No more naked derivative exposure for P-note holders; Sebi ban takes effect

Sebi says existing positions need to be liquidated before December 2020 or by the date of maturity

Capital markets regulator the Securities and Exchange Board of India’s (Sebi’s) ban on holders of participatory notes (p-notes), also called offshore derivatives instruments (ODIs), from taking unhedged derivatives has come into effect.

This means p-note holders won’t be able to take naked exposure to the derivatives market anymore. All their existing positions will have to be squared off by the end of 2020 or by the date of maturity of the instrument, whichever is earlier. 

The market regulator has said ODI-issuing foreign portfolio investors (FPIs) will have to provide a certificate that fresh derivatives positions are “only for hedging the equity shares on a one-to-one basis.”

“The ODI-issuing foreign portfolio investors (FPIs) shall not be allowed to issue ODIs with derivative as underlying, with the exception of those… taken by the ODI-issuing FPI for hedging the equity shares held by it, on a one-to-one basis,” Sebi said in a circular late Friday.

“It is clarified that the term ‘hedging of equity shares’ means taking a one-to-one position in only those derivatives which have the same underlying as the equity share,” it further said.

In other words, an investor through p-notes will be able to deal in Infosys’ derivatives contracts only if the investor holds the underlying shares of Infosys. 

Last month, the Sebi board had approved the decision to bar p-notes from the derivatives market to curb speculative trading and also to encourage overseas investors to access the Indian markets through onshore registration. 

According to Sebi data, the notional value of p-note exposure to derivatives was about Rs 40,000 crore in April, down from Rs 54,000 crore in March.

The share of p-notes in the overall FPI investment pie has come down from around 10 per cent a year ago to just six per cent. This is following continuous tightening of the p-note framework by Sebi.

“The ODI issuance has reduced significantly in the recent years. The additional restriction will further impact ODI issuance and thereby market liquidity. This could also possibly lead to export of Indian capital market to other countries. Industry players who were accessing Indian market through ODI route for variety of reasons may now be forced to come to India directly and the number of FPI registration is also likely to go up,” said Suresh Swamy, partner, PwC.

While Sebi on one had has been tightening p-note regulations, it has also been easing the FPI registration norms to facilitate easier entry. 

Sebi had recently floated a discussion paper to further ease of FPI entry norms. 

Meanwhile, some experts said there is small window for p-notes to take unhedged positions.

“A p-note holder will be able to take unhedged derivative position if the issuing FPI has exposure to the stock. This is because the calculation is being done at FPI level and not at individual p-note holder level,” said an industry expert.

For instance, a same FPI has issued p-notes to subscriber A and B. A owns shares of Infosys and B doesn’t. This could potentially enable B to take derivative exposure to Infosys based on A’s underlying holdings.