FPIs ask Sebi to clear haze around p-notes circular

Foreign portfolio investors (FPIs) are seeking clarity on the circular on participatory notes (p-notes) or offshore derivative instruments (ODIs), issued by the Securities and Exchange Board of India (Sebi) in July.

Investors are unclear whether the hedging position needs to be looked at, at the issuer level or at the subscriber level, and whether the derivatives positions can be taken against equity investments indirectly through foreign currency convertible bonds (FCCBs) or American depository receipts/global depository receipts (ADRs/GDRs). 

FPIs have told the regulator it would be difficult for issuers to discern between speculative and hedging positions of individual investors, and to ascertain the exact number of open positions held by investors. This will especially be the case if the investors deal with multiple p-notes issuers. 

Sebi is expected to come out with clarifications on some of these issues.

“The language of the circular seems to suggest that it is at the issuer level but the intent appears to be otherwise,” said a person on condition of anonymity.

The regulator needs to clarify whether the issuer needed to issue ODI on equity shares to the same subscriber who is looking to subscribe to ODIs on derivatives, the source said: “Can the issuer issue an ODI against derivative to a subscriber who already holds an equity position through the FPI route or an ADR/GDR under the FDI (foreign direct investment) route?” 

ADR and GDRs are depository receipts traded in the local stock exchange but represent a security issued by a foreign public listed company. 

Illustration: Ajay Mohanty

Sebi had issued a circular in July banning p-notes holders from taking naked exposure to the derivatives market. It also 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.

Only those derivative positions that are taken by an ODI issuing FPIs for hedging the equity shares held by it, on a one-to-one basis, are allowed now. A one-to-one position means derivatives which have the same underlying as the equity share. ODIs against a basket of shares such as the Nifty or Sensex are ruled out. Even those against a same-sector index are rule out. Practically, only players who want to engage in arbitrage would buy equity on the spot and sell the derivative. 

“There is lack of clarity on the hedge basis to be adopted. The circular seems to suggest that the issuer holding the equity, must be holding the derivatives on such equities (as a hedge), to be able to issue ODIs on such derivatives. A concern is that this expects a delta-one hedging mechanism which may not be reflective of the current practices in constructing and maintaining hedge inventory by institutional issuers,” said Richie Sancheti, head–funds practice, Nishith Desai Associates.

"Certain concerns seem to have been raised as to how the Sebi circular will apply in different scenarios. Sebi's view is quite clear that derivative positions will be allowed via p-notes only if the same ODI investor has an underlying equity position in the same stock. This means no index futures, and no derivatives against equity positions of the p-notes issuer. Sebi, however, could consider clarifying whether derivative positions can be taken against equity investment indirectly through ADRs/GDRs and FCCBs,” said Rajesh Gandhi, partner, Deloitte.  

FCCBs are bonds issued by listed companies overseas and allow the issuer or bondholder the option to convert the bonds into shares at a pre-agreed price.

“The larger challenge is that while the ODI route appears to have been closed, the direct route is not available to US hedge funds as Indian single stock futures are yet to be approved by the Commodity and Futures Trading Commission (CFTC). Large US funds who were accessing India through the p-notes route will be out of the market. This needs urgent resolution,” said Suresh Swamy, partner-financial services, PwC India.