Home / Opinion / Online-views /  PN stock powers short sales abroad

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.

To listen to Mint columnist Mobis Philipose take on short-selling click below

c504d5a4-67bb-11dd-b2a5-000b5dabf613.flvThese 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.

Some of these brokerages that are lending PNs for short- selling own Indian stocks worth billions of dollars on behalf of their PN clients and many of them have multiple FII accounts through their arms.

This inventory of PNs, which used to be worth at least $20 billion, has come down to about $15 billion after Sebi imposed regulations on such offshore derivative instruments last October. The meltdown in Indian stock markets has trimmed their value further this year.

In a research report in June, analysts Nemkumar (he uses only one name) and Ashutosh Datar at the institutional broking wing of India Infoline Ltd had noted that foreign funds accumulating such short positions had gone up so high that there was a shortage of PNs inventory available for such trades.

According to broking executives familiar with such transactions, FIIs had lent more than 50% of the available inventory to short sellers. Infrastructure, real estate and banking stocks have been in demand for short-selling.

“There was a continuous demand for this activity, as many investors were willing to bet on a drop in Indian stocks during the second quarter of this year," said a Hong Kong-based executive of a large foreign brokerage.

Sebi scrutiny

According to a senior Sebi official who did not wish to be named, the regulator is looking closely at this offshore activity that had caused intense bearishness in Indian markets. The Economic Times last week reported that the stock market regulator is asking FIIs details on their offshore clients.

However, there is nothing illegal about the activities. An executive with a foreign brokerage, who does not want to be identified as he is not authorized to speak to the media, blamed the failure of securities lending and borrowing mechanism in India for such offshore activities. Sebi introduced this mechanism in April for enhancing liquidity and price discovery, but it has not yet taken off for some technical reasons. “Since you can’t do this onshore, you are doing it offshore," the executive said.

This parallel market in Hong Kong may have hugely offset the positive view taken on Indian stock valuations by many FIIs in India and the original foreign PN clients, who are mostly long-only funds.

Long-only funds typically do not take a short-term view on a market. Nor do they indulge in short-selling as their mandate is to manage capital for a longer term with lower risk.

India’s own securities lending and borrowing mechanism has flopped because of excessively restrictive regulations. The large stock lending activity in a parallel market overseas indicates that there is a genuine demand for stock lending and borrowing.

The trend of borrowing PN stock inventory has taken another part of the Indian market offshore. Sebi’s PN restrictions have also led to the export of a large chunk of Nifty futures trading to the Singapore Exchange, where foreign investors (registered and unregistered) can participate without restriction.

According to a head of institutional equities in India at one of these foreign brokerages who does not want to be named, many of the short positions were reversed after mid-July, when crude oil prices started correcting.

In October, Sebi had partly banned PNs in an effort to force some of these anonymous foreign participants in the Indian capital markets to register as FIIs. Since then, there had been an increase in such accounts.

FIIs and their sub-accounts were asked not to issue fresh PNs against underlying derivatives. They were also asked to wind up their existing positions in 18 months.

While the focus was primarily on the “quality of anonymous money", the move also attempted to stabilize the foreign exchange value of the domestic currency against the US dollar, in which investments were being made.

According to Sebi, there were 34 FIIs and sub-accounts issuing PNs in August 2007 and the outstanding value of their exposure was at around Rs3,53,484 crore at that time. This constituted 51.6% of the net assets owned by all FIIs and their sub-accounts in India. Excluding PNs with derivatives as the underlying assets, the value was little more than 30% of the entire FII ownership in Indian markets.

According to Sebi guidelines, top foreign brokerages could issue PNs with underlying stocks purchased in the cash markets only by selling an equivalent amount of shares.

While Sebi’s move to contain a flood of foreign investments into India through this offshore product helped contain the sharp rise in the Indian currency and accelerated the entry of new FIIs, it has also led to a lot of capital outflow from the market.

Many of the earlier PN clients of large brokerages continue to take exposure to Indian stocks by trading in the derivatives contracts of the National Stock Exchange’s Nifty index in Singapore.

Some of the foreign brokerages which were champions of the PN business and a few domestic brokerages that purely serve institutional clients believe that Sebi could now review the curbs placed on such products.

According to these brokers, even if the regulator does not lift the curbs put on PNs, it could simply introduce a new product to bring back a section of global investors to the Indian market who prefer to play from outside.

Sebi will on Wednesday review rules on PNs, according to an official at the regulator who did not want to be named,

Mobis Philipose and Reuters contributed to this story.

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