Wednesday, August 20, 2008

The Impact of Status Quo on Participatory Notes

Last week, there was expectation that SEBI would make some announcements regarding issuance of participatory notes (P-notes) by foreign institutional investors, particularly that curbs on P-notes will be removed. However, no decision was taken by SEBI and it was decided to defer the matter.

In an editorial, the Financial Express comes out very strongly in favour of removal of all restrictions against offshore derivative instruments such as P-notes. It says:

“Sebi and the government continue to dither on the problem of participatory notes (PNs). PNs are over-the-counter (OTC) derivatives (i.e. bilaterally negotiated derivatives) on Indian equity that are transacted offshore. Restrictions on PNs are supposedly motivated by the need to do supervision of the stock market. This is a canard. All over the world, there are enormous OTC derivatives markets that thrive alongside exchange-traded markets. The managers and supervisors of the London Stock Exchange, New York Stock Exchange, etc., seem to be very comfortable with delivering on their supervisory responsibilities on these exchanges, despite the OTC derivatives market that flourishes alongside.


India has reaped enormous benefits by a highly limited opening of a closed economy. That process of opening must go on. The way forward consists of moving on with the removal of capital controls, and not going back to having more of them. The FII framework was an appropriate idea in 1992. Its utility needs to be increasingly questioned. What does India gain by having a foreign company come to Sebi and register itself? Would it not be better for India to remove the FII framework altogether, and only ask foreign investors to have direct depository accounts with NSDL or CDSL? This way, an entire layer of a permission raj would be eliminated. In addition, the possibility of policy mistakes—such as the restrictions on PNs—would also be removed.”
There is need for caution here. The success of free market regulation (that this editorial advocates) is, and continues to be, a debatable issue. Recent events and the ongoing financial crisis that emanated in the US have questioned the success of market regulation even in advanced economies such as the US, what with collateralized debt obligations (CDOs) and other unregulated instruments wreaking havoc in the financial markets. In this background, it is not entirely certain whether such a prescription will work at all in an emerging economy like India. The relaxation of capital controls necessarily has to be a progressive and controlled process.

Requiring foreign portfolio investors to register with SEBI directly (through the “front door”) rather than resort to indirect routes such as participatory notes has several advantages: it would subject these entities to supervision by the Indian regulators, enhance transparency in the markets and ensure that the capital markets are not exported offshore through indirect (and derivative) instruments. What is important though is that there is a proper, streamlined and timely process followed by SEBI for registration for FIIs, failing which the registration method would not function effectively.

These views are lent some support in today’s editorial in the Economic Times, which finds merit in SEBI’s decision to continue with status quo, and also sets out some data to indicate the lack of any adverse effect to the markets because of the prevailing position:

“SEBI has done well not to rush through any change in its present regimen governing promissory notes (PNs), offshore derivative instruments that allow foreign investors to invest indirectly in a country’s stock markets without disclosing their identity. The restrictions on foreign institutional investors (FIIs) and their sub-accounts, prohibiting them from issuing or renewing PNs with underlying as derivatives and directing them to unwind their positions within 18 months are based on sound logic. They are driven by the need to bring transparency into the market and ensure that beneficial interest is known so that suspect or tainted money does not enter the stock market. Any policy reversal must, therefore, be preceded by thorough examination of the imperatives that led to the imposition of restrictions in the first place.


To the extent FIIs resorted to PNs only because Sebi’s registration processes were cumbersome, the right remedy is to ease the process. This is precisely what Sebi has done; the number of FIIs has gone up from 1,219 in December 2007 to 1,457 in July 2008. But if the fear is that business being is being driven out of India to places like Singapore, where the volume of trading on Nifty futures and options has surged in recent times, the remedy is to improve procedures and product offers on our exchanges, not to reinstate a bad idea; which is what PNs are, a bad idea ab initio.”

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