'Sebi evaluating FII investments through certain routes'

 There has been a steep rise in the markets over the last few months. In order to strengthen safety and stability of the markets, various measures have been initiated by SEBI.

 There is rolling settlement with shortening of the settlement cycle to T+2. Delivery percentages are around 20 per cent and there is greater institutional participation. There is however need for a constant vigilance, alertness and prompt action.

 On reports of illegal dabba trading market

 Based on informal market information, complaints and media reports, Sebi's Market Intermediaries Regulation and Supervision Department conducted inspections of certain reported dabba trading operators and for the first time, search and seizure power were used during the action. Entities involved in dabba trading have been banned from the market and FIRs has been lodged in the case.

 FII inflows

 In the wake of increasing level of FII investment particularly through certain routes, Sebi has started looking into the matter, enlisting the assistance of other regulatory authorities.

 Sebi has been looking into the sources of FII funds. From the information collected so far, it was observed that the main sources of funds for the Flls/sub-accounts are the following:

 

 

Equity/preference capital from the parent company/group companies/associated entities.

Loans from the promoter companies/group companies/associated entities

Issue of synthetic instruments such as PNs/warrants etc. to certain identified or unidentified parent/group companies.

 The identities of the ultimate beneficiaries of these PNs are not known. Instances of non-reporting of information about issue of PNs/warrants etc by some FIIs/sub-accounts were noticed.

 Subsequent to amendment to the FII Regulations, a regular system of periodical disclosure by FIIs of data of PNs outstanding/issues by them or their sub accounts has been put in place.

 Warning to investors

 Warnings have been issued to market players particularly from June, 2003 and also investors have been cautioned against market rumours.

 While a number of steps, as mentioned above, have been taken by Sebi, it needs to be mentioned that given the complexity and size of our markets, there are limitations in terms of systems, infrastructure and resources for surveillance of market activities.

 It is expected that the envisaged automated system for integrated surveillance would be able to cater to the system and infrastructure requirements The complexity introduced by lack of unique identification of investors is being addressed by the proposed Central Registry Depository.

 Sebi is also in the process of increasing its manpower to meet the need of enhanced surveillance at the regulatory level.

 Most world markets have shown a rising trend during the period April 1 to October 13, 2003 in the range of 11 per cent to 60 per cent.

 While the Sensex has risen by 57 [er cent, the more broad-based BSE-500 index has risen by 73 per cent, showing that the rise in markets is broad-based and has spread to lower cap stocks.

 Delivery percentages which had gone up from around 18 per cent earlier to about 27 per cent till about August 2003 have declined in September to the range of around 20 per cent-22 per cent, indicating higher delivery-based trading.

 Further, the price earning multiples of Indian market was at 16.53 on October 13, 2003, whereas the PE multiple in other markets varies from 10 to 57

 It may be pertinent to note that while market movement is influenced by various factors such as company results, industry performance and outlook, economic indicators, market sentiment, movements in global markets, political developments, monsoon and agricultural production etc., the areas of concern from the regulatory perspective are that market integrity and safety are being maintained and rules and regulations are followed by market participants.

 FII equity turnover

 It can be seen that FII equity turnover constitutes about 6 per cent of the total market turnover in the cash segment.

 Thus, around 94 per cent of the turnover in cash segment is accounted for by entities other than FIIs/sub-accounts registered with Sebi.

 Sebi has introduced fortnightly reporting of off-shore derivative instruments against underlying Indian securities from August 2003.

 Based on the analysis of reports till September 15, 2003, it is seen that investments on account of offshore derivatives instruments against underlying Indian securities is Rs 15528.4 crore which is 20.56 per cent of the total net FII investments in India.

 Taking opposite positions

 Taking opposite positions in the cash market and the derivatives market constitutes hedging. Hedging is a normal capital market activity which is used to minimise risk.

 All investments including FII investments in the capital markets are subject to market risks and returns on investments are affected by the associated risks.

 As can be seen, FII equity turnover in the cash segment constitutes about 6 per cent of the corresponding total market turnover.

 The FIIs are permitted to transact business in the cash segment of the market only on the basis of taking and giving deliveries of securities bought and sold and are not permitted to engage in short selling in securities.

 It may be observed that net FII investments have been consistently positive in all the years from 1992-93 except only in the year 1998-99.

 Institutional participation in trading has also gone up with FIIs alone accounting for gross purchases of Rs 12270.5 crore and gross sales of Rs 8095.2 crore in September alone. Net FIIs inflow in September was Rs 4175.5 crore.

 In the month of October 2003, net FII inflow till October 13, 2003 is Rs 2921.3 crore. Till October 13, 2003 FII has made gross purchases of Rs 69,398 crore and gross sales of Rs 48,021.9 crore.

 Since September 18, 2003, report on FII trading/position in derivative market is being compiled on the basis of reports submitted by the NSE & BSE. Open Interest of FIIs in the stock futures segment as on October 14, 2003, was Rs 2,866 crore.

 The cumulative FII position as per cent of total gross market position in the derivative segment as on October 14, 2003 is 15.80 per cent.

 Analysis of FII investment

 Of the FII net investments till October 13, 2003, which was about Rs 80,325 crore, it is seen that Rs 15,528 crores is the value of investments through PNs (as on September 15, 2003) which constitutes about 20 per cent of the total net FII investments. Remaining about 80 per cent of the FII investments is through direct investments from Flls/Sub Accounts.

 Analysis of the FII investment during the period March 1, 2003 to July 10, 2003 was carried out and it indicated that the total purchases made by Mauritius based Fll/sub-account / accounted for about 38 per cent of total gross purchases and 25 per cent of total net investments of all FIIs.

 Many of the Mauritius based entities were registered as sub-accounts with Sebi and hence the details of these sub-accounts were not known to Sebi as they are not required to submit this information. Sebi had taken examination of these investments in July 2003.

 Although the Fll/sub-accounts were required to submit to Sebi about the details of issue of PNs in terms of Circular dated October 31, 2001 it was found that some Fll/sub-accounts were not furnishing this information to Sebi.

 Subsequently, on August 28, 2003, FII regulations were amended to provide for furnishing of information by Fll/sub-accounts about issue of all offshore instruments on the underlying Indian securities A comprehensive format was also circulated to all the Fll/sub-accounts to furnish information on a fortnightly basis beginning from August 14, 2003.

 These details are analysed with a view to know the identity of the underlying investors, the extent of their purchases, the underlying securities etc

 As of September 15, 2003 the following is the status.

 

 

Out of 509 Flls/sub-accounts registered with Sebi, 12 Flls/sub-accounts are found to be issuing offshore derivative instruments.

The total net investments of these 12 entities were about Rs S5133 crore and the value of the outstanding PNs were about Rs 15528 crore. (Net investments indicate the actual investments whereas the value of PNs indicate the outstanding value) Analysis of FII investments from September 01, 2003 to October 13,2003 indicated that the investments were widespread among many FIIs. The maximum concentration in terms of the net purchases was not more than 20 per cent with any single FII in September and , October, 2003. Top 10 FII purchases constituted about 86 per cent of the total FII investments during September, 2003 and about 66 per cent in October, 2003.

 The following are the observations and status of actions taken by Sebi:

 

 

The details with regard to names and addresses of investors in these derivative instruments, their proportion of investments, nature of underlying scrips, timing of investments were perused. It was noticed that there were several layers of investors in these offshore j derivative instruments. The levels varied from one Fll/sub-account to the other and there j were minimum three layers of investors.

Based on the significant proportion of issue of PNs the following sub-accounts were taken up for calling additional information with regard to the ultimate investors. Many of these entities were not willing to part with these details because of confidentiality with the investors. The top executives, of these entities were called by Sebi and were impressed upon the regulator's need to have the additional information about the ultimate investors in these instruments. After obtaining approval from their clients these entities have started submitting their information and so far information have been received from the following 4 entities. It was also noticed that this information were generally given by them only up to the next layer and they stated that the investors beyond this level is not known to them.

 

 

a) Citigroup Global Markets Mauritius Pvt. Ltd.

b) Copthall Mauritius Ltd. (J P Morgan Chase)

c) HSBC Financial Services (Middle East) Ltd.

d) Goldman Sachs Investments Mauritius Ltd.

 Next level of information is being called for from the other Fll/sub-accounts. All these entities have given declarations stating that generally they have not issued these derivative instruments to directly or indirectly to Indian residents/ NRIs/ PIOs/ OCBs.

 The analysis of the information so far does not reveal any major irregularities so far other than the following.

 A Mauritius based OCB (Magnus Capital Corporation Ltd.) had subscribed to the PNs issued by Citigroup and Goldman Sachs against various underlying securities. Sebi has informed RBI for necessary action at their end.

 Similarly, it was noticed that about 31 entities appeared to be OCBs have subscribed to PNs issued by some of the above Flls/sub-accounts. List of such entities are given and the same are forwarded to RBI for verification and necessary action.

 Issues relating to risk containment measures for the derivatives market

 Derivatives trading commenced in India on the National Stock Exchange and the Bombay Stock Exchange in June 2001 after Sebi granted the final approval to this effect in May, 2001. Sebi approved trading in index futures contracts based on S&P CNX Nifty Index and BSE-30 Index.

 Trading in index options commenced in June, 2001 and trading in options on individual securities in July, 2001. Single stock futures have also been introduced since 9th November 2001.

 Such trading and settlement in derivative contracts is done in accordance with the rules, bye-laws and regulations of the respective exchanges and their clearing house/corporation duly approved by Sebi and notified in the official gazette.

 The risk containment measures specified in the derivative markets are comparable with most developed markets.

 A portfolio based margining approach has been specified by Sebi which values, at a client level, a portfolio of futures and options contracts under different scenario of price and volatility changes so as to cover 99 per cent Value at Risk.

 Since the introduction of derivative trading, the risk management framework has stood the test of time even during the period of high volatility. Speculative activity is very much a part and parcel of derivative trading.

 The arbitrageur itself provides the opportunity to correct any mispricing in the. market. What is vital for the smooth functioning of a derivative market is the risk containment measures which have been put in place to take care of any sort of market manipulation.

 The contract design for derivative market is the first form of defence against manipulation. It is not possible for the illiquid stocks to qualify as eligible stocks for trading in the derivative segment of the capital market.

 The stock selection criteria for derivatives trading in India ensure that stock is large in terms of market capitalization, turnover and has sufficient liquidity in the underlying market.

 So the liquidity and non-manipulatability are integral to the contract design for derivatives. Also, the limit for FII exposure in the derivative market is co-terminus with other trading members.

 The Advisory Committee on Derivatives and Market Risk Management (ACDM),of Sebi had recommended certain regulatory initiatives for the derivatives markets, viz:

 

 

Reduction of derivatives contract size from Rs. 2 lakh to Rs. 1 lakh.

Criteria for the eligibility of the stock for derivatives trading chosen from top 500 scrips in terms of market capitalization and turnover shall be that the stock's median quarter-sigma order size over the last six months shall be at least Rs. 1 lakh and the market wide position limit of the stock shall be at least Rs. 50 crore.

 Introduction of physical settlement of derivative contracts.

 These recommendations of the ACDM were approved by the Sebi Board. However, the Sebi Board had left the timing of the implementation of the recommendations to SEBI.

 Since it was felt that the introduction of these measures in the derivatives market would have an impact on the cash market, the views of the secondary market advisory committee (SMAC) was sought on the timing of the implementation.

 It was observed by the SMAC that the derivatives segment has seen rapid growth. However, notwithstanding changes in the market structure and growth in the derivatives segment, the SMAC felt that there was need for caution before allowing further expansion of the market.

 As regards the reduction of contract size, the Committee was of the view that at the first stage, the lot size can be reduced to Rs. 2 lakhs to make it equivalent to the contract size.

 As regards the introduction of physical settlement of derivative contracts, the Committee was of the view that physical settlement may be introduced subject to putting in place an efficient securities lending and borrowing system.

 On the issue of criteria for eligibility of stocks for derivatives trading, the committee observed that by revising the criteria for eligibility of stocks for derivatives trading, the number of stocks could be increased. However, the committee felt that Sebi should expand the list cautiously.