What we do know is that if we are able to put in a clearing corporation and a world class trading mechanism that cared more about the ‘how’ of transacting on an exchange, rather than the ‘who’, we could achieve better preparedness for growth in volumes. The participatory notes (PN) debate has spent so much energy in describing both the ‘who’ and the ‘how much’ on the assumption that regulating these are important.

India is one of the few regimes that restricts the entry of foreign investors, through a piece of regulation that defines who can be a FII. Hedge funds continue to not figure in that category. India is also one of the few regimes that prescribe a registration process. If the intent is to know and approve those who can invest in Indian markets, the surge in PNs only points to the inability of regulation to achieve this purpose. Those who would like to invest will do so anyway, and those who make money from such investors will continue to find innovative ways to enable them to do just that. It is now widely accepted that some of the money of our own, which was stashed away abroad, has managed to find its way back through these structures. Efforts to ‘find out’ the identity of the original investors may be tougher than currently envisaged. It is also not clear how knowing the identity of the investor would help in managing any stability and systemic risks issues that the regulators are most concerned about.

Anonymity in itself may not be an undesirable feature. It may also not be feasible to extend the information disclosure argument beyond a point when it comes to entities like hedge funds. While several have questioned the opaque investment strategies of hedge fund managers, investors seem to prefer them for the very same reasons, trying to get an edge over other strategies that are well known and publicised. Regulation can only extend itself to issues of default and solvency, and the threats to stability of markets from unexpected failures. Measuring these risks has been complicated by the creation of several sophisticated structures. The disclosure of ‘who’ is unlikely to lead the regulators into knowing, understanding and dealing with these complexities.

The obsession with ‘how much’ is even more dangerous, because it can not only make unrealistic assumptions about size, but may impose limits that are arbitrary. Consider the numbers in the SEBI consultative document. The notional value of PNs outstanding was at Rs 31,875 crore (20 per cent of assets under custody, AUC) in March 2004. It has grown to Rs 3,53,484 crore (51.6 per cent of AUC) by August 2007. The proposal is to limit the issuance of PNs to 40 per cent of AUC. If 51 per cent is undesirable, and 20 per cent could be tolerated for three years since 2004, what makes 40 per cent optimal? What if there are other ODIs, which the regulator’s limits provide the incentive to create? What is the assumption about growth in AUC? In the last three years, AUC has grown by 23 per cent compounded per annum. Does the 40 per cent limit have an assumption on this number as well? The concern seems to be about the ‘copious’ forex flows that the FIIs have brought in. If AUC grows at a higher clip, given the much discussed attractiveness of India, won’t inflows still be copious, despite the 40 per cent cap? The ‘how much’ in this debate is actually not even about stock markets, derivatives or its ability to deal with these instruments or their volumes. It is about the pressures this brings on the exchange rate and the RBI, given our capital controls regime. What would a quantitative restriction do, when the real problem is about a central bank still unprepared for global flows?

The concern for regulation should be about the several unanswered ‘hows’ that go with the increased interest in India, its economy, its markets and its stocks. How can this interest enable the creation of global sized companies with practices that match the best in the world? How can this interest be harnessed to create global-sized banks that can deal with the flows it brings?

The first surge of FII interest in the 1990s pushed policy towards demat and derivatives. The next surge should take the markets to the next level, and those with the agenda to develop the economy need to figure that out. Smaller markets like Israel, trouble-ridden markets like Chile, and control-freak markets like Taiwan have had road maps. It would be a shame if India chose to bring back controls instead.

The writer is managing director, Centre for Investment Education and Learning