In October 2007, when the benchmark indices were hitting new highs on a weekly basis – the Sensex took just four sessions to rise from 18,000 to 19,000 points – the market regulator was worried.
The then-Chairman of the Securities and Exchange Board of India (Sebi), M Damodaran took a big call – he proposed to ban fresh issuances of participatory notes (P-notes), ordered winding up of existing positions within 18 months and capped the investment limit to 40% of the foreign institutional investors’ assets.
After the proposal, the Sensex fell 1,700 points on a single day, forcing then-Finance Minister P Chidambaram to step in and say that P-notes, the most popular in the overseas derivative instrument (ODI) category, won’t be banned completely.
Eighteen years later, Damodaran’s wish list seems to be coming true. With the Sebi deadline that imposes several restrictions on ODIs, which allowed foreign investors to gain exposure to Indian equities without any direct registration expiring in November and December, interest in P-notes is expected to wane significantly.
But Sebi is also on a better wicket now. With the Rs 75.61 lakh crore mutual fund industry attracting funds from domestic investors , especially through systematic investment plans (SIPs) at the time foreign investors have been fleeing the market, it can afford to ignore ‘unknown and non-transparent hot money’. In September, SIP inflows were at an all-time high of Rs 29,000 crore.
The good news is investments through P-notes have been on the decline. In FY07, investments through this route stood at a whopping 44% of the total investments made by foreign portfolio investors. In FY25, it crashed to just 1.8%.
In terms of value, the total value of investments through P-notes were Rs 2.40 lakh crore in FY07 as compared to mutual fund industry’s assets under management at Rs 3.3 lakh crore. The value of P-notes have fallen to Rs 1.36 lakh crore now. To put the numbers in perspective, the rupee has fallen from Rs 40 in 2007 to around Rs 88 to a dollar now.
Clearly, this gives the market regulator a lot of comfort to phase out these instruments. The latest curbs include, ban on derivative-based ODIs, stricter hedging rules, increased disclosures and separate registration for foreign portfolio investors interested in hedging.
“ODIs offered entry and exit to wealthy offshore investors. With rising compliance, that edge is eroding,” said the CEO of a large institutional brokerage firm.
In December 2024, Sebi provided a one-year transition period to unwind existing derivative-linked ODIs. As a result, from December 17, rollovers of such positions will not be allowed.
Among other guidelines, Sebi also mandated that FPIs must maintain dedicated registration for issuing ODIs, with the suffix “-ODI” tagged under the same PAN. It also prohibited them from hedging ODI exposure. Industry experts said these sharply limit the scope for future synthetic exposures.
After the liberalisation in the early 1990s, it took the market regulator about a decade to realise that the markets were being manipulated by non-transparent players – something that played out in the South East Asian crisis in 1998.
So Damodaran had a good reason to be concerned. The abundant inflow of capital had pushed up the rupee to below 40/$, hitting exporters’ profit margins that forced the government to offer interest subsidies, duty concessions, and service tax refunds.
To quote him, “I don’t think any regulator wants non-transparent investment in the market. I don’t think investors want non-transparent investment. And therefore, what we have done is consistent with what we needed to do as mandated by a statute and consistent with a long-term roadmap to provide a more direct and easy route for investment.”
However, the subsequent fall in the market in early 2008 due to credit-default swaps in the US led to a worldwide crisis, and the next Sebi chief C B Bhave, did not have the option to implement the proposals.
The recent overhaul in regulations mean that ODIs will be “accessible only under increasingly restrictive conditions and this raises questions on their future relevance,” said a report on ODIs this week by IC RegFin Legal.
According to two senior executives at a foreign bank, the structures of ODIs had become more layered and intricate since 2019. Sebi’s enhanced cooperation with counterparts in the United States and FATF-member countries, helps it track ultimate beneficiaries (UBOs) more effectively, they said. This led to the P-notes losing owner-anonymity, a main feature, they said.
ODIs, through swap structures, such as total return swaps or contracts for difference, emerged popular among unregistered foreign investors, with faster liquidity and offshore exit options.
Global brokerages including Goldman Sachs, UBS, BNP Paribas, Societe Generale, Morgan Stanley and Citigroup are among major ODI issuers. “Even now, some of the largest block deals are executed on behalf of clients through swaps,” noted the head of another institutional brokerage.
All this is set to take a hit after Sebi’s curbs get implemented.