Ajay Shah: Making sense of P-notes

INSIGHT

It is important to fully understand the "over the counter" (OTC) derivatives business and its linkages with exchange-traded derivatives. The foundation is a group of overseas financial firms who stand ready to sell customised derivatives on Indian equities on the OTC market. As an example, a customer might go to one such firm and ask for a Nifty put option with December 2010 expiration. The financial firm would sell him this product.

Each of these financial firms is said to "run a book", which is the portfolio of exposures that have been sold on the OTC market. Some of these exposures are simple "" like a straight exposure to an Indian stock or index. Some of them are complex "" including optionality and other non-linearities.

Sometimes the OTC vendor is lucky, and finds himself with two opposite exposures on his book, which cancel out. After all this cancelling out is done, he is left holding a certain portfolio of exposures. The OTC vendor obviously has no interest in bearing such risk. Hence, he turns to the exchange-traded derivatives market in order to hedge this risk. When there are non-linear products in the book such as options, this requires a dynamic trading strategy where the hedge is an approximation which is continuously adjusted.

All this hedging takes place in India, because there are no other venues in the world where there is exchange-trading of Indian equities. It is important to remember, however, that what we see in India, as transactions on the exchanges, are the transactions caused by hedging the net risk of a book. These transactions are part of a dynamic trading strategy intended to lay off the risk of the OTC book.

This understanding of the OTC equity derivatives business is a little different from the standard perception of PNs. PNs are often seen as mere back-to-back investments on the spot market. What is going on is actually much more subtle. The transactions by the OTC vendor in India are not back-to-back. The transactions in India reflect the requirements of a dynamic hedging strategy based on the net risk on the book that is being run.

Indian exchanges as producing a critical raw material "" liquidity in the equity spot and some equity derivatives. The OTC vendors buy this raw material, and transform it to something even more useful: they make solutions that cater to the exact needs of customers.

These business relationships are healthy and valuable. We should recognise the role for such a healthy interplay between the exchange-traded and OTC markets. Both are needed in a well-functioning financial system: the exchanges for producing high liquidity on standardised products, and the OTC market for doing customisation.

In India, we do not have an OTC equity derivatives market. The substantial size of the offshore OTC equity derivatives market should, ideally, trigger an examination of what holds back the onshore OTC equity derivatives market. We should be trying to bring some of this business to India, to make Mumbai an international financial centre.

The frictions of the FII framework give foreign investors an incentive to use OTC equity derivatives to gain an exposure to India. We should be looking beyond the FII framework so as to eliminate these frictions.

As for the subject of banning or restricting this business, I believe this is fundamentally infeasible. When steel is exported from the country, we do not then control what kinds of ball bearings are made out of it. The foreign buyer of Indian steel is not obligated to tell an Indian regulator what he does with it, or obey the Indian government when it says that steel should not be used to make certain kinds of ball bearings.

In similar fashion, once we have the FII framework, and foreign financial firms are able to obtain exposures on the NSE and BSE for the spot market and for the exchange-traded derivatives, they then use this "raw material" to construct all kinds of innovative products "" ranging from emerging market funds to Nifty put options. This is feasible, desirable and inevitable.

In summary, the policy positions of the Indian state on the subject of offshore derivatives on Indian equities are riddled with problems. We are focused on "PNs" when these are but a small part of a much bigger game. We have an intuition of back-to-back exposures when the reality is a more complex book-running. We demonise this trade, when instead we should see that it is healthy and useful for India that a clutch of global financial firms are offering risk management services connected with India. We think we can ban them. We can't. The right thing for us to do is to (a) replace the FII framework with direct depository accounts for foreigners and (b) build an onshore OTC equity derivatives market.