Investors should be aware of regulatory risks but abruptly changing rules is hardly investor-friendly either.
Independent analyst & columnist
The players in the market seem to have been bested. It is only because they chose to focus on the upside and ignore the downside
Regulatory arbitrage is something that speculators thrive on. Investments can be based on fundamental or technical analyses, under typical situations. Regulatory arbitrage is outside the realm of both of these. Here, the investor is typically betting on a regulatory action by someone over whom he has no control. There is hope that a crowd action will force the regulator to amend the laws in a manner that does not disappoint the crowd. The investors are great believers in the adage that “Wall Street writes the rules”.
In this instance, the Securities and Exchange Board of India (Sebi) has stuck to its promise. Statistical evidence proves that liquidity was adequate in the Indian Depository Receipt (IDR) market and hence it did not warrant conversion. Now, there is no point in breaking down the figures of liquidity and saying that this liquidity is actually “illiquid”. Do we ever see a broker or an institution using the same trading logic when it comes to midcap shares in the domestic bourses?
Sebi not only has to ensure fairness in its action as a regulator but presumably also has a developmental role when it comes to the market and expanding the market. Besides this, it also has a role to be equal-handed when it comes to dealing with various investor classes.
There would be a hue and cry saying that Sebi will kill the future of IDR issuances. We have seen what global depository receipts have done. Liquidity is provided by market makers. The same set of people cannot now come back and say that liquidity is an issue.
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When an “informed” investor (which most institutional investors ought to be, including the high net worth individuals they advise and use as parking stations for their positions many times) takes a view, surely he is aware of the risks. At the point of investment, there are two outcomes. One is favourable and the other is not. So, one has surely evaluated both outcomes and then placed the bet. Now, the protest is simply because the outcome is not favourable. It is like a baby crying to acquire the latest toy.
I also do not believe that this action, will, in any way deter future IDR issues. Ultimately, fundamental valuation is something that should be driving investments. This would be the factor that brings arbitrage down to minimal levels. Arbitrage in equities (an equity share is an equity share, whichever form it is held) that is driven by quirks is a high-risk game and beyond the realm of investment. The regulator is not bound to “protect” someone who invests anticipating regulatory action of a particular nature.
I also believe that this is not the end of the road as far as the matter goes. Regulations are rarely etched in stone. A good regulator will change regulations in tune with the times and needs. Now, if everyone loses interest in the IDRs, two things should happen:
(i) The instrument would become illiquid due to lack of interest and force the regulator to take a relook at this decision;
(ii) Future IDR issuances will factor in the (equal) possibility of the absence of the two-way fungibility of an IDR.
Sebi’s move has in no way hurt “investors”. Investors had the option of either buying the IDRs or the main share. Even an Indian citizen could have bought these shares in the Hong Kong market, given the freedom to an individual to invest in overseas funds and investment vehicles. The set of investors that presumably bought these IDRs on the sole consideration of arbitrage have taken risks beyond the realm of investing. It is smart money and smart money should be aware of the downsides also.
Of course, speculators who have taken positions in the IDR will protest loudly. However, in this instance, there is no case of “equity” or “fairness” being vitiated or violated by the regulator.
For once, the players in the market seem to have been bested. It is only because they chose to focus on the upside and ignore the downside. The interesting thing is that no one here seems to be making an assessment of whether the IDR at these levels is investment-worthy or not, which is what the money managers ought to be doing instead of acting like spoilt children.
CEO, EM Capital Management
If I were on the Sebi board, I would set a regulation that tightly limits foreign ownership of IDRs but also eliminate fuzzy one-year hold rules
In developed and developing markets, nothing annoys investors more than abrupt changes in rules and particularly those that are applied retroactively. In every offering document there is a “Risks Section” and in documents for emerging markets investments there is a section titled “Emerging Markets Risks”. The reality is that few investors carefully read these boiler-plate sections. Investors who have read the Risks Section must believe their investment will be immune to the potential risks described in the documents, including emerging markets risks. Otherwise, only an irrational person would ever decide to invest in an emerging market.
The Securities and Exchange Board of India’s (Sebi’s) June 3 announcement that the Indian Depository Receipts (IDRs) may not be redeemed for the underlying shares unless the IDRs meet an illiquidity test is a perfect example of Emerging Markets Risk. Sebi’s announcement came virtually one year after the Standard Chartered Bank (StanChart) issue, when investors had been told they would be able to redeem their IDRs for underlying shares. It is important to note that the StanChart IDR is the first and only IDR and it doesn’t require an MBA to understand its importance as a test for India’s future IDR market. Although we are neither a customer nor shareholder of StanChart, the bank should be recognised for demonstrating its long-term commitment to the Indian market and to provide the opportunity for Indian investors to participate in its long-term success. The bank certainly didn’t need to raise money in India, it wanted to signal that India is one of its most important markets. The listing of StanChart IDRs provided an easily assessable mode of inclusive financial growth and empowered individual Indian investors the chance to diversify their investments.
Despite the best intentions, we discover that the StanChart IDR listing for the most part failed to provide access to Indians. We have since learned that approximately 70 per cent of the StanChart IDRs have been held by foreign investors with Indian retail investors owning only 8 per cent. Instead, the IDR created a new arbitrage opportunity for foreign professional investors. The sharp decline in the IDRs on June 6 underlines the fact that foreign investors were holding the shares with the sole intention of redeeming them for the underlying shares to realise a sizeable arbitrage profit based on their discount to StanChart shares listed in London and Hong Kong. It would not surprise me if deeper research indicates that a majority of the foreign investors holding StanChart IDRs are not even Sebi-registered Foreign Institutional Investors (FIIs) and bought using participatory notes (P-Notes) or some other structured product sold by the most vocal FII banks such as Credit Suisse. Foreign P-Note investors could have bought the underlying shares directly in the first place, if they really wanted to own StanChart.
Sebi certainly risks institutional credibility by abruptly changing or simply issuing a rule clarification, in this case on day 360 of a one-year hold rule. It must have been obvious to the regulator that most of the issue is foreign-owned and what the IDR holders’ investment strategy has been most of the past year. This is precisely the kind of Emerging Market Risk a securities regulator should avoid. However, I do not feel any empathy for the foreign arbitrageurs. They should have read the Risks Section.
If IDRs are supposed to provide Indians access to foreign securities, individual Indian investors should have full IDR redemption rights up to the existing Reserve Bank of India regulation allowing up to $200,000 in permitted external investments. IDRs support the inclusive financial growth needed for India and their availability reinforces India’s rapidly growing global importance. If I were on the Sebi board, I would set a regulation that tightly limits foreign ownership of IDRs but also eliminate fuzzy one-year hold rules that are too tempting and easy for a nervous regulator to change. Sebi should create mechanisms and products that encourage domestic investors to buy and hold India equities. This will enable inclusive financial growth without creating new opportunities for foreign investors to scrape off short- and long-term gains that distort liquidity and valuations. In every case, regulatory consistency and transparency and the goal of eliminating India from the “Emerging Market Risks section will facilitate moving from emerging to developed.