P-Notes - Concept, Rationale and Concerns

P-Notes – Concept, Rationale and Concerns

Question - P-Notes have seen a resurgence in the Indian investment market in recent times. Discuss the concept of participatory notes and rationale for issuance of the same as well as concerns underlying them.

Investments through P-notes in the Indian market has surged to INR 2.72 lakh crore over a 7 year period in March 2015

Concept of P-Notes

• Participatory Note or P-Note is a derivative instrument issued in foreign jurisdictions by SEBI registered FIIs or sub accounts or associates against underlaying securities from India

• P-Notes/PN are also known as

- Overseas Derivative Instruments,
- Equity Linked Notes,
- Capped Return Notes, and
- Participating Return Notes

• In January 2014, SEBI issued new Regulations for Foreign Portfolio Investors and PN were formally defined as Offshore Derivative Instrument

• Investor in PN does not own underlying Indian security held by FII who issues PN

• These notes are used by overseas HNIs, hedge funds and foreign institutions to invest in Indian market through FIIs

• This is essential for saving time and money through the route can be used for round tripping of black money

Rationale For PN Issuance

• Restrictions on foreign investments have led to the emergence of offshore derivative market

• Lack of full CAC also creates entry barriers for foreign investors

• Offshore derivative market enables investors to access local shares without time and cost involved in direct investments

• Foreign investor pays PN issuer through certain basis points on the value of PNs traded by him as cost

• PNs are tools for managing risk, lowering cost of financing and enhancing portfolio yields

• They also offer an important hedging tool for foreign investors registered as FII

• Trading in PNs also provides offshore entities with access to commission based business model

• Efficiency is the key benefit of PNs

Concerns Regarding P-Notes

• P-notes can easily be transferred causing obfuscation of real beneficial owner

• P-Notes create multiple layers and concerns about identity of ultimate beneficial owner and source of funds arises

• Real time market surveillance is beyond the jurisdiction of SEBI

• Money coming from market via PNs could be black money parading as FII investment

Facts and Stats

• As per data released by SEBI, the complete value of P-Note investments in Indian markets including equity, debt and derivative rose to INR 2.72 lakh crore (approximately 2,72,078 crore) towards March end from INR 2,71,752 crore in the previous month

• This is the highest investment since February 2008 when cumulative value of investments was pegged at INR 3.23 lakh crore

• Quantum of FII investments through P-Notes has claimed to 11.3% last month from 11.1% in February

• P-Notes used to account for more than 50% of total FII investments a few years back

• They have been accounting for 15-20 percent of total FII holdings in India since 2009

• This used to be in the range of 25-40 percent in 2008

• It peaked to 50% during the 2007 bull run