P-note short-selling at 3-year high

FIIs’ exposure to Indian markets at over Rs 9.79 lakh crore in September and Rs 10.25 lakh crore in October.

The use of participatory notes in equity markets is at a three-year high. Foreign funds are extensively using these offshore derivatives instruments for short-selling, say market players.

According to the data from the Securities and Exchange Board of India (Sebi), the share of P-note positions of FIIs against their overall debt, equity exposure, including equity derivative segment, stood at 17.9 per cent in September and 17.6 per cent in October this year. The FII exposure to Indian markets stood at over Rs 9.79 lakh crore (close to $ 210 billion) in September and Rs 10.25 lakh crore (close to $ 219 billion) in October, which is the latest data available on Sebi website.

Accordingly, FIIs’ exposure to equity derivatives segment stood at over Rs 59,000 crore and Rs 63,000 crore in September and October, respectively. Market players say a large portion of these positions is on the short side, which has seen a sharp increase in July. Between July and November, the BSE benchmark index, Sensex, fell over 11 per cent on a closing basis and intra-day movements in stock prices were even more erratic. Also, stocks in the mid- and small-cap derivatives segments have seen a stupendous fall.

Further evidence of short-selling through P-notes can be seen in the market fall of May this year. In May, derivatives expiry series, both Sensex and Nifty, fell 6.5 per cent. During this month, FIIs took positions worth Rs 3,000 crore in equity derivatives. Overall, in debt and equities, the FII position rose by 4.5 percentage points during the month from 15 per cent to 19.5 per cent. (Taking positions)

“Large funds are short-selling through P-notes, as they cannot offload their position in the cash market. There is not enough depth. Almost all hedge funds are using P-notes to short-sell, this saves them a lot of additional costs, like the currency hedging cost,” said a dealer with a foreign brokerage who did not want to be named due to compliance issues.

Sebi publishes combined data for debt and equity segment in a column, while the combined data for the same, including derivatives, is published in a separate column on its website. One can calculate the FII exposure to equity derivatives through P-notes by subtracting FII positions in debt and equity from the other column. India has no derivatives market for debt securities which permit P-note positions. Also, the exchange-traded bond market is not so liquid, so positions including derivatives can only be in the equity segment.

P-notes are ‘hot money’ instruments used by traders who do not wish to bring money directly into India. Such high P-note exposure to equity derivatives market, at a time when the volumes in the domestic markets are extremely thin, is alarming. Market players say that the current situation is somewhat similar to October 2008, when short-selling through P-notes peaked, with US investment bank Lehman Brothers filing for bankruptcy, leading to a global freeze in lending and borrowing activities of banks. The domino effect of this also hurt global trade. Then, Sensex and Nifty had crashed by nearly 30 per cent in a single derivative expiry cycle.

After the Lehman fall, Sebi had warned FIIs against the use of P-notes to short-sell Indian stocks overseas. The then Sebi chairman C B Bhave and Finance Minister P Chidambaram had expressed the view that short-selling of FIIs, if at all, should be done onshore — and not offshore. Though no formal ban was imposed on such short-selling, FIIs were compelled to furnish regular data of their P-note leading and short-selling activity. Short-selling of P-notes happens through overseas lending and borrowing activity. This may not be illegal but disturbs the stock market equilibrium. Currently, no domestic institution or portfolio manager is allowed to indulge in short-selling in the cash segment of the market.

The use of P-notes was at its peak in 2007, when FII positions reached 60 per cent of their total investments in the country.

Short sales refer to the sale of shares investors do not own. They are usually “borrowed” from other entities and bought back later. Investors selling short believe the stock price would fall. Experts say physical settlement of equity derivatives segment will go a long way in bringing positive structural changes in the market. Short-sellers in India are exploiting the cash-settled derivatives market. That is a reason why domestic market players are extremely worried.