Sebi may extend deadline for unwinding of P-notes

The Securities and Exchange Board of India (Sebi) is expected to review the restrictions on participatory notes (P-notes) at its board meeting tomorrow. Market players feel the regulator, which had curbed the issuance of P-notes in October last year, may bring in two key changes in the guidelines.

The first is an extension of the period for unwinding of P-notes in the derivatives segment from 18 months to 24 months and the second, an increase in the cap on issuance of P-notes in the spot segment from 40 per cent to 45 per cent.

While putting restrictions on P-note issuances by registered foreign institutional investors (FIIs), Sebi had asked FIIs to unwind their entire positions in the derivative segment within 18 months.

It also said that P-notes issued in the spot market cannot be more than 40 per cent of the total assets under custody (AUC) of FIIs.

However, analysts said the 18-month window is too short, given the fact that since August last year, only 30-40 per cent of such unwinding has happened in the derivative segment. The notional value of the total P-notes outstanding was Rs 3,53,484 crore (51.6 per cent of the total AUC of FIIs registered with Sebi) in August 2007.

The value of outstanding P-notes with underlying as derivatives was Rs 1,17,071 crore. The big five FIIs — Morgan Stanley, Merrill Lynch Capital Markets Espana, Citigroup Global Markets, Goldman Sachs and CLSA Merchant Bankers — accounted for 60 per cent of P-notes issued in India.

P-notes are derivative products with shares or derivatives as underlying, issued by FIIs to overseas clients who cannot invest directly in India.

While the rapid fall in the share prices may have been the reason for the slow speed of unwinding, market players said the share prices would have fallen much more if FIIs adhered to the Sebi-prescribed deadline.

Apart from transparency concerns, P-notes were also restricted in a bid to moderate capital inflows that were booming at the time. That is no longer a problem. Compared with the last calendar year’s net inflows of $17 billion, 2008 has seen net capital outflows of $6.4 billion so far. Given that reversal, FIIs had asked the finance ministry to consider easing the restrictions, which had adversely affected their investments into India.

Sanju Verma, executive director and head (institutional business), HDFC Securities, said market players would be happy if Sebi relaxes the cap imposed on FIIs issuing P-notes considering the drastic change in the scenario. When the curbs were imposed, there was a huge concern about FII inflows and a sharp appreciation of the rupee. “The condition now is such that one needs to bring back the FIIs,” Verma said.

Raamdeo Agrawal, joint managing director at Motilal Oswal Financial Services, said the government had tightened the policies regarding inflow of foreign funds last year due to concerns over huge capital inflows. The situation has changed drastically and we would be happy with whatever relaxation comes at the Sebi board meeting tomorrow, he said.

Over- the-counter (OTC) lending by FIIs too has been a matter of concern for the markets of late. OTC lending is when P-note holders lend their shares to a third party who then uses it to short the domestic markets.

According to a senior executive at a large institutional brokerage, out of the total FII selling of over $7 billion in the domestic stock markets since January 2008, nearly $3-4 billion could be mere lending of shares, which were used for shorting the markets. The benchmark indices have witnessed a fall of over 30 per cent during this year.

A section of the market said Sebi may clamp down on this OTC lending.

But Verma said this may not be necessary as the activities in OTC lending may slow down on its own as not many may have the courage to drastically short the Indian markets at these levels.