Sebi p-note curbs shut India door on several hedge fund

Experts say rules prevent global hedge funds from taking direct exposure to single stock derivatives

The market regulator Securities and Exchange Board of India's (Sebi's) move to ban participatory note (p-note) subscribers from taking unhedged positions in the derivatives market has virtually shut the door on several global hedge funds.

Tax experts say numerous jurisdictions, including US, Germany and France do not allow their local funds to invest directly in Indian single-stock derivatives. The majority of the p-note participants, who unwounded their derivative positions post the Sebi circular last month are unlikely to come back to the Indian markets.

While nothing stops them from direct registrations, their local rules won't allow them to deal single-stock derivatives, preventing them from rebuilding their portfolios. Experts peg their India exposure at Rs 30,000 crore.

"Since stock futures and index futures (other than Nifty and Sensex) are not approved by the US regulators. US based funds may not be able to invest even if they are registered as an FPI in India. Investment flows may, therefore, be diverted to other countries" said Suresh Swamy, Partner, Financial Services, PwC.

Until now p-notes used to be a convenient route for these funds to overcome this regulatory hurdle as the route doesn't involve them subscribers from taking the direct exposure. Instead, the exposure is taken by a bank or custodian who in turn offers contracts to these funds.

According to sources, the Sebi circular has put a host of active hedge funds operating through the offshore derivative instrument (ODI) route in a tricky position.

Among the worst-hit are US-based funds, who account for lion's share of ODI subscribers, experts say. US Commodity Futures Trading Commission (CFTC) is the concerned regulator for this particular subject. Although CFTC allows US-based hedge funds to trade in index futures like Nifty and Sensex, they don't allow direct exposure to single-stocks futures traded on the NSE and BSE.

The development also assumes significance from the overall market perspective as these investors are crucial for the liquidity in the futures market despite their smaller size.

"The decision could adversely impact the liquidity of the futures market as turnovers could dip in the range of 10-15 per cent and we could lose out 1, 000 to 2, 000 investors. We are in touch with various regulators including the US SEC and FMA (German regulator) to find a solution. However, the process will take time," said a custodian.

The new rules are a part of Sebi's effort to curb the misuse of p-notes for money laundering. Sebi also aims to reduce the speculative trading in the market through this move. In the circular, Sebi also decided to levy additional fees of $1,000 for each p-note subscriber.

"There is no longer a compliance or cost advantage for investors who chose to come through p-notes. This encourages the foreign investors to opt for direct participation. Some of the tightening measures could have a short-term impact on the market. However, from a long term perspective I think foreign investors will continue to show interest in the Indian market," said Siddharth Shah, partner, Khaitan & Co.

Sebi has been tightening the framework for p-notes ever since the Supreme Court-appointed Special Investigative Team (SIT) on undisclosed money had raised concerns 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 has diminished drastically in the last decade. 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.

Not a ‘note-able’ future

* Sebi released a circular in July banning p-notes subscribers from taking derivative positions in Indian markets for any purposes other than hedging
 

* The idea was to promote direct participation and curb speculative trading
 

* However, a majority of the p-notes subscribers will not be able to trade in single stock futures even if they register directly

* Domestic laws in countries such as the US, France and Germany don't permit their funds to directly own single stock futures in the Indian markets
 

* Experts peg the India derivatives exposure of these funds at around Rs 30,000 crore