India steers offshore investors away from P-notes towards direct market access

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The implementation of a new foreign investment framework by the Securities and Exchange Board of India (Sebi) will encourage overseas institutional investors to enter the Indian market directly by registering with designated depository participants rather than investing via offshore derivative instruments or participatory notes (P-notes), say observers.

P-note use in India has been declining since its peak in 2007 as a result of increased regulatory scrutiny. In 2007, P-note issuance accounted for roughly 50% ($77 billion) of all foreign institutional investment into India but this has fallen to approximately 11% ($26.7 billion) at the end of 2013.

This is set to decrease further following the issuance of new foreign portfolio investment regulations by Sebi on January 7 which tightened the rules of entities allowed to issue P-notes as the regulator seeks to limit the flow of unregulated offshore investment into India.

The new regulations replace existing Sebi regulations for foreign institutional investors (FIIs) with a new class of investor known as a foreign portfolio investor (FPI), comprising all FIIs, their sub-accounts and qualified foreign investors (QFIs). Under the new norms, FPIs have been divided into three categories as per their risk profile.

Sovereign wealth funds and other government entities which invest on behalf of a foreign country's central bank are classified as low risk and as Category I investors. Category II includes regulated entities such as foreign-based mutual funds supervised by other nations' regulatory agencies. Those that do not fall into the first two categories, such as unregulated hedge funds, are included in Category III.

Vasudha Sundararaman, chief executive of the custodial arm of the State Bank of India, SBI-SG Global Securities Services, says the new regime will encourage existing P-note participants to enter the Indian market directly through custodians and in a cost-efficient way.

"As of now, P-note holders have to pay approximately 2-2.5% of their assets for participating in the Indian market. In the new regime, where such entities can enter directly as FPIs and transact in the Indian market, they will need to pay a flat fee of $3,000 if they enter under Category II and $300 if under Category III every three years for registration in addition to any transaction costs. Thus this is a much cheaper option for investors and it is likely P-note issuance and subscription will reduce over time," she says.

Designated depository participants or custodians will also be responsible for the registration of foreign investors under the new rules, a process which could have taken up to six months under Sebi.

"The new FPI regime will speed up the approval process for foreign investors to gain access to the local cash segment of the market and will allow participants to enter the Indian market through a number of approved depositories, rather than all participants applying directly to Sebi. This will result in a more efficient application process whereas previously under the FII/sub-account regime it could have taken a few months," says Jean-Paul Linschoten, director, prime service sales at HSBC in Hong Kong.

In addition to encouraging direct market access, the regulator has also imposed new restrictions that limit the ability of certain entities to access the Indian market via P-notes.

"Category II funds that are regulated can continue to issue P-notes notes but if you are an unregulated entity in your home country then you are barred from issuing overseas derivative instruments," says Naresh Makhijani, partner at KPMG in Mumbai.

Kishore Joshi, senior associate at law firm Nishith Desai Associates, says the intent of the new regulations is for Sebi to have a degree of control over foreign investors by making sure that issuance of P-notes is through an appropriately regulated entity.

"Because P-notes are not directly governed by Indian regulators including Sebi as they are offshore instruments, the intent is to make foreign investors invest directly into India by registering as FPIs, instead of coming through the P-note route. Sebi has allowed only regulated entities to issue or subscribe to P-notes, ensuring that such entities can be easily reached through foreign regulators," he says.

This will have a significant impact on hedge fund investment into India, as the majority of hedge fund accounts are unregulated entities, says the head of compliance at a European bank in Mumbai.

"Typically it will affect the hedge funds because what we have seen is that the fund manager is regulated, but the fund itself is not as the funds don't get registered or regulated anywhere as it is privately held money. Whereas in a typical mutual fund you have both the fund manager and the fund regulated. Unfortunately the bulk of the ODI [overseas direct investment] market is made up of the hedge funds having such fund structures so this could potentially lead to a 50% decline in hedge fund investment in P-notes," he says.

However, according to the head of compliance it may be difficult for dealers to quantify the exact number of funds affected.

"Previously unregulated funds were allowed to issue P-notes as long as the fund manager was regulated so this was not an issue. We think that 40-50% of clients may find it difficult to continue as they won't be able to book trades in that particular account or fund name because it is not regulated. We can't put an exact number on it simply because some of these funds are in the Cayman Islands and Mauritius and the type of certificate they hold may actually enable them to be classified as regulated but no one has done any research on this," he says.

However, as the new rules have not yet been ratified by the Reserve Bank of India (RBI), market participants say that the regulator has been made aware of this issue, with dealers hopeful that Sebi will reverse its decision to prohibit the issuance and subscription of P-notes by unregulated offshore funds.

"Investor associations have gone back to Sebi and identified this issue of unregulated funds, Sebi has understood the problem and that there was a slip-up between what has actually been drafted and the original recommendations and there is a high probability of Sebi coming back with further clarification," says one local dealer.

"While these regulations have been released by Sebi, they are not technically active as you need the other regulators such as the RBI to actually bless them and make similar provisions in the foreign exchange rules as the foreign investor regime is governed by two regulators. Until the RBI comes out with those clarifications these regulations will technically remain on paper as it is and there is a bit of time between now and the RBI clarification where these issues can be rectified," he adds.

What are P-notes?

Participatory notes, or P-notes, are offshore derivative instruments used by foreign investors such as high-net worth individuals, hedge funds and other foreign institutions to invest in Indian markets without the need to register with Securities and Exchange Board of India (Sebi). Equities, fixed income and derivatives may be used as the underlying assets which are issued by brokers and foreign institutional investors registered with Sebi.

 

Asia market access for offshore investors

Within Asia, swaps and P-notes have traditionally been used by foreign investors to access emerging and frontier markets due to operational ease in settlement, custody and regulatory reporting and filing. Over the past decade, China and India have been the most prevalent markets for P-note use, say market participants.

According to the head of equity structuring at a US investment bank in Hong Kong, the market demand for access to China via P-notes is still strong due to capital controls limiting the flow of offshore money.

"The demand has not slowed for China as P-notes are still the primary tool used by overseas investors to access the market. Although the establishment of the QFII and RQFII schemes has opened the market up somewhat, the quota is still held by a limited number of market participants. P-notes, therefore, still offer a cheap and effective way to access China," he says.

However, with certain regulators within Asia looking to reduce P-note use, he cautions that proper documentation within the P-note contracts is needed in the event that a regulator decides to clamp down on P-notes.

"While the main risk is the market risk on the underlying exposure, there is also a risk that a change in regulations or stock exchange rules will mean that P-notes are no longer viable in that market. Therefore, for market access products we make sure that we include in our documentation details of how the product will be wound up or resolved in the event of access termination or a trigger event," he says.

Although P-notes have experienced a decline in some markets following the financial crisis due to concerns over the counterparty credit risk of the issuing brokers, Jean-Paul Linschoten, director, prime service sales at HSBC in Hong Kong, says the notes still have a role to play in Asia.

"As more frontier markets start to come online, P-notes are a quick and efficient means to gain exposure to these markets. While the local regulators in all instances would encourage funds to register in the local market they are cognisant of the fact that it may not be economical for these funds to do so. For example many of the regional funds may have small exposures to various markets in Asia, and it does not make sense for them to go through the local on-boarding procedures in some of these markets," he says.

Indeed for some frontier markets such as Bangladesh and Pakistan, market access through exchange-traded funds (ETFs) that use swaps or P-notes provides a cheap and efficient way to access the market.

"While it is possible for overseas investors to invest in most of the Asian countries, the rules can be complex and you might not find the broker having access to these markets so access products such as ETFs are a simple and cost-efficient way to get access to these markets," says Marco Montanari, head of passive asset management for Deutsche Asset and Wealth Management.

Deutsche is currently the only ETF provider offering exposure to Bangladesh and Pakistan, with assets under management of $23 million and $20 million for each ETF respectively.

"Historically having a swap product was the most efficient solution in order to access these markets. It is natural for the regulators to want to have an asset management company based locally as it means that their local financial centres will grow in size. However they need to realise that this is not always economically and operationally possible. In the case of ETFs, you will have to set up 20 different management companies to manage various funds across Asia. This is a consideration that regulators need to take into account as ETFs are a low cost product and based on economies of scale and so it is more efficient to have a single platform rather than being based in each country," says Montanari.

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