Curbs on p-notes shut door on several hedge funds
Legal experts say local rules prevent global hedge funds from taking direct exposure to single-stock derivatives
The Securities and Exchange Board of India’s (Sebi’s) move to prohibit participatory note (p-note) subscribers from taking unhedged positions in the derivatives market has virtually shut the door on several global hedge funds.
Tax experts say numerous jurisdictions including the US, Germany, and France don’t allow their local funds to invest directly in Indian single-stock derivatives. A majority of p-note participants who unwound their derivative positions after the Sebi circular last month are unlikely to come back to the Indian markets.
While nothing stops them from direct registrations, their local rules won’t allow them to deal in single-stock derivatives, preventing them from rebuilding their portfolios. Experts peg their India exposure at ~30,000 crore.
“Since stock futures and index futures (other than the Nifty and Sensex) are not approved by the US regulators, US-based funds may not be able to invest even if they are registered as foreign portfolio investors (FPIs) in India. Investment flows may therefore be diverted to other countries,” said Suresh Swamy, Partner, Financial Services, PwC.
Until now p-notes used to be a convenient route for these funds to overcome this regulatory hurdle as the route doesn’t compel them to take a direct exposure. Instead, the exposure is taken by a bank or custodian, who, in turn, offers contracts to these funds.
According to sources, the Sebi circular has put a host of active hedge funds operating through the offshore derivative instrument (ODI) route in a tricky position. Among the worst-hit are US-based funds, which account for a major share of ODI subscribers, experts say.
The US Commodity Futures Trading Commission (CFTC) is the regulator of this. Although the CFTC allows US-based hedge funds to trade in index futures like the Nifty and Sensex, they don’t allow a direct exposure to single-stocks futures traded on the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE).
The development is significant because these investors are crucial for the liquidity in the futures market despite their small size.
“The decision could adversely impact the liquidity of the futures market as turnovers could dip in the range of 10-15 per cent and we could lose out 1,000 to 2,000 investors. We are in touch with various regulators including the US Securities and Exchange Commission and FMA (German regulator) to find a solution. However, the process will take time,” said a custodian.
The new rules are part of Sebi’s efforts to curb the misuse of p-notes for money laundering. Sebi also aims to reduce speculative trading in the market through this move. In the circular, the regulator decided to levy an additional fee of $1,000 on each p-note subscriber.
“There is no longer a compliance or cost advantage for investors who chose to come through p-notes. This encourages foreign investors to opt for direct participation. Some of the tightening measures could have a short-term impact on the market. However, from a long-term perspective I think foreign investors will continue to show an interest in the Indian market,” said Siddharth Shah, partner, Khaitan & Co.
Sebi has been tightening the framework for p-notes ever since the Supreme Courtappointed Special Investigative Team (SIT) on undisclosed money had raised concerns that the ODI route was being misused for money laundering.
In the first series of regulation tightening, Sebi had made Know Your Customer (KYC) norms for p-note subscribers stringent in 2016. Sebi issued curbs on transferability, and prescribed more stringent reporting for p-note issuers and holders. It also mandated issuers to follow Indian antimoney laundering laws, instead of the norms in the jurisdiction of the end-beneficial owner.