SEBI Proposal on Participatory Notes

I wrote an article in the Business Standard today on the Discussion Paper put out by the Securities and Exchange Board of India (SEBI) proposing to limit the issuance of Offshore Derivative Instruments (participatory notes) by Foreign Institutional Investors (FIIs) in India.

This discussion paper produced a wide range of commentary in the financial press. An excellent summary of this discussion has been put together by Ajay Shah in his blog. The key points that emerge from this analysis are:

• India allows only registered foreign institutional investors (FIIs) to invest in the Indian market.
• Many foreign investors do not register as FIIs because they are not eligible to register or because they do not wish to pay the registration fees or because they do not want to go through the paper work involved.
• These investors who have not registered as FIIs seek to invest in India through derivative instruments (participatory notes) that reference Indian securities. These participatory notes are issued outside India by registered FIIs who hedge them in the Indian market to which they have access.
• India should move away from the FII framework to a regime of direct access to various classes of foreign investors
• India should also simultaneously develop an onshore over-the-counter (OTC) equity derivative market.
• If we do all this much of the participatory note market would die a natural death.

My Business Standard article did not dwell much on any of these but focused on some of the details of the SEBI proposal.

SEBI’s first proposal is to ban participatory notes that have a derivative as the underlying. This is a very confusing statement. The intention appears to be to ensure that a participatory note is backed by a cash market position and not a derivative position. If this is what SEBI indeed wishes to do, it should explicitly ban the use of derivatives to hedge participatory notes.

SEBI should recognize that the term “underlying” is a technical term with a well defined meaning in the world of finance. The underlying of a participatory note is the instrument from which the participatory note derives its value; it is the instrument which is delivered on settlement of the participatory note or with reference to whose price the participatory note is cash settled. The “underlying” in this technical sense has nothing to do with the portfolio that the FII uses to hedge the participatory note. A participatory note that is cash settled using the Nifty index futures price has the future as the underlying even if the FII hedges it using cash equities. Similarly, if the participatory note is cash settled using the cash price of the Nifty index, its underlying is the cash index and not the index future even if the FII hedges the note using index futures.

A financial regulator should respect the semantic integrity of well defined technical terms and not abuse the term “underlying” to mean what it does not and cannot mean. In this context, the use of the word “against” before the word “underlying” in regulation 15A of the FII regulation is also unfortunate as that word is perhaps the source of this confusion.

Enough of semantics. I now turn to the substance of the proposal. If SEBI bans the use of derivatives to hedge participatory notes, it would have three implications.

1. Since cash equities are less liquid than the futures, the hedging costs would increase. The increase would be even greater if the underlying is an index where hedging using the constituent shares is far more difficult than using the index future. If the participatory note contains some option-like features (non linear payoffs), the hedging risks could also increase as the volatility risk of options cannot be hedged using only the cash market. The FII would therefore have to charge a wider spread to its clients. OTC derivatives tend to be carry large spreads anyway (annualized costs of 4% to 8% of the notional principal are not uncommon). A mere increase in transaction costs would not probably kill the participatory note market.
2. SEBI’s proposal would prevent participatory notes that involve a short position in Indian equities (for example by a long-short hedge fund) since short selling is not feasible in the cash market today. Since short selling is essential for a well functioning market, this is clearly an undesirable consequence of the SEBI proposal.
3. SEBI’s proposal would also prevent issuance of participatory notes that are essentially synthetic rupee money market instruments because these synthetics can be created only by offsetting positions in cash and futures markets. It is doubtful whether any significant amount of participatory notes are of this kind.

The second major proposal of SEBI is to ban participatory notes issued by sub accounts of FIIs. In my view, this is largely an administrative measure which would not have a significant long run impact. An FII which is active enough to issue participatory notes should be willing to register as a full fledged FII.

SEBI’s third proposal is to limit participatory notes issuance by any FII to 40% of the assets under custody of that FII. Today, issuance of participatory notes is concentrated in the hands of a few FIIs. This is a very natural phenomenon. Running a derivative hedge book is a very complex activity and those with superior skills in doing this will get more business because of their lower costs and their ability to offer a wider range of products. There are also significant economies of scale in running a derivatives book because if an FII sells a long position to one offshore client and a short position to another offshore client, it needs to hedge only the net position in the Indian market. When the efficient hedgers have exhausted their 40% limits, buyers of participatory notes would have to buy from less efficient hedgers who have not reached the 40% limit. This would increase the costs and would amount to more “sand in the wheels” whose long term impact would be modest.

I also believe that the 40% limit can be circumvented by an FII buying cash equities and selling stock futures or index futures. This synthetic rupee money market position would not increase the FII’s exposure to the Indian equity market but it would increase assets under custody and allow the FII to issue more participatory notes. In the context of a strong rupee and a positive interest rate differential, this synthetic money market position may also be a profitable low risk investment for the FII. It would indeed be a delicious irony if a proposal designed partly to reduce capital inflows leads to more capital inflows.

Posted at 6:19 pm IST on Fri, 19 Oct 2007         permanent link

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