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Short-selling through P-notes in revival mode
September, 22nd 2011

Off-shore activity in Indian equities is showing signs of revival. Market experts believe a high amount of short-selling of stocks in August was done through the use of off-shore derivative instruments (ODIs) or participatory notes (P-notes).

Last month, large hedge funds and traders took P-note positions worth nearly Rs 7,000 crore in the derivative segment of Indias stock market. The FII (foreign institutional investor) position through P-notes in debt and equities, including derivatives, rose by nearly Rs 14,000 crore to 15.4 per cent in August from 14 per cent in July, going by data by the Securities and Exchange Board of India (Sebi).

The financial instruments regulator publishes combined data for debt and equity segment in a column, while the combined data for the same, including derivatives, is published in a separate column on its website. India has no derivative market for debt securities that permit P-note positions. Also, the exchange-traded bond market is not so liquid.



Price on BSE (in Rs)

% Chg

May 20, 10

Sep 21, 11

Piramal Health.
















Sun Pharma




BSE Health.




Compiled by BS Research Bureau

The key indices S&P CNX Nifty of National Stock Exchange and Sensex of BSE crashed by 11 per cent in a single month during the August series of derivative expiry. The fall in individual benchmark stocks was steeper than the index. They included Reliance Capital (down 33 per cent), Tata Motors, Reliance Communication (22), Reliance Infrastructure, Axis Bank, Sterlite Industries (20), State Bank of India, ICICI Bank (16) and Sesa Goa and DLF (over 15) among others. Most of these stocks have had high P-note activity, say market players.

Of this Rs 14,000 crore, nearly half the FII positions were in equity derivative segment. The data shows P-note holdings of FIIs in equities and debt, excluding derivatives, rose by nearly Rs 5,900 crore. The August-month P-note positions in equity derivatives and a crash in benchmark indices clearly indicate that Indian equities were short sold overseas, said Deven Choksey, managing director of Mumbai-based K R Chkosey Shares and Securities.

Further evidence of short-selling through P-notes can be seen in the market fall of May. In May, derivative expiry series, both Sensex and Nifty, fell 6.5 per cent. During this month, FIIs took position worth Rs 3,000 crore in equity derivatives. Overall, in debt and equities, the FII position rose by 4.5 per cent during the month from 15 per cent to 19.5 per cent.

Hedge funds are known to take exposure to India through P-notes, pointed out Saurab Mukherjea, head of equities at Ambit Capital. But in August, even long positions were seen ahead of the Jack Hole meet of the Federal Reserve in US and in anticipation of a third round of quantitative easing.

P-notes are 'hot money' instruments used by traders who do not wish to bring money directly in India. The use of these instruments was at its peak in 2007 when FII positions reached 60 per cent of their total investments in the country. In October 2008, short-selling through P-notes peaked as US investment bank Lehman Brothers filed for bankruptcy, leading to a global freeze in lending and borrowing activities of banks. The domino effect of this also hurt global trade. Then, Sensex and Nifty had crashed by nearly 30 per cent in a single derivative expiry cycle.

After the market crash in India post the Lehman fall, Sebi had warned FIIs against the use of P-note to short-sell Indian stocks overseas. Sebi's then chairman C B Bhave and Finance Minister P Chidambaram had expressed the view that short-selling of FIIs, if at all, should be done onshore -- and not off-shore. However, no formal ban was imposed on such short-selling, but FIIs were compelled to furnish regular data of their P-note leading and short-selling activity. Overseas lending and borrowing activity in P-notes may not be illegal, but it disturbs the stock market equilibrium. Currently, no domestic institution or portfolio manager is allowed to indulge in short-selling in the cash segment of the market.

Overall, FIIs hold stocks and debt instruments worth Rs 9,85,893 crore or nearly $210 billion. Out of this, nearly Rs 1,50,000 crore worth of debt and equity instruments are held through P-notes. Interestingly, there are some 26 P-note issuing FIIs, but all have told Sebi that they were not indulging in any lending or short selling of P-notes overseas -- a claim that experts say should be looked into.

Short sales refer to the sale of shares investors do not own. They are usually borrowed from other entities and bought back later. Investors selling short believe the stock price will fall. Experts say physical settlement of equity derivatives segment will go a long way in bringing positive structural changes in market. Short-sellers in India are exploiting the cash settled derivative market. After much debate, Sebi introduced physical settlement in 2010, but left the choice on stock exchanges to implement the system.

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