To be or not to be

The Securities and Exchange Board of India has taken the right decision in clamping down on participatory notes with derivatives as the underlying basis. The reaction of the market to the move could have suggested the manner in which p-notes on equities and debt could be unwound in future. The regulator’s order, issued last July, to unwind all p-notes linked to equity derivatives that were not issued for hedging, led to a 95 per cent drop in such positions since January 2017. However this unwinding had scant effect on the equity derivative section in Indian markets; the value of monthly turnover in February 2018 was 40 per cent higher compared to June 2017. Stock prices were also largely unaffected with the Nifty recording fresh life-time highs early this calendar.

Clearly, participatory notes do not wield any influence on stock prices or trading in equity markets anymore. In 2007, when the spotlight was first turned on these instruments, more than 50 per cent of foreign portfolio money was channelled through this route. There had been a broad-based sell-off in the stock market when SEBI imposed restrictions on p-note issuances then. The opaque nature of these instruments that enabled the end users to remain hidden, had led to their rampant misuse by money-launderers prior to 2007. SEBI has, since then, tightened disclosure requirements and imposed restrictions on the entities to whom these instruments can be issued. The share of p-notes in FPI assets has fallen significantly as a result of this tightening. The value of p-notes as a proportion of FPI assets was 3.4 per cent in January 2018, a sharp decline from 7.1 per cent a year ago and 16.5 per cent in January 2011. The value of p-notes outstanding on stocks is currently ₹84,278 crore, accounting for just 3 per cent of total FPI holding in equity. Similarly, p-notes account for around 7 per cent of FPI holding in Indian debt (₹32,194 crore,).

The dwindling share combined with the smooth unwinding of p-notes on derivatives imply that the regulator can move ahead with a total ban on p-note issuances in India. If the RBI is still worried about money-laundering through this route, closing this channel could help. The move to ease compliance requirements for foreign portfolio investors, coupled with the rapid growth of offshore exchanges in the Indian International Financial Service Centre at GIFT City, will eventually make the p-note route redundant anyway. The question is, should p-note issuances be stopped entirely? There are genuine overseas investors, especially in debt, who use p-notes due to the ease in transacting. The regulator needs to weigh the consequences carefully and arrive at a decision that does not hurt investors, but discourages black money creation. The final decision needs to be communicated clearly to market participants and the regulator should avoid future tinkering with these rules. Foreign investors prefer jurisdictions where regulatory uncertainty is minimal.

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