A day after the Securities and Exchange Board of India (Sebi) announced a series of curbs on participatory notes, through which brokers say the bulk of the incremental foreign institutional investment (FII) inflows into the market have occurred, the surprise was not that the markets hit the downward circuit in less than five minutes of trading, but rather in the sharp bounce that followed.

Before the markets opened, it certainly seemed that taking a short position would be an easy way to make money. But by the end of the day, it was those who took net long positions who gained. Those brave souls, who were able to take long positions in the Nifty futures market in those crucial few minutes before trading was halted in the morning, were the ones who gained the most. Contracts worth Rs2,341 crore were traded at an average Nifty level of 5,256. The index closed the day at 5,534, resulting in gains of 5% for those who held on to their long positions. Those who went short would have burnt their fingers, unless they were just squaring off their earlier long positions.

What’s more, traded turnover was the second highest ever on Wednesday, despite an hour lost because of the circuit breaker.

Market experts say the bounce-back after the market reopened demonstrates the resilience of the Indian market, and its attractiveness to foreign investors, especially when prices correct a bit.

Of course, it did help when Sebi gave a clarification on Wednesday that participatory notes (PNs) with derivatives contracts as the underlying can be renewed until a period of 18 months. The discussion paper on Tuesday was ambiguous about the matter.

But while it would help that the unwinding of derivatives positions would happen in a staggered manner, the key point that seems to have been almost completely ignored in Wednesday’s trading session is that there would be practically no fresh inflows from the PN route, even in the cash segment. Only FII brokers who have less than 40% of their Indian exposure through PN issuances can issue fresh notes, and that too, only at an incremental rate of 5% of their total assets. It’s important to note that a few large FII brokers account for most participatory note issuances, and it won’t be surprising if they already are close to or have breached the 40% mark.

These brokers run large books (akin to mini exchanges), offering clients access to the Indian markets through regular PNs or through structured products in offshore markets.

The markets seem to have disregarded the fact that all these activities would get curtailed considerably from 25 October, when Sebi intends to pass the proposals as regulation.

Markets experts say that volatility will remain high until Sebi’s 25 October meet, and, if all the proposals are implemented, there could be a sell-off. The action in the stock market was mirrored by what was happening in the foreign exchange markets. The rupee opened 1.3% lower at 39.80 but closed well above that level, at 39.54. Information technology (IT) stocks moved up on Wednesday anticipating a softer rupee, as capital flows moderate.

As a matter of fact, the finance minister P. Chidambaram let the cat out of the bag in his comments on the Sebi paper, when he said the move was part of the policy aimed at curbing the rapid pace of capital inflows. That suggests the worries about the appreciating rupee, rather than a concern about the quality of inflows is actually behind the move. It’s a legitimate concern, best seen from anecdotal reports of the impact that the strong rupee is having on small export units.

Volatility also rose sharply on Wednesday, and a number of traders and investors would have lost large amounts.

While Chidambaram has said the move is for the benefit of everyone in the market, there’s no doubt in anyone’s mind that it could have been done in a better way, perhaps by preparing the market better for its move. The bounce-back on Wednesday was welcome, but investing is not a one-day match.

Comfort is provided by the fact that the PN investors can unwind their investment within 18 months, so there’s no real urgency to sell immediately.

But the fact is, from 25 October onwards, around half of the incremental inflows will be missing from the market. Nor is it easy for hedge funds to go through the FII route. Apart from the time and expense involved in getting registered, hedge funds will have to set up back offices in India and, if they trade in the derivatives market, they have to open rupee accounts and have Indian bankers and custodians.

There is also the issue of paying taxes, or setting up an establishment in countries such as Mauritius.

And then there is the fundamental problem of huge amounts of money flowing in at a time when earnings growth for Indian companies is slowing. There’s no getting away from the fact that liquidity has been driving this market up and a large part of that liquidity is going to be curbed, at least in the short term.

It’s always possible that unwinding by PN investors could be compensated by buying from FIIs or domestic funds and life insurance companies. But it would be surprising if the rate of growth in the market continues at the same pace as in the past few weeks.

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