Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

SEBI Proposal on Participatory Notes

I wrote an article
in the Business Standard today on the Discussion
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

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

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
  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.


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