What are P-Notes?

pratikbharti

pratikbharti

Pratik Bharti
A Securities and Exchange Board of India proposal to tighten the rules for purchase of shares and bonds in Indian companies through the participatory note route took the breath away of the Indian stock market and it suffered its biggest fall in history.

So what are these participatory notes? And why do they have this huge impact on the Indian securities markets?

P-Notes

Participatory Notes -- or P-Notes or PNs -- are instruments issued by registered foreign institutional investors to overseas investors, who wish to invest in the Indian stock markets without registering themselves with the market regulator, the Securities and Exchange Board of India.

Financial instruments used by hedge funds that are not registered with Sebi to invest in Indian securities. Indian-based brokerages to buy India-based securities / stocks and then issue participatory notes to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors.

Why P-Notes?

Since international access to the Indian capital market is limited to FIIs. The market has found a way to circumvent this by creating the device called participatory notes, which are said to account for half the $80 billion that stands to the credit of FIIs. Investing through P-Notes is very simple and hence very popular.

What are hedge funds?

Hedge funds, which invest through participatory notes, borrow money cheaply from Western markets and invest these funds into stocks in emerging markets. This gives them double benefit: a chance to make a killing in a stock market where stocks are on the rise; and a chance to make the most of the rising value of the local currency.

Who gets P-Notes?

P-Notes are issued to the real investors on the basis of stocks purchased by the FII. The registered FII looks after all the transactions, which appear as proprietary trades in its books. It is not obligatory for the FIIs to disclose their client details to the Sebi, unless asked specifically.

What is an FII?

An FII, or a foreign institutional investor, is an entity established to make investments in India.

However, these FIIs need to get registered with the Securities and Exchange Board of India. Entities or funds that are eligible to get registered as FII include pension funds; mutual funds; insurance companies / reinsurance companies; investment trusts; banks; international or multilateral organisation or an agency thereof or a foreign government agency or a foreign central bank; university funds; endowments (serving broader social objectives); foundations (serving broader social objectives); and charitable trusts / charitable societies.

The following entities proposing to invest on behalf of broad based funds, are also eligible to be registered as FIIs:

* Asset Management Companies
* Investment Manager/Advisor
* Institutional Portfolio Managers
* Trustees

How does Sebi regulate FIIs?

FIIs who issue/renew/cancel/redeem P-Notes, are required to report on a monthly basis. The report should reach the Sebi by the 7th day of the following month.

The FII merely investing/subscribing in/to the Participatory Notes -- or any such type of instruments/securities -- with underlying Indian market securities are required to report on quarterly basis (Jan-Mar, Apr-Jun, Jul-Sep and Oct-Dec).

FIIs who do not issue PNs but have trades/holds Indian securities during the reporting quarter (Jan-Mar, Apr-Jun, Jul-Sep and Oct-Dec) require to submit 'Nil' undertaking on a quarterly basis.

FIIs who do not issue PNs and do not have trades/ holdings in Indian securities during the reporting quarter. (Jan-Mar, Apr-Jun, Jul-Sep and Oct-Dec): No reports required for that reporting quarter.

Who can invest in P-Notes?

a) Any entity incorporated in a jurisdiction that requires filing of constitutional and/or other documents with a registrar of companies or comparable regulatory agency or body under the applicable companies legislation in that jurisdiction;

b) Any entity that is regulated, authorised or supervised by a central bank, such as the Bank of England, the Federal Reserve, the Hong Kong Monetary Authority, the Monetary Authority of Singapore or any other similar body provided that the entity must not only be authorised but also be regulated by the aforesaid regulatory bodies;

c) Any entity that is regulated, authorised or supervised by a securities or futures commission, such as the Financial Services Authority (UK), the Securities and Exchange Commission, the Commodities Futures Trading Commission, the Securities and Futures Commission (Hong Kong or Taiwan), Australian Securities and Investments Commission (Australia) or other securities or futures authority or commission in any country , state or territory;

d) Any entity that is a member of securities or futures exchanges such as the New York Stock Exchange (Sub-account), London Stock Exchange (UK), Tokyo Stock Exchange (Japan), NASD (Sub-account) or other similar self-regulatory securities or futures authority or commission within any country, state or territory provided that the aforesaid organizations which are in the nature of self regulatory organizations are ultimately accountable to the respective securities / financial market regulators.

e) Any individual or entity (such as fund, trust, collective investment scheme, Investment Company or limited partnership) whose investment advisory function is managed by an entity satisfying the criteria of (a), (b), (c) or (d) above.

Sebi not happy

However, Indian regulators are not very happy about participatory notes because they have no way to know who owns the underlying securities. Regulators fear that hedge funds acting through participatory notes will cause economic volatility in India's exchanges.

Hedge funds were largely blamed for the sudden sharp falls in indices. Unlike FIIs, hedge funds are not directly registered with Sebi, but they can operate through sub-accounts with FIIs. These funds are also said to operate through the issuance of participatory notes.

30% FII money in stocks thru P-Notes

According to one estimate, more than 30 per cent of foreign institutional money coming into India is from hedge funds. This has led Sebi to keep a close watch on FII transactions, and especially hedge funds.

Hedge funds, which thrive on arbitrage opportunities, rarely hold a stock for a long time.

With a view to monitoring investments through participatory notes, Sebi had decided that FIIs must report details of these instruments along with the names of their holders.

Sebi Chairman M Damodaran has said that the proposals were against PNs but not against FIIs. The procedures for registering FIIs were in fact being simplified, he said.

Sebi has also proposed a ban on all PN issuances by sub-accounts of FIIs with immediate effect. They also will be required to wind up the current position over 18 months, during which period the capital markets regulator will review the position from time to time.

Sebi chairman M Damodaran, in a recent interview Business Standard, said that the amount of foreign investment coming in through participatory notes keeps changing and is somewhere between 25-30 per cent. "Recent indications are that it has gone up a little but again after the sub-prime crisis, there have been some exits. But it's a fairly significant percentage, it's not something you can ignore."

When asked if he was comfortable with almost one-fourth of the market being held by P-Notes, he said that he wasn't 'entirely uncomfortable.'
 
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P-notes highest in HDFC, ICICI Bank

The country's two ubiquitous financial powerhouses, HDFC and ICICI Bank, have been the darling of participatory notes, the instrument through which overseas investors invest indirectly - through foreign institutional investors - in India's stock market.

Among the stocks comprising Bombay Stock Exchange's Sensitive Index and National Stock Exchange's S&P Nifty, HDFC has the highest P-Notes holding in value, 14.2 per cent, followed by ICICI Bank's 9.1 per cent.

Next in line are Mahindra & Mahindra with 8.5 per cent, Tata Steel (8.1 per cent), Satyam Computer (7.9 per cent), Bharti Airtel (5.8 per cent), ACC (4.8 per cent), Reliance Energy and Ranbaxy (2.7 per cent each), State Bank of India (2.5 per cent) and Grasim (2 per cent).

Two public sector giants, Steel Authority of India (1.6 per cent) and Bharat Heavy Electricals Ltd (1.3 per cent), bring up the rear.

FII holding in Sensex and Nifty stocks is worth to Rs 55,173 crore (Rs 551.73 billion) - 20.27 per cent of the total FII holding and 4.91 per cent of the total market capitalisation of the Sensex companies.

Interestingly, FIIs seem to be holding less than 1 per cent through P-notes in Reliance Industries, which has the largest market capitalisaiton of all companies in the country.

FII holdings through P-notes, as of on Wednesday, stands at Rs 86,660 crore (Rs 866.60 billion), accounting for 24.4 per cent of the total market value of FIIs holding.

This is based on data covering 69 companies in which FII holding through P-notes accounts for more than 1 per cent of the total share capital. FII holding in these companies is worth Rs 355,572 crore (Rs 3555.72 billion), which is 24.11 per cent of the total market capitalisation of the 69 companies.
 
FIIs can rollover PNs up to 18 months: SEBI

In a bid to calm the investors, market regulator SEBI on Wednesday said Foreign Institutional Investors would be allowed rollover Participatory Notes in derivatives market, provided it does not exceed the 18-month limit.

"It is made clear that there is no proposal to bar an Overseas Derivative Instrument (ODI) contract expiring this month or in the following months, being renewed provided the renewal does not go beyond 18 months," SEBI said in a clarification to its draft discussion paper on ODI that includes Participatory Notes (PNs).

The SEBI clarification clears the air of uncertainty over the fate of renewal of PNs that are due to expire this month or will expire in the coming months.

SEBI had on Tuesday invited public comments on its proposal to restrict with immediate effect, issuance of PNs in derivative markets by FIIs and their agents.

As per the proposals, FIIs and their sub-accounts are required to wind up the current ODI position over 18 months, during which SEBI will review the position from time to time.

SEBI has sought comments from public by October 20 on its discussion paper, which Finance Minister P Chidambaram today said will become regulations "with or without some modifications."

SEBI's clarification came after the Sensex crashed by over 1,700 points within minutes of commence of trading, leading to closure of the markets for an hour. The markets, however, have recovered considerably after an assurance by the Finance Minister that there is no proposal to completely ban Participatory Notes.
 
Sebi leaves room for higher PN exposure

The Securities and Exchange Board of India (Sebi) has left room for foreign institutional investors (FIIs) to increase their exposure in the stock markets through participatory notes (P-notes), as against fears that it would severely restrict the use of this popular offshore derivative instrument by investors who want to remain anonymous.

According to estimates by Citigroup India, P-note investments, excluding the underlying shares, account for 34 per cent of FII assets with custodians in BSE-500 companies.

Sebi stipulates that P-Notes can account for up to 40 per cent of FII assets under custody. This leaves room for FIIs to increase their exposure through P-notes 6 percentage points.

The Citigroup note said that as in August 2007, total FII holdings in India stood at $204 billion excluding American Depository Receipts (ADRs) and Global Depository Receipts (GDRs).

ADRs and GDRs are negotiable certificates that represent a given number of a company's shares and are listed and traded independently from the underlying shares.

"Excluding ADRs/GDRs, that number would have been around $172 billion," the note said.

Calculated on the August-end data provided by Sebi, FIIs' total P-note exposure is $59 billion. If this is 34 per cent of the total P-note value, excluding derivatives, FIIs can invest $10.4 billion more.

In its draft proposal on restricting use of P-notes, Sebi has proposed an incremental rate of 5 per cent for issue of P-Notes for FIIs with less than 40 per cent of their assets in P-notes.

The real concern, according to Citi, is that lack of new P-Note issues with underlying derivatives will take away hedging options for exposure in the cash market.

This could be a deterrent for new hedge fund inflows since investors hedge their positions in derivatives. Sebi has proposed to disallow issuing P-notes for derivatives contracts.

Another issue is that there is no data available on sub-account exposure in P-notes with derivatives as underlying.

Analysts handling FII business with domestic brokerage houses say the data given by Sebi in its draft proposals is up to August and the real increase in P-notes after that period is not known.

According to an FII representative, if FIIs increase direct investment, the percentage of P-notes to total investment will drop further, giving them headroom to issue fresh P-notes.
 
CPI(M) seeks ban on participatory notes

At a time when the UPA government is making efforts to allay fears of foreign institutional investors over participatory notes, its key left ally, CPI (M) on Friday demanded a complete ban on these instruments.

"The CPI(M) is of the firm opinion that PNs should be prohibited, as has been recommended by the RBI," a statement issued by the CPI (M) Politburo said, coinciding with the market meltdown on the SEBI's proposals to curb such offshore derivatives.

The CPI (M) said massive pull-out of funds which induced a huge fall in the market reflected defiance of regulatory institutions by the FIIs.

Asking the government to move towards insulating the financial system from speculative capital inflows, the party said financial markets globally are already witnessing turmoil following the sub-prime mortgage crisis in the US.

"Financial entities that are unwilling to meet the disclosure norms should not be allowed to participate in the Indian capital markets," the politburo said in its statement.

The government should realise that the surge in FII inflows, encouraged by rupee appreciation and interest rate hikes can eventually have serious implications, it said.

As per the SEBI proposals, derivatives-based PNs should be wound up within 18 months. It has also proposed to lay curbs on derivatives based on assets under management of FIIs.

Finance Minister P Chidambaram had earlier explained to FIIs at length that the government did not propose a complete ban on PNs.

The politburo called the SEBI's discussion paper as reflective of tentative attitude of the government in regulating financial entities.
 
Responsible policies for FIIs, P-notes

The Securities and Exchange Board of India (Sebi) announced how it wanted to control capital inflows via restricting/banning the use of Participatory Notes (P-notes) by foreign institutional investors (FIIs).

This regulator-induced correction made the stock market go down 10 per cent in less than 10 minutes; it then recovered most of the decline and ended down only 2.5 per cent. You could say that the markets are confused; the same can be said about most of the commentators and most of those speaking on behalf of the new policy.

Herewith some suggestions for a new policy and how it meets all our goals, including not having an excess of foreign inflows and therefore pressure on the rupee. This policy also opens up markets and indeed allows the market to clear the air rather than a bureaucrat, a regulator, or the government.

This wonder proposal - written several times over the last decade, discussed in several government committees, but always met with the bureaucratic response of what do you know about markets - is simple and as follows. First, anybody who wants to invest in India can freely invest, and do so by freely and without Kafkaesque procedures registering with Sebi.

No licensing from Sebi. Please, we are not living in 1975 (not that we should have had control freak control raj even then). Second, no legal status is given to off-shore derivatives. If anybody wants to invest in derivatives, he can freely do so onshore. End of story, and with it the market will spell the end for P-notes. Na rahega baanz, na baje gi bansauri.

After registration - the foreign individual, or corporate, or pension fund, or Mr Bush - opens a bank account with a domestic bank, say Citibank, or Bank of Scotland. The foreign bank opens an account with a bank in India, say Kotak. Both sets of banks - foreign and domestic - will enforce KYC (Know Your Client) norms to ensure that the monies are clean etc.

If the monies are not as advertised, the banks get into trouble and so have no incentive to launder money. This takes care of the nonsense perpetrated by some controllers that licensing is required to ensure that only clean money enters our so squeaky clean shores. Sebi will, by registration, also know the identity of the client; so much for the other nonsensical concern that P-notes should be banned because we do not know the identity of the investor.

Wouldn't this openness make severe the problem of capital inflows, a problem that the finance minister described as the real target of the new P-notes policy? No; indeed, the problem will be a lot less than the self-created FII licensing wound that the government and the regulator have inflicted on the system and all investors, big and small. Most countries, including India, have limits on stock ownership (delivery stock and derivatives) across different sectors - X per cent for technology, Y per cent for banks, etc. Foreigners as a combined entity cannot invest more than this fraction, and for several important stocks (and their derivatives) the limit has been reached.

So what will the foreign investor do? She can either invest in ADRs, which is fine, and that does not affect capital inflow. Indeed, this helps decrease net capital inflow into India. Or she can invest in a second-rung or third-rung company in India, e.g. Oxus Investments! A lot riskier for this foreign investor, and will restrain her impulse to make some quick bucks, i.e. the so-called "hot money" will seek warmer climes elsewhere.

This policy will reduce excessive capital inflows and make monetary management easier, i.e. prevent the rupee from excessively appreciating, as it has done this year. Such appreciation hurts the economy and only helps the foreign investors and their advisers. (However, I still fail to understand why India, alone among 150 nations, finds handling relatively small foreign capital inflows so difficult).

As with any control policy, there are several myths surrounding its use (myths, not facts, because the latter expose the hollowness of the myths). For example: we need FII licensing to control laundered money, or market manipulation. Or we need FII licensing (and therefore P-notes) to prevent Indians abroad from investing in India via tax havens like Mauritius. We should understand that while a tax haven like Mauritius was important when the domestic capital gains tax was 33 per cent and 20 per cent (short term and long term, respectively) , it is today insignificant as a factor determining investment decisions (the short-term tax rate is 10 per cent and long-term is zero).

In conclusion, this simple policy has all the attributes to recommend it: it makes India a more open economy, it removes the last vestiges of control raj, and it decreases "excessively hot" capital inflows that are so problematical for our monetary authorities. It will also open the floodgates for the Indian financial industry. Total foreign portfolio investment in India is now more than $350 billion (net investments, $70 billion, and capital gains, $280 billion, since the market was opened up to foreign investors in 1993).

None of this money is being managed by the domestic fund managers. Why? Because Sebi prohibits, yes bans, foreign investors from employing domestic fund managers. Indian fund managers have to go settle in Singapore, or Pakistan, or the moon to manage money in Indian stock markets. Why? Search me. You can ask why to all the regressive policies prevailing in our financial markets and you still won't proceed beyond zero base. But the policy makers should realise how many jobs are being lost, and government tax revenue lost, by its stupidly stupid policy of favouring foreign fund managers over domestic fund managers.
 
P-Notes will remain in vogue

It was only last week that we had discussed the issue of Participatory Notes (PNs) under the heading "The brutal power of liquidity".

And as if we had a premonition of things to come, this is what we wrote - "The near-vertical rise in the stock prices and the FII inflows taken together indicate that days of the unencumbered use of PNs may be numbered. That is the only thing that may explain this anxiety to bring home the booty before the shutters are pulled down."

The issue of PNs has always bothered me. Around eight months ago, writing before the budget in the February 17 column, PNs were termed as the "bomb in our attic". Last week, SEBI dusted those bombs off and delivered them into our drawing rooms.

Though these are essentially only guidelines, they will get altered in the light of the suggestions received from the players concerned.

And going by the tenor of the speech made by the finance minister at a jamboree organised by a leading investment bank in New York on Thursday, substantial leeway could be granted in the final document.

These have been adequately discussed in the media, so we are not repeating the same. But I have a few points to add, which do not appear to have been discussed.

My first suggestion is that having already belled the cat, there is no need to feel apologetic about it. RBI has been long concerned on this front and SEBI has done an excellent job in terms of reducing the instances of PN use, though holes remain. And these holes may have been deliberately left open so as not to snub this segment of investors.

We will go digging for those holes later, but first why North Block should not backtrack: at any point of time, whenever such harsh measures have to be introduced, the markets tumble and investors suffer in a knee-jerk reaction. That has already happened. The price has been paid, not by the PN investors but by the sane Indian retail investors, who think that the government means what it says and will implement it. There is no need now to pussyfoot on the issue or sugarcoat it further.

The second observation is that despite these guidelines, the use of PNs may not substantially decline. To answer how, we will have to go back to the holes we talked about.

According to the SEBI discussion paper, there were 14 FIIs/sub accounts that had issued PNs till March 2004. This number is now 34. So there are not more than 34 FIIs or sub accounts that have issued PNs.

Essentially, the curbs would effect the business of these known entities. But there are 1,078 other registered FIIs that don't know the spelling of PN. Those hell-bent on bringing money through this route could well teach them how to do it. These FIIs who do not have exposure to the PNs yet can issue PNs at an incremental rate of 5 per cent of their non-derivative assets under custody (AUC).

There is a small hitch, however. The guideline says, "The FIIs who are currently issuing ODIs with notional value of PNs outstanding (excluding derivatives) as a percentage of their AUC in India of less than 40 per cent shall be allowed to issue further ODIs only at the incremental rate of 5 per cent of their AUC."

What does the term incremental 5 per cent mean? What is the period after which a fresh 5 per cent can be bought? Logically, it should be a year, but the final guidelines will eventually clarify.

The third suggestion that I would want to make is that the regulators should share their data with the investing fraternity as to what is the ratio of PN money in the total FII inflow. RBI tells us from time to time, on an annual basis.

But it always tells us that percentage of PNs till date. Why can't it tell us that what is the percentage of the PN money in the inflows that have come during a period? That will leave no room for any inferences to be drawn individually.
 
RBI wants tighter P-note regime

The Reserve Bank of India (RBI) has suggested stringent conditions for participatory notes (P-notes) that are issued even by registered foreign institutional investors (FIIs).

In a note sent to the finance ministry on the eve of the Securities and Exchange Board of India's (Sebi's) board meeting to decide on restrictions for P-notes, the central bank has reiterated its earlier stance of a complete ban on P-notes.

If that is not possible immediately, RBI has suggested including two key conditions for issuance of P-notes by FIIs.

The first is limiting P-note investments in sensitive sectors such as real estate and financial services. The second is imposing a lock-in period for liquidating investments made under P-notes.

The RBI nominee on the Sebi board is expected to raise these issues at Thursday's board meeting.

Sources close to the development said a lock-in period could help check speculative inflows. These recommendations are based on the second report of the Tarapore committee on capital account convertibility.

The sources said that there is a case for capping the P-note investments in sectors that have an upper limit on foreign investment -- both foreign direct investment and FII.

Sources added that Sebi will be clarifying at the board meeting the basis for its recommendation that FIIs with 40 per cent of assets under custody cannot issue fresh P-notes.

Sources said the government is of the view that banning P-notes will curb speculative inflows into India. Since the India growth story is strong, inflows from genuine investors cannot be stopped.

If some categories of instruments are banned or the Indian markets are made costlier for the foreign investors, investors will choose other routes like the non-deliverable forward market or the overnight interest rate swap market abroad over which Indian regulators do not have any control.

So the government feels it is important to address the long-term issue of accessibility of the Indian markets through more instruments.
 
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