New instruments

BS OPINION

The innovative products outlined in Sebi's discussion paper aim to help investors and issuers while making the markets more efficient.

The proposal to migrate the trading of rights renunciations from the current over-the-counter market to their listing and trading in electronic form, for instance, will ensure liquidity and price discovery for investors, while the direct issuing of rights in electronic form by crediting the demat accounts of shareholders will curb costs for issuers.

Similarly, the plan to introduce put warrants into fixed price buy-back or takeover offers will ensure that share prices are not affected by the buy-back or takeover offer price. All such offers above the market price have resulted in the stock price shooting up, only to collapse thereafter.

The solution mooted now is for the company to issue put warrants to shareholders on a pro-rata basis, representing the number of shares the company wants to buy back. The investor in these warrants has the right to sell the warrant back to the company on a fixed date at a strike price.

Since the warrants will be listed and traded on the market, they would capture the difference between the cash and the tender offer price, eliminating the volatility in the underlying stock.

Issuers will be able to earn a premium for issuing the warrant as well as interest on the premium, and delay the purchase of the share by the life of the warrant, so the cost in present value terms will be lower. The investor can always sell the warrant in the market at any time.

The paper also talks about covered warrants. A covered warrant is like a traded option, giving the investor the right to buy or sell an underlying equity at a specified price, on or before a specified date.

The term 'covered' refers to the fact that the financial institution offering the warrant will cover its position with the actual underlying stock. The life of these warrants will be longer than those of exchange traded options and they will be more flexible, adapting to the needs of the financial institutions issuing them.

However, warrants on illiquid stocks won't work, and Sebi will have to think carefully about the risks involved in writing naked or uncovered warrants.

As for the proposal to allow companies to buy back shares by handing debt instruments to investors, the point is that buy-backs are meant to give money back to shareholders and borrowing for a buy-back defeats that purpose.

In contrast, the suggestion to embed put options in bond issues addresses the problem that bondholders can do little even when the credit rating of the bonds they hold plummet, simply because a market doesn't exist for many bonds.

Finally, while Sebi's aim to ensure that India's stock market has the latest innovative products is laudable, it will also have to pay attention to ensuring that markets for such products work. Both the retail debt market and the interest rate futures market, for instance, have not taken off.