OFFSHORE DERIVATION

INSTRUMENT

What are offshore derivatives instruments?
In the context of the Indian market, offshore derivatives instruments (ODIs) are investment
vehicles used by overseas investors for an exposure in Indian equities or equity derivatives. These
investors are not registered with SEBI, either because they do not want to, or due to regulatory
restrictions.
These investors approach a foreign institutional investor (FII), who is already registered with
SEBI. The FII makes purchases on behalf of those investors and the FII's affiliate issues them
ODIs. The underlying asset for the ODI could be either stocks or equity derivatives like Nifty futures.

What are participatory note or P-Notes?
Participatory notes (PN) is one of the categories of ODIs. At a basic level, the underlying asset class
could be stocks, and returns would be directly related to the appreciation in prices of those
stocks. In some complex forms, returns could be linked to the appreciation in Nifty over a given
time frame and could be even linked to a combination of change in Nifty and a basket of stocks. For
instance, the holder of a P-Note may be promised a return of 10% if Nifty rises by 5% within a month.
Other categories of ODIs include equity-linked notes, capped return notes, participating return notes,
etc.

What are FII sub-accounts?
Sub-accounts are special purpose vehicles floated by foreign funds in which they manage
money on behalf of their overseas clients. FIIs also form proprietary sub-accounts to invest
their own money.

What are third party sub-accounts?
This facility has been discontinued by SEBI. Earlier, overseas clients could nominate a fund
manager of their choice to manage their money in a sub-account of an FII to whom they
have entrusted the funds.

Are ODIs/P-Notes less transparent?
There are fears that P-Notes are being used as a vehicle by promoters, market operators, and
politicians to repatriate illegitimate funds parked abroad. Quite a few promoters are said to be
using this route to ramp up their stocks. Then there is also a concern that terrorist
organisations could be channelling money through ODIs and using profits to fund their nefarious
activities.
As per SEBI rules, the FII issuing ODIs/P-Notes should know the eventual beneficiary to
whom the instruments are being issued to. But through multiple layering, it is possible to conceal
the identity of the original client. Then there are concerns that too much money flowing into the
derivatives segment through the P-Note route is adding to volatility, not to mention the
pressure on the currency.

Does the SEBI proposal mean that no fresh P-Notes can be issued?
No. P-Notes with stocks as underlying assets can be issued by an FII, subject to a limit of 40%
of the overall assets under the custody of that FII. Simply put, if an FII has $100 million worth
of assets under custody (AUC), only $40 million of those assets can be in the form of equity-based P-
Notes. Where P-Notes with equity derivatives are the underlying assets, SEBI has proposed that
these cannot be issued anymore, and the existing positions have to be unwound over a
period of 18 months.

What if an FII has issued P-Notes up to 25% of its total assets under custody?
Can he issue P-Notes for another 15% of his AUC overnight?
No. As per the SEBI proposal, he can raise it by only 5% at a time

What will be the broad impact if SEBI' s proposals on P-Notes are implemented?
In the short term, inflows could be affected to an extent. But it is a positive move from a long-term
perspective. For some time, SEBI has been saying it wishes to encourage FIIs to enter our stock
market through the front door (by registering themselves) and not through the back door (via P-
Notes). If more overseas players register with SEBI, it will be easy for the regulator to keep tabs on the
fund flow into the market.