Participatory Notes And Current Issues

pn.jpgThe Securities and Exchanges Board of India (SEBI) caused a furore in the stock market by imposing restrictions on money flowing in through participatory notes or P-notes, as they are more commonly called.

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 market 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.

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.‘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 benefits: 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.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 for specifically.However, Indian regulators are not very happy about participatory notes since they have no way in knowing who owns the underlying securities. Regulators fear that the 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.According to the SEBI Web site, the current position of these instruments is as follows: “Currently, 34 FIIs / Sub-accounts issue ODIs. This number was 14 in March 2004. The notional value of PNs outstanding, which was at Rs 31, 875 crore (20 per cent of Assets Under Custody of all FIIs/Sub-Accounts) in March 2004, increased to Rs 3,53,484 crore (51.6 per cent of AUC) by August 2007. The value of outstanding ODIs, with underlying as derivatives, currently stands at Rs 1,17,071 crores, which is approximately 30 per cent of total PNs outstanding. The notional value of outstanding PNs, excluding derivatives as underlying as a percentage of AUC is 34.5 per cent at the end of August 2007.” (SEBI – Paper for Discussion on ODIs). This implies that more than 50 per cent of the funds are flowing through this anonymous route which needs to be re-thought with regard to this entire issue.Kanika Bahadur

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