Mumbai: The restrictions placed by markets regulator Securities and Exchange Board of India (Sebi) on participatory notes (PNs) in 2007 and the subsequent Wall Street crisis of 2008 have helped domestic brokerages take business away from their onshore foreign counterparts.
PNs are offshore derivative instruments used by overseas investors and funds not registered in India for investing in Indian stocks.
As overseas funds route their investments into India from offshore PNs to onshore foreign institutional investors (FIIs), domestic brokerages are making the most of the shift.
While the market has expanded with the rise in the number of registered FIIs since Sebi gave a number of approvals after October 2007, local brokers are increasingly coming into their own as their foreign counterparts lose key employees as well as market share, say fund house executives and brokers.
Graphics by Sandeep Bhatnagar / Mint
As many as 567 new funds were registered in the past 20 months to take the total to 1,680.
Overseas investors cannot directly invest in Indian shares unless they are registered with Sebi. Entities who did not want to register with Sebi, or were not allowed by it, used the offshore derivative instruments issued by Sebi-registered FIIs to participate in the Indian equity markets.
This route gained popularity between 2004 and mid-2007 when PNs rose from under 20% of total assets managed by FIIs to at least 55% in June 2007. Such notes accounted for a major chunk of the $17 billion (Rs82,790 crore today) that was invested by FIIs in 2007.
In June 2007, PNs accounted for Rs3.67 trillion, or 55.7% of total FII assets of Rs6.59 trillion. At the end of June, PN assets stood at less than Rs1 trillion of Rs6.29 trillion.
However, the financial crisis of 2008, which saw storied Wall Street firms such as Lehman Brothers Holdings Inc. collapse, has dented the invincibility of foreign firms’ balance sheets. Realizing the counterparty risk in PNs, investors are now moving business onshore and are more open to trading with local firms, say brokers.
Since September, when Lehman Brothers collapsed, the share of PNs slipped below the 20% mark for the first time since March 2004 and has been declining since.
Seth Freeman, chief executive officer (CEO) of EM Capital Management Llc., a San Francisco-based FII, said the real question is whether investors will trade local shares or use PNs as the market continues to recover and FIIs become more active with Indian investing.
“However, many investors are now well aware of counter-party risk of investing in P-notes and if Sebi continues to make it simpler and faster for foreign funds to invest into India, then domestic firms could be major recipients of volume growth from investors shying away from P-notes,” he said.
Anish Jhaveri, CEO of Antique Stock Broking Ltd, said that there has been a sea change in the attitude of foreign funds since the financial market crisis. “Earlier, they used to cite inferior balance sheets, sub-standard products and poor compliance to stay away from Indian brokers. Now many have started empanelling local brokers as they realize their balance sheets are in far better shape than some of their foreign counterparts,” he said.
“The dramatic change happened seven-eight years earlier,” said Ullal Ravindra Bhat, managing director of Dalton Strategic Partnership Llp., an FII. “Then the capitalization of brokers was important. After Clearing Corporation of India (CCIL) came into existence, capital was not important.”
“With reducing importance of P-notes and CCIL guaranteeing trades, more business is going local brokers’ way. Local brokers have also learnt the tricks of the trade. The larger domestic brokerages can do it (execution and research) themselves,” he said.
Local brokers, who had a presence in the institutional business, such as Kotak Securities Ltd, Motilal Oswal Financial Services Ltd and Edelweiss Capital Ltd, have strengthened their profiles, while traditionally retail-focused firms such as India Infoline Ltd and Anand Rathi Financial Services Ltd have entered the space by hiring key personnel from foreign brokers.
“The pie has certainly become larger (for local brokers). It is only logical that the fading popularity of P-notes is helping the business of local brokerages,” a senior official with the institutional business of Kotak Securities said on condition of anonymity.
Antique Stock Broking, for example, has empanelled at least 130 institutions, of which 70% are foreign funds, said Jhaveri.
Though foreign investors have become more open to local brokers, some issues remain.
Typically, foreign funds look for three key parameters, experts said. The first quality is execution, meaning that the broker and its traders must have the expertise and skill to execute trades with the least amount of market impact and capture the best prices.
Secondly, funds want to deal with brokers that have outstanding client service and consistent back-office procedures and daily reporting that can beat the multiple time zone issue.
Thirdly, foreign funds look for value-added services such as ideas, research, roadshows and conference calls, among other things.
Industry experts said while there is little to choose between top local brokers in execution systems and compliance standards, the real differentiator would be value-added services.
Andrew Holland, CEO (institutional equities) at Ambit Capital Ltd, said: “At the end of the day, funds will go to those brokers who give them good ideas to invest; everything else is just (an) add-on.”
“While balance sheet and financials are essential elements for foreign funds, it is the products and services and actionable investment ideas that decide the extent of relationship with the clients,” said Ratnesh Kumar, CEO (institutional equities) at Anand Rathi Financial Services, who moved to a local brokerage after working with Citigroup Inc. for eight years. “Only those models, which have the ability to provide good products and services, will succeed, whether foreign or local.”
It is here that the quality of personnel at local brokerages is critical. The financial crisis also led to a number of key officials moving from foreign brokerages to domestic entities. Local players have also been able to attract top of the line talent from marquee firm such as Merrill Lynch and CLSA Asia-Pacific Markets (CLSA).
The Reliance-Anil Dhirubhai Ambani Group started its institutional business, Reliance Equity International Ltd, in June 2008 with executives from Deutsche Bank AG.
Hongkong and Shanghai Banking Corp. Ltd’s senior management team moved to Antique Stock Broking.
During the 2008 crisis, DSP Merrill Lynch Ltd’s Holland moved to Ambit Capital to expand its institutional business.
In May 2007, four top CLSA officials moved to India Infoline.
Ravi Krishnan contributed to this story.