Wednesday, October 24, 2007

IT and the financial sector

Globalization through global high-speed data highways has led to a significant increase in IT spending especially for financial concerns. Absorption of new technology has seen financial companies able to instantaneously transfer funds and price sensitive information across the globe, computers have enable the industry to store, process and analyze huge masses of information. Most importantly computers have led to new complex products to be devised and priced in real time.

Technology has had a dramatic effect on how banks function as well as their profitability. Facilities such as ATMs, debit cards and RTGS have reduced the staff burden on one side and also reduced the cost of servicing. In fact the marginal cost of making a transfer through a debit card is less than 5% of processing a cheque payment. Development of databases has meant that new web based services can be offered such as core banking[1] as well services can be targeted at the customer.

However this is not just software –hardware game, where in the corporate entity with the best hardware and software wins. The human capital needs are also changing. The complexity of some of the newer financial products o offer has meant that higher skill sets are needed than those of traditional traders. This in turn means a significant increase in man power costs. The shifting of back office and processing operations to cheaper locations than traditional expensive financial hubs by leveraging IT connectivity could be a way out of this.

The cost of transitioning to newer technologies is extremely high. Also the question of maintaining ‘backward compatibility’ with existing systems means that taking full advantage of latest developments is just not possible. Security issues such as identity theft and hacking also need to be addressed using expensive software’s and consultants. Most financial institutions may even find it difficult to earn an adequate return on their capital investments, especially when the advantage they may gain is usually transient as their competitors catch up.

This is where market share becomes important. Technology has changed the balance between fixed and variable cost to a great extent. The initial high capital costs of hardware and software can be offset by the low marginal costs of serving the client. This directly means that a financial concern with a large market share can cover up its high initial costs faster before competition catches up.

[1] Services such as where a customers can operate their accounts, and avail banking services from any branch

Tuesday, October 23, 2007

Offshore derivatives instruments and the P notes

In the context of the Indian market, offshore derivatives instruments (ODIs) are investment vehicles used by overseas investors for an exposure in Indian equities or equity derivatives. These investors are not registered with SEBI, either because they do not want to, or due to regulatory restrictions.

These investors approach a foreign institutional investor (FII), who is already registered with SEBI. The FII makes purchases on behalf of those investors and the FII’s affiliate issues them ODIs. The underlying asset for the ODI could be either stocks or equity derivatives like Nifty futures.

What are participatory note or P-Notes?

Participatory notes (PN) is one of the categories of ODIs. At a basic level, the underlying asset class could be stocks, and returns would be directly related to the appreciation in prices of those stocks. In some complex forms, returns could be linked to the appreciation in Nifty over a given time frame and could be even linked to a combination of change in Nifty and a basket of stocks. For instance, the holder of a P-Note may be promised a return of 10% if Nifty rises by 5% within a month. Other categories of ODIs include equity-linked notes, capped return notes, participating return notes, etc.

What are FII sub-accounts?

Sub-accounts are special purpose vehicles floated by foreign funds in which they manage money on behalf of their overseas clients. FIIs also form proprietary sub-accounts to invest their own money.

What are third party sub-accounts?

This facility has been discontinued by SEBI. Earlier, overseas clients could nominate a fund manager of their choice to manage their money in a sub-account of an FII to whom they have entrusted the funds.

Are ODIs/P-Notes less transparent?

There are fears that P-Notes are being used as a vehicle by promoters, market operators, politicians to repatriate illegitimate funds parked abroad. Quite a few promoters are said to be using this route to ramp up their stocks. Then there is also a concern that terrorist organisations could be channelling money through ODIs and using profits to fund their nefarious activities.

As per SEBI rules, the FII issuing ODIs/P-Notes should know the eventual beneficiary to whom the instruments are being issued to. But through multiple layering, it is possible to conceal the identity of the original client. Then there are concerns that too much money flowing into the derivatives segment through the P-Note route is adding to volatility, not to mention the pressure on the currency.

Does the SEBI proposal mean that no fresh P-Notes can be issued?

No. P-Notes with stocks as underlying assets can be issued by an FII, subject to a limit of 40% of the overall assets under the custody of that FII. Simply put, if an FII has $100 million worth of assets under custody (AUC), only $40 million of those assets can be in the form of equity-based P-Notes. Where P-Notes with equity derivatives are the underlying assets, SEBI has proposed that these cannot be issued anymore, and the existing positions have to be unwound over a period of 18 months.

What if an FII has issued P-Notes up to 25% of its total assets under custody. Can he issue P-Notes for another 15% of his AUC overnight?

No. As per the SEBI proposal, he can raise it by only 5% at a time.

What will be the broad impact if SEBI’s proposals on P-Notes are implemented?

In the short term, inflows could be affected to an extent. But it is a positive move from a long-term perspective. For some time, SEBI has been saying it wishes to encourage FIIs to enter our stock market through the front door (by registering themselves) and not through the back door (via P-Notes). If more overseas players register with SEBI, it will be easy for the regulator to keep tabs on the fund flow into the market.

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