Investors in hiding

The participatory note debate is coming to the boil again, with corrective options being debated before action begins. A participatory note (PN) is a derivative instrument with Indian shares as the underlying security that an FII, which is registered in India, issues to foreign investors who are not registered. The FII issues PNs and buys/sells the security on its own account, thereby protecting its risks. Besides circumventing the regulatory requirement of registering with Sebi, PNs also provide anonymity to the client. In the official records, a purchase will be recorded in the name of the FII issuing the PN. So far, Sebi has been worried about the identity of the entity behind the purchase of PNs. There are fears, and rightly so, that Indian promoters may be using the PN route to increase their shareholding in their companies, bypassing the creeping acquisition limit. Operators may also be using PNs to suck out liquidity in stocks.

Sebi's FII Regulations clearly state that FIIs are required to fully disclose information concerning the terms of, and parties to, offshore derivative instruments such as PNs entered into by it or its sub-accounts or affiliates relating to any security listed in India, as and when required. Nevertheless Sebi's requests for information on PN transactions have met with limited success. Even in the May 17 fall and the UBS showcause notice, Sebi found it difficult to get information out of UBS about the PN buyers' beneficial owners. The punitive action of barring UBS from issuing offshore derivative instruments against the positions held by UBS for one year was like closing the stable door after the horse had bolted. After the UBS case, Sebi has told FIIs to inform their clients that they would reveal information on their PNs to Sebi as and when the regulator sought details. Subsequently, the appellate body overturned Sebi's order and said Sebi's "Know Your Client" requirements were vague and had not been defined anywhere by the regulator.

Nevertheless, both Sebi and the government seem to be comfortable with the PN route at present. The reason is that any change in status quo will mean the liquidation of PN positions, which can make the stock market take a tumble. It will also mean reduced portfolio investments in the country, which is not what the government wants.

Concerned at the rising exposure to FIIs, the RBI governor called for a debate on the volume and quality of FII flows in the stock markets, in January this year. The RBI has suggested a ban on PNs and sub-accounts of FIIs to stem foreign flows, because these can be volatile. While the RBI is sitting on foreign exchange reserves of $142 billion, its concern over $5 billion in PNs may appear out of place, unless it believes that a lot of these investments are held by undesirable or domestic investors. The central bank is also concerned that this investment may jeopardise liquidity in the system, which is already tightening. It could also be that it wants to stop any excesses in the issue of PNs in the future.

The government and the regulator have a few options to deal with the PN issue. They could phase out the PN route altogether over the next three years, as is likely to be a Lahiri Committee recommendation, giving all participants enough time to liquidate their positions. Given that a number of large foreign institutions are now looking at India as an important investment destination, this may be the opportune time for such a move. A softer option would be to institute more disclosures so that the name of the client is communicated to the stock exchanges. They could also introduce a lock-in period in PNs so that short-term investors are not able to exit overnight.