P- Notes ‘The backdoor entrants’:
Foreign Institutions, or FIIs as we refer to them, are overseas entities registered with the country’s stock market regulator, SEBI. On registration, these entities can directly invest in Indian stocks, mutual funds, government securities, derivatives and debt. But there is one category of foreign investors who are not under the regulatory purview, investors who buy stocks through Participatory Notes (P-Notes).
P-notes are instruments issued by registered FIIs to other overseas investors for investing in the Indian stock market.
Like most derivative instruments the value of the PN's fluctuates depending upon the price of the underlying stocks. On issuing participatory notes and collecting funds, FIIs invest in the Indian market on behalf of the P-note holders. So, when FIIs buy in their name they might be actually transacting on behalf of an unidentified P-note holder.
Participatory notes serve as a short cut for foreign investors who don’t want to go through the procedural formalities and the process of registering as FIIs. Investors who take the P-note route are often anonymous, with the issuing FII not required to disclose the identity or profile of the P Note holder, unless specifically asked by SEBI. This results in the regulator having no idea of their identity, investment status or objectives.
Panic behind the P- Notes:
1. It is tough to establish the beneficial ownership or the identity of the ultimate investor.
2. PN may also pave way for Indian Money Launderers, who might first ship money out of the country through Hawala and might then get it back using PNs.
3. Investments by P-Notes (participatory notes) are generally a short term investment with easy entry and exit options; hence it would render the market volatile.
4. It is possible for the investor to sell the PN to another player resulting in multi-layering.
SEBI’s control on P- Notes:
FIIs, who issue P-Notes, are required to report on a monthly basis to SEBI by 7th of the following month.
SEBI requires the registered FII to verify the identity of investors before issuing P-Notes under the 'Know Your Customer' (KYC) guidelines. Registered FIIs are also required to reveal the identities of such P-Note investors to SEBI, if asked.
Ban on P- Notes:
The year 2007 saw a significant rise in investments by FIIs. Investments through participatory notes accounted for a significant chunk of this foreign institutional investment.
The huge inflows had led to ‘overheating’ of the markets at that time, making it difficult for the financial market regulators to handle the excess liquidity.
Regulators were unhappy as they thought hedge funds investing through P-Notes could create havoc in the market.
In October 2007, SEBI banned all fresh issue of P-Notes with derivatives as underlying. Outstanding positions were to be wound-up in 18 months. The total amount for which P-notes could be issued by each FII was also capped at 40 per cent of the total assets under the custody of the respective FII.
The objectives behind the new regulation were very clear. SEBI wanted to track and regulate foreign investments coming into the country and stop unhealthy speculation in the market, by unknown investors. By closing the P-Note option, the regulator wanted foreign entities to take the FII route whereby they would have to make full disclosures, thereby increasing the transparency in the flow of funds.
End of the
Despite the P-note ban, Indian indices continued to move northward in the period following this move for a full four months until January 2008. But the rally didn’t extend as financial turmoil in the
As a chain of events unfolded, big investment firms such as Lehman Brothers and Merrill Lynch went bankrupt, FIIs continued to be net sellers.
As a consequence, the rupee started depreciating and the regulators once again had to intervene to make the situation better.
There has been a massive flight of capital from the domestic markets following the turmoil in the global financial markets.
P-Notes back on SEBI’s Agenda:
As the market was famished for funds, On October 6 2008, SEBI announced the lifting of all its earlier restrictions on p-notes. Foreign institutional investors can now issue P-notes with derivative as underlying. The 40 per cent cap on P-note issue stands removed and P Note holders are no longer required to wind up their positions in Indian stocks.
The SEBI’s move to ease the curbs on P-Notes, sources said, was intended to shore up market sentiments and to bring in fresh liquidity, arresting the outflow of funds from the Indian Capital Market.
The reversal, though it took immediate effect, hasn’t helped reverse the direction of fund flows. FIIs continued to be net sellers and the market stood bear hit.