Timely move

The Securities and Exchange Board of India says that its draft regulations for hedge funds aim "to provide a limited window to this growing segment of the asset management industry".

Sebi acknowledges that hedge funds have already entered Indian markets through the participatory notes route and they currently account for about 5 per cent of total FII investment.

But rather than enter through the back door, Sebi wants them to invest directly in the market, and wants to allow hedge funds "transparent and regulated access with abundant caution".

The conditions attached include the stipulation that hedge funds should be broad-based, and that at least a fifth of their corpus should be contributed by pension funds, universities, banks, endowments and other institutional investors, who are presumed to have a more long-term perspective.

By allowing direct registration by hedge funds, Sebi wants to ensure that it has control over the kind of hedge funds that invest in India.

The concern is understandable "" hedge funds have gained notoriety as a destabilising influence, especially in shallow emerging markets, although they have the capacity to cause mayhem even in developed markets, as the failure of Long-Term Capital Management illustrated vividly.

But it is debatable whether all hedge funds deserve that reputation. Indeed, the Sebi report lists many of the virtues of hedge funds, such as their contribution to market liquidity and to price discovery, and their ability to invest in instruments new to emerging markets, such as securitised financial instruments.

Nevertheless, the leveraged nature of many hedge funds does contribute to volatility, and there is little doubt that the very low rate of interest prevailing in the US has encouraged the carry trade, with hedge funds borrowing cheap and investing the money in emerging markets.

Now that interest rates are set to rise, some of that "hot money" is flowing back. The time is right, therefore, for market regulators to be concerned about the destabilising effects of hedge fund outflows.

However, there are several objections to that point of view. First, it can be argued that hedge funds show less of a herd-like behaviour than institutional investors, because of their constant search for superior returns, which often leads them to take contrarian positions. This contributes to market stability.

Moreover, the damage that hedge funds can do in India is limited. Like FIIs, they cannot trade in the currency or in commodities, nor can they borrow in India.

Like FIIs, they will not be allowed to sell short and all their trades must result in deliveries. Sebi rules for FIIs specify position limits in derivatives, and scrip-wise and fund-wise limits as well.

In fact, the Sebi paper points out that "These limits will help diversify the foreign hedge fund investments and will help in jettisoning concentration in any specific scrip."

Moreover, while some of the hedge funds may opt for registration, it will be impossible to plug the participatory notes route.

So, while Sebi's attempt to register hedge funds is welcome, onerous restrictions should be avoided. Hedge funds constitute a large and growing source of capital for emerging markets, and Sebi must keep that fact in mind.