ALL ABOUT PARTICIPATORY NOTES

Participatory Notes – The Indian Context

P-Notes
Participatory notes are the instruments used by Foreign Investors, including hedge funds to invest in Indian market, but do not wish to register with SEBI.
Participatory notes (PNs / P-Notes) are instruments used by investors or hedge funds that are not registered with the SEBI (Securities & Exchange Board of India) to invest in Indian securities. Indian based brokerages buy Indian-based securities and then issue PNs to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors. In a way it is a contract between a foreign investor registered in India, and another who is not. The underlying securities of PNs are Indian stocks.
Participatory notes are instruments used for making investments in the stock markets. However, they are not used within the country. They are used outside India for making investments in shares listed in that country. That is why they are also called offshore derivative instruments.
In the Indian context, foreign institutional investors (FIIs) and their sub-accounts mostly use these instruments for facilitating the participation of their overseas clients, who are not interested in participating directly in the Indian stock market. For example, Indian-based brokerages buy India-based securities and then issue participatory notes to foreign investors
Any entity investing in participatory notes is not required to register with SEBI (Securities and Exchange Board of India), whereas all FIIs have to compulsorily get registered. Trading through participatory notes is easy because participatory notes are like contract notes transferable by endorsement and delivery. Secondly, some of the entities route their investment through participatory notes to take advantage of the tax laws of certain preferred countries. Thirdly, participatory notes are popular because they provide a high degree of anonymity, which enables large hedge funds to carry out their operations without disclosing their identity.
FIIs issue these notes to investors abroad with details of scripts that can be bought and expected returns over specific periods of time. If the client agrees, they deposit the funds with the overseas branch of the FII. Then, the Indian arm of the FII proceeds with the transaction, buying the scripts in the Indian market and settling it on its own account. The details of the ultimate investor are not revealed at all in the Indian market or to the SEBI. Further transfer of these can also be made only to other regulated entities. The SEBI rule, however, says that P-Notes can be issued only to regulated entities (in any country). Further transfer of these can also be made only to other regulated entities. Further, the FIIs are not allowed to issue PNs to Indian nationals, Persons of Indian Origin or Overseas Corporate Bodies (a majority of which are controlled by NRIs). This is done to ensure that the P-Note route is not used for money laundering purposes.
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. Many market participants believe that PNs are bad because they are unregulated. Some key brokers have said the market for P-Notes may become as big a market as the regulated exchanges — BSE and NSE — and end up dictating prices from outside. There is a reason to believe they will not.
Despite the huge growth of P-Notes, the Indian markets remain fundamentally stronger and more efficient compared to almost all other emerging markets. That gives it the power to determine prices of stocks, without being influenced by parallel markets. In this entire hullabaloo over P-Notes, this is a fact that has somehow gone unnoticed.
So how are Indian stock markets able to decide prices? For that one would need to consider the concept of impact costs, a measure of liquidity in the market. Simply put, impact costs are what the investor pays every time he buys scrip above the most efficient price of the stock.
In India, impact costs have been declining. As impact costs fall, the market tends to become more efficient. Here’s the evidence: Over a five-year period, impact costs for a portfolio of Rs 50 lakh invested in all Nifty stocks has fallen from 0.17% in December ’01 to 0.06% in August ’06.
At the same time, a broader set of investors such as hedge funds, pension funds, global mutual funds and private equity funds have made a beeline for the Indian market, especially in the past three years. This has helped push up market efficiency a few notches higher. Even stocks with high promoter holding have seen a decline in impact costs. Consider the example of Wipro, where the promoter Azim Premji and his family control 81.09%. In such cases, a high concentration of shares would allow a set of investors to have an edge over others in terms of information availability. Yet in Wipro’s case, impact costs have fallen from 0.97% in October ’02 to 0.06% now, driven by the fact that an additional 2% of the promoter group’s stake is now with the public.
It works like a virtuous circle. As impact costs crash on the Indian exchanges, more and more FIIs are likely to head here because they would find it cheaper to trade here. Lakshmi Sharma, a professor at TA Pai Management Institute, says that a 1% change in impact cost would cause a 102% change in FII investment. She also says that the higher the quantum of shares with non-promoters category, the higher the FII investment and vice-versa.
A 1% change in the shareholding of non-promoters’ category of shareholders would cause a 0.327% change in FII investment. Like in the Wipro case, the additional liquidity acted as a spur for FII investments. In turn, this would make the stock more efficient and push up the liquidity levels a few notches higher.
P-Notes will always be in a minority and will always take price cues from the main market without affecting it. To paraphrase Mark Twain, the fear of the P-Note may be greatly exaggerated.


Investors:
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.


Benefits to FII
The big rush by foreign investment companies to register with SEBI was mostly because of their interest to invest in the Indian market. Registered FII's also make money by allowing unregistered investors to invest through P-Notes since it is risk-free.
Being a SEBI-registered FII is like getting a license, which gives the right to directly invest in one of the most lucrative stock markets in the world. Others who cannot register themselves, both scamsters and genuine investors, have to necessarily invest through these licensed entities. Since global investor interest in Indian markets has been quite high, these registered FIIs have been making quite a tidy sum as service charges from P-Note investors over the last few years.
These FIIs have a stake in the continuation of the system of P-Notes. Many suspect that every time a move to ban P-Notes is contemplated, these large foreign investment firms spread the fear that restricting or investigating P-Notes would lead to a huge market crash.
There have been some recent reports that some of these registered FIIs have started functioning like virtual stock exchanges. If a client wants to purchase a particular stock and another client is holding the same stock, the FII would complete the transaction internally. This is in violation of the guideline that all transactions should be routed through a stock exchange. Moreover, the FIIs successfully evade the securities transactions tax (STT).
Our regulators defined overseas investment bodies and gave them the nomenclature of FIIs out of their zeal to improve transparency and prevent the inflow of 'bad money'. Then they allowed instruments like P-Notes, which ironically defeated the very purpose of registering foreign investors since the source of the funds could not be identified.
If just about anybody is allowed to invest through a registered FII, then why register FIIs on the pretext of trying to keep away undesirable investors?
To make it worse, the country is losing tax revenues through this rather strange arrangement. Most of these FIIs are incorporated in tax havens like Mauritius and do not pay any tax here. Considering the gains from the domestic markets over the last few years, revenue loss to the government may run into billions of dollars.
The argument that having registered entities, through whom all inflows are routed, provides better control to regulators have some merit. At least, there would be someone to blame in a crisis. But if that is the reason, why not allow domestic intermediaries to do the job? More jobs would be created within the country and the government would get additional tax revenue as well.
It is quite possible that a part of this money is coming back to the country through the P-Note route. Returns from the Indian stock markets have been among the best in the world for the last few years and promoters of domestic companies who had moved funds abroad earlier would have found the markets especially lucrative. They could move such funds back into stocks of their own companies, to push up the stock prices and further improve the value of their domestic holdings in such companies.
Uses
While one reason for using PNs is to keep the investor’s name anonymous, some investors have used the instrument to save on transaction costs, record keeping overheads and regulatory compliance overseas. A report said investors often find it expensive to establish broker and custodian bank relationships, deal in foreign exchange, pay taxes and/or filing, obtain or maintain an investment identity or regulatory approval in certain markets, where their total exposure is not going to be very large. Such investors look for derivative solution to gain exposure in individual, or a basket of, stocks in the relevant market. Sometimes, investors enter the Indian markets in a small way using PNs, and when their positions become larger, they find it advantageous to shift over to a full-fledged FII structure.

Participatory Notes Crisis of 2007
On the 16th of October, 2007, SEBI (Securities & Exchange Board of India) proposed curbs on participatory notes which accounted for roughly 50% of FII investment in 2007. SEBI was not happy with P-Notes because it is not possible to know who owns the underlying securities and hedge funds acting through PNs might therefore cause volatility in the Indian markets.
However the proposals of SEBI were not clear and this led to a knee-jerk crash when the markets opened on the following day (October 17, 2007). Within a minute of opening trade, the Sensex crashed by 1744 points or about 9% of its value - the biggest intra-day fall in Indian stock-markets in absolute terms. This led to automatic suspension of trade for 1 hour. Finance Minister P.Chidambaram issued clarifications, in the meantime, that the government was not against FIIs and was not immediately banning PNs. After the markets opened at 10:55 am, they staged a remarkable comeback and ended the day at 18715.82, down just 336.04 from Tuesday’s close after tumbling to a day’s low of 17307.90.
This was, however not the end of the volatility. The next day (October 18, 2007), the Sensex tumbled by 717.43 points — 3.83 per cent — to 17998.39, its second biggest fall. The slide continued the next day when the Sensex fell 438.41 points to settle at 17559.98 at the end of the week, after touching the lowest level of that week at 17226.18 during the day.
The SEBI chief, M.Damodaran held an hour long conference on the 22nd of October to clear the air on the proposals to curb PNs where he announced that funds investing through PNs were most welcome to register as FIIs, whose registration process would me made faster and more steam lined. The markets welcomed the clarifications with an 879-point gain — its biggest single-day surge — on October23, thus signaling the end of the PN crisis. SEBI issued the fresh rules regarding PNs on the 25th of October, 2007 which said that FIIs cannot issue fresh P-Notes and existing exposures were to be wound up within 18 months. The Sensex gave thumbs up the next day - Friday, 26th October by re-crossing the 19,000 barrier with a 428 point surge. The coming Monday (October 29, 2007) history was created when the Sensex leaped 734.5 points to cross the hallowed 20,000 mark for the first time.