PN issuances: equity derivatives market to take the biggest hit

PN issuances: equity derivatives market to take the biggest hit

Mumbai: Investors using participatory notes (PNs) to access the Indian derivatives market would soon have no option but to register with the market regulator as foreign institutional investors or as FII sub-accounts to continue trading.

The Securities Exchange Board of India (Sebi) has proposed a total ban on derivatives-based PN issuances, which would have implications not only for the Indian derivatives market, but also for the underlying cash market.

While large PN investors could register with the regulator to be able to continue trading, this would happen only with a time lag. In the interim, the markets would have to grapple with gross positions worth nearly $30 billion being unwound gradually over the next 18 months.

Last month, derivatives trades accounted for nearly three-fourths of all trades done on the National Stock Exchange and the Bombay Stock Exchange. The derivatives market leads in price discovery because of its higher liquidity.

A hit on derivatives trading would necessarily have a bearing on the cash market as well, as the lack of options such as hedging or going short could discourage some investors from taking positions in the Indian markets.

Foreign institutional investors have taken to the Indian derivatives market in a big way, accounting for more than 35% of the gross outstanding position, almost exactly in line with their share in underlying stocks. These investors flock the derivatives segment simply because it offers higher liquidity. Also, it allows them to go short (banned in the cash segment), hedge long positions by selling futures or trading options, and gain from arbitrage opportunities between the cash and derivatives segments.

According to Sebi, PNs with derivatives as their underlying amounted to nearly $30 billion as in August. This is a misleading figure because it doesn’t net out long and short positions on the same contract, which means there’s some element of double counting when open interest is calculated.

After all, total FII gross positions in the derivatives segment amount to just $18 billion.

But the $30 billion figure does suggest that a large proportion of FII derivatives positions are taken through PNs. These could be through the issue of plain-vanilla PNs for trades in the derivatives market, or through structured products like capped return notes, long-dated options or other over the counter (OTC) derivatives.

While one reason for the use of structured products/PNs is the lack of access (this can be addressed through direct registration), another is the non-availability of OTC derivatives products in India. The fact that these products thrive in offshore markets indicates that there is a genuine demand for them. Ajay Shah of the National Institute of Public Finance and Policy says India should try and compete and introduce onshore OTC derivatives. The high-powered expert committee on making Mumbai an international financial centre had this to say on offshore derivatives products: “When Indian financial regulation obstructs derivatives, offshore production of these products helps end-users to obtain these services and thus undertake better risk management of their securities portfolios. This helps the sophistication and growth of the Indian economy."

It’s bad enough that Indian regulators have shied away from introducing these products onshore. They have now found a way of blocking these products offshore as well.

J.R. Varma of the Indian Institute of Management Ahmedabad says the specific ban on derivatives-based PNs could be because of the twin worries about the leverage the market provides and the large inflows for arbitrage transactions between the cash and derivatives segments.

As Susan Thomas of the Indira Gandhi Institute of Development Research puts it, “Sebi’s paper and the initial market reaction to it was a classic demonstration of the regulatory risk in the Indian markets."