NSE, CFTC talk hedge funds in derivatives

Participation of US hedge funds in domestic single stock derivatives has halted after the p-note ban

India’s biggest bourse, the National Stock Exchange (NSE), is lobbying with the US derivatives market regulator, Commodity Futures Trading Commission (CFTC), to allow greater participation of US-based hedge funds in the domestic derivatives market.

The current rules don’t permit any US hedge fund to invest in futures other than those approved by CFTC. These funds used to take the participatory notes (p-notes) route to trade in Indian single stock futures, as this doesn’t amount to direct exposure. However, the Indian markets regulator, Securities and Exchange Board of India’s (Sebi) decision to ban p-note participants from taking unhedged positions in the futures market has left these funds without any route to trade in Indian single stock futures.

“NSE and Sebi have been trying to get approval from CFTC for Indian single stock futures. The move will help deepen the Indian derivative markets. However, such an approval is subject to some compliance requirements. We are at least hopeful of getting a go-ahead for the top 100 companies listed on the NSE,” said a source.

Market participants say CFTC approval could be a huge advantage for Indian markets, as it would attract more hedge funds. In the past two decades, hedge funds have emerged as a crucial set of investors in developed markets. For instance, the US hedge fund industry held assets worth $3.1 trillion as on January 2017, about one and a half times the total market capitalisation in India. 

Until 2002, single stock futures were banned in the US markets. Subsequently, the US government allowed US-based funds to invest in single stock futures, both domestically and internationally, and the segment was brought under CFTC’s purview. 

In the aftermath of the Lehman crisis, the US government had constituted the Dodd-Frank committee to prescribe curbs on  excessive risks taken by US banks and hedge funds. In line with the recommendations, the US markets regulator, Securities and Exchange Commission, in collaboration with CFTC, brought a new framework of restrictions on the investments made by hedge funds in derivative markets. 

By these rules, there are three categories of derivatives — broader indices, narrow indices and single stock futures. Broader index futures are derivatives of global benchmark indices which have diversified constituents and no single entity has a weightage of more than 20 per cent. The US regulator is very liberal in giving clearances to these products. In fact, both the Nifty and Sensex, the benchmark indices of the two major Indian bourses, have already been approved by CFTC. Narrow index derivatives involve customised products offered for the funds, with the basket consisting of fewer stocks.

Single stock futures essentially are contracts whose underlying security is single scrip. If a US-based fund has to invest in single stock futures, CFTC needs to give a ‘no action’ letter to the stock exchange where these securities are listed. While giving approval, CFTC takes into consideration several parameters, including the settlement system, anti-money laundering laws of that country and overall liquidity in the futures segment of the exchange. 

Sebi has been tightening the framework for p-notes ever since the Supreme Court-appointed Special Investigative Team on undisclosed money had raised concerns that the p-note or Offshore Derivative Instruments route was being misused for money laundering.

In the first series of rule tightening, Sebi had made Know Your Customer 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 prominence of p-notes has come down drastically in the past few years due to various regulatory actions taken by Sebi. A decade ago, p-notes use to account for more than half of foreign portfolio investment (FPI) flows but their contribution to overall flows has come down to single digit. On the other hand, the FPI registrations are in vogue, as the market regulator has significantly simplified the direct participation route,” said Tejesh Chitlangi, partner, IC Legal. 

According to depository participants, the timeline for FPI registration has come down from two months to three or four weeks since the new regime for foreign institutions came into effect in 2015. Under the new regime, Sebi no longer deals with the registration process; custodians have been assigned the responsibility.

LOBBYING FOR GREATER HEDGING

• A team of NSE to meet CFTC officials next week
• CFTC regulates the US derivatives markets along with SEC
• A CFTC approval is mandatory for any derivative product that US hedge funds invest in
• Indian single stock futures are not approved by CFTC, hence US funds cannot directly trade in them
• P-notes used to be the route through which these funds would participate in the single stock futures
• Ever since Sebi banned P-notes from taking naked positions in the Indian futures markets, these funds have been left with no options
• Market participants say CFTC approval could be a huge advantage for Indian markets, as it would attract more hedge funds
• The US hedge fund industry held assets worth $3.1 trillion as of January 2017, about one and a half times the total market capitalisation in India