Future Developments in our Securites Market- from institutional investor perspective

…….Pratik Shah
Adding more to series of articles on Securities Market, I would like to list down developments which will help our market to scale new heights

Future Securities Market Developments to be undertaken from an institutional investor perspective

- Seamless STP from start to finish encompassing Front end to Middle Office to Back Office. There should not be any breaks in STP in the entire settlement cycle. Advanced Reforms required both in Equity and Debt market

- Introduction of Corporate Debt trading platform given that now we have a central clearing house for Corporate Debt and Money Market instruments (NSCCL/IICL)

- Online Mutual fund platform through the stock exchange infrastructure

- Developments in IPO Market- Primary market today is paper based with a wider time frame. Technical automation will be a big enabler for the primary market

- Single Pay date concept will be a big advantage especially for the investors to manage their cash flows and market can offer products like Contractual Income.

- Early remittances on T+2 for foreign investors

- No boundaries. Our Depositories and Clearing Houses can become international depositories in lines with Euro Clear and Clearstream. However, full rupee convertibility will be a big enabler for this development

- Penetrating use of new products like Interest rate futures, Currency Futures, SLB, etc

- Implementation of physical settlement of equity derivatives

- Implementation of Smart Order Routing

- Commodity markets have traditionally been quite volatile. It is important to allow institutional investors to invest in commodity markets as they bring significant trading experience.

- More and more investment in technology for speeding up settlements, risk containment measures and seamless connectivity between market intermediaries

Other Recommendations for a robust securities market (Source: recent PwC report)

 Investor education and regulation of mutual fund distributors
 Allowing AMCs the flexibility to charge fees
 Innovative products across different asset classes including operationalisation of REMFs
 Amending tax regime to encourage domestic AMCs to manage foreign funds from India
 Allowing higher investment by domestic institutional investors such as insurance companies, pension funds and provident funds to make investments in capital markets
 Make tax regime friendly for issuers/investors of IDRs
 Make implementation of proposal of SME stock exchange effective
 Developing a legal and regulatory framework for Islamic finance and structure new capital market products that are Shariah compliant
 Allowing institutional investors to participate in commodity markets

Securities Services- journey from physical to electronic

………….Pratik Shah

Most foreign banks had built up their Securities Services franchise in the 90’s around when the government had opened up the capital markets for foreign investors. It was a new playground for foreign investors and for them the challenge was to meet the expectations of the institutional investors and at the same time contribute to the growth of the Indian Capital Markets. It was a physical era where securities were traded in physical form and settled on an account period basis i.e there was a weekly settlement cycle with securities being physically delivered to Clearing Houses/Brokers. Each exchange had different timelines for Pay in and Pay out. For example On BSE, the trades contracted between Monday to Friday, pay in use to happen on next Wednesday and pay out use to happen on next Friday. It was a long drawn settlement process. Today we have a T+2 rolling settlement with pay in and pay out happening in an interval of 30 minutes on T+2 and settlement advices are sent to the clients in 30 minutes after pay out. It is so fast today! I can imagine how today’s scenario was unimaginable in the physical era.

The market has witnessed the migration from account period settlement to Rolling settlement and within rolling settlement the change from T+5 to T+3 to T+2 cycle. This era symbolised trading in physical form with associated systemic risks of bad paper, objections, frauds, delays, etc. Exchanges had an active Bad Delivery Cell (BDC) and Objections unit. Lodgment/Registration/Vaulting of securities was an active function at the custodian’s end which is more or less dormant in the current market scenario. The physical era was low volume high efforts game and today the scenario is of high volumes low efforts.

Dematerialisation or immobilization came into play to facilitate faster turnarounds of trade settlement and prevention of paper based frauds. The dematerialisation process gradually started in 1996 with minimal coverage and by 1999 most of the traded securities were converted into Demat form. Today 99.95% of the trades happen in demat form. Stamp duty was waived on electronic transfers. The Depositories Act was enacted to facilitate the electronic book entry transfer of securities through depositories. Depositories like NSDL have played a vital role in strengthening the Indian Securities Market.

In 2000 domestic investors started gaining market share and Mutual funds and Insurance companies started getting active in the market. Today the market volumes are equally driven by domestic and foreign institutional investors

In the 90’s till 2003, Contract Notes were paper based and Client instructions use to come in Swift format for foreign investors and in Fax format from domestic investors. Securities Services had a strong interface with the Exchanges, Depositories and the Brokers to ensure accurate settlement of trades on the exchanges. In 2004, the big leap in the market was Electronisation of Contract Notes; moving away from paper based contracts to electronic contract notes which stepped into the custodians processing system. The market moved to the electronic era in 2004. By 2007, the Contract Notes, Trade Instructions went electronic and today Equity trades are processed in a STP mode

Today, Clearing Houses operate with minimum number of resources with advent of smart technology and transaction terminals as compared to the manual era of settling clearing house trades

The growth in our Fixed Income market has been at a slow pace. Debt market was predominantly monopolized by Bank’s treasury, Primary Dealers and then followed the Corporate Treasury, Mutual funds and Insurance Companies. FII’s were allowed to invest in gilts and debts but within prudential limits. Government will not allow high stakes in sovereign money to foreign investors

Gilts were traded by SGL and CSGL members. They were physically settled with RBI PDO office. NDS (Negotiated Dealing System) replaced the physical settlement and facilitated online confirmation eliminating physical delivery with CCIL as central counterparty. TGF was set up for the same. Later, repo was opened up for CSGL clients. RBI auction also moved from physical bidding to an e-platform (NDS auction OM)

Corporate Debt and money market instruments were characterised by bilateral settlement completely in Physical mode with High value clearing for cash transfer. It gradually moved to demat settlement with cash leg settling through RTGS. Today there is novation in Corporate Debt through NSCCL/ICCL as clearing corporations

In 2008 SEBI mandated margining of trades as a risk containment measure. Post the financial crisis, the market regulator had taken a more conservative stand to protect the market from getting exposed to systemic risk learning from failure of Bear Sterns and Lehman brothers.

Now our markets are globalised and custodians can play a bigger role in integrating the markets. Today custodians offer regional/global custody services from India. Information technology has emerged as a strategic tool to enhance speed, efficiency and transparency in market operations and financial sector reforms.

All market intermediaries should work together along with the regulator for increasing the market participation, expanding issuers, streamlining processes and deepening product markets.

With India becoming an active member of BIS, G20 and other global securities forums, it will foster exchange of best practices and introduction of new products in the emerging markets

Indian Securities Market Overview_2010

………Pratik Shah 02nd December 2010

India has been growing from 2004 until 2010 at an average quarterly GDP growth rate of 8.37 percent and is now a more than a trillion dollar economy. Suddenly, the entire world has its attention on the two most powerful and emerging economies ‘India’ and ‘China’. The last decade we have seen a paradigm shift on how Indian economy has performed; Beyond billion and multi-billion-dollar business deals on a regular basis, the stock market indices are at all-time high levels, real estate prices have touched stratospheric levels, domestic sales of automobiles have crossed the two-million mark and magazines are now full of advertisements for ultra-expensive jewellery, wrist-wear, pens and other accessories. The macro economic indicators have been positively showing signs of growth.

Nevertheless, the securities market has shown the most robust and calibrated growth over the decade. It is today one of the advanced barometers indicating the strength of the country’s economic growth.

Before moving on to the securities market in the current context, I would like to brief you on how the securities market has evolved in the last three decades

I would divide the Indian Securities Market growth into pre 1992 and post 1992 era. Prior to the early 1990s, most of the financial markets in India faced controls of pricing, entry barriers, transaction restrictions, high transaction costs and low liquidity. A series of reforms were undertaken since the early 1990s so as to develop the various segments of financial markets by phasing out administered pricing system, removing barrier restrictions, introducing new instruments, establishing institutional framework, upgrading technological infrastructure and evolving efficient, safer and more transparent market practices. Let me highlight more on this.

The Indian Securities Market before 1992 was characterised by restrictions on foreign investment, license raj, poor governance and transparency, lack of political will to liberalise, etc

Stock Exchanges were run as brokers clubs whose management was dominated by brokers. The regulations were fragmented & there was multiplicity of administration. Stock exchanges were regulated through the Securities Contracts (Regulations) Act. Trading was limited to Equity Shares through Open outcry trading system (Floor based trading) with longer settlement period. Primary markets were not in the mainstream of the financial system. Mutual funds were virtually unregulated with potential for conflicts of interest in structure. Private MF’s were not permitted to enter the market. Merchant bankers and other intermediaries were unregulated and there was no concept of capital adequacy. Investor protection was much on paper than in reality.

This era symbolized closed doors to Indian market, poor governance and backward technology.

The Indian Securities Market post 1992 saw the benefits of liberalization measures announced by the Indian government and the political will to open up the financial sector for foreign investment. The Indian securities markets have witnessed farreaching reforms in the post-liberalization era in terms of market design, technological developments, settlement practices and introduction of new instruments. The markets have achieved tremendous stability and as a result, have attracted huge investments by foreign investors. Let me highlight few of those

 Securities Exchange Board of India (SEBI) was formed for regulating the markets and bringing primary and secondary market intermediaries within the regulatory framework.

 Information technology emerged as a strategic tool to enhance speed, efficiency and transparency in market operations and financial sector reforms

 Free pricing of securities came into play. Capital Issues (Control) Act of 1947 was repealed and the office of Controller of Capital Issues was abolished

 There was a shift from Floor based trading to a fully computerised automated trading known as BOLT (BSE on Line Trading) and NEAT (National Exchange Automated Trading) System

 Rolling Settlement was introduced in the market – reducing the settlement cycle to T+2

 Dematerialisation (immobilization) of securities was mandated and today almost all securities are traded in immobilised form on the floor of the exchanges. The Depositories Act was enacted to facilitate the electronic book entry transfer of securities through depositories. Depositories like NSDL have played a vital role in strengthening the Indian Securities Market.

 Foreign Investment was allowed in Indian Capital Market through Foreign Direct Investment (FDI) and Foreign Institutional Investor (FII) route

 Indian companies and Mutual funds were lately permitted to access international capital markets within prudential limits

 Wholesale Debt Market was formed for trading in Corporate Bonds and Gilts

 Trading in Equity Derivatives instruments was introduced and was made available to all institutional investors

 Mutual Funds emerged as an important segment of Indian Capital market

 Regional Stock Exchanges lost their relevance and the entire market share was divided between NSE and BSE

 Grading of IPOs was made mandatory and primary market has become highly regulated

 More focus is on Investor protection and corporate governance

 Margining of institutional trades and mandatory settlement through clearing house mechanism

 Higher technology has enabled settlement through real time gross settlement systems. Today we have integrated trading, clearing and payment platforms which enables seamless settlement of transactions.

 The participation in Equity, Debt and Derivative Markets is unprecedented.

This era symbolizes open door policy for foreign investors, use of information technology as a strategic tool, increased regulatory governance over market reforms and lays a strong foundation to grow exponentially in the coming years. As per Mckinsey study, increasing the market participation, expanding issuers, streamlining processes and deepening product markets are the key elements that will lead to a three-fold growth in India’s capital markets by 2020
The progress made by the Indian capital markets in the post-liberalization phase in terms of implementing international standard practices, widening and deepening of capital markets and the technological progress has been remarkable. It should, however, be noted that this period was also marked by greatest turmoil that the markets have ever witnessed. With timely and appropriate policy initiatives, systemic failures were avoided

The development of corporate debt market is, however, still relatively inadequate. The investors are mostly institutions with very few retail investors. Transparency is limited both in the primary and the secondary markets, liquidity is poor and many bonds are held till redemption

Future products, technology, migration of best practices from developed markets, regulatory vigilance, and development of debt and primary markets will be the focus areas.

Microfinance Institutions- the holy cow of financial inclusion

………Pratik Shah

The ups and down of MFI’s is what we have been hearing in the news and media. Just thinking of why suddenly we have started focusing on these institutions. They have been in town for many years now. All credit goes to the stock market listing of SKS microfinance; the first MFI to list on the bourses in India. So what has changed? The change is that the story of MFI success is out in the open with series of events happening like a bumper listing for SKS followed by sacking of its CEO Suresh Gurumani in a power struggle, allegations by Vikram Akula’s wife on him of misappropriation and pending court cases. This was a parody to the entire MFI industry. Many MFI’s like Spandana, Baxis, etc had made plans to list themselves on the bourses trying to emulate the so called success of SKS. Many foreign investors like Soros fund, Catamaran (Mr Murthy’s PE) had invested in SKS at 300 and 600 levels giving this company alarming valuation. Other MFI’s are now playing the wait and watch game.

I use to always talk to my colleague when the IPO offer of SKS had come and wondering that how can this company quote at such a high premium. It is not worth it. It is a MicroFinance institution and their role is to build social capital and promote financial inclusion. They are not here to make money. However, knowing the inside story, we know that how these MFI’s are enjoying higher margins than banks and how they are able to maintain such lower NPA’s. I advised him to subscribe the issue only for listing gains given the euphoria around the issue. Today when I am penning my views the stock is quoting below its IPO price. Its real worth will now be unfolded.

Thinking deeper what has caused all this mess- It is not only the MFI’s, but the government, Banks, politicians are also responsible for this madness. From an objective of being non profitable they are solely existing for making profits & competing with the money lenders. There is money in madness but when the madness ends money disappears. I have some points to share:-

• The biggest financial inclusion measure was taken by the government when it nationalized 14 banks in 1969. In 1992, the Self Help Group (SHG) concept floated with the help of NABARD and Banks was a big success. It today supports 86 mio households who are really below the economic line and has lent INR 23000 crore. The difference is that SHG’s used to lend against savings as collateral whereas MFI’s are carrying out unsecured and aggressive lending.

• Banks had to meet their Priority Sector Lending (PSL) norms and they wanted to avoid taking on the tail portfolio on its books. The best way was to fund MFI’s who in turn will fund Self Help groups (SHG) or teams at very high interest rate. For example banks fund these MFI’s at 7-8% and MFI’s in turn fund at 24-40%. The NPA’s were low as SHG or team of borrowers also had the responsibility of ensuring repayment. If somebody does not repay that person would be ousted from the group and will not be eligible for loans in future. The MFI had a transactional relationship with the borrower rather than an informal and in-depth understanding of the borrower.

• The greed increased and MFI’s started lending to people who were on daily wages apart from borrowers having steady income flows. This started the subprime lending in MFI industry. Villagers became smart due to the prevalence of multiple MFI’s and all chasing common borrowers. The credit culture changed and villagers stopped repaying (guided by local politicians). They started borrowing from multiple MFI’s and then defaulting. Today, there is no common database for MFI borrowers like CIBIL in banks. Earlier MFI’s used to cajole the villagers to take loan and today they have become smart enough to shun MFI’s if the rates are not in their favor. Choice of lenders provides more flexibility to the borrowers.

• The highest share of MFI lending is in Andhra Pradesh. The new ordinance passed by AP govt to register MFI’s and put a cap on its activities is acting as a big dampener to their business. Also the govt has put a cap on the NREGA employment mandays to 100 which restricts employability in AP. In AP, there are two types of land; farm and non farm. In farm land people had other options to earn by selling coconuts, bananas, etc. In non farm, people live on single produce. Due to heavy rains and cap imposed by NREGA the income stopped which lead to defaults

Today the situation is that the revenue model of these MFI’s will undergo a big change as the government has started intervening to ensure that credit is available at lower interest rates and it indeed leads to financial inclusion. We have seen SKS cutting rates to 24% all inclusive from the high’s of 32%. This shows that there was unprecedented pricing in this industry. We hope that sanctity prevails and MFI’s continue to do the good work with a noble cause.

Six things to achieve excellence

Hi

As per research and studies, following are the six key things which will help you excel at your work place

Pursue what you love. – Passion is an incredible motivator. It fuels focus, resilience, and perseverance.

Do the hardest work first. - We all move instinctively toward pleasure and away from pain. Most great performers, Ericsson and others have found, delay gratification and take on the difficult work of practice in the mornings, before they do anything else. That’s when most of us have the most energy and the fewest distractions. Practice intensely, without interruption for short periods of no longer than 90 minutes and then take a break. Ninety minutes appears to be the maximum amount of time that we can bring the highest level of focus to any given activity. The evidence is equally strong that great performers practice no more than 4 ½ hours a day.

Seek expert feedback, in intermittent doses. – The simpler and more precise the feedback, the more equipped you are to make adjustments. Too much feedback, too continuously, however, can create cognitive overload, increase anxiety, and interfere with learning.

Take regular renewal breaks.- Relaxing after intense effort not only provides an opportunity to rejuvenate, but also to metabolize and embed learning. It’s also during rest that the right hemisphere becomes more dominant, which can lead to creative breakthroughs.

Ritualize practice. -Will and discipline are wildly overrated. The best way to insure you’ll take on difficult tasks is to ritualize them — build specific, inviolable times at which you do them, so that over time you do them without having to squander energy thinking about them.

How to enrich your brains performance – a Harvard study

Our brain is the most important part of our body as it controls our body, our senses, our emotions, our actions, etc. Our performance depends on how best our brain can perform in a normalistic scenario. The below mentioned tips are based on research study and have been proven through thorough research. One can emulate them to enrich their brains performance in a work context

• Give your brain a rich bank of life experiences. Expose it to diverse environments and situations. Increasing the breadth of your experiences provides richer information for your brain to draw on as it helps you anticipate new situations.
• Let it borrow from the experiences of others by communicating, reading, or interacting with or about others.
• Think about what you want from the future. Take time to reflect on individual and team values and goals, both immediate and down the road. These will help guide your brain as it envisions future scenarios that may best help you achieve your objectives.
• Actively ponder future rewards or accomplishments. Emphasize rich, detailed thinking about long-term outcomes. This reduces the lure (and the danger) of instant gratification.
• Give yourself periods of relatively uninterrupted thought during which you let your mind wander. Doing this gives the brain’s memory system extra time to recombine your prior experiences in ways that can help you envision future possibilities.

These tips won’t help you find those pesky car keys, but they could help you shape the future of your work life.

Moving to Base Rate- a paradigm shift

RBI had mandated the use of Base rate from July 01 2010 which now has been adopted by all banks in India. The earlier PLR/sub PLR regime had some regulatory leverage for banks to lend to customers on differential basis. With base rate coming in lending to customers will be above a threshold rate. Banks are competing amongst themselves on who can provide the lowest rate and at the same time ensuring that they do not fall too low. This will change the way core banking will work. It will have real implications in short term as well as long term

The principal reasons for formulating a “Base rate” were:

1. Pricing parity amongst commercial and retail borrowers,
2. Better transmission of policy rates, and
3. Transparency.

Base rate adoption is expected to have following implications:

1. Transparency in pricing.
2. “Bargain hunting” for rates would be curtailed. CPs would be the favored channel for short-term borrowing.
3. Banks NIM could see an improvement in the short term, although one would also need to factor the current crisis and increasing default rates.
4. Banks would fund corporates need for short-term resources indirectly through CPs. Resources would be diverted from the Bank’s loan book to it’s investment book. May result in lazy banking which would be unhealthy for banks.

Base rate = Cost of funds + Operating cost + CRR/SLR + credit Risk + applicable profit margin. Banks wil stronger CASA deposits will be able to sustain their base rate at a lower end of the industrial average. Savings and Current account give a cheap source of funding. The key implication of base rate regime will be the impact on large corporates who use to enjoy loans at lower rates. Since the regulator does not allow any lending below the base rate, large corporates will tap other sources of borrowing. A Macquarie report indicates the strong pick up in corporate paper issuance which it believes is a sustainable trend and not just a function of the excess liquidity in the system last year. This in hindsight will be beneficial for lagging corporate debt market. Corporate borrowing through non bank sources will definitely inject depth and liquidity in the debt market and help it revive.

All banks will be required to disclose information on base rates at all branches and on their website, and the basis of computation will be auditable by RBI. This is expected to increase the transparency in movement of floating rates of consumer loans, besides improving the efficiency of the transmission of monetary policy changes to actual lending rates. It will also set the stage for the higher rated companies to raise capital through the external commercial borrowings (ECB) route, especially given the very low interest rates across much of developed world. A strengthening rupee (vis-a-vis dollar) will only increase the attractiveness of such fund raising.

The other point of note is that banks have been allowed to change this base rate as required at any point of time over the next six months till 31 December 2010. This indicates that the RBI has taken a more experimental route allowing banks to tweak models and parameters over this period in order to determine the most efficient formula which best responds to changes in the environment, including monetary policy moves.

Base rate is indeed a positive move to inculcate transparency in the lending sector. It is a paradigm shift for the Banking sector and will go a long way in instilling more confidence in this sector

NPS gets a boost in the revised DTC

Further to my blog on the New Pension Scheme http://pratikshah.wordpress.com/2010/02/05/new-pension-scheme-the-right-step/ there is a positive development on the NPS

The government in its revised Direct Tax code (DTC) has moved NPS under the Exempt Exempt Exempt (EEE) regime which means that the proceeds from NPS will not be taxable. This will surely give a lift to the daggling NPS scheme.

The government has also proposed tax on Long term capital gains at a marginal rate which is a demotivator for the markets and will drive people away from Equity markets. NPS will be benefitted from this development

I am not sure whether EEE will be applicable for Tier II withdrawls also. We need to wait and watch

Nevertheless I am going to open my pension account. It will give me a tax free long term equity exposure. One can consider allocating 20% of their investible surplus in NPS

Happy Investing!

Euro crisis-the cycle is getting more vicious

….Pratik Shah

From last one month we have been hearing about the EURO crisis and the impact it would have on the world economy and markets. I have been following this quite closely and do feel that it is a vicious cycle in which not only the Euro countries but the entire western economy will suffer. There are four points of contention:-

a) The depreciation of Euro against the dollar is leading to a deflationary environment. The US government can’t afford to appreciate its dollar against the Euro as it would have a big contagion effect

b) The credit downgrades of sovereign bonds issued by Greece and Spain government and the inter country debt amongst Euro countries is a cause of concern. The debt to GDP ratio of these countries is reaching cautionary levels. Banks have become wary of lending to other banks and they have lost confidence on their counterparts. The further impact of this credit squeeze is shown by the behaviour of the money market indicators

1) The LIBOR spread has doubled from 0.25 % to 0.5% and economists have a strong view that it will triple to 1.5% in coming months. This indicates the unwillingness of the banks to lend

2) The OIS (Overnight Indexed Swap) rate, which is also the risk free rate has moved northwards, indicating loss of confidence in the sovereign debt. Also, the spread between OIS and LIBOR has tripled. When Lehman collapsed, the spread was atleast 10 times. Though, Euro markets have not reached this limit, but there is lot of strain on the economy

3) Banks are hoarding cash and the trust in the system is gradually declining. The trend is not encouraging

4) The CDS spreads have surged significantly indicating that the insurers are not willing to take risk even on big banks at a smaller premium. The increase in premia is much more for smaller banks.

c) Above all, the lender of last resort comes into play. ECB (European Central Bank) plan to inject/have injected 800 billion pounds in the banking system in lieu of downgraded bonds. Where does this money come from? Printing more and more of Euro’s against  depleting reserves of Gold.

d) Economist world wide do not have comfort in the strategies adopted by the government as a damage control measure. This is similar to what US government had done to bail out its banks. Print money; No gold reserves, risk of inflation dampening the ecomonic growth and the contagion booming back to the government when the debt is not serviced by the borrowers.

Though the bail out measures adopted by western governments provide a temporary relief, the bigger risk lies when the junk bonds held by the government come for redemption/interest payments. If the money flow in the system is not able to revive the market, then who will bail out the government sitting on a big fiscal imbalance?

Think about it. I strongly feel that we will see high bout of volatility in the stock markets worldwide. Emerging markets will not be immune to the impact but in hindsight benefit from better allocation of monies from the western fund managers. The impact has already been seen on the Euro and US markets and emerging markets will suffer to the extent of pull off by institutional investors from these markets to service internal debts.

Make the right decision about your investments. After all its your hard earned money.

Indian Depository Receipt- framework in India

We have heard a lot about Indian Depository receipt’s these days and IDR’s will be big enablers for Indian Securities Market to make it globalised. Companies of international repute will be coming to India to raise capital and show their commitment to the market. It provides a good diversification oppurtunity for the Indian investors. The key advantages are

• No Currency risk
• No hassles of opening foreign broking account, demat account, etc
• trade like normal Indian shares
• Tax rate would be at 10% for Long term whereas it will be considered as Other Income if you hold a foreign security which can be taxed at the highest slab
• Asset diversification

I have given a small primer on IDR’s covering the regulatory framework and market intermediaries

What is Indian Depository Receipt (IDR)

IDR’s are like American Depository Receipts or Global Depository Receipts, except that the issuer is a foreign company raising funds from the Indian market. IDRs are rupee-denominated and created by a domestic depository against the underlying equity shares of a foreign company.

IDR is an instrument in the form of a Depository Receipt created by the Indian depository in India against the underlying equity shares of the issuing company. In an IDR, foreign companies would issue shares, to an Indian Depository (say National Security Depository Limited – NSDL), which would in turn issue depository receipts to investors in India. The actual shares underlying the IDRs would be held by an Overseas Custodian, which shall authorise the Indian Depository to issue the IDRs

Regulatory Framework in India

IDR’s are governed in India under the below regulations 

• SEBI (Issue of Capital and Disclosure requirements) regulations, 2009
• Companies (Issue of Indian Depository Receipts) Rules, 2004
• RBI guidelines

The key regulatory requirements have been summarised below 

• Only a foreign company which meets certain eligibility criteria on net worth, turnover, profitability, etc is permitted to issue IDR’s in India. 
• The issuer company shall procure the prior approval of SEBI to raise funds through IDRs. It shall also obtain the necessary approvals or exemptions from its appropriate home regulators under the relevant laws relating to issue of capital, where required.
• The issuer company is required to appoint an overseas custodian bank, a domestic depository and a merchant banker for the purpose of the IDR issue.
• Issuer is required to file a due diligence report as well as a prospectus with the Registrar of Companies and SEBI three month prior to proposed listing
• The IDRs are required to be listed on a recognized stock exchange in India having nation wide trading terminals.
• The IDRs issued in any financial year cannot exceed 15 percent of the paid-up capital and free reserves of the issuer company, and the size of the IDR issue shall not be less than Rs 500 million (ie approximately US$ 10.5 million).
• In every IDR issue at least 50 percent of the issue shall be subscribed by Qualified Institutional Buyers (“QIBs”) as defined by SEBI in its DIP Guidelines. The balance 50 percent of the issue shall be available for subscription by non-institutional investors and retail individual investors, including employees. The minimum application amount in an IDR issue shall be Rs 20,000 (ie approximately US$ 415).
• The IDRs issued are to be denominated in Indian Rupees and the proceeds of the issue are to be immediately repatriated outside India by the issuer foreign company
• The IDRs cannot be converted into underlying foreign shares before the expiry of one year from the date of their issue.
• Automatic fungibility of IDRs is not permitted i.e RBI approval will be required to convert the IDR into underlying shares
• Reverse fungibility in IDR is not permitted i.e IDR’s converted into underlying shares cannot be reconverted into IDR’s
• Mutual funds and other financial institutions can convert their IDR’s into underlying shares and hold them without any restriction subject to overseas investment limits. However. Indian resident retail investors converting IDR’s into shares need to sell them on an overseas stock exchange within 30 days from the date of conversion.
• With regard to the tax treatment, there is more clarification required than the present position. Currently, there are no specific provisions in respect of the taxability of IDRs under the Income Tax Act, 1961 (the ACT).
• IDRs are not specifically covered under the category of instruments such as listed equity shares that are currently subject to Securities Transaction Tax (STT) and therefore, the corresponding beneficial regime of capital gain taxation available to listed equity shares will not be available to IDR holders.
• IDRs are not specifically covered under the category of instruments such as listed equity shares that are currently subject to Securities Transaction Tax (STT) and therefore, the corresponding beneficial regime of capital gain taxation available to listed equity shares will not be available to IDR holders.
• This would mean that exemption from long term capital gains under section 10(38) of the Income Tax Act and the concessional tax rate for short-term capital gains under section 111A of the Act that is available to listed equity shares will not be available to IDR holders on transfer of IDRs. Therefore, under the existing laws, the resident IDR holders will be taxed as under: Long-term capital gains: 20% with cost indexation benefit and 10% without cost indexation benefits (plus applicable surcharge and education cess); short-term capital gains: 30% (plus applicable surcharge and educational cess).
• In case of non-resident tax payers, the tax rate on short-term capital gains could be as high as 40% depending on the category of the investor. Also, the conversion of the IDRs into equity shares may be considered as a taxable transfer.
  Dividends from Indian companies are tax exempt because the company declaring dividend would pay dividend distribution tax (DDT). As the dividends on IDRs would not be subject to DDT, IDR holders would not be eligible to claim exemptions from dividend income on IDRs.

Who are the Intermediaries:

• Issuer Company- Foreign Company who wishes to issue IDRs to raise money.
• Registrar/ Transfer Agent – They are responsible for Collection of application / subscription form and co-ordination with merchant banker, co-ordination with domestic depository for creation of security with NSDL and allotment of IDR to investors.
• Merchant Bankers – responsible for compilation and filling of offer document and listing agreement with exchanges
• Global Custodian- responsible for safekeeping of underlying deposited shares and facilitating the local or domestic depository in the issuance and cancellation of IDRs.
• Domestic Custodian- responsible for safekeeping of underlying depository receipts and for issuance and cancellation of IDRs.
• Domestic Depository Bank- responsible for appointment of the Custodian and the Registrar (in conjunction with the Issuer), setting of record dates for corporate action entitlements of DR holders, distribution of company information (e.g. annual reports) , performing reconciliations against the underlying shares and facilitating regulatory reporting
• Exchanges – Investors will buy/sell IDRs on the stock exchanges through brokers