Mumbai: India’s stock market regulator wants foreign institutional investors (FIIs) to become more transparent in their investments and trades, which will, in turn, make the stock markets, still largely driven by such investors, more stable.

Specifically, the Securities and Exchange Board of India (Sebi) wants FIIs to increase the proportion of funds they deploy through so-called broad-based sub-accounts.

The regulator is likely to make it mandatory for FIIs to route the money through this avenue, according to four officials with direct knowledge of the matter. Sebi has been in touch with FIIs in this regard and the new requirements are aimed at lowering liquidity risks and the volatility of fund flows from such investors.

Broad-based sub-accounts typically belong to large overseas wealth funds and have a wide investor base. Money that comes in through them is long term in nature, besides which the investors’ identities are known, ensuring quality and stability. Currently, a significant part of trading takes place through proprietary sub-accounts, which are essentially the FII’s own funds, though brokers say it’s difficult to arrive at an exact proportion for this.

FIIs originally came to India through broad-based accounts, but were allowed to also do so through the proprietary route on the understanding that they would pump in money through both.

“But we have noticed that a few FIIs are not following the spirit of the arrangement. We want them to run broad-based accounts and a portion of their investments should come through them," a Sebi official said, speaking on condition of anonymity. None of the other officials and executives Mint spoke to wanted to be identified because the issue is a sensitive one and the communication between Sebi and FIIs has not yet been made public.

The Sebi official did not specify the proportion of investment the regulator wants to be routed through broad-based accounts. Three of the officials cited above said FIIs will be given 12 months to conform to the new rules.

“We are not telling them to cut down proprietary trade or specifying what percentage of trade should be through broad-based accounts, but we insist that they should follow Sebi norms in spirit," added the Sebi official.

In 2007, Sebi had sought to arrest the surge of overseas money of uncertain origin (there have been persistent whispers that some of this money was actually Indian money being routed back into the country) being pumped into Indian stocks through curbs on participatory notes, offshore derivatives that were being used to invest in the markets. The current attempt at cleaning up such flows comes during a year in which FII money has been going the other way. Since January, FIIs sold shares worth a net $627 million (around 2,830 crore today), having bought a record $29 billion of Indian equity in 2010.

Given this situation, the regulator is seeking to coax the funds into making the changes. Sebi told FIIs in a recent letter that they should have at least one broad-based sub-account portfolio and ensure that they trade through this.

“The letter asks if they have broad-based sub-accounts. If not, they have been asked to open such an account as their registration has been done as an ‘investment manager’, within 12 months," said an executive at a large legal consultancy firm that deals with Sebi-registered FIIs. “If not, their licences will be cancelled."

According to Sebi, there are 1,718 FIIs and 5,745 FII sub-accounts. A majority of the registered FIIs have at least one sub-account and most of them have traditionally invested through these, of which a majority are proprietary.

“There will be a significant proportion of FIIs who are trading only through proprietary sub-accounts," said a senior lawyer at a Mumbai-based legal advisory firm. “Sebi’s stand is that the FII ‘investment manager’ licence was granted to them on the assumption that they would be managing the money of others. Many investors might have used this category as an easy way to get clearance from Sebi."

A broad-based sub-account needs a group of at least 20 investors with none of these holding more than 49% of the funds. Typically, large overseas funds, including sovereign wealth funds, privately managed pension funds, endowment funds, children welfare trust funds and university funds, can register themselves as broad-based sub-accounts when they do not enter India as FIIs directly.

These funds do not have short-term liabilities and are capable of investing for a much longer term than other global funds. Proprietary sub-accounts have a smaller investor base, with a single or a small group of high networth individuals holding a majority in the corpus. Proprietary sub-accounts are shown as FIIs’ own money. The transparency of broad-based sub-accounts is much higher than that of proprietary sub-accounts, negating the chances that the money may be round-tripped and ensuring that its source is a bona fide overseas investor.

FII sub-accounts are also used by fund mangers when they have multiple schemes with different allocations for India. Such sub-accounts, however, are treated as broad-based as their corpus comes from a large number of investors.

The relevant clause that Sebi quoted in the letter says that an asset manager will be allowed to open an account to make investments on behalf of clients and trade through a proprietary account, if any. Sebi’s interpretation is that since an FII has been registered as an investment manager, it should be managing clients’ money, not just its own, as in the case of proprietary accounts.

“There are discussions going on with Sebi," said the executive at the legal and consulting firm. “We are also advising them and clients have expressed their reservations."

Any change that Sebi seeks should not be to the clients’ detriment, the lawyer said.

Smaller FIIs will be hardest hit, especially as they manage their own money through proprietary accounts that are used to generate offshore derivatives using participatory notes, according to another official familiar with the matter.

Though the process of FII registration and fees have been relaxed in the last few months, opening a sub-account is still much easier, cheaper and less time-consuming. This has persuaded a large number of overseas investors to invest through what are primarily proprietary sub-accounts.

The move by Sebi is of a piece with its bid to encourage sovereign wealth funds, which manage at least $4 trillion globally, but just 35,000-40,000 crore in India, to invest in the country. Sebi recently allowed these funds to buy up to 20% in an Indian company without requiring them to make an open offer, if the acquisition doesn’t involve a change in control of the target company.

To be sure, there are those who doubt the regulator will be able to implement the changes that it’s seeking to bring about.

“Many of the FIIs have a short-term view and do not want to trade for the long term," said the head of a Mumbai-based financial services firm that manages foreign investments.

Despite compliance costs coming down, overseas investors may not be convinced that they need to come to the market directly, he said.

“I do not really expect that you would be able to compel FIIs to get a larger number of clients, even if you impose quotas on how much trading can be done through proprietary sub-accounts," he said. “There are many creative ways of bypassing such rules. It is possible for the compliance department to break up a single fund into 10 entities to circumvent such a rule."