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The SEBI note and why FIIs are creating a fuss


Firstly, sorry for being silent the last two days. Life’s been hectic.

Let’s see a little more into what this whole SEBI rule is about, which has spooked the markets. But first, a little history.

Foreign Institutional Investors, or FIIs, are a class created by SEBI (why, I do not wholly understand) and that consists of “non domestic institutional investors” meaning they don’t need to adhere by (Know-your-customer) KYC norms or the level of regulation of the domestic folks (DIIs). But FIIs did have disclosure norms on how much they invested etc. and of course they had to register with SEBI. Mostly these people came from tax havens like Mauritius for saving capital gains tax.

Some other foreign institutions did not want to even register with
SEBI. So SEBI bent backwards and said, fine, you can come through an
existing FII who will create a “sub-account” for you.

Then some hedge funds and pension funds decided they would not even go and become a
sub-account (which does have SOME regulation, to be honest). So FIIs said, tell you
what, let’s buy in the Indian market, and we’ll give you a
participatory note based on what we buy. We’ll put out a price to the
note every day and that will reflect the dollar value of the
“underlying” meaning whatever we issued the p-note against.

SEBI, overlooking all the negatives of this approach, said ok to
p-notes. Now, FIIs dont have to reveal who the p-note buyer is
(because effectively the FII holds the security)

Now P-Notes could be used for equity shares or for debt
(bonds etc.) But FIIs also started issuing it on derivatives
(stock/index futures and options). This is a little unfair because
Indian citizens under RBI laws can’t invest on margin when they invest
abroad (that’s how you trade futures) – but then when was life fair.

Now SEBI has realised that a large amount of the copious inflow of dollars has come against P-notes issued against derivatives. So SEBI wants to remove any p-notes based on derivatives, completely. And it wants to restrict all p-notes to a certain % of the FII’s total limit.

The specification is: no new p-notes after Oct 25 against any derivatives. Existing such notes have to be terminated within 18 months. And in general, p-notes must not exceed 40% of the FIIs total assets under control in India.

Meaning, it’s telling the hedge funds, come forth and get registered
with us directly, if you want to do derivatives. And the KYC norms
will apply.

That’s the long story, and the reason for spooking the markets is
that this rule unsettles things for a while. Still, it’s not all that
bad, because when they say “you can’t do it anymore” it doesn’t quite
mean that.

What it means is – (SEBI saying) listen, you got them p-notes, right?
So go ahead and keep them for 18 months from oct 25. At the end of 18
months, you can unwind the underlying derivatives. You can’t issue any
NEW p-notes based on derivatives. You can’t issue more than 40% of
your total investment as p-notes.

Problem is: these FIIs that issue p-notes are brokers, like Merrill Lynch and Morgan Stanley. Hedge funds want to route their business through these brokers only (some very incestual relationships here) but now they can no longer do so if they want to invest in derivatives, and they really want to. Hedge funds love derivatives for the leverage provided. So what can they do? They can come and register in India, and deal through the ML/MS offices in India.

But the relationships are between the US offices of the hedge funds and the US offices of the brokers! The hedge fund managers give the brokers (in the US) business, so they get pampered by getting tickets to ball games, parties, cruises etc. If they start dealing with Indian brokerages, won’t it remove them from the ‘special’ lists? I think *that* is the biggest problem. After all, hedge funds can easily register as FIIs themselves, and put a few blokes here to take care of the regulation and disclosures. Big deal. But now the big issue is that they have to change brokers, and they’re complaining.

Obviously the foreign brokers themselves are unhappy because they lose the fat margins they used to make on the p-notes. And Indian brokers are happy because now they will get a piece of the foreign investor pie.

The markets have overreacted to what is a correct course of action, and have tanked quite a bit. Don’t bother. This will correct itself in a week. Some good buying opportunities will come, just avoid the folks that have been taken sky high already like REL, RPL and so on. Whatever you do, keep your stop losses ready, but widen them a bit for such overreactions.


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