Participatory Notes (PNs) are financial instruments that facilitate investment in Indian securities by foreign investors or hedge funds that are not registered with the SEBI.

Indian brokerage houses buy the securities on behalf of these foreign investors and hedge funds and issue PNs to them. Any dividends or capital gains collected from the underlying securities will keep going back to the foreign investors and hedge funds.

PNs and other instruments like Equity Linked Notes and Capped Return Notes are called Offshore Derivative Instruments or ODIs. ODIs are generally issued to overseas investors and they are so called as they derive their existence from the ownership of underlying shares in an Indian company. Equity Linked Notes are instruments whose return is determined by the performance of a single equity security, a basket of equity securities or an equity index. Capped Return Notes have a pre-established profit cap.

Simply speaking, all these are bilateral contracts between FIIs and investors for taking exposure in specific stocks.

The SEBI and the Centre are worried that the till-Tuesday bull run in the bourses was because of funds from foreign institutional investors using ODIs.

For instance, the notional value of PNs outstanding shot up over 10 times from Rs 31,875 crore in March 2004 to Rs 3,53,484 crore in August this year. Similarly the number of FIIs and their agents issuing ODIs also increased to 34 from 14 in March 2004.

Which means the recent surge in the market is almost entirely driven by the FIIs with little involvement of retail investors. This has also allowed some people to take speculative positions. These inflows are also contributing to a steep rise in the rupee, which has hit Indian exports very badly.

The SEBI proposal which triggered the Wednesday crash in the markets, is to bar FIIs and their agents from issuing or renewing ODIs such as Participatory Notes, Equity Linked Notes and Capped Return Notes. The suggestion, as of now, is that SEBI will ask the FIIs to wind up their current positions over the one-and-a-half year, during which the regulator would review the position from time to time.