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Sunday, February 19, 2006

Imagine there's no `FII'

In India, all of us are used to the notion of `FII' as being the channel through which foreign investors access the Indian market. But looking forward, the future easing of capital controls in India will some day involve eliminating the concept of the FII, and opening up the equity spot and derivatives markets to anyone in the world. The FII is a piece of State-induced canalisation, and it will surely (someday) go the way of canalisation to favour the State Trading Corporation or import licence holders.

It is, hence, of interest to all of us to ponder what lies beyond. What is the institutional structure through which normal market economies engage in cross-border financial flows? I believe a key piece of the plumbing is the concept of an "Omnibus Account". This week, Futures Industry magazine has an excellent article describing this structure: Omnibus Accounts: The Portal to Cross-Border Trading, by Leslie Sutphen & Jeff Huang. This article is U.S. centric, but similar structures work for all normal market economies.

The picture that I'm getting is that if India is able to obtain the "Part 30.10 exemption" from CFTC, then it will pave the way for Indian brokers to directly sell to US customers. Else, the Omnibus Account is the only way. It will involve bilateral contracts between a U.S. brokerage firm and an Indian brokerage firm. The Indian firm will treat the orders coming from the U.S. brokerage firm as one big customer, except for the purpose of a `large trader reporting system' (which isn't yet in place in India) where the names of large positions are required.

The article says: Regulatory authorities in some countries have responded by banning omnibus accounts, but this leads to at least two problems. First, it becomes less efficient for global brokers and their customers to enter those markets, and in some cases legally impossible. Second, some market participants will resort to trading "look-alike" contracts with their broker on an over-the-counter basis. The broker then offsets these contracts by establishing an identical position on the exchange. This arrangement does allow these customers to trade these markets, but it provides the regulators with even less information on the ultimate customer. In any case, many institutional investors do not like the lack of price transparency of over-the-counter contracts, so they avoid these markets. This deprives new exchanges of liquidity.

In India, these "look-alike" contracts go by the name of Participatory Notes. :-)

I found it fascinating that in the same issue of Futures Industry magazine, there was an article on developments in Taiwan which is a country which is in the midst of this FII -> Ombinus Accounts transition. Taiwan is like India in having a very big direct retail participation in the securities markets. Roughly 10% of their population trades - in an Indian setting, that would translate to 100 million direct market participants. Taiwan is trying to move towards one thing which we have already done right: a merger between the spot stock exchange and the futures exchange. Right from the L. C. Gupta report onwards, India has been clearheaded on this, requiring no silly separation between the spot and the derivative. But the other frontiers which Taiwan is moving on are a jump ahead of us. They are removing their QFII system, and shifting to omnibus accounts. They are worrying about offering a range of traded products which are interesting to global market participants - such as gold futures and a dollar denominated Taiwanese stock market index - so as to make Taiwan a trading centre for market participants from all over the world. They are increasing the size of position limits. Taiwan is one of the unhappy countries which has taxation of financial transactions - a bad idea in public finance if there ever was one. They seem to be headed to drop the tax rate from 2.5 basis points to 1 basis point. Finally, you might find this article on Mexico interesting; they already have omnibus accounts.


  1. De facto, a lot of the `proprietary trading' of stock broking firms is actually agency fund management for customers. They are running hedge funds. It's just that in India, there is no formal framework for a tax-passthrough but-not-regulated entity that's a hedge fund.

  2. Mr. Shah, what you are saying is that basically KYC, AML etc. all are meaningless farce and surveillance is wholly dispensable. Let have these removed for our Indian investors as well.

    And contrary to your opinion, I understand, omnibus accounts are dying everywhere post 9/11 and US Patriot act.

  3. I wasn't aware that the omnibus account framework is dying. How fascinating. Could you tell us more?

    My basic claim is simple. Dozens of well run countries have open capital accounts without an FII framework. I used to think this is done using omnibus accounts, but maybe I'm wrong and the mechanism is different. I believe the FII framework is unnecessarily restrictive. It introduces frictions for non-FII participants - why is that in India's interest? It reduces the diversity of players in India, thus hindering liquidity and market efficiency. And if you believed that capital controls are desirable owing to monetary policy reasoning, the FII framework doesn't deliver anything because for FIIs the capital account is open. In short, the FII framework gains nothing and loses something. So I think we should move forward to an open capital account for the purpose of the equity market, as is done in dozens of other countries.

    If a US investor wants to buy UK stocks, how is it done?

  4. Actually, I had discussed the issue sometime back with a practitioner who has managed custody operations in many countries for some of the best names in business. I quote from his e-mail :

    "The debate between omnibus (nominee) and end-beneficiary accounts goes way back.
    Not all developed countries operate at an omnibus level (actually most of them are working within an end-client level environment).
    The US, Hong Kong, Canada, The Netherlands, Greece, France, Italy, all the GCC countries and many more are operating at an end-beneficiary level.

    As you guessed correctly, the end beneficiary level is a prerequisite condition for various laws/restrictions to apply (money laundering, foreign investment restrictions, substantial shareholders etc). Although the global trend had been towards omnibus schemes, after the September 11th incident (and of course the US Patriot Act), this trend came into an end.

    In xxxxxx, our customers (global custodians holding assets on behalf of their
    customers) are required to open and maintain several accounts (one account per each end-client, instead of one account for all clients). This requirement imposes additional costs and procedural requirements (PoAs, Certificates of Incorporation, notarizations, consularizations etc.).
    Still, besides the additional work required (and higher costs), all our customers agree that having depository accounts at end beneficiary level is always the best and safest way to reconcile assets.

    So, to answer your question, the account structure in xxxxxx country may sometimes being troublesome, but at a fairly acceptable level (in fact, this is the least of our clients' problems)."

    At times, it is difficult to substantiate such operational experiences but I'll try to provide some. Many a times, costs of compliance and operational risks force organisations to abandon certain practices which are otherwise available. I think it would be a good idea to get this it sorted out by interviewing few other practitioners.


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