Market manipulators are still at it, or so it seems. Despite the regulatory efforts to discourage participatory notes (PNs), there has been a sudden surge in PN issuance during the last couple of months by the 'proprietary sub-accounts' of foreign portfolio investors.

The trend has fuelled concerns over the possible use of the sub-account route by certain operators to escape the regulatory glare. The share of PNs as a percentage of total foreign portfolio flows rose from 32% late last year to 42% at the end of March 07, according to data maintained by the regulators.

The rise in issuance of PNs during this period has been attributed mainly to the issuance of such instruments by proprietary sub-accounts. Participatory notes are like a derivative instrument issued against an underlying security (in this case, shares).

These are issued by foreign portfolio investors (FIIs) registered here to overseas clients who may not be eligible to invest in the markets here. The holder of PNs will be able to gain from the capital appreciation of the underlying shares.

Sub-accounts are usually smaller accounts which the FII manages for a smaller group including partnership firms and individuals for a fee. Existing rules do not explicitly bar proprietary sub-accounts of FIIs from issuing PNs. But by their very nature, such accounts are meant only for trading by investors on their own behalf. The surge in PNs by these investors has caught the attention of regulators.

Officials at top broking firms and fund houses say that the sub-account route is being exploited by big market operators to manipulate stock prices. They say that one such player, who has been banned by Sebi for his involvement in the stock market scam of 2001, is said to be actively trading in the market. And other operators, whose activities have aroused Sebis suspicion, are also said to have adopted this sub-account route.

The modus operandi is like this. Operator A routes moneyusually through the hawala routeinto some offshore firm which exists only on paper. This firm then opens an account with a reputed bank B, and deposits this money. The bank B then approaches a foreign institutional investor C, who is already registered with Sebi.

This FII will set up a sub-accountusually in some tax havenand manage the funds handed over to it by B in that sub-account. The FII C will invest in Indian equities on behalf of the bank and issue participatory notes to it.

The FII thus fulfils the Sebi norm that it should know the antecedents of the investor in its sub-account. For all practical purpose, the ultimate beneficiary of the sub-account is the bank B. It will be a tough task for Indian authorities to prove that B is actually acting as a conduit for A.

It is not just market operators who are exploiting the sub-account route. In fact, there have been concerns relating to the role of FII sub-accounts, reflected in the report of the Joint Parliamentary Committee which probed the 2001 securities scam.

The report had indicated that quite a few FII sub-accounts are merely fronts for Indian promoters, who use them to ramp up their own share price or for warehousing their benami shares. There are quite a few FIIs who are willing to rent out sub-accounts for a fee. Plugging the regulations may now be called for. say officials.