Who uses P-Notes anyway?
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The Securities and Exchange Board of India (Sebi) has proposed a further tightening of norms for participatory note (P-Note) issuances. While Sebi hasn’t said it in so many words, its policy seems to be to make the product less attractive and increase the cost of compliance to a point where P-Notes become irrelevant.
To a large extent, Sebi has already been successful in reducing the attractiveness of P-Notes. In September 2007, just before it imposed major curbs on the issuance of participatory notes, the outstanding value of these instruments stood at around Rs4.1 trillion, and accounted for half of all assets held by custodians on behalf of foreign portfolio investors (FPIs). This fell by three-fifths to Rs1.7 trillion in April 2017, and more importantly, P-Notes accounted for only 6% of all assets owned by FPIs.
From the looks of it, the curbs on P-Notes have hardly affected flows into the country. Assets owned by FPIs have risen by 3.5 times to Rs27.9 trillion between September 2007 and April 2017, a period when the markets have roughly doubled in value.
But before we say “R.I.P.: P-Notes”, it’s important to note that there are a number of foreign investors who do not want to or cannot access Indian markets directly. For one, this could be because they want to avoid the rigmarole and the cost of registering with another regulator, simply because of a lack of means. In fact, it’s not uncommon for fund houses to use participatory, or access notes, as they are called in some other jurisdictions, or other instruments such as depository receipts, to trade some emerging markets. In some other cases, there may be restrictions in investment mandates; for instance, some pension funds have a mandate for buying only dollar denominated securities.
And for those who read P-Notes as money laundering, Sebi has itself categorically denied any links, stating that it hadn’t received any complaints or evidence about these links from anyone, including investigating agencies.
In this backdrop, any attempt to make P-Notes irrelevant is foolhardy. It basically signals that flows from legitimate investors who don’t want to register directly with Sebi don’t matter.
To be fair to Sebi, its discussion paper on participatory notes doesn’t propose a complete clampdown. Even so, one of its proposals could well sound the death knell for P-Note issuances with equity derivatives as the underlying.
The markets regulator has suggested a ban on notes issued against derivatives, except in cases where the position is for hedging. It elaborates in its paper that the proposed prohibition is against trades that are speculative in nature. The $6 billion question—the outstanding value of P-Notes which have derivatives as their underlying—is how the regulator will define what is speculative and what qualifies as hedging. This is a tricky question and has been discussed in this column earlier. A fund manager who chooses not to hedge his portfolio can be seen as speculating that prices won’t fall. And it can be argued that one who does choose to hedge is taking a bet that there is a likelihood of price correction. Who’s hedging and who’s speculating?
And even assuming that Sebi requires an underlying position in the cash market, for the derivatives position to qualify as a hedge, the question that remains is whether it will permit a hedge using a sector benchmark or a broad market index. Besides, an investor may prefer taking a directional bet on a stock using derivatives, because of higher liquidity in the market; but this form of investing may well be frowned upon if Sebi’s proposals become rules.
Depending on how tight Sebi’s rules are on P-Notes which use equity derivatives as the underlying, demand for this instrument could either shrink or altogether disappear.
Sebi has also proposed a $1,000 fee every three years for each P-Note client, with a view to curb instances where one client uses multiple brokers, perhaps to mask positions. Another reason could be to increase costs to a point where the client considers registering directly with Sebi as an FPI. The stated reason, of course, is that Sebi entails a large cost in monitoring the P-Note market and participants, and that the fee will help offset some of these costs. Whatever the reason, market participants don’t consider this rule change to move the needle materially. Nevertheless, it may well push some investors to register directly with the regulator.
In this regard, Sebi will do well to simultaneously streamline the FPI registration process. While it has improved over the years, there’s a lot of room to grow. And as pointed out in this column earlier, other avenues for overseas investors, such as unsponsored depository receipts should be allowed as well.
While foreign flows to India have surged in recent years, that shouldn’t be an excuse for lax policy when it comes to overseas investors; both the kind who are willing to invest directly, as well as those who prefer to use notes or receipts issued overseas.