SEBI's move to ban participatory notes based on derivatives is well-intentioned but some market participants fear that it has cut out one leg of the market.
MUMBAI: The Securities and Exchange Board of India’s (Sebi) move to ban participatory notes based on derivatives is well-intentioned, but some market participants fear that it has cut out one leg of the market: the one that allowed large and informed investors such as hedge funds to take a negative call, or, in other words, go short on the market.
Therefore, a large part of the rise of Indian equity markets over the past two weeks can be attributed to this market inefficiency that has crept in.
The Sebi discussion paper barring P-notes was put out on October 16, 2007, which led to a collapse of the market immediately.
However, since then the market seems to have found renewed vigour, with the Sensex breaching 20000 on October 29, 2007.
On Friday, when other world markets tumbled, Indian equities sat pretty. Even on Monday, when benchmark indices in Hong Kong and Shanghai fell 5% and 2.5%, respectively, the Sensex slipped just 1.9% (See chart), with the broader Indian market ending in the green.
What explains this apparent strength in a market that has so far this year moved in tandem with global swings?
An intermediary, who did not wish to be named, said: “Hedge funds were responsible for most of the short positions. Now they cannot short because of the ban on P-notes based on derivatives. Most of the shorts were created through that route.”
P-notes are financial instruments used by foreign investors not registered with Sebi to take an exposure to Indian companies.
Meanwhile, derivatives are instruments that have shares as underlying, which investors use to take a positive or negative view on the market. If their call goes write, they make money.
The other mechanism through which institutions can take a negative view, called short-selling, has not yet been put in place by Sebi, though the regulator has been talking about it for some time now.
So now, with Sebi banning P-notes with underlying as derivatives, the only window through which foreign investors (read hedge funds) took negative calls has been shut out completely.
Banks are barred from shorting the market and mutual funds hardly ever short.
“Clearly, there is that element of existing shorts getting squeezed, and more shorts not allowed to get created, in the rise of the market,” corroborates Rajeev Malik, executive director (Asia Economic Research), JP Morgan.
“The technical position has become challenging, where FIIs (p-notes are issued by FIIs) are no longer in control of the market. But the situation will get evened out ultimately,” adds Bharat Iyer, ED and head of India equity research at JP Morgan.
The anomaly brings to focus James Surowiecki’s article in The New Yorker on December 1, 2003: “If you think of a stock price as a weighted average of the expectations of investors, restrictions on short-selling skew that average by shutting out people with contrary opinions. It’s a bit like setting a point spread for a football game by allowing people to bet only on one side.”
He cited a study by a team of Yale university management professors, of 47 stock markets, which concluded that markets with active short sellers reacted to information more quickly and set prices more accurately.
“A traditional justification for short-selling regulations-including the rule the SEC (Securities Exchange Commission) the US regulator wants to repeal, which prevents short selling when prices are already falling - is that they protect markets from panics. Yet the study found no evidence of it,” Surowiecki wrote.
But Vijay L Bhambwani, chief executive officer of BSPLindia.com, speaking on the recent happenings in the Indian market, says:
“In a bull market like India, as the number of shorts getting created is low as compared with the longs, it means FIIs being incapacitated to short the market here (through p-notes), is contributing only to a limited degree to the rise of the market.”
Deepak Jasani, head of retail research at HDFC Securities, says even if such a problem exists, it should get corrected soon as more foreign investors start coming in directly, rather than through participatory notes.
But when the market realises this inefficiency, a fall cannot be ruled out.
“Is it likely to fall off the cliff? My answer would be no,” said Iyer of JP Morgan, not ruling out intermittent volatility and a correction.
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