Faced with a relentless surge in capital inflows, regulators seem to have finally bitten the bullet on the participatory-notes (PN) issue, and have released a discussion paper to effectively phase out the instrument. Given the upward pressure on the rupee and the impact the exchange rate appreciation is having on the real economy, one can understand the pressure the authorities are under to stem inflows. However, the measures proposed may have a greater impact than is commonly understood.

First of all, by restricting the issuance of PNs by any FII which already has more then 40 per cent of total assets in PNs, the authorities are effectively banning fresh issuance. Most FII brokers whom I have spoken to are already at or over this limit, and thus will have no further PN issuance capacity. Therefore, if the regulations go through as proposed, one can expect very little new capital coming into the equity markets from users of PNs, as they will not be able to get any broker to write a PN for them. The best most brokers will be able to offer, is that if you want to buy new stock through PNs, then you will have to sell an existing position to offset this. Without saying so explicitly, this is effectively a banning of PNs as we will see very little capacity in the system to issue fresh PNs.

The proposed regulations also ban any fresh PN issuance from FII sub-accounts. Unfortunately, as of today, the writer of the PN in many cases is a sub-account of the FII broker, thus if you ban sub-accounts issuing PNs, then that also shuts down the instrument.

The draft also talks about no new PNs being issued against derivative instruments, though a subsequent clarification allows roll-overs of existing positions for the next 18 months. This will seriously damage liquidity in the F&O markets as trading volumes come down, and also severely impinge the ability of long/short and macro-funds to hedge their underlying cash equity positions.

As these funds are unable to hedge, you will see many of them reducing their underlying equity positions as well. In the case of these funds if they are unable to hedge their exposure to Indian equities, they will have to reduce their overall Indian exposure as their mandates do not permit them to run long on only cash equity positions without some mechanism to reduce market risk.

One can understand what the authorities are doing, viz, trying to reduce flows into equity markets without a collapse in the underlying market itself. However, they should put in place a transition mechanism, so that all funds have the next six-nine months to apply to Sebi and get a direct FII licence. Once this period is over, Sebi should do whatever it wants with the PN instrument as it has given all legitimate funds enough time and notice to get direct FII status.

The problem with the draft is that you will create an interim period of six-nine months when effectively no current PN user will be able to increase its equity holdings in India. Funds will take at least six months to go through the process of applying to Sebi and getting approvals.

The authorities should create a mechanism so that these market participants are not shut out of the equity markets in this transition phase of moving from PNs to direct FII. Otherwise, the way the draft is written, many players can only sell for the next six months or till such time as they get their FII licence.

Sebi also needs to make sure it has the machinery and criteria in place to handle the expected flood of new applications for FII. The norms Sebi uses to decide on the new FII applications will be critical, as it will effectively determine how many of the current users of PNs will be able to continue participating in the Indian equity markets.

Whichever way you cut this, it can only, on the margin, be negative for equity markets. At least 50-60 per cent of incremental equity flows were coming through PNs. The authorities will have effectively stopped these flows till such time as market participants transition to a direct FII licence. How many of these market participants will come back to the equity markets and in how much time depends on Sebi and the time and criteria it puts in place to clear FII applications.

However, given current criteria, there is a significant portion of the current users of PNs like the macro and long/short guys, who will not clear Sebi's criteria for FII licence. These players and their money will exit the Indian equity markets permanently. The quantum of this lost capital and its pace of exit will determine the market's direction from here.