BackWhy Sebi’s action on P-Notes deserves only two cheers
Sebi needs to work on a number of fronts to improve access for foreign investors. More curbs on P-Notes may keep some bad elements out, but it will be a pity if in the process genuine investors are also pushed away
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The Securities and Exchange Board of India (Sebi) has again tightened the norms for issuance of participatory notes (P-Notes). Since there have always been concerns about the misuse of P-Notes for money laundering, the move isn’t entirely surprising.
According to a 21 May report in Mint, it appears that Sebi’s strategy is to make the product less attractive. With the increased cost of compliance, P-Notes may gradually become irrelevant, the report added.
We could have lauded the move, without qualification, if P-Notes were being used only for money laundering. The fact of the matter, however, is that these are largely used by foreign investors who do not want to or cannot access Indian markets directly. This could be either because they want to avoid the rigmarole and the cost of registering with another regulator, or because of restrictions in their investment mandates (for instance, some pension funds have a mandate for buying only dollar-denominated securities).
Consequently, when Sebi is making access through P-Notes increasingly cumbersome, it should make attempts to ease access for genuine investors through other means. The evidence is quite the opposite.
Consider that the Indian government liberalised regulations on depository receipt (DR) issuances in November 2014. This was a welcome move as far as improving access to foreign investors was concerned. (See bit.ly/1U8USow and bit.ly/1Tugf1E.) Unfortunately, market participants are still awaiting clarity from Sebi for operating guidelines related to these new regulations.
Meanwhile, some depository banks have filed a slew of applications (over 150) for unsponsored DR programmes against shares of Indian companies, and a handful of Indian companies, including Bharti Airtel Ltd and Axis Bank Ltd, have taken board approval for issuance of level 1 sponsored DRs. Both forms of issuances are of the non-capital raising variety. Companies that prefer the sponsored variety are those that want to be actively involved in the issuance and as a result have access to the new investor base.
Even in cases where companies don’t want to be actively involved, i.e. in the unsponsored DR category, the fact that depository banks have filed so many applications shows that there is demand for such an instrument in the US market. In a survey of 32 active North American portfolio investors by The Bank of New York Mellon Corp., 59% of the respondents said that they are restricted from directly investing in India by buying ordinary shares. It is hardly surprising to note, then, that mutual funds, pension funds, sovereign wealth funds and hedge funds accounted for nearly three-fourths of the 2,500 or so P-Note users, according to a Press Trust of India report.
Besides the fact that they help overcome difficulties relating to direct access, some investors also like to use P-Notes because of the flexibility they provide. P-Note issuers are known to issue over-the-counter derivatives products that are customised to their customers’ needs. This could be a put option for a tenure that is not readily available in Indian markets, or an exposure to an index that is not traded, or something far more exotic. To the extent that such products are not available in the onshore markets, there will always be a demand for such structured products in the form of P-Notes. An increase in the cost of compliance for P-Note users may push some of them to directly register; but if flexibility with product structuring is what some of them are really after, then the new curbs may not exactly act as a deterrent. Sebi should then consider allowing over-the-counter derivatives products in the onshore markets.
Of course, this has been said for over 10 years now, and no one will hold their breath waiting for this to happen. But if Sebi is really interested in making P-Notes irrelevant over time, it needs to address the underlying reasons that make the product a success.
As far as the procedures involved in registering directly with Sebi is concerned, things have certainly improved under the new foreign portfolio investor regulations. But according to the head of one of India’s largest custodians, while things may have improved, some investors still find the whole process cumbersome. Clearly, they won’t mind the extra cost of compliance with P-Notes, as compared to the cost of registering directly.
In sum, Sebi needs to work on a number of fronts to improve access for foreign investors. More curbs on P-Notes may keep some bad elements out, but it will be a pity if in the process genuine investors are also pushed away. Especially so when there are ways to improve access without compromising on compliance.
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