Yesterday, the Securities and Exchange Board of India (SEBI) fired a warning shot across the bows of unregistered foreign institutions speculating anonymously on Indian stocks. The shockwave drove the benchmark Sensex index down more than 9% at its opening today. Many Indian companies offering American depositary receipts actually anticipated the decline during New York trading yesterday, with HDFC Bank (NYSE:HDB) down more than 10%, and other companies like Infosys (NASDAQ:INFY), Tata Motors (NYSE:TTM), and Satyam Computers (NYSE:SAY) also dropping precipitously. The drop hit the entire country hard: The closed-end India Fund (NYSE:IFN) dropped 8.5%, while the Morgan Stanley India Investment Fund (NYSE:IIF) took a 6.5% hit.

The warning took the form of a draft discussion paper proposing that foreign institutional investors stop using a type of offshore derivative instrument known as participatory notes. These notes are typically issued by locally registered institutional investors to unregistered ones, who can then trade in the market without revealing their identities or positions. 

According to the proposal, the notional value of participatory notes on Aug. 31 was $90 billion, up from $10 billion in March 2004, when foreign institutions were first allowed to use them. Citing concerns about the anonymity behind these notes, the increasing use of such derivative instruments, and the heavy inflow of foreign funds, the SEBI asked for urgent comments on its proposal to immediately stop the use and issue of such derivatives, have current positions unwound within 18 months, and severely restrict further issues.

Catch me if you can
The urgency of the proposal and the immediacy of the required action triggered a stampede for the exits, calmed eventually by personal reassurances by India's finance minister, Palaniappan Chidambaram, that they weren't really banning participatory notes but instead were just trying to limit how much foreign inflow was channeled through them. The SEBI followed up with a clarification that current contracts could be renewed or rolled over for up to 18 months.

Chidambaram also said the offshore foreign institutions would be invited to register with the Indian authorities, in an effort to call the bluff of offshore hedge funds trying to preserve their anonymity.

Unfortunately, hedge funds are notorious for not being accountable to any national regulators, so the chances of their bowing down to any Indian regulators are rather remote. Even if they do unwind their current offshore positions, there's nothing to prevent them from finding even more creative ways to take highly leveraged positions in Indian assets and roil the market even further. Nor are they obliged to disclose their comings and goings to anyone. So Indian regulators will have to stand patiently in line while the rest of the world's financial brains struggle with this modern financial puzzle.

Lesson learned?
Warming to the clarifications, the Sensex bounced back to close down just 1.9%. Many Indian ADRs have rebounded sharply today. But it remains to be seen whether the Indian stock market has come to its senses, as it's still up well over 30% year to date.

Once again, derivatives-driven speculation needlessly roiled a market with otherwise strong fundamentals and great prospects. For many years, India's leaders have lamented how foreign funds were bypassing them en route to China. In the course of just one topsy-turvy day, Indian regulators experienced the downside of welcoming foreign fund inflows without really understanding the fine print on their visiting cards.

Hopefully, this will teach them to stay focused on the arduous task of building sustainable market growth based on real fundamentals, not on easy money.

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Fool contributor Saibal Saha likes to keep his feet firmly planted onshore. He doesn't own shares of any of the stocks mentioned in this article. You can see his holdings here. Satyam is a Stock Advisor recommendation. The Motley Fool has a disclosure policy.