After new Sebi curbs, FPI derivatives' positions dwindle

Unsquared positions hit record low in July; some worry on liquidity getting hit in short term

The Securities and Exchange Board of India's (Sebi's) move to ban participatory note (p-note) subscribers from taking naked derivatives positions has led to a sharp drop in the active contracts held by foreign investors.

The number of active contracts, termed Open Interest, has dropped to a record low of 1.7 million, from 1.9 mn last month. Further, the short positions rolled over by foreign portfolio investors (FPIs) halved to 23 per cent during expiry of July series contracts on Thursday. Rollover is carrying forward of open positions from one series to another. This unwinding has also impacted overall market-wide rollovers, which fell to 77 per cent from 84 per cent last month.

Derivatives experts say p-notes could have unwound as much as 95 per cent of their open positions after the Sebi circular on July 10. The heavy unwinding also caused a sharp rally in stocks in the pharmaceuticals and information technology sectors, where they had built short positions.

P-notes, also called offshore derivative instruments (ODIs), account for less than a tenth of FPI assets. However, being active investors, they contribute significantly to the liquidity.

"The rollover in the Nifty (68.41 per cent) is lower than its quarterly average of 71.82 per cent. Further, market-wide rollovers are also on the lower side. The open interest in Nifty at present is lowest since the start of 2017," said Sneha Seth, analyst, Angel Broking.

The derivatives markets could see some dip in liquidity, as p-note subscribers would not be able to trade in Indian futures for any purposes other than hedging. Experts say there could be a 10 per cent dip in FPI participation in the futures market, in the backdrop of the current development.

"A majority of ODI subscribers have already unwound their naked positions. From a short-term perspective, derivatives markets could see some liquidity crunch. However, many of the ODI subscribers are expected to come back to Indian markets through the direct route, though the process will take a few months," said Bhavin Shah, leader, financial services tax, PwC.

By the new Sebi rules, no p-note holder is to trade in the derivatives market unless it is for hedging purposes. For instance, if a p-note holder has a cash market exposure to a stock, X, he will be allowed to buy only the contracts for X in the futures market. Further, Sebi had decided to levy additional fees of $1,000 for each p-note subscriber.

This tightening is a part of the regulator's efforts to discourage foreign investors from taking the ODI route. The Supreme Court appointed Special Investigative Team (SIT) on undisclosed money had raised concern that the ODI route was being misused for money laundering.

In the first series of regulation tightening, Sebi had made Know Your Customer (KYC) norms for p-note subscribers stringent in 2016. Sebi also issued curbs on transferability, and prescribed more stringent reporting for p-note issuers and holders. It also mandated issuers to follow Indian anti-money laundering laws, instead of the norms prevalent in the jurisdiction of the end- beneficial owner.

The attractiveness of p-notes as a mode of participation for FPIs has come down significantly in the past decade, due to the tightening of rules. According to data compiled from Sebi, the total value of p-note investments in the Indian markets - equity, debt and derivatives - was Rs 1.65 lakh crore at the end of June. P-notes currently account for only 5.7 per cent of total FPI investments in the country. This is a steep fall from nearly 50 per cent in 2008.