Curbing speculative flows

Sebi's move against p-notes is timely

The latest proposal by the Securities and Exchange Board of India (Sebi) regarding participatory notes (p-notes) is consistent with its strategy of gradually phasing out this opaque instrument. It is proposed to outlaw the use of p-notes for “naked speculation” in derivatives. Sebi also wishes to levy a fee of $1,000 per p-note on the issuer, thus raising the cost of usage. A p-note may be issued by a foreign portfolio investor (FPI) to one of its clients, which does not wish to be burdened with the hassle of enlisting as an FPI on its own account. The FPI is expected to satisfy stringent know-your-customer norms and record all details of the client before issuing a p-note. About a decade ago, the instrument was very popular and over 50 per cent of all FPI assets used to be held under p-notes. But p-notes had an unsavoury reputation of being used by money-launderers and traders who used it to conceal their identity. However, over time, rules have been tightened to counter their abuse – for example, non-resident Indians (NRIs) are now barred from using them – and as such, barely 6 per cent of FPI assets are now held through p-notes. However, even this meagre percentage amounts to Rs 1.7 lakh crore in absolute terms. About Rs 40,000 crore, or 24 per cent, of this total consists of p-notes issued against derivative positions. The proposal to charge a fee will cause minor friction. 

P-note clients typically deal in portfolios worth eight figures (in US dollars) or more. Hence, FPIs will easily pass on the additional charges. However, the attempt to stop “naked speculation” is awkward and does not, at first glance, appear easy to implement. When an FPI takes a derivative position on a p-note holder’s behalf, it will have to check if the note-holder owns an underlying asset. Positions without underlying assets – “naked speculation” – will not be allowed anymore and any such existing positions must be phased out by December 2020. If, however, the p-note holder does own requisite underlying assets, the FPI will then have to check if the proposed derivatives position is a hedge that guards against some risk to an underlying asset. But, in practice, it is extremely complicated and unwieldy to ascertain this, especially in real time. It may also be hard to ascertain if a combination of multiple derivatives positions is being held as a hedge, or for arbitrage, or as purely speculative transactions.

This also begs the question as to why the regulator should discourage speculation, or care if a transaction is speculative, so long as sufficient margin is deposited to cover the trade. Speculators generate volumes and the more the volume, the lower the transaction costs and the easier it is to actually hedge if some entity so desires. However, if this “anti-speculation” proposal goes through, it will interfere with the multi-layered transactions that some p-note holders do carry out across markets. Presumably, this will coerce note-holders to move to apply for an FPI clearance allowing them to continue untrammelled derivatives trades. The intention is clear enough and the financial services industry has braced itself for such a move. It is praiseworthy that Sebi has allowed positions to be unwound in an orderly manner, thus avoiding a sudden liquidity crisis. This move will plug one obvious route for money-laundering and round-tripping.