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Knowing the investor

A discussion paper issued by the Securities and Exchange Board of India on Tuesday on offshore derivative instruments (ODIs) will have far reaching implications for the flow of foreign money into Indian stocks. Better known as participatory notes (PNs), the ODIs are derivative instruments issued by registered foreign institutional investors (FIIs) to their clients abroad for participating in the Indian stock markets. The PNs give an overseas investor a chance to invest in India without having to go through the long process of registering with SEBI. Many, including the RBI, have for long argued that the anonymity that this route provides goes against transparency and makes the task of monitoring capital inflows onerous. In 2003, a high level co-ordination committee consisting of representatives from the principal financial regulators decided against banning the issuance of the PNs but suggested some safeguards that the FIIs have to follow. All these have proved inadequate. From the Indian standpoint, the PNs have remained opaque instruments, gaining popularity as the quantum of FII investment increased dramatically, especially in recent months. According to SEBI, the notional value of PNs outstandings has climbed to Rs.3,53,484 crore constituting more than 51 per cent of all assets under the custody of the FIIs. Particularly worrisome, because of their potential for leverage, has been the fact that the value of ODIs based on derivatives is around a third of all PNs outstandings.

If, as expected, the policy measures proposed are adopted by the SEBI board, neither the FIIs nor their sub-accounts can issue or renew the PNs which have invested in derivatives. Within a period of 18 months, they will have to wind up their existing positions. Other measures contemplated include the fixation of a limit for each FII. As pointed out by Finance Minister P. Chidambaram, the idea is not to ban investments in the PNs but only to regulate them. It is expected that some of these investors would register as FIIs, and SEBI needs to simplify and quicken the process. For the government and the RBI grappling with huge capital inflows, the new regulations would be helpful in two ways. There will be a moderation in the quantum and, more important, the quality of the inflows can be ascertained. The stock markets did not receive these proposals with equanimity. On Wednesday morning, trading stopped after the Sensex dropped by more than 1700 points. Towards the close, though, the markets rebounded to a large extent. Most market participants probably realise that the short-term discomfort that these regulations will cause would be offset by gains accruing over the medium-term.

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