PN curbs may rein in stock markets

PN curbs may rein in stock markets

Mumbai: Indian stock exchanges could open significantly lower on Wednesday after stock market regulator Securities and Exchange Board of India (Sebi) said on Tuesday night that it is considering immediate curbs on the flow of foreign funds into shares through instruments known as participatory notes (PNs), which it said had allowed large and anonymous inflows into Indian equities.

Sebi’s proposals, currently in the form of a paper on its website, have been made in consultation with the Union finance ministry and on Tuesday night, television channel NDTV Profit, citing unnamed people, said that the ministry would clear this.

A file photo of M. Damodaran, chairman, Sebi

Sebi’s proposed curbs are actually on a larger family of instruments called offshore derivative instruments (ODIs). They include PNs, equity-linked notes, capped return notes and participating return notes.

PNs are financial instruments that help investors and institutions that are not registered with Sebi to invest in domestic securities.

Registered FIIs buy the equities on behalf of such investors and issue them PNs. The owner of the underlying equities, therefore, remains anonymous. Analysts say that PNs are attractive investment tools because they protect the identity of the investors and give them easier entry and exit options.

According to the Sebi paper, currently 34 FIIs and their sub-accounts issue ODIs, up from 14 in March 2004; the notional value of outstanding PNs has risen from Rs31,875 crore to Rs3.53 trillion between March 2004 and August 2007. That translates into around 51.6% of the assets under custody (AUC) of FIIs.

Excluding derivatives, about 34.5% of FII holdings in Indian companies is through PNs.

Sebi’s desire to push through the new norms is evident from the fact that it gave only four days for people to respond to its report—it usually gives around a month or more.

According to the Sebi report, FIIs and their sub-accounts cannot issue PNs where the underlying asset is in the derivatives market.

It also calls for FIIs, who have taken positions in the derivatives market, to unwind these positions within 18 months. Those FIIs that have issued PNs on Indian equities (other than derivatives), whose notional value is less than 40% of their AUC in India, will be allowed to issue further ODIs only at an incremental rate of 5% of their AUC in India.

In the last instance, if the notional value of Indian equities (excluding derivatives) is higher than 40% of their AUC, FIIs will be allowed to issue new PNs only against cancellation, redemption or closure of existing PNs of at least an equivalent amount.

Brokers say that Sebi’s new curbs on PNs will not have a major impact on the stock markets because the time allotted to FIIs to unwind positions in ODIs is, at 18 months, quite long.

“This is a welcome invite for front-door entry for many foreign investors who have been investing through PNs. If Sebi also liberalizes the norms for listing as an FII in India, most of the current PN owners will get registered with Sebi through fresh accounts," says a broker who does not wish to be named because of the sensitivity of the issue.

Officials at India’s finance ministry have previously said that banning or placing curbs on PNs would send the wrong message to foreign investors.

Another broker said that Sebi’s move would bring down undesirable activities where equity transactions happen outside India and PNs with underlying Indian securities are sold by one investor to another. This broker added that Sebi’s curbs on PNs would not affect foreign investment in the Indian market, though it could induce panic, leading to a sell-off in the short term.

American depository receipts (ADRs) of Indian firms, including HDFC, Tata Motors, Wipro, Dr Reddy’s Labs, ICICI Bank and Satyam Computers were down between 1% and 8% in early trades in the US.

Reuters and PTI contributed to this story.