly, the board for prescribing qualifications for fund managers was cleared this morning. I think at the next board, we will clear the structure of what qualifications people need to manage funds. Other jurisdictions have that, no reason why we should not, especially when they are managing huge sums of money.

The second issue is in terms of what is happening within the business of asset management.

We believe trustees have an extremely important role to play. I think this business of trustees being the custodians of the fund and asset managers only being responsible to manage the investments properly, be consistent with regulations and deliver results over a long period of time - that somehow has got diluted in the public consciousness.

People have begun to believe that you give money to Asset Management Companies and they are the custodians of the fund. The theoretical possibility that trustees can tell the AMC that you are not performing well and we are ready to change you and bring in someone else should be conveyed to the public. I am not saying that the trustees can get up every morning and change the AMC. We don't want that destabilisation.

But the message should go across that the trustees have the responsibility to question the AMC if they do not deliver and, if not satisfied with the answers or believe that practices followed by the AMC are inappropriate, they have the right to change the AMC keeping the investor interests in mind.

The point is: Who are the people who are appointed as trustees? And I have said this before. They are people who come from good backgrounds and are appointed for the right reasons. That said, whether they have a complete understanding of not just the letter of the regulations but of the spirit of it - who are trustees, what are their responsibilities, what do they need to do? Not simply as one level of compliance but also as first level regulators of the industry. There is much more work involved.

This should be discussed more with them. We are now corresponding with them much more than earlier. We are writing back to them too. We want them to be more proactive and do their job correctly.

For instance, on new fund offerings we have told the trustees that they need to see if there is anything new in the scheme. Is there already a scheme in their basket which is being duplicated? At least now people have started to justify NFOs. Earlier there was no need for justification. In a couple of cases we have sent it back to the trustees telling them to look at this scheme again and tell us how this is different from the existing ones. At the end of the day, it is their judgment versus mine - is it different or is it not? Not that we are going to take the final call but we force them to look at it a little more closely. It is not that we will not clear it but we are certainly going to tell the trustees to certify that they looked at what is being offering and are of the opinion that it is different.

What other issues are you tackling?
We have now persuaded the asset managers to identify distribution as a problem. We are not yet regulating distributors but we have told them till such time as we do, they are your agents and you are responsible for any misconduct.

That is a kind of double whammy for them. On one hand they find that the distributor is walking away with the money and they are not getting too much because we have capped what they can get. On the other, they are being held responsible for the distributors. Yet, they say, how can we reach out to people, we need these distributors.

We told them is that if you find that the distributor has committed some wrong, you must get rid of that guy quickly and convey the message that you are serious.

Over time, driven by distributors, fund houses have come out with new schemes and never marketed the old ones even though they may be great performers for years. Simply because there is nothing in it for the guy marketing it. This cannot go on.

I have started telling the players that their success is not measured by the number of schemes they launch. Neither is it success measured by the Assets Under Management. This is something we want to get into now - the battle for AUMs. Everyone is taking credit for “my AUMs”. But if most of your money is in the market and the market goes up by 1000 points, your AUM will go up without you doing anything. We are saying, look at your unit capital and start reporting unit capital - we will operationalise this soon - then you will see whether the industry is growing or not or just moving from here to there because of stock prices.

We are also looking at advertising. We are now in dialogue with AMFI and have got their written suggestions on this issue. Does the advertisement communicate the essence of the scheme or is it obscure and confuses the investor? Is the scheme wrong projected? We want all advertisements and marketing material to communicate clearly about the scheme and not mislead.

Another issue that happens with the lack of frequency of disclosure is exiting from questionable stocks just before the reporting date. Buying and selling into questionable stocks between two reporting periods because you don’t want it seen on your portfolio. These are practices that happen and we cannot impose legislation or prescribe for all of these. But we can create a climate and that is what we are working towards.

In the next 12 months, the mutual fund industry will be a hot topic of discussion where we ensure that some of these issues will be raised and addressed by us and we will want the players to respond to it.

You mentioned frequency of disclosure. Transparency is a great deterrent to any scam. Why do you ask only for a six month disclosure of portfolio and not more frequently? In spite of this, most fund houses declares it on a monthly basis, but some stick to the regulations and declare it once in six months.
Well, if market practice is better than regulations - which is the case here where they are disclosing more often though they are required to do so only every six months - then we need to move regulation towards market practice rather than vice versa.

As they say - sunlight is the best disinfectant. The more things come out in the open, the better.

Having said that, you should not prescribe a regime which is extremely costly. No one is in this business for charity. At the end of the day, all the costs involved in some manner or the other get passed onto the investor.

Compliance is very good but should not become so costly that it’s a disincentive to the investor. As regulators we are in the business of compliance but we also have to grow the market and ensure that first time investors see mutual funds as an entry level into the market and should not see it as prohibitive. They may see the high costs and shy away.

So you have to put in place a frequency of disclosure which is not disproportionate. For example, there is one regulation, when I was on the other side I found it quite amusing, every six months we had to declare all our holdings in all our schemes in a newspaper. We had to take out a 28 page advertisement. Now who would read a 28-page advertisement?

Frequency of disclosure in a cost effective manner has to be addressed. For instance, putting it on the company website is definitely a more cost effective method rather than a newspaper advertisement. It can be made available on a continuing basis on the website of an AMC. But, the problem with this country is that not everyone who is invested in the mutual fund industry is looking at a website. I would not call it a digital divide but a digital inequality and some will access it and some will not.

But, undoubtedly, it will bring accountability once put into the public domain. Clearly, frequency and disclosure on the website is something we can look at.

The issues that fund managers face is that if they disclose their portfolios everyday, their stocks ideas will be open to the public. So would you suggest disclosure with a time lag of a month or even longer?
I don’t buy the argument of a time lag and of someone saying that I had this great idea that came into the public domain. Just because someone had a great idea does not mean everyone will buy into it and think it is great. The greatness of the idea will be known over time.

I don’t think it is the issue of the time lag, I think that it is a matter of convincing people that if you have been doing something that is better than what the regulations demand, then continue with that spirit.

How happy are you with the fact that now all funds are launching close-ended schemes to take advantage of the amortisation ruling?
You have close ended funds being launched now or funds that are close ended for 18 months and then become open ended. Even during this 18 month close-ended time period, they have intermediate dates for exit.

We saw that there was a problem. We decided to fix it. Close-ended funds were discouraged at one point in time and everyone was told to make all funds open ended. I remember in the past (referring to his UTI days) where we too converted some close-ended funds into open-ended ones.

But now, the issues that faced the industry then are addressed separately so we do not see it as much of a problem as fund houses launch close-ended funds. The advantage of a close-ended fund if you do not allow too many intermediate entries and exits, you have a finite time frame. The investor will know for how long the money will stay locked and exit only at the end. The fund manager, on the other hand, will know how long the money will be with him and where he can invest for that time frame.

But taking advantage of it in order to curb the structure is something we will definitely look into. We are seeing how people are using their ingenuity to work around regulations. End of the day we will see how it affects the investor.

The issue which I find needs to be addressed is this: If someone in the fund for a short term, should he be subsidised by someone who is in the fund for the long term? The fee structure should reward the person who stays longer.

Another problem we have is the way funds are presented and judged by people who write about them. They look at performance over a month and then hype it up as the best performing fund. That is not in the interest of investors. I am not saying look at the lifetime performance of the fund because that will depend on the year the fund was launched and the market performance then. But look at reasonably comparable performances like a three- and five-year time frame.

End of the day, we also have to see how this industry can be grown. It is our firm belief that we need to grow the fund industry to see that more people come to the market. We don’t want the average man to enter the market by himself and then come to grief.