The Securities and Exchange Board of India has been proved right in the stance it took against P-Notes on derivatives. In July 2017, the regulator had imposed restrictions on P-Notes on equity derivatives that were not issued for hedging. Following this move, the notional value of P-Notes with derivatives as underlying have moved down to ₹3,084 crore towards the end of January 2018.

This is a sharp 95 per cent decline from the outstanding amount of ₹55,779 crore towards the end of January last year.

The clampdown has also managed to pull down the total outstanding P-Notes to over ₹1.19 lakh crore by January, down 32 per cent since January 2017. Surprisingly, foreign portfolio investors have remained positive on Indian equity in this period, with the FPI assets under custody (AUC) increasing to over ₹33.81 lakh crore from over ₹24.56 lakh crore registering 37 per cent increase.

The contraction in outstanding P-Notes, combined with increase in FPI assets has resulted in P-Notes as a percentage of FPI assets under custody halving to 3.5 per cent in January compared to a year ago. It may be recalled that P-Notes accounted for 55 per cent of FPI assets in June 2007. While the share did come down after the restrictions imposed in the fall of 2007, it had hovered between 10 and 20 per cent until January 2016.

 

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P-Notes or offshore derivative instruments, as they are also called, are derivative instruments with Indian equity, equity derivative or debt as underlying. These are issued by FPIs registered in India to overseas investors. The opacity of these instruments makes it relatively easy to hide the identity of the end-user, making them the preferred choice of money launderers. It’s perhaps for this reason that both the RBI and SEBI have been issuing guidelines from time to time to close the loopholes that enables round-tripping through this route.

The ruling and its effect

Last July, SEBI had ruled that FPIs could issue P-Notes only if they were for hedging purpose. P-Notes outstanding that were issued for speculative purpose had to be liquidated by the date of maturity of the P-Note or by December 31, 2020, whichever is earlier. Fresh issuances of P-Notes on derivatives had to be accompanied by a certificate from the compliance officer of the FPI stating that they were issued for hedging purpose only.

SEBI’s suspicion that most of the P-Notes with derivatives as underlying were issued for speculative purpose only, has now been proven right. Data now shows that only 5 per cent of these instruments are being used for hedging. Even in these, it’s possible that some could be speculative trades using equity holding of the FPIs.

SGX impact

While P-Notes on derivatives have evaporated, P-Notes on equity have recorded a lower decline of 22 per cent in the period. It’s possible that the reduction in P-Notes on direct equity could partially be due to trading in Nifty futures on Singapore Stock Exchange gaining traction in 2017.

Also, the higher yield on Indian debt instruments appear to have found favour with overseas investors.

P-Notes on debt as underlying increased 200 per cent to ₹32,194 crore in the one-year period to January 2018.

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