Participatory Notes Spoil the Show

Tuesday, April 29, 2008 | | |

It has been a comatose start to the much awaited stock lending and borrowing (SLB) mechanism flagged off by the Securities and Exchange Board of India last week. In seven trading sessions since its inception, only a measly 15 shares have been transacted in the SLB segment. Market watchers say participation by foreign institutional investors holds the key to the success of this mechanism. But these investors are unlikely to come rushing, at least not while they have a far more efficient route to short sell Indian equities, they feel.

Even before the introduction of SLB, many foreign institutional investors — especially hedge funds — that were not registered with SEBI, had recourse to short selling shares which they felt were over valued. These players did so through foreign institutional investors who were authorised to issue a derivative instrument known as participatory notes (PNs), with equity shares as the underlying.
FIIs registered with SEBI set up PN accounts in which they buy and sell shares on behalf of overseas investors who are not listed with the Indian regulator, either out of choice or because of their inability to fulfil certain criteria. The underlying shares are held by the registered FIIs in their own names, and they issue participatory notes to their clients.

Since the PN-issuing foreign fund transacts on behalf of a number of overseas clients, and retains ownership of those shares, it has an assorted inventory of shares at its disposal. It can then lend these shares to those overseas funds which are looking to go short on the market, for a fee. What is more, even those FIIs registered with SEBI, and which have presence in international markets, can borrow shares from a PN-issuing competitor through this offshore route.
It works like this.

FII A has bought 1,000 shares of ACC in its PN account on behalf of client B. Another foreign client C, based in say, Singapore, wants to go short on thousand shares of ACC. FII A has an arm in Singapore, which will enter into an agreement with C specifying the interest charges and the duration for the short sale, and issue the PN stating that C is short 1,000 shares of ACC. FII A will then sell the 1,000 ACC shares in India. When C wants to reverse its transaction at a later date, FII A will buy 1,000 shares of ACC from the market.

“It is hard to see SLB in the current format gaining popularity with foreign funds when they have a route that offers them better liquidity, flexibility in contract tenure, as well as anonymity,” said an official at a foreign brokerage house.

In SLB, the tenure of the contract is for seven days, ie the borrowed shares have to be returned on the eighth day. In the PN route, the duration of the contract can be six months or even more.

Then there is the issue of anonymity. In SLB, the market can get to know of the short position in a particular stock. Since participatory notes change hands outside India, it is impossible for the market or for even the regulator to know if some foreign fund is actually going short on a particular stock.

Sources at foreign brokerage houses say hedge fund activity has declined significantly since the market crash in January this year, and that has also led to a drop in lending and borrowing transactions through PNs. However, they add that it will continue to be a preferred route when the market regains buoyancy, unless some radical changes are made to current SLB format.