After Sebi crackdown on P-notes, most hedge funds may take FPI route

Some might find this unviable and opt out; impact clearer in some weeks

A majority of hedge funds which came in through the participatory notes (p-notes) route are preparing to register themselves directly as foreign portfolio investors (FPIs).

Last week, the Securities and Exchange Board of India (Sebi) had issued a circular banning p-note holders from taking naked exposure to the derivatives market. It said all existing positions would have to be squared off by the end of 2020 or date of maturity of the instrument, whichever was earlier.

On Monday, FPIs requested Sebi for a three-month extension to roll over their July positions. Sebi hasn't said it would.

Most stock derivative contracts currently trading on Indian exchanges expire in 30 to 90 days. To that extent, the impact of the Sebi restriction will be felt in the coming weeks, said experts.

“Some hedge funds with reasonable India exposure have already started the process of (direct) registration. A few are finding it difficult to set up their own FPIs, given their insignificant dealings in Indian derivatives relative to their overall operations and unwillingness to accept any additional regulatory or tax compliance burden,” said Bhavin Shah, financial services tax leader at consultants PwC India.

Illustration: Ajay Mohanty

Experts say it would be easier for hedge funds based in European jurisdictions to register their own FPIs for derivative trades in India. For, most European countries have tax treaties which exempt such entities from Indian tax on gains they make by trading in Indian derivative instruments. For hedge funds based in places such as Hong Kong or Cayman Islands, the gains on Indian derivatives will be subjected to tax at 30-plus per cent. These will need to review the commercial viability of investing in Indian derivatives vis-a-vis the net returns from other jurisdictions.

“The Sebi circular permits hedging on the same stock on a one-to-one basis. This significantly reduces the possibility of using p-notes for taking derivative positions in India, particularly short positions. Therefore, many funds would prefer to invest directly into India through the FPI route. The main concern of funds would be the 30% tax on derivative income and if that can be lowered to more moderate levels it would significantly encourage further FPI investment in derivatives thereby increasing liquidity and deepening the market,” said Rajesh Gandhi, partner, Deloitte.

According to experts, this decline in derivatives trades might also result in some investors pulling out from equities investment, which could have a larger impact in the long term. Restricting of derivative trades would impact liquidity and price discovery in the market, beside raising the cost of exposure to Indian stocks for those coming through the p-note route.

In the case of issuance of new p-notes with derivatives as the underlying product, a certificate has to be issued by the compliance officer (or equivalent) of the FPI. This must certify that the derivatives position, on which the p-note is being issued, is only for hedging the equity shares held by it, on a one-to-one basis. The said certificate is to be sent with the monthly p-notes report.

“The migration to direct investing through the FPI route will increase the reporting and compliance requirements for existing p-note investors. For several funds that take a macro call on India and use a long-short strategy, the p-note route would be more preferable as opposed to coming directly,” said Vaibhav Sanghavi, co-chief executive at Avendus Capital Public Markets Alternate Strategies.

According to Sebi data, the notional value of p-note exposure to derivatives was about Rs 40,000 crore in April, down from Rs 54,000 crore in March. Of this, about 90 per cent of the positions are unhedged, said experts. The share of p-notes as a percentage of overall FPIs in Indian markets has declined to under seven per cent, from over 50 per cent about a decade earlier.