Mumbai: Foreign investors not registered with the capital market regulator Securities and Exchange Board of India, or Sebi, could be responsible for at least 60% of the $7 billion (about Rs29,400 crore) net capital outflow from Indian equity markets between January and the middle of July, according to senior executives at many domestic and foreign brokerages.
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These investors have been trading in Indian stocks through Sebi-registered foreign institutional investors, or FIIs, who are authorized to issue participatory notes, or PNs. Some of these FIIs issue PNs to unregistered clients, promising returns that are equivalent to those of an underlying transaction involving Indian equities.
A PN could be as simple as an exposure to a stock or as complex as a long-dated option on the Nifty index. Any dividend or capital gains from the underlying securities go to the investors in PNs.
Whenever FIIs issue a PN, they have to buy the underlying shares to hedge their bets. They can no longer take the underlying position using derivatives, since Sebi banned the use of derivatives for issuing PNs last October.
The shares thus acquired normally lie idle for months and years, since many PNs are issued for a long duration. FIIs have been lending these idle shares to short sellers overseas who wanted to benefit from the falling markets, according to at least half-a-dozen executives of foreign brokerages, none of whom was willing to be named.
Short-selling, or shorting, is the process of selling securities one does not own. The settlement obligation for the short sale is met by borrowing shares which are lent under the condition that they will be returned to the lender on a specified date.
The shares from the PN inventory are lent on the condition that they will be returned before a specified date. The short sellers who borrow these shares from foreign brokerages cannot directly participate in the Indian market, as they, like the PN holders, are not registered with Sebi. So, the brokerages themselves short sell on behalf of these investors. This ensures that they get fees for lending stocks as well as a brokerage fee for trading.
This “parallel market”, largely based in Hong Kong, is dominated by top foreign brokers including Citigroup, CLSA Asia Pacific, Merrill Lynch, Morgan Stanley, UBS Securities, Goldman Sachs, Lehman Brothers, Barclays Capital and ABN Amro Securities.
Mint spoke to some of these brokerages and learnt that the practice of lending to short sellers has strained their relationships with some large Indian clients, as some promoters could not digest the fall of their stocks.
Sensex, the Bombay Stock Exchange’s benchmark index, has lost at least 23% this year after almost a 3,000-point recovery in the past 18 trading sessions. FIIs have sold Indian stocks worth $6.5 billion this year so far net of purchases after pumping in at least $17 billion in 2007.