Stock market regulator SEBI, in a draft proposal, has suggested sweeping changes and restrictions to dollar inflows into the stock markets through the Participatory Note or the P-Note route. According to SEBI note, FIIs should not renew or issue PNs with underlying as derivatives and sub-accounts should not issue P-notes. The market regulator also suggests that PNs issued against derivatives to be wound up in next 18 months.

Sebi has also proposed an incremental rate of 5% for issue of PNs for FIIs with less than 40% of assets in PNs. Those with over 40% of assets in PNs can issue PNs only against redemptions or cancellations. The proposals, which have been framed in consultation with the government, will be implemented urgently, after feedback from market participants within four days.

The move is aimed at arresting the surge in foreign inflows through PNs, which are offshore derivative instruments that allow foreign investors to invest indirectly in a country’s stock market. PNs are issued by Sebi-registered FIIs that do not want to disclose their identity, or those who want to buy stocks and derivatives without waiting for Sebi registration.

Meanwhile, the MoF says that the SEBI proposal is an attempt to control leveraging flexibility of PNs. Outstanding PNs as on Aug 2007 stood at almost Rs 3.53 lakh crore. This is 51.6% of securites owned by FIIs. Outstanding PNs with derivatives as underlying are around Rs 1.17 lakh crore. This is approx 30% of total outstanding PNs. Currently 34 FII/sub-accounts issue PNs.

Reacting to the proposed moves by SEBI, former NSE MD RH Patil says that the SEBI's proposed move is not a wholehearted step. He says that a bubble has been built up in markets and the small investors have deserted. He mentioned that the market regulator should have taken a step on P-Notes earlier.

Vallabh Bhansali Chairman of Enam says,"I think the RBI has always been very worried about the P-note instrument and the government has been able to pacify it. But given the strength of the rupee, the way exports are getting hurt. This may have been one big massive assault on the whole P-note sub account structure giving it enough time to unwind itself."

Meanwhile a knee jerk reaction can be expected in the Indian markets today. The ADRs sold off yesterday and all of them ended in the red. A sell-off by hedge funds, and other short-term players cannot be ruled out which may drag the indices significantly lower.

"I think if they had announced it 6 months earlier, at least this bubble would not have actually built up. We could see a sell off and this could be a sentimental sell off. But there should be a much bigger sell off once it becomes a directive," says Ambareesh Baliga of Karvy Stock Broking.