India's stock market regulator tightened investment rules for unregistered foreigners as expected on Thursday by clamping down on issuance of indirect investment notes to stem inflows of anonymous money.
The Securities and Exchange Board of India (SEBI) said the new regulations on so-called participatory notes (P-notes) would come into effect at the close of trade on Thursday.
The regulator says P-notes allow foreigners to make a backdoor entry into the market without registering with Indian authorities and it wants them to register to create greater transparency on inflows.
"We are saying we are registering more FIIs. We are saying that we are fast-tracking the system of registration," SEBI Chairman M. Damodaran told a news conference after its board approved the new regulations.
"What we are doing is to clean up the regulatory environment, that is our terrain, rather than seek to do something else."
P-notes are issued by foreign institutional investors (FIIs) registered in India to unregistered overseas investors. Registered FIIs buy Indian securities and issue the notes based on the underlying asset.
The new rules follow the lines of a draft issued by SEBI last week.
FIIs and their sub-accounts -- vehicles set up by registered FIIs to issue P-notes -- are no longer allowed to issue P-notes whose underlying asset is a derivative.
"The related decision that the current position would be wound up over 18 months has also been approved by the board," Damodaran said.
Fresh issuance of other P-notes by sub-accounts would stop immediately and they would be required to wind up their current position over 18 months. However sub-accounts applying for FII status could continue business with their application pending.
SEBI also imposed a P-note issuance limit of 40 percent of assets under custody. Entities below 40 percent would be allowed an annual 5 percent incremental increase capped at 40 percent.
"But those who are going above 40 percent now had to stay where they are, and clearly those who are below 40 percent cannot be allowed to run away indefinitely," Damodaran said.
Other steps included allowing P-notes to be issued only to regulated entities.
Indian shares, which have been volatile since SEBI first made its plans public last week, ended up 1.4 percent ahead of the announcement, with investors optimistic the rules would largely be as the regulator had already outlined.
India, the world's fastest-growing major economy after China, has battled a surge of foreign capital this year, which has pushed the rupee to its strongest against the dollar since 1998 and helped power the stock market to a series of record highs.
The finance minister has said India is also trying to moderate inflows to avoid a stock market bubble.
Net foreign portfolio investments so far this year are more than $17 billion, well above the full-year record inflow of $10.7 billion in 2005.
More than $8 billion of foreign funds flowed in the weeks after the United States cut interest rates in mid-September, prompting SEBI to announce its plans.
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Thursday, October 25, 2007
SEBI curbs P-notes to boost transparency
Wednesday, October 17, 2007
SEBI's mooted curbs on PN (P-Notes) flows causes BSE, Nifty to hit lower circuit
Curbing the flow of hot money into the country has side effects. Bulls discovered this to their cost, when market regulator SEBI placed limits on participatory notes.
What is participatory notes?
Participatory notes (PNs) are instruments used by investors or hedge funds that are not registered with the SEBI (Securities & Exchange Board of India) to invest in Indian securities. Indian based brokerages buy Indian-based securities and then issue PNs to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors.
Participatory notes are instruments used for making investments in the stock markets. However, they are not used within the country. They are used outside India for making investments in shares listed in that country. That is why they are also called offshore derivative instruments.
Like any other derivative instruments, their value is determined on the basis of the underlying asset. In the case of participatory notes, the underlying assets are shares listed on the stock exchanges.
In the Indian context, foreign institutional investors (FIIs) and their sub-accounts mostly use these instruments for facilitating the participation of their overseas clients, who are not interested in participating directly in the Indian stock market. According to one estimate, participatory notes constitute more than 25% of the cumulative net investments in equities by FIIs.
Today's fall
India's stock market benchmark Sensex crashed by 1,743 points within the first few minutes of opening this morning (17 October 2007), prompting the suspension of trade for an hour.
This is fallout of market regulator Securities and Exchange Board of India (SEBI) clamping down on anonymous participatory notes (PNs) to arrest the flood of foreign inflows. The fall came just days after finance minister P Chidambaram expressed surprise at shooting stock prices - the Sensex had shot up by 5,000 points in less than two months - and hoped that things would cool down.
Soon after the stock markets closed on hitting the down-circuit, Chidambaram said in a live telecast that the government was neither against PNs, nor was it banning them. Proposals to moderate portfolio investment by foreign investors were part of a series of steps to moderate capital inflows, he emphasised.
Earlier, on Tuesday, SEBI proposed partial restrictions on investment through offshore derivative instruments, including participatory notes (PNs), equity linked notes and capped return notes.
SEBI issued a discussion paper suggesting that FIIs and their sub-accounts should not issue or renew offshore derivative instruments (ODIs) with underlying derivatives, with immediate effect. "They are required to wind up the current position over 18 months, during which period SEBI will review the position from time to time," the paper said, inviting comments from the public about the new proposals.
FIIs currently issuing ODIs the with notional value of PNs outstanding (excluding derivatives) as a percentage of their assets under custody (AUC) in India of less than 40 per cent should be allowed to issue further ODIs only at an incremental rate of 5 per cent of their AUC in India.
Those FIIs with a notional value of PNs outstanding (excluding derivatives) as a percentage of their AUC in India of more than 40 per cent should issue PNs only against cancellation or redemption or closing out of the existing PNs of at least equivalent amount.
Though only a proposal, the SEBI move effectively halted the FII-led rally. FIIs invested over $5.45 billion in October alone, taking their total investment for 2007 to $17.69 billion.
The huge inflows have pushed up the value of the rupee against the dollar. The year-on-year increase in ODIs, the anonymity that it provides to investors, and the copious inflows into the country from foreign investors have been areas of concern for the government and regulators like the Reserve Bank of India (RBI) and SEBI.
Earlier, the High Level Committee on Capital Markets (HLCC), as well as various committees set up by the government and regulators had made recommendations that included issuing of PNs only to regulated entities subject to know-your-customer (KYC) requirements.
Main causes for concern
The notional value of PNs outstanding, which was Rs31,875 crore (20 per cent of AUC) in March 2004 has grown over 10 times to Rs3,53,484 crore (51.6 per cent of AUC) by August 2007
The value of outstanding ODIs with underlying derivatives is Rs1,17,071 crore - about 30 per cent of total PNs outstanding
The notional value of outstanding PNs - excluding those with underlying derivatives - as a percentage of the AUC was 34.5 per cent in August 2007
At present, 34 FIIs and sub-accounts issue offshore derivative instruments (ODIs), against 14 in March 2004
