Open up some more

Hedge funds have been growing by leaps and bounds across the world. Assets under hedge fund management have grown 10-fold in the last five years, and are estimated at almost $1 trillion.

Given this background, it should be expected that hedge fund managers will try to take advantage of the India story, which has become one of the buzzwords in investment circles worldwide.

It's no surprise, therefore, that hedge funds have been investing in Indian stocks through the participatory note avenue.

Looking at this development from the receiving end, the fact that participatory notes have accounted for almost half of the investment flows into the country this year, with hedge funds accounting for a large chunk of the PNs, should set a red light blinking at the Securities and Exchange Board of India.

Since hedge funds are not regulated entities, they cannot register as foreign institutional investors (FIIs) under Sebi's regulations.

That forces those who want to invest in the country to do so either by having sub-accounts with FIIs, or through participatory notes""which are synthetic derivative instruments based on an underlying pool of Indian assets, sold by FIIs to foreign investors.

However, Sebi does have in place "know your customer" rules, which require FIIs to disclose the beneficiaries of these investments.

The FIIs themselves may not be in a position to know who the ultimate beneficiaries are, since the investors in participatory notes may be fronting for other investors.

The problem has been around for years now, and after a spate of press reports of hedge fund activity through PNs, Sebi had formed a committee to study how best to regulate hedge fund investment into India. The committee submitted its report six months ago, but Sebi is yet to act upon it.

The broad thrust of the report was that hedge funds should be registered with Sebi, subject to certain criteria.

These included the requirement that at least 20 per cent of the corpus of hedge funds seeking to register in India as foreign institutional investors should be contributed by pension funds, charitable trusts, endowments, banks, insurance companies and other institutional investors; that the fund should be broad-based, meaning it should invest in a basket of 30-40 stocks; that the fund manager or investment advisor must have a minimum three-year track record in managing funds with an investment strategy that is similar to that of the applicant fund.

Essentially, the concept paper realised that hedge funds represented alternative investment pools which, if allowed to invest in Indian markets, will be a source of additional liquidity and will also diversify the pool of foreign investments in the market.

It therefore proposed to put in place rules that would minimise risk while allowing the bigger and safer hedge funds access to the Indian market.

This is the right approach and Sebi needs to realise that the longer it delays announcing the hedge fund regulations, the longer will the current opaque system continue.

The worry is that hedge fund operators with their short-term views of the market will exacerbate volatility, which could increase systemic risk in the stock market.

One way of reducing that risk is to swiftly put the rules in place so that there's more transparency. The other way would be to increase the participation of long-term investors such as pension funds, provident funds, and life insurance companies in the market.