Foreign flows to India derivatives swell amid regulator scrutiny

Foreign fund flows into India through an obscure offshore derivative are rising even as regulators make it harder for hedge funds and wealthy individuals to invest anonymously.

Investments through so-called participatory notes in Indian stocks, bonds and hybrid securities jumped 56 per cent to 1.43 trillion rupees ($17.3 billion) at the end of January, from 914.6 billion rupees a year earlier, according to data from the Securities & Exchange Board of India.

The rise comes despite heightened disclosure requirements aimed at verifying client identity, as India’s booming stock market attract investors looking for alternatives to China. Still, the authorities have been wary about participatory notes due to the potential for money laundering through this route.

“India has long been a favored market based on economic growth, but given the downdraft in China this has been emphasized in the last year or so,” said Joshua Crabb, a fund manager at Robeco in Hong Kong.

Meanwhile, bankers have been holding conversations with the regulator to present their views on the additional disclosure requirements that took effect last year, according to people familiar with the matter. 

The norms were announced to prevent round-tripping — a process where funds are returned after being transferred to a shell company — by company founders using the foreign portfolio investment route. They follow criticism about the lack of oversight over inflows into sprawling Indian conglomerates such as the Adani Group. 

Concentrated holdings

The new rules demand global funds holding more than 5 per cent of their equity assets in a single business group must provide details of all entities with any ownership, economic interest and control rights in the investor. The regulation also applies to foreign investors with more than 250 billion rupees in local equities.

University funds and endowments of a certain size have been exempt from the requirement. 

“The regulator wants to discourage investments in P-notes and is worried that it is being misused by Indian promoters to invest in their companies and characterize it as public shareholding, or by Indian resident investors who are not allowed to invest in them but route them through offshore accounts,” said Abishek Venkataraman, an independent lawyer. 

Global banks that sell these instruments through their offices elsewhere in Asia have stepped up the unwinding and reallocation of the notes in the secondary market to keep exposures under the thresholds, the people said.

This approach helps them protect the identities of their clients while still enabling investment in the country, they added.

US short-seller Hidenburg Research’s scathing report against Adani last January had alleged that a web of foreign funds mainly based in tax havens with opaque ownership structures had been investing in the group’s companies, pumping up stock prices. The accusations, repeatedly denied by the conglomerate, triggered a rout in the group’s stocks and bonds, before they began recovering late last year.