Sensex crash today - could it be a steadying influence ?

SEBI introduced a paper on Tuesday that seeks to restrict Offshore Derivative Instruments' (Participatory Notes) involvement in the Indian stock market. The regulator's philosophy behind this move seems to be to slow the recent deluge of foreign capital flows into the stock market that sent the Sensex to a record high of 19000.

Participatory Notes (PN) have been popular with foreign investors who are not registered as Foreign Institutional Investors (FII) in India and therefore cannot invest directly in Indian capital markets. They get the required exposure by buying offshore derivatives that are issued by financial services players operating in India. Risk of these derivatives are then hedged using India exchange traded derivatives.

This structure appears to have created a four fold problem for the regulator:

1. Ultimate investor identity may not be clearly known as they are investing through offshore derivatives where the risk can be further laid off
2. Facilitates much larger flow of foreign funds than envisaged by registered FII route
3. Money can leave as quickly as it came creating significant volatility in Sensex and NIFTY
4. Foreign inflows have also led to the strengthening of the rupee vs the dollar creating discomfort in some government circles.

Essentially, the SEBI paper suggests that Offshore Derivative Instrument exposure which have underlying as Indian exchange traded derivatives unwind positions over the next 18 months. This sent the market into a major selling spree resulting in loss of 1000 points in early trading - triggers were hit and markets were suspended for an hour. Trading has resumed and some of the loss seems to have been recovered though Sensex is still in the red by about 800 points at the time of this post. Market analysts expect that there could be further unwinding of positions and therefore market volatility could continue for some time.

The government has clarified that it does not plan to ban Participatory Notes but is seeking to moderate capital inflows. The government continues to encourage investments by registered Foreign Institutional Investors (FII) and is seeking to reduce the complexity of registering as a FII.

Can the retail investor now hope for more realistic pricing ?