With participatory notes (P-notes) losing their appeal as an investment vehicle, most banks that issue P-notes to foreign clients are changing their business model.
Most banks have stopped "non-leveraged" aspect of their business, and are focusing only on the part that involves financing, sources said.
The P-notes business does not involve financing or funding component. Here's how it works. Investors approach a bank (P-note issuer) to take exposure to Indian stocks. The bank issues P-notes and hedges itself by executing the trade in India and holding the shares. Whenever the clients want to unwind positions, the shares will be sold and money returned to the client. In the process, the bank earns only a small commission, which is essentially a facilitation fee.
Till a few months ago, most banks were okay with the arrangement as the volumes compensated for the small margins from these trades. However, the change in Know Your Client rules and anti-money laundering norms last year and changes in tax treaties with Mauritius and Singapore have affected volume of trades through P-notes.
"The real money for these banks is not in these kind of (non-leveraged) trades. It is in issuing instruments that involve funding," said an official familiar with P-notes. "Such products are demanded by clients such as hedge funds. This is where the bank is able to not only earn commission but also funding spread," he said.
Not everyone is convinced the non-financing business will die. "While it is true that banks may focus more on the financing part of the P-note business, they will not entirely give away the non-leverage part as they will still make a small margin by way of brokerage and other fees," said Suresh Swamy, partner, financial services, PwC India.