The rise & fall of Participatory Notes

Participatory notes have been an integral part of India’s securities markets for many decades now and have been in the news most of the time. The government and regulators have been taking differing positions on whether to allow them or ban them in Indian securities markets.

Their competing stand highlights the dilemma faced by them in attempting to regulate the Foreign Institutional Investors while also attracting foreign investment in India. SEBI has been imposing restrictions and issuing guidelines from time to time, as it feels that sudden withdrawal by FIIs causes huge volatility in stock markets. For instance, when the government imposed restrictions on trading in participatory notes in October 2007, the Sensex plunged nearly 8% or 1,744 points during the day’s session.

The government is not keen on banning Participatory Notes completely, primarily because it fears any such move could lead to a flight of capital from a country that has a current account deficit (CAD) and needs foreign investment desperately to reduce it. The markets have always reacted violently whenever the Finance Ministry, SEBI or RBI have taken a stand on Participatory notes sending wrong signals to the Foreign Institutional Investors (FIIs). So what are Participatory notes, P- Notes, or simply PNs? Let us try to demystify them.

What Are Participatory Notes?

Participatory notes are financial instruments issued by foreign institutional investors (FIIs) to investors and hedge funds in foreign countries who want to invest in Indian securities.

P-Notes are Offshore Derivative Investments (ODIs) with equity shares or debt securities as underlying assets. An FII is an investor registered outside India but wants to invest in India. They collect money from investors and issue P notes to them. The PNs provide liquidity to the investors as they can transfer the ownership by endorsement and delivery.

While the FIIs have to report all such investments each quarter to SEBI, they need not disclose the identity of the actual investors. Any dividends or capital gains arising out of the investments are passed back to the investors. The genesis of PNs can be traced back to 1991-92 when Foreign Institutional Investors (FIIs) were allowed to buy stocks listed on Indian exchanges.

The problem was all investors were required to register themselves with SEBI. To get around these restrictions, FIIs started issuing participatory notes to investors. The practice was legitimized in 2002 during the tenure of SEBI Chairman R Mehta.

This system was a godsend gift as overseas investors like HNIs, hedge funds and other investors could buy Indian shares without the need to register with SEBI. PNs soon became popular investment channels as investors as they did not have to go through cumbersome regulatory approvals thus saving them time and cost.

They could also hide their identity and remain anonymous. However, because of the anonymity, regulators found it extremely difficult to trace the identity of the owner of participatory notes. Therefore, the concern for the regulator was to stop the substantial amounts of illegal and unaccounted money entering the country through participatory notes.

There were also reports that Indians were routing their black money and indulging in round-tripping and integrating it into the economy. After the passage of the PMLA Act policy makers felt a need for stricter compliance of rules as this practice of round-tripping of funds was used for criminal and illegal activities.

Share of PNs decline

Though FIIs have been investing aggressively in the Indian stock markets the share of PNs has been declining steadily as SEBI has been tightening compliance and regulatory requirements for PNs.

In 2017 it prohibited FIIs from issuing overseas derivative instruments (ODIs) having derivatives as their underlying security other than for hedging their position in equity. The circular also directed investors to liquidate their P-Note investments having derivatives as the underlying security by the date of the instruments’ maturity or by 31 December 2020.

(The writer is a CFA and a former banker & currently teaches at Manipal Academy of Banking, Bengaluru)