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Jan 25, 2004

Participatory notes - how will the markets react ?

Was the huge rally on Friday justified ?

The last week has seen extreme volatility ever since a leading pink paper reported that SEBI was considering banning p/notes ( participatory notes ) for FII's. What are these instruments and how will the markets react to the latest developments ? We try to clarify the issue below - 

P/N's - what they are ?

participatory notes are an indirect exposure to the underlying securities which are issued by FII's to other FII's. When you buy a stock future, you are taking a position on the underlying equity shares, without ever buying those shares in physical form. Since un-registered FII's cannot buy equities in India, they take exposure through the registered FII's in this indirect fashion. SEBI regulations are applicable only to the registered FII's and the P/N's are therefore often into un-registered hands ( read that as hedge funds ). P/N's totalled about Rs 20,000 crs or approximately 25 % of FII inflows. SEBI was reportedly aiming to rectify that.

What has SEBI done now ?

SEBI has stopped fresh issue of P/N's after Feb 03, 2004 to unregistered FII's. The existing notes will be invalid after 5 years or be wound up ( expire ) on their tenure day, whichever is earlier. Since un-registered FII's cannot take the P/N route, hedge funds will be effectively halted from investing in equities. This is expected to give greater control to the regulators in knowing where the inflows are coming from. The P/N's are to be issued by FII's only after the KYC ( know your client ) documents are completed, therefore enabling SEBI to ascertain the last mile source of funds. Effectively, all fresh inflows of un-registered nature are blocked, whereas the existing funds can remain invested.

The effect on the markets

The markets have reacted a little too euphorically in my opinion. The market players have assumed that P/N's will not be banned and all is hunky dory. Once the finer print is digested, we feel the mood maybe somewhat sombre. In the near term, there maybe a higher degree of volatility and the market players maybe cautious, however, we feel the longer term effects are likely to be highly positive. It is important that the future rally be built on a solid foundation with long term funds and not just opportunistic players. This fact will take a few days to sink in and till then, the markets will consolidate. We feel this is a very mature step by SEBI - for larger benefits.

Your call of action

Look before you leap on Tuesday ( Jan 27, 2004 ) and avoid buying left right and centre. We feel investors should await the expiry of the January series before taking a fresh view on the markets. The worst is clearly over in terms of downsides. We do not see any fresh crash.

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Have a profitable day.

Vijay L Bhambwani
Ceo :- Bsplindia.com

The author is a Mumbai  based investment consultant and invites feedback at Vijay@BSPLindia.com and  ( 022 ) 23438482 / 23400345.


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