Participatory notes or PNs are back in the news, with the SEBI (Securities and Exchange Board of India) issuing a draft discussion paper on ODIs (overseas derivatives instruments).
If that is too much of an alphabet soup to start, on a day that saw the markets in a tizzy, here is Ms Bahroze Kamdin, Director, BSR & Co, a firm of chartered accountants, explaining things about the new animal that has been let loose on the bourses!
Excerpts from an e-mail interview.
If ODI is not one-day international, what’s it?
ODI or ‘overseas derivative instrument’ includes PNs, but there are more. Such as, equity-linked notes, capped return note, participating return note, investment note and similar instruments issued by FIIs (foreign institutional investors) and their sub-accounts outside India against their underlying investments in listed or proposed to be listed securities (shares, debt or derivative) in India.
Is there a law in place about ODIs?
Yes, with effect from February 3, 2004, ODIs against underlying Indian securities can be issued only to regulated entities subject to ‘know your client’ requirements, according to the SEBI (FII) Regulations, 1995.
Further, transfers, if any, of these instruments can also be to other regulated entities only. FIIs/sub-accounts are required to ensure that no further downstream issuance of such derivative instruments is made to unregulated entities. FIIs issuing ODIs are required to furnish report on a monthly basis to SEBI.
All this, because, to discharge regulatory responsibilities, SEBI would need to be in a position to ascertain, when circumstances so warrant, the details of the ultimate investors investing through PNs etc. in the Indian market.
Now, what does the draft discussion paper from the market regulator propose?
One, FIIs and their sub-accounts shall not issue/renew ODIs with underlying as derivatives, and the current position should be wound up within 18 months. SEBI has subsequently clarified that ODIs expiring this month or in the following months, can be renewed, provided the renewal does not go beyond 18 months.
Two, sub-accounts of FIIs cannot issue ODI with underlying all securities (including shares) with immediate effect. They will be required to wind up the current position over 18 months.
And three, FIIs who are currently issuing ODIs (excluding underlying as derivatives) are allowed to issue further ODIs – where notional value of ODIs outstanding as a percentage of their ‘asset under custody’ (AUC) in India is less than 40 per cent, only at the incremental rate of 5 per cent of their AUC in India; and where notional value of ODIs outstanding as a percentage of their AUC in India is more than 40 per cent, only against cancellation, redemption or closing out of the existing PNs of at least an equivalent amount.
Why the focus on ODIs?
ODIs are generally issued by foreign securities brokering houses and foreign banks. It is believed that entities which otherwise are not eligible to invest, e.g., hedge funds, use the ODI route to invest in the Indian market. Also, that foreign nationals with small value portfolio invest through the ODI route to avoid cumbersome regulatory and tax compliance requirements in India.
Nothing new, because in the latter half of 2003, a committee comprising representatives of the RBI, IRDA, SEBI and NSE, extensively discussed PN-related issues such as allowability, monitoring, and phasing out. The committee had acknowledged that any measures taken should be ‘practical, pragmatic, non-disruptive and enforceable without great difficulty’.
Now, the recent document from SEBI, takes note of “the year on year increase in ODIs, the anonymity that the ODI provides to the investors and the copious inflows into the country from foreign investors,” all of which have been engaging ‘the attention of the Government and the regulators such as the RBI and SEBI’.
Do we have the numbers?
The discussion paper describes the current scenario with data. There are currently 34 FIIs / Sub-accounts issuing ODIs, as against 14 in March 2004. The notional value of PNs outstanding has grown almost ten-fold during the period, from about Rs 30,000 crore (20 per cent of AUC) in March 2004 to more than Rs 3,50,000 crore (52 per cent of AUC) by August 2007.
“The value of outstanding ODIs with underlying as derivatives currently stands at Rs 1,17,071 crore, which is approximately 30 per cent of total PNs outstanding. The notional value of outstanding PNs, excluding derivatives as underlying as a percentage of AUC is 34.5 per cent at the end of August 2007.”
Will the new proposals be effective? And what are your suggestions in this regard?
The proposed measures of SEBI are welcome provided that the registration process and the tax compliance process are simplified for foreign investors to invest in the stock market.
In the past few months SEBI has taken measures to increase the list of foreign entities eligible to invest as FIIs. Further SEBI is also considering allowing hedge funds to register as sub-accounts, a measure that is good and should be continued.
SEBI proposes to ban the issue of ODIs where the underlying is derivative. In the case of global derivative houses, the specialisation lies in getting returns only in the exchange traded derivative market. Exchange traded derivative is a security and it is not the case that investment in derivative is done only as a hedging tool.
As ODI with underlying of shares is permitted subject to limits similarly, it is suggested that FIIs issuing ODIs with underlying as derivative should be permitted.
Further, one wonders if this measure is apt for controlling the unprecedented capital inflows into the country, or whether the government should resort to other measures to manage capital inflows into India.
What do you foresee as the impact of the move?
Generally, we observe that the majority of ODIs issued to foreign investors are by sub-accounts from tax-friendly treaty countries. With the proposed ban on sub-accounts to issue ODIs, there will be substantial reduction of inflows through this route.
D. Murali
CAclubindia
