Participatory notes account for over 40 pc of FII inflows

Our Bureau Mumbai , Sept 21 FUNDS routed through participatory notes account for almost 42 per cent of the $8.3 billion invested by FIIs in the Indian securities market so far this year. The share of P-Notes (as participatory notes are commonly referred to) has gone up from 24 per cent earlier this year to the current level, according to SEBI sources. The pace at which the Indian markets have moved so far this calendar year has left regulators worried about possible misuse of P-Notes. FII investments, directly and through the P-Notes route, have provided the biggest liquidity support to the current bull run. While FIIs were net investors to the tune of $8.5 billion during the last calendar year, expectations are that they would invest close to $12 billion this year. This would take the market's exposure to P-Notes to over $5 billion, if the same ratio were maintained for the next three months. The total number of registered FIIs now stands at 782. This is up from 632 on December 31, 2004. Market participants say that the new FIIs registered this year are largely Japanese and Scandinavian investors. Participatory notes are like contract notes. These are issued by FIIs to entities that want to invest in the Indian stock market but do not want to register themselves with the SEBI. FIIs registered with the SEBI and their sub-accounts can issue, deal, or hold PNotes. The underlying security against these notes would be listed or proposedto-be-listed securities on any Indian stock exchange. FIIs issue these notes to investors abroad with details of scrips 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 scrips 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. 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. FIIs are not allowed to issue P-Notes to Indian nationals, persons of Indian origin or overseas corporate bodies (which are majority owned or controlled by NRIs).

This is done to ensure that the P-Note route is not used for money laundering purposes. FIIs are required to report to the SEBI on a monthly basis if they issue, renew, cancel, or redeem P-Notes. The SEBI also seeks some quarterly reports about investing in P-Notes.

What do experts read into Sebi's PN move?
2007-10-17 09:14:57 Source : moneycontrol.com Email

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The Securities and Exchange Board of India, or Sebi, has released its report on P-Notes, or participatory notes. It suggests that FIIs should not renew or issue PNs with underlying as derivatives. It also wants sub-accounts to not issue PNs. The regulator has asked for comments on its paper by October 20. So, what do experts have to make of Sebi's latest proposal? R H Patil, Former MD, NSE, said, Sebi's proposed move is not a wholehearted step. "There is a bubble built up in markets and small investors have deserted. We should not have allowed this bubble to build up to such a level." The regulator, he feels, should have taken a step on PNs earlier. "The markets would have imploded if Sebi's proposed move hadn't come. The proposed move is positive as 18,000-19,000 for the Sensex is unrealistic." He doesn't feel the market is safe enough to enter. “Those who wanted to encash their investments have already encashed. “The tussle that is going on among big players and the huge amount of money that is coming in is a dangerous thing as it is resulting in an exchange rate appreciation in a big way. The foreign investor, whether the fundamentals are good or not or whether he does a technical study or not, just brings in money and gets a safe return as the rupee is depreciating.” SS Tarapore, Former Deputy Governor, RBI, said the Committee on Capital Account recommended a ban on PNs and within one-year allowed PNs to run-off. "Don't allow fresh PNs to be created."

Ambareesh Baliga of Karvy Stock Broking said the bubble in the markets wouldn't have built up if Sebi moved six months ago. "We could see a sell-off and this could be a sentimental sell-off. But there should be a much bigger sell-off once it becomes a directive." Subodh Kumar, Chief Investment Strategist, Subodh Kumar & Associates, said international investors would not like such intervention. "The effect of Sebi's proposed move could be more violent in the short-term. A 10% correction in stock prices will not be a big deal. Long-term investments though are likely to remain."
Vallabh Bhansali, Chairman, Enam, expects an immediate knee-jerk reaction in the market. " What

we may not be able to see in this guideline is that this has given the rupee strength. Given the rupee strength, the market is ready to move to a convertible structure." At one level, Sebi just thought that if we have to get into the regime post P-Note, this is the best time to start because of the level of the market, he said. “This is a draft guideline. They want to get reactions and want to allow time. This time the allowance business is seen in some features and not in others; it is not uniform. I do see the attitude of Sebi and that is let us allow some time and not disturb the market too much. The market is ready to move to a more convertible kind of structure. May be I am an optimist. I see some positives also lurking in this. The markets have shown tremendous maturity and they work themselves out pretty fast. I think its healthy pause for the market.”

Participatory note fear- real or unfounded
Close on the heals of Sensex scaling new dizzy heights, comes the spectre of P-notes with its potential to wreak havoc on Indian economy. Cognizant of the power, inclination and history of P-note holders to hold economies to ransom, the central bank (RBI) in a letter this month requested the Finance ministry to ban the issuance of P-notes in susceptible sectors like Banking, Petroleum and telecommunication. The Central bank’s worry is that that these notes can be misused for money laundering and there is an added risk in allowing those

offshore investors to invest in India who are not the vigilant radar of their countries and Indian regulators may not be able to catch hold of them. RBI is also concerned with the fact that P-notes even bypass the ownership norms applicable for Private banks. It was this anxiety that spurred the RBI to acknowledge shares in private banks amounting to 5% or more. There is a flurry of activity of bank share counters which has added to woes of RBI. Central bank interprets that any foreign investor, not registered with SEBI and bullish on any Indian private bank can purchase below 5% limit shares from one broker and is issued P-notes by that broker. After some time that very investor can buy similar block of same private bank scrip through other broker. Besides money laundering and skirting of ownership rules applicable to Indian private banks, RBI has also cited national security concerns for imposing curbs on P-notes. But before going into the merits of RBI’s concern and reaction of Finance ministry and SEBI or its missive, we need to first understand what Participatory notes actually are. Participatory notes are derivative instruments which are issued by FIIs to foreign investors who like FIIs are not registered with SEBI but want an exposure to Indian equities. In a way it is an understanding between a foreign investor

who is registered here and the other one who is not registered. Underlying securities in Participatory notes are Indian stocks. Foreign investors who want to trade in Indian securities anonymously use PN route. The RBI’s concern to impose ban on the issuance of P-notes may have been aggravated three factors. First and foremost is an appeal pending with the Securities Appellate Tribunal Bombay in UBS Vs SEBI. UBS securities is a foreign institutional brokerage firm which was banned from issuing P-notes by SEBI after the historic crash of Indian stock market on Black Monday i.e., 17th may 2004. In this case UBS issued the P-notes to Caxton International, a foreign based fund not registered in India. After the historic crash of stock market, SEBI asked the UBS securities to name the end beneficiaries. UBS’ answer that Caxton international was the end beneficiary, did not satisfy the SEBI and it banned the UBS from dealing in Indian securities. RBI governor too quite often than not alluded to nameless and faceless investors whose money is coming into Indian market. The second factor is Joint Parliamentary Committee report that followed Ketan Parekh led stock market crash of 2001. The JPC even without completing the probe laid down the

points that need to be investigated. One pertinent point that caught their attention was to probe the role of P-notes in sending the money offshore and plough back it in India. The underlying fear was that Indian traders could use the NRI route. The last but not the least important is the history of P-note holders to affect the economies of countries they thrive on by resorting to shenanigans like capital flight. They were allegedly involved in Asian Tiger Economies crisis of 1997 which was the outcome of sharply falling Baht (Thai currency) and Ringgit ( Malaysian currency). Their hidden hand is also seen in the great Mexico Financial crisis of 1994 where Peso nosedived. For the last 30 months or so an astronomically high amount of $ 20.5 bn has been pumped into Indian equity investment by FIIs and our stock market regulator (SEBI) is of the view that of that $ 20.5 bn money about 20 to 25 percent of FIIs investment in Indian bourses has been routed through P-notes. This makes upto $ 5 bn in just 30 months which makes a phenomenal amount. If this amount is withdrawn, The gung ho position on the bourses will become like the frost smitten flower.

The final view on the RBIs letter is yet to be taken by the government. Finance minister has recently said that if some offshore investor is bullish on India and wants to park his money here, there is nothing wrong with it. According to SEBI chief M. Damodaran “know your investment requirement norms”, if some one wants to come to Indian market, he must register himself as an FII which means subscribing to all the requirements. Maximum level of transparency and comfort regarding the kind of players and origin of money is what is imperative according to Damodaran. He tries to assuage the feelings of foreign investors by saying that UBS ban should not be mistaken as a blanket ban on all P-notes. Government is not comfortable with the ban on P-notes because it reckons that this will be a reversal of its policy decision on Portfolio investment. P-note holders are wealthy private investors and large institutions with their money bags. They take big bets in stock markets. They have even been described as highway man of global economy. They have the financial muscle to move the market up and down with breath taking speed. A blanket ban on them will not do. As it will bring the market down and erode the confidence of all including small investor. A middle path enunciated by SEBI is the best bet. According to SEBI, extreme views should not

be taken. If one chooses to register (like any other FII) and come in, It ( SEBI ) will be more comfortable. Once one is registering as an FII, he is subscribing to all the requirements including transparency. Though SEBI’s suggestion is contested by fund managers on the ground that Investors like Swiss Bank do not want to be known. Also, they are apprehensive of their name reaching the regulator. It is also feared that anything filed with Indian government organization is for sale. So time will tell what view the govt. takes on the subject.
FIIs get RBI missive on participatory note details
Rakesh P Sharma, Anindita Dey & Anusha S in Mumbai | August 07, 2003 11:59 IST

The Reserve Bank of India on Wednesday sent out letters to a section of foreign brokerages seeking details of their turnover in the participatory notes business, as also the underlying scrips on which these notes are issued. The RBI is reportedly looking to check the origins of these funds. The move follows its concerns over possible misuse of participatory notes by hedge funds and other entities that are not allowed under the current regulations. Participatory notes are like contract notes issued by registered FIIs to their clients outside India. These are issued to investors who do not want to go through the various regulatory processes in India which require them to make at least a minimum level of disclosure. According to broking sources, participatory notes enable foreign hedge funds to invest in India through broking firms. Now with the yields moving up in the United States, they have started liquidating these investments at a time when the Indian market has started looking up. This sends negative signals to the market and affects the overall business sentiment. It may be recalled that the Securities and Exchange Board of India had first raised the issue of participatory notes through a circular in October 2001.

The circular said some FIIs were issuing derivatives/financial instruments against underlying Indian securities. The circular had said these instruments were known by various names such as participatory notes, equity-linked notes, capped return notes and participating return notes. With a view to monitoring the investment by FIIs through participatory notes, Sebi had decided that FIIs must report details of these instruments along with the names of the holders of these instruments. In order to increase transparency, Sebi had in October 2001 issued a circular to all FIIs and their custodians advising them to report to the regulator as and when any derivative instrument with Indian underlying securities were issued/renewed/redeemed by them either on their own account or on behalf of sub-accounts registered with them. Accordingly, FIIs are sending reports from time to time whenever they are issuing PNs. The disclosures in the reports submitted by FIIs are to be enhanced.

What are participatory notes?

Participatory Notes
Financial instruments used by investors or hedge funds that are not registered with the Securities and Exchange Board of India to invest in Indian securities. Indian-based brokerages buy India-based securities and then issue participatory notes to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors. In many ways, this is similar to an informal ADR process, where brokerages hold on to stocks for foreign investors. 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.

American Depositary Receipt (ADR)
A negotiable certificate issued by a U.S. bank representing a specified number of shares (or one share) in a foreign stock that is traded on a U.S. exchange. ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution overseas. ADRs help to reduce administration and duty costs that would otherwise be levied on each transaction.

This is an excellent way to buy shares in a foreign company while realizing any dividends and capital gains in U.S. dollars. However, ADRs do not eliminate the currency and economic risks for the underlying shares in another country. For example, dividend payments in euros would be converted to U.S. dollars, net of conversion expenses and foreign taxes and in accordance with the deposit agreement. ADRs are listed on either the NYSE, AMEX or Nasdaq.

Global Depositary Receipt (GDR)
1. A bank certificate issued in more than one country for shares in a foreign company. The shares are held by a foreign branch of an international bank. The shares trade as domestic shares, but are offered for sale globally through the various bank branches. 2. A financial instrument used by private markets to raise capital denominated in either U.S. dollars or euros. 1. A GDR is very similar to an American Depositary Receipt. 2. These instruments are called EDRs when private markets are attempting to obtain euros.

P-Notes, right move for medium term: Uday Kotak
2007-10-17 09:42:18 Source : CNBC-TV18 Email

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Uday Kotak, VC and MD, Kotak Mahindra Bank believes the P-Notes move

in the medium-term, is a right move, but it may hold short-term pain. He said the direction of proposals does not go against capital flows. Sebi will encourage direct FIIs to register and may give FII registrations much faster than before, he said. Kotak is of the view that there is no immediate pressure to sell on PNotes issued for the cash market. Excerpts from CNBC-TV18's exclusive interview with Uday Kotak: Q: Mr JR Varma, Former SEBI Member, is making the point that he would have done it differently, would you have too or do you agree with this way? A: I think first to step back and go to the concept, which is a medium-term right directional move by SEBI with short-term pain. We can talk about tweaking separately, but on a fundamental basis, medium-term move is the right move and there will be some short-term pain. Q: How would you tweak it? How would you implement it now if you had to today?

A: If you really look at it, there are some nuisances, which obviously have to be looked at. Like in the case of derivatives, if there is a P-Note position on the 25th and 18 months is allowed, whether rollovers will be allowed or not, but if you look at the direction of what the proposed note is saying, it's not saying no to capital flows. At the same time the sense we are getting is, SEBI would be moving in a pretty fast manner to register a lot more FIIs and therefore is saying, let me know who the investors are and I welcome them to come directly. So this is a structural move and I do not think we should look at it as just a way to stop flows. It is a move to get direct investors to participate in Indian market rather than through paying rent. Q: I am quoting from what a lot of reports are suggesting today, including the IMF saying that restrictions on capital flows have generally not facilitated lower real appreciation. Just to be completely right on - do you read this as a capital control measure? A: This is not a cap on capital flows. What regulator is saying, I need to know who the investors are and I believe the regulator will encourage direct FIIs to register. All PN holders, which are legitimate, should come and apply through the front door as FIIs. And I believe that SEBI will be in a positive mood to give registrations much faster and on a significantly more active basis than before. So you are just making sure that people come through the front door and not behind the door. Q: Your point about the medium-term impact is taken, but if this was the question then could it not have been achieved by the sunset time by which sub-accounts or P-Note holders would have to be necessarily registered as FIIs instead of doing the reverse and saying you need to wind-up your positions within a certain specified time? A: If you go through the proposed guidelines for all investors who are in the cash market, either they are on hold or there is a period of 18 months for which they can continue to hold. Therefore investors in the cash market are protected. PN has been issued in the cash market, there is no immediate pressure to sell on the market. As regards the derivative positions, effectively some of the foreign brokerages were operating as mini-stock exchanges offshore and therefore you had many stock exchanges in addition to our stock exchanges and that is unsustainable from a longer term view. And the Indian mood is that it moves slowly, but surely. Q: On SEBI clause: A: The first clause talks about 18 months for unwinding derivative positions also. Q: I will also bring to your notice that the same clause you referred to, also says that FIIs and sub-accounts shall not issue/renew overseas derivative instruments. A: Clarification is required; there is a disconnect between the first line and last line, so maybe in the final guideline there could be a clarification. But subject to that, if there is an 18 months window within which unwinding is required, I think that’s fair. Q: Is this differentiating between the colour of the money right now?

A: My point is, longer term the whole concept of FII registrations needs to be looked at; if you and I as individuals vis-à-vis US regulation want to buy US stocks, we just get registered with a US broker and we are allowed to buy and sell stocks in the US. At some point of time India has to move there, where anybody from outside India wants to deal in stocks, the broker in India does the KYC, should be competent to do a KYC, should be able to convince the regulator that he is doing a good job on that and thereafter the investor should be dealing directly with that broker. This whole concept of registration is a unique Asian concept; many countries are going away from it and I think at some point of time India must allow free flow with making the security swarm or the broker directly accountable for doing the investor KYC and that’s how you move in this market. But in the interim, you are going to see a significant increase in direct registrations and there I would tend to agree with Mr Varma on this point that we must have more and more direct registrations and not have too much of baggage about whether a long-short fund is good or not. I think those judgments we've got to leave it as long as the investor is genuine or set of persons who are identifiable. We should not worry about giving them direct registration and I think that’s the direction India will move toward in the interim till we finally move to direct registrations with brokers themselves. Q: Just a practical question on what happens over the next few days, since your organization interacts with a large number of these clients. Would people find it easy to move to other instruments where they can park some of their India positions? How much time does it take to open an FII account from a sub-account of a Participatory Note instrument? A: There is interim pain and that pain will reflect both in the cash market and the futures market. I would believe that SEBI would move faster on giving new registrations and maybe that’s a question SEBI is best positioned to answer. But if there is a clear signaling by SEBI that they are giving registrations faster and in a speedier manner, that will allay some fear of this interim situation. I would tend to hope that registrations happens faster. Q: What’s happening on the other side of the capital market, that is the currency? For many, this seems to read as a move to control the currency than the equity markets. Where do you stand on that? A: I suppose when policy makers take decisions - first of all I don’t believe that SEBI has been influenced by the currency decision. Having said that the decision has been taken collectively by all concerned. There was a high noise level from exporters and others, where millions of jobs were, so there was an issue there, which needed to be addressed. But I do not think SEBI has given any signal that they want to stop capital flows. Therefore in a sense, it’s a positive move to clean up the quality of capital flows as the regulators see it. At some level there will be a short-term pain in the capital markets undoubtedly, but structurally if we can manage more registrations, front door entry culminating into direct registration with the securities firms themselves that is where India has to move like a modern market.

SEBI move positive from policy perspective
2007-10-17 11:05:56 Source : CNBC-TV18

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The Securities and Exchange Board of India, or Sebi, has released its report on P-Notes, or participatory notes. It suggests that FIIs should not renew or issue PNs with underlying as derivatives. It also wants sub-accounts to not issue PNs. The regulator has asked for comments on its paper by October 20. From a policy perspective, the Sebi move looks like a positive move, but it has come too late. An important part is that everytime the RBI and Sebi have spoken about P-Notes, the Finance Ministry has come and said that they have nothing against the P-Notes. Now that the draft has come in, it seems that the Fin Min has changed its stance on P-Notes and says that P-Notes are not the right entity through which to enter India and further more, they have a put a 40% cap on inflows into India through P-Notes. The FII positions in F&O are at Rs 73,000 crore. A lot of the positions are short positions in that sense. The FIIs have roughly around Rs 20,000 crore of positions in the Index. In stock futures, their positions are around Rs 37-38,000 crore. The Sebi has given 18 months for the FIIs to unwind their positions, which is not exactly right because, at one time you only issue contract notes for 3 months. So basically, you cannot roll over your positions. You have to shift your position to registered FIIs.

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