Foreign investors seek Sebi relief on p-note ban

Ask for a 3-month extension to roll over their July positions; say curbs will kill the p-note market

Foreign banks met with markets regulator, the Securities and Exchange Board of India (Sebi), to seek relief from a new rule that requires investors to liquidate some of their offshore derivatives contracts, people with knowledge of the matter said.

Sebi on Friday issued a circular that said the derivatives must be liquidated by the end of 2020 or by the instrument’s date of maturity, whichever was earlier. Banks, representing their clients, met with Sebi officials on Monday to seek a three-month extension to roll over their July positions. The contracts usually have monthly maturity, meaning existing products will have to be rolled over by the end of this month or be liquidated upon expiration. Liquidating all contracts at once will create huge volatility in stocks, the banks said, according to the people.

At issue are contracts known as participatory notes (p-notes), which foreign banks create for offshore investors looking to trade in India’s $2-trillion equity market without registering onshore with Sebi. The regulator has been taking steps to cut down on the use of the so-called p-notes, culminating in Friday’s announcement. The banks told Sebi officials the rule would effectively kill the p-notes market, said the people, who asked not to be identified because they weren’t authorised to speak on the subject.

“It remains to be seen what the full effects of this recent change will be on foreign funds, and if some funds choose to set up their own foreign portfolio investment accounts to trade directly, or exit the market altogether,” said Phillip Meyer, general counsel and chief operating officer of hedge fund firm Oasis Management (Hong Kong), which has traded in Indian securities for more than 15 years.

In a discussion paper floated last month, the markets regulator had proposed to bar p-notes from taking speculative positions in the derivatives market. Sebi had suggested that ODI (offshore derivatives instruments) issuers be given time till December 31, 2020, to wind down any outstanding derivatives exposure taken for a purpose other than hedging. 

Illustration by Ajay Mohanty

The markets regulator has said ODI-issuing foreign portfolio investors (FPIs) will have to provide a certificate that fresh derivatives positions are “only for hedging the equity shares on a one-to-one basis”.

“The ODI-issuing FPIs shall not be allowed to issue ODIs with derivative as underlying, with the exception of those… taken by the ODI-issuing FPI for hedging the equity shares held by it, on a one-to-one basis,” Sebi said in a circular last Friday.

Sebi will allow p-notes in single stocks for hedging cash positions of the same stocks, but it won’t allow hedging of index derivatives even if there is an underlying cash position, according to the people. A Sebi spokesperson didn’t respond to an email and a phone call seeking comment.

The regulator said at the meeting with foreign banks it wants hedge funds to register as direct foreign investors and start trading derivatives onshore while they can still use p-notes to hedge their stock holdings, the people said. 

Restricting derivative 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.

The role of p-notes has diminished over the past decade as the regulator made it easier for foreigners to directly access the India’s market. P-notes accounted for just 6.3 per cent of the Rs 28.6 lakh crore ($443.4 billion) held in equities, bonds and derivatives at the end of May, according to Sebi data, down from 56 per cent at the end of June 2007. The notional value of p-note exposure to derivatives was Rs 47,670 crore in May, down from Rs 55,780 crore at the start of the year, data from the regulator show.

The issuer of a p-note is typically a prime broker such as Morgan Stanley, CLSA and JP Morgan. The client or investor approaches them to purchase a synthetic exposure to underlying stocks. The prime brokers issue a swap contract/derivatives 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.