life in financial markets: why allow pnotes at all when you can set them completely free?

A little over a month back, I contributed to the magazine I currently write for, a story on how foreign institutional investors (FIIs) investing in India should not want to -- nor be allowed to by the Indian securities market regulator -- to issue access notes or participatory notes to global investors wanting to invest in Indian equities.

I wrote all foreign individual or corporate investors should instead be allowed direct access to Indian equity exchanges through the local brokers of National Stock Exchange and Bombay Stock Exchange. Here is that story:

Close back door, open front one
It is time for Sebi and the finance ministry to take focus away from encouraging P-notes and instead permi foreign investors to invest directly in India's listed equities

Emboldened by the 19-20 May spike in the equity prices, the domestic bulls, on the back of global bulls, are bracing themselves to go on the rampage in the Indian equity market in the coming months.

In next few months, it could get inevitable that the issues of access to Indian market for foreign investors and its potential of being used as a backdoor conduit for Indian hot money are likely to play on the minds of the government and the capital market regulator, Securities and Exchange Board of India (Sebi).

BW takes stock of the impact of the happenings on this front in the last two years and the potentialities of regulatory improvement going forward.

A few months before—and culminating in—October 2007, Sebi, under sustained pressure from the finance ministry to help curb the rupee's rapid rise against the dollar by reining in the large net foreign institutional investor (FII) inflows that were understood then to be the largest contributors to rupee appreciation.

Sebi banned any FII or their sub-account (FII-SA) from trading in Indian exchange-traded equity derivatives that were used as underlying in the issue of participatory notes (P-notes). P-notes are access notes that, usually global investment banks, issue, chiefly from Singapore and Hong Kong, to leveraged long or short funds (usually, hedge funds) and small-sized long-only asset managers who find the registration process, in any market such as India's, too cumbersome.

Sebi had then also barred all FII-SAs from issuing P-notes. The idea then was to make the P-note issuing FII-SAs register with Sebi as FIIs and in the process get more information about them to regulate them better. This was because there were doubts about Indian hot money, stashed overseas, entering the Indian market through the backdoor using P-notes.

But there was a bit of flip-flop. In May 2008, the October 2007 restrictions were legally notified as amendments to Sebi's regulations for FIIs. But young turks in the finance ministry were putting pressure on Sebi to remove the restrictions on P-notes and only require that investors to which FIIs would issue P-notes to were regulated in their home countries.

On 30 October 2008, Sebi once again amended its FII regulations and removed most of the restrictions, including the ban on P-notes with derivatives as underlying. The P-note issuance ban on FII-SAs, however, stayed. From then till date the FIIs, though, were again free to issue all kinds of P-notes with the only condition being that the end-investor has to be regulated in its home country.

The results from all this flip-flop have been mixed. The issuance of P-notes by the earlier largest P-note issuing FIIs has certainly come down. This is seen from the greater-than-1% shareholding data in companies from stock exchanges' quarterly shareholding pattern data. The largest (as of October 2007) P-note issuing FIIs that were have significantly scaled down their exposure (see table: Where did they disappear?).

(click on the image below to see it enlarged & clear)

Further, P-notes with the end-result being that of a short in the Indian cash or derivatives market have been near-zero for more than a year now. This is seen from the twice-a-week disclosures made to Sebi by the FIIs which are made public by Sebi.

The global financial crisis and the global economic slowdown also intervened to make P-note unattractive for a while. "Every thing fell off the rail in 2008 with the Lehman collapse and the crises in the other large investment banking firms as the global liquidity got sucked out," says Akil Hirani, managing partner in Majmudar & Co, a corporate law firm that has FII clients among others.

Despite all this, post-October 2007, the trading volume figures of FIIs in the Indian cash and derivatives market (see graph, 'Hit a bit') do not show a decline any sharper than the overall fall in traded volumes in the market.

(click on the image below to see it enlarged & clear)

Hedge funds, usually the investors to which P-notes are issued by Sebi-registered, have seen a rise in their assets under management in May. As per Eurekahedge, a hedge funds monitor, the industry got $11.3 billion net inflows in May, the largest in ten months.

If there is a global liquidity explosion once again the regulators will again be seized of the consequent dollar's decline against the rupee and the concerns of Indian hot money routed through P-notes. But market players are hoping that this time the policy debate goes beyond harping on the role of P-notes and FIIs or FII-SAs.

As Indian investors get to invest in overseas securities markets (under the overall Reserve Bank of India (RBI) ceiling of $2,00,000) such as that of the US and UK where they have to only comply with the Know-your-client (KYC) norms of the exchanges' brokers, questions are being asked of when the reverse will be allowed. "Why should the P-note exist at all?" asks Shankar Sharma, managing director of First Global Broking. "P-notes create artificial barriers and jacks up transaction costs for, say, Mr. Robinson, from investing directly in securities traded on Indian exchanges."

In May 2008, Sebi had relaxed the FII regulations compliance requirements for foreign pension and university endowments that did not thereon had to be regulated in their home country, like the rest of the FIIs, to seek Sebi registration as FIIs and invest in Indian market. But can it go further and do away with the need for registration for at least foreign individual investors wanting to invest in the Indian securities market. "In my view, Sebi should restrict the use of P-notes completely and allow direct and unfettered access to foreign investors," says Sharma.

In any direct access, foreign investors will have to sign up as clients of Indian brokers having membership of stock exchanges here and trade directly like an Indian investor does. Other Indian market intermediaries are also warm to the idea of such unfettered access for foreign investors. "Even if it involves foreign exchange convertibility issues, I would welcome a move to allow foreign investors from directly accessing our equity markets," says Vineet Suchanti, managing director of Keynote India.

Concerns of Indian hot money and backdoor route can be addressed by laying down strict enforcement of existing KYC and anti-money laundering (AML) norms. "Keep the documentation and eliminate the foreign middle men," says Sharma. Indian brokers get a chance to compete for broking revenues from such free access.

If un-licensed direct access to foreign investors is allowed then Sebi will have to make the two stock exchanges do a thorough surveillance of the KYC and AML compliance by the brokers catering to such foreign clients.

The US and UK regulators, for instance, allow foreign investors to trade directly on the stock exchanges there without any licensing process. But they make their exchanges, the NYSE Euronext and the London Stock Exchange for instance, require their member-brokers to seek thorough information, as compliance to KYC and AML norms, of their clients regardless of whether they are local or foreign.

The same can happen in India as well. But Sebi will have to seek the Reserve Bank of India's permission to allow flow of dollars into and out of the country by the foreign investors who are not registered with Sebi as FIIs. It is a doable proposition and could be the way forward.