A Securities and Exchange
Board of India proposal to tighten the rules for purchase of shares and
bonds in Indian companies through the participatory note route took the
breath away of the Indian stock market and it suffered its biggest fall in history.
So what are these participatory notes? And why do they have this huge impact on the Indian securities markets?
P-Notes
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 markets 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.
Why P-Notes?
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.
What are hedge funds?
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 benefit: 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.
Who gets P-Notes?
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
specifically.
What is an FII?
An FII, or a foreign institutional investor, is an entity established to make investments in India.
However,
these FIIs need to get registered with the Securities and Exchange
Board of India. Entities or funds that are eligible to get registered
as FII include pension funds; mutual funds; insurance companies /
reinsurance companies; investment trusts; banks; international or
multilateral organisation or an agency thereof or a foreign government
agency or a foreign central bank; university funds; endowments (serving
broader social objectives); foundations (serving broader social
objectives); and charitable trusts / charitable societies.
The following entities proposing to invest on behalf of broad based funds, are also eligible to be registered as FIIs:
- Asset Management Companies
- Investment Manager/Advisor
- Institutional Portfolio Managers
- Trustees
How does Sebi regulate FIIs?
FIIs
who issue/renew/cancel/redeem P-Notes, are required to report on a
monthly basis. The report should reach the Sebi by the 7th day of the
following month.
The FII merely investing/subscribing in/to the
Participatory Notes -- or any such type of instruments/securities --
with underlying Indian market securities are required to report on
quarterly basis (Jan-Mar, Apr-Jun, Jul-Sep and Oct-Dec).
FIIs who
do not issue PNs but have trades/holds Indian securities during the
reporting quarter (Jan-Mar, Apr-Jun, Jul-Sep and Oct-Dec) require to
submit 'Nil' undertaking on a quarterly basis.
FIIs who do not
issue PNs and do not have trades/ holdings in Indian securities during
the reporting quarter. (Jan-Mar, Apr-Jun, Jul-Sep and Oct-Dec): No
reports required for that reporting quarter.
Who can invest in P-Notes?
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.
Sebi not happy
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.
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.
30% FII money in stocks thru P-Notes
According
to one estimate, more than 30 per cent of foreign institutional money
coming into India is from hedge funds. This has led Sebi to keep a
close watch on FII transactions, and especially hedge funds.
Hedge funds, which thrive on arbitrage opportunities, rarely hold a stock for a long time.
With
a view to monitoring investments through participatory notes, Sebi had
decided that FIIs must report details of these instruments along with
the names of their holders.
Sebi Chairman M Damodaran has said
that the proposals were against PNs but not against FIIs. The
procedures for registering FIIs were in fact being simplified, he said.
Sebi
has also proposed a ban on all PN issuances by sub-accounts of FIIs
with immediate effect. They also will be required to wind up the
current position over 18 months, during which period the capital
markets regulator will review the position from time to time.
Sebi chairman M Damodaran, in a recent interview Business Standard,
said that the amount of foreign investment coming in through
participatory notes keeps changing and is somewhere between 25-30 per
cent. "Recent indications are that it has gone up a little but again
after the sub-prime crisis, there have been some exits. But it's a
fairly significant percentage, it's not something you can ignore."
When
asked if he was comfortable with almost one-fourth of the market being
held by P-Notes, he said that he wasn't 'entirely uncomfortable.'
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