How to phase out participatory notes

The Securities and Exchange Board of India’s war against participatory notes (p-notes) also called offshore derivative instruments, seems an endless one. While the enemy was a giant threatening to destroy the country’s capital markets earlier, it has shrunk to a very tiny size now. Despite this, the regulator is continuing to be troubled by it.

Why else would another discussion paper be released to propose more tweaks to p-note regulations? The proposals — to stop issuing p-notes with derivatives as underlying that are not for hedging purpose by December 2020 and to levy a fee of on foreign investors issuing p-notes — is unlikely to affect those misusing the route.

The regulator has to first decide which aspect of p-notes is of concern — that these instruments are being used by money launderers or that short-term speculative traders from overseas can cause volatility in markets using this route.

If it is the former, SEBI can bite the bullet and stop fresh issuances of these instruments altogether. Despite all the controls, there will be loop-holes that will be exploited for round-tripping. If the regulator is worried about hot money causing volatility, then there isn’t much that can be done. For foreign fund flows will be erratic and volatility is on par for the course for markets.

If the regulator decides to stop issuances of p-notes altogether, there is a sequence. First p-notes on debt should be stopped, followed by p-notes on equity and then p-notes on derivatives.

P-notes are derivative instruments issued by foreign portfolio investors registered with SEBI, to overseas investors who wish to buy Indian equity and debt instruments without going through the rigmarole of registering with the Indian regulator. It was primarily targeted at foreign funds that have a short-term investment horizon and prefer to move their funds in and out of a country rather quickly.

But the instrument initially had many flaws, including limited disclosure about the beneficial owner of the p-note. Further onward issuances of these instruments also made the trail complicated. These features made p-notes a popular channel for round-tripping funds.

The issue moved in to the limelight in 2007 when excessive issuances of p-notes with derivatives as underlying had made SEBI prohibit fresh issuances of them. P-notes accounted for almost 56 per cent of FII assets in June 2007. But regulatory scrutiny combined with a slew of order issued by SEBI since then on improving disclosure and restricting the entities who could subscribe to these instruments has made their in FPI assets shrink to just 6 per cent by April 2017.

The latest salvo fired by the regulator against p-note holders, laying down that a fee of $1,000 is to be paid by foreign portfolio investors issuing p-notes every three years for each overseas client who buys these instruments through them is unlikely to stop issuances. One, the fee is not large enough, considering it is for three years. Two, money laundering can be done more easily through a single issuer, if the issuer and subscriber work hand in glove.

The second proposal — to allow fresh issuances of p-notes only if they are bought for hedging and to wind up all outstanding p-notes on derivatives issued for speculative purposes — will bring issuances of p-notes on derivatives to a halt. It is unlikely that these instruments are used for hedging purpose.

If the regulator decides to close the p-note channel altogether, it is best to start with stopping p-notes on debt. Unlike equity, the limit allowed to FPIs to invest in debt instruments, particularly government securities, is much lower.

Of the total G-Secs issued, FPIs held just 3.65 per cent towards the end of 2016. The Centre and the RBI have been wary about allowing foreign investors to hold Indian government debt due to the destabilising effect of fund outflows on currency. So, allowing speculative traders from overseas to hold Indian debt through p-notes does not really make sense.

The risk is highlighted when we look at numbers. P-notes on debt soared in April and May 2013 when the rupee started weakening. Outstanding p-notes, however, fell after November 2013 when the rupee stabilised following the measures taken by Raghuram Rajan.

The second category that the regulator can target is p-notes drawn on equity. Value of these towards the end of April 2017 was ₹109,541 crore; 85 per cent of all p-note issuances. But if we consider the share of these p-notes in free-float market capitalisation of Indian equity market, it is just 2 per cent. While there could be turbulence for a short period as these instruments are wound up, the long-term impact is likely to be immaterial.

Another reason why p-notes on equity ought to be targeted by regulators is because these are more likely to be used for round-tripping when compared to p-notes on derivatives as sums that can be transferred in to the country will be larger here. Also, genuine users of p-notes, such as hedge funds, are less likely to use p-notes on equity.

It is suggested that the regulator should turn its sights on p-notes on derivatives last. According to SEBI, ₹40,165 crore of p-notes on derivative instruments was outstanding towards the end of April 2017. This accounts for roughly 16 per cent of the outstanding derivative positions on the National Stock Exchange. Clamping down on this section will therefore impact liquidity on the exchange.

If we look at the outstanding p-notes on derivatives since January 2012, it is seen that the outstanding value of these instruments tends to increase when there is a global stock market sell-off. In October and November 2012, when the euro zone crisis increased global risk-off sentiment, outstanding p-notes on derivatives rose above ₹80,000 crore. In mid-2015 too, when the yuan devaluation caused a global turmoil, the value outstanding moved above ₹60,000 crore.

So, it is obvious that there are authentic global short-term investors that are using these instruments to trade in Indian markets during such events. The regulator needs to take a call whether we need these investment flows or not. If foreign investors based in India are allowed to trade in Indian equity markets during such phases, there is no reason why foreign investors based outside India should be stopped.

Banning p-notes on derivatives is not likely to halt round-tripping either, since p-notes with equity and debt are likely to be preferred by those wanting to launder money.