Market regulator Securities and Exchange Board of India (Sebi) has finally decided to check the “copious” flow of foreign funds into the stock markets and the runaway rise in the Sensex. It has proposed partial restrictions on investment through offshore derivative instruments, including participatory notes (PNs), equity linked notes and capped return notes — all used by foreign institutional investors (FIIs) to invest in Indian stocks.

In a discussion paper issued today, Sebi said that FIIs and their sub-accounts should not issue or renew ODIs with underlying as derivatives with immediate effect. “They are required to wind up the current position over 18 months, during which period Sebi will review the position from time to time,” it said, inviting comments from the public about the new proposals

Foreign institutional investors that are currently issuing ODIs with notional value of PNs outstanding (excluding derivatives) as a percentage of their assets under custody (AUC) in India of less than 40 per cent should be allowed to issue further ODIs only at an incremental rate of 5 per cent of their AUC in India. Those FIIs with notional value of PNs outstanding (excluding derivatives) as a percentage of their AUC in India of more than 40 per cent should issue PNs only against cancellation or redemption or closing out of the existing PNs of at least equivalent amount.

“Though it’s only a proposal, the Sebi move will halt the foreign institutional investor-led rally for the time being. We can expect a correction on Wednesday,” said a fund manager. The Sebi move follows huge FII inflows in the last one month. The Sensex has risen by over 5,000 points in the last two months on the back of FII inflows. FIIs have invested over $5.45 billion in October alone, taking the total investment for the year 2007 to $ 17.69 billion.

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