FPIs red flag Sebi's plan to curb p-notes

Overseas investors have written to the Securities and Exchange Board of India (Sebi), opposing the proposed curbs on participatory notes (p-notes), or offshore derivatives instruments (ODIs).

In a discussion paper floated last month, the market regulator proposed to bar p-notes from taking speculative positions in the derivatives market. Also, the paper talks about levying fees of $1,000 per ODI per subscriber every three years. Sebi has suggested that ODI issuers be given time till December 31, 2020, to wind down any outstanding derivatives exposure taken for a purpose other than hedging.

FPIs have told the regulator that it would be difficult for issuers to discern between speculative and hedging positions of individual investors, and to ascertain the exact number of open positions held by investors without any underlying. On the other hand, most investors would be reluctant to disclose their trade positions. 

“If p-note issuers insist on a proof and not self-declaration, it could be practically challenging for investors to give adequate documentation to prove their trades are for hedging purposes, especially if they deal with multiple p-note issuers. Issuers may also find it inconvenient to maintain such data,” said Rajesh Gandhi, partner, Deloitte.

Restricting derivatives trades would impact liquidity and price discovery in the market, as well as increase the cost of exposure to Indian stocks for those coming through the p-note route, say experts.

In their feedback, investors have said they may not be able to meet the regulator’s demand of investing through single ODI issuers as multiple ODI issuers are a means to mitigate credit and operational risks.

Foreign investors have also sought clarity on the definition of hedging. “Does hedging refer to taking a stock-to-stock position? Is one allowed to hedge against a basket of stocks such as Nifty or do a country-to-country hedge, say, by shorting on India and going long on China?” asked a person who deals with FPIs.

Other than a halt in speculative trades, a narrower definition could put the brakes on hedging activity as well, feel investors.

Currently, the issuance of a p-note with underlying derivatives allows benefit of leverage and can provide significant exposure to the p-note holder at marginal cost. 

A large number of investors coming into India through p-notes, especially hedge funds, are looking to switch from equities to derivatives as India’s tax treaties with Mauritius, Singapore and France exempt gains made in the derivatives space.

While investors have told the regulator that they could meet the new fee requirement, some FPIs want the regulator to levy a one-time fee in lieu of the proposed fee of $1,000 every three years per ODI issuer per subscriber.

Each p-notes issuer handles 200-300 clients on average. This means each issuer will have to shell out $200,000 to $300,000 as against $3,000 paid every three years at present.

FPIs have also expressed their willingness to work more closely with Sebi to automate the exchange of information between ODI issuers and Sebi, and reduce cost at Sebi’s end.

Sebi has been spending money to put in place the right technology and resources to monitor investments coming through the ODI route.

Investors have told Sebi that funds with a small exposure to India may exit their positions altogether rather than pay the fees or invest directly through the FPI route.

“There are a number of investment funds that have a very small exposure to India. Requiring them to register as an FPI to carry out those trades will add to their administrative burden. There are also a number of value-added centralised services ODI issuers provide, like foreign exchange risk management across many restricted currencies, margin funding, etc. It will be unviable for these investment funds to do it in-house,” said Suresh Swamy, partner - financial services, PwC India.

P-notes are issued by registered FPIs to overseas investors who want to invest in the Indian stock market without registering themselves with Sebi. The underlying assets could be equities, debt or derivatives.

The value of p-notes stood at Rs 1.68 lakh crore at the end of April, which comes to about 6 per cent of total foreign investments in Indian shares and equity derivatives. Of this, the notional value of p-notes on derivatives stood at Rs 40,165 crore, about 25 per cent of the total p-notes value.

The share of p-notes as a percentage of overall FPIs in Indian markets has declined to under six per cent from over 50 per cent about a decade ago.

The issuer of a p-note is typically a prime broker such as Morgan Stanley, CLSA, JP Morgan etc. The client or investor approaches them to purchase a synthetic exposure to underlying stocks. The prime brokers issue a swap contract/derivative contract to the purchaser/investor. In doing so, the issuer creates an exposure to an underlying Indian stock and then may decide to hedge this exposure by buying the underlying stock directly under the FPI route.

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