Comment. SEBI moves a step closer to banning P-Notes

The stock market regulator, the Securities and Exchange Board of India, has been gradually strengthening the regulations governing P-Notes (participatory notes) over the last few years. The latest measure regarding P-Note on derivatives will help shrink the issuances of these instruments drastically, taking the country closer towards the goal of completely closing this channel.

SEBI had issued a discussion paper in May in which it had laid down two ways in which the P-Note regulations could be tightened. One, it had proposed a regulatory fee of $1,000 for each P-Note subscriber, to be collected once every three years from FPIs who issue P-Notes. The second measure proposed was to phase out P-Notes on derivatives that were issued for speculative purpose. The SEBI board has accepted both these proposals.

SEBI’s war against P-Notes has been a long-drawn one. These are derivative instruments issued by foreign portfolio investors registered with SEBI, to overseas investors who wish to buy Indian equity and debt instruments without registering with the Indian regulator. The opacity offered by these instruments, wherein the final beneficial owner of the instrument can remain hidden, had led to the misuse of these instruments by money launderers. There was also fear that hedge funds located overseas could cause volatility in the market by moving funds out of the market at short notice, using p-notes.

However, SEBI has been tightening the screws over the last few years, with the result that share of P-Notes as a proportion of FPI’s assets under management had fallen to just 6 per cent currently from over 50 per cent in 2007.

Towards the end of April 2017, P-Notes issued against derivatives were valued at ₹40,165 crore, accounting for 24 per cent of outstanding P-Notes on that date.

SEBI has now laid out that fresh P-Notes on derivatives should be issued only if they are bought for hedging purpose. In other words, the P-Note subscriber has to prove that he holds the underlying stock, in order to buy the P-Note on derivative. The P–Notes on derivative that are currently outstanding (and issued for speculative purpose) have to be extinguished by the end of 2020.

This move is likely to throttle P-Note issuances on derivatives. It is quite unlikely that any overseas investor is trying to hedge the position he has in the spot market through these instruments. Almost the entire outstanding amount is likely to be speculative. Overseas investors such as hedge funds are likely to be using these instruments to take leveraged bets on Indian equity market. The positive is that overall P-Notes outstanding could reduce by at least 25 per cent over the medium-term.

The flip-side to this is that P-Notes account for 16 per cent of the volume in the equity derivative volume on the NSE. Curbing these instruments will impact liquidity in this segment. Also empirical data suggests that P-Notes on derivatives are being used by genuine foreign investors who prefer to use the instruments for the speed and easier compliance requirements. SEBI might not be doing right in shutting the door for these investors.

It would not be right to argue that the move will curb round-tripping since money launderers are more likely to use P-Notes drawn on equity, as they can transfer larger sums with these instruments.

The levy of $1,000 for each subscriber, every three years, is unlikely to be effective as it is too small to be a deterrent as it translates in to just ₹21,000 or so every year, per subscriber. In the discussion paper, SEBI had stated that the regulator incurs a large expenditure on manpower and on IT infrastructure in scrutinising the P-Note data. The fee could help cover some of the expenses borne by the regulator.

But the claim of the regulator that the fee will discourage the P-Note subscribers from taking this route and encourage them to directly take registration as an FPI is unlikely to materialise.

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