P-note issuers rejig business model

The P-notes business does not involve financing or funding component

With participatory notes (P-notes) losing their appeal as an investment vehicle, most banks that issue P-notes to foreign clients are changing their business model to shore up margins. 

According to sources, most banks have stopped the “non-leveraged” aspect of their business, and are now focussing their attention only on the part that involves financing. 

The P-notes business, the way it is generally understood, does not involve a financing or funding component. Here’s how it typically works. Investors approach a bank (P-note issuer) to take exposure to Indian stocks. The bank issue p-notes and in turn hedges itself by executing the trade in India and holding the shares. At a later date, whenever the clients want to unwind their positions, the shares will be sold and money returned to the client. The bank earns in the process only a small commission or brokerage, which is essentially a facilitation fee for putting the trade. 

Most banks were okay with the arrangement till a few months ago as the volumes, in some ways, compensated for the small margins from these trades. However, the change in know your client and anti-money laundering norms last year as well as the amendments in tax treaties with Mauritius and Singapore has impacted the volume of trades coming through the p-note route. 

“The real money for these banks is not in these kind of (non-leveraged) trades. It is in issuing access instruments that involves a funding component,” said a senior official familiar with how P-notes work in India. “Such access products are demanded by clients such as hedge funds that have a higher risk taking appetite and who chose to magnify their gains (and losses) through the use of leverage. This is where the bank is able to not only earn the commission or brokerage but also a funding spread,” he said.

Financing is typically given at Libor, which is the base rate, plus an additional margin which varies from client to client. The funding could be for a period as long as the client desires and is agreed upon at the beginning of the contract. The banks would have usual covenants on margin placement, loan to value, etc. 

The share of p-notes as a percentage of overall foreign portfolio investments in Indian markets has declined to under 7% from over 50% about a decade ago.

Not everyone is convinced, however, that the non-financing business will die out completely. “While it is true that FPIs/banks may focus more on the financing or leverage part of the P-note business, they will not entirely give away the non-leverage part as they will still make a small margin by way of brokerage and other fees,” said Suresh Swamy, partner - financial services, PwC India. 

P-notes are issued by registered foreign portfolio investors (FPIs) to overseas investors who want to invest in Indian stock markets without registering directly with the regulator.

Market regulator Securities and Exchange Board of India is reportedly looking at further tightening the norms for p-notes to address concerns raised by the Special Investigation Team (SIT) on black money.