Mrunal (Economy) Participatory Notes (P-Notes), Hedge Funds, New Limits On FII, FPI, REFI Explained Mrunal

6/18/2014
Mrunal [Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI, REFI explained Mrunal
[Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI,
REFI explained
1. Foreign Investment rules: SEBI Vs RBI
1. SEBI new classification of FPI
2. SEBI: Alternative investment fund (AIF) classification
2. What are Hedge funds?
3. Difference between Hedge Fund & Mutual fund
4. What is Participatory Note (P-Notes)?
1. Why Ban Participatory Notes (P-notes)?
2. P-Notes, Money laundering & Terror Financing
3. P-notes and CGT evasion
5. Appendix: How Hedge funds make money?
1. #1: Short selling
2. #2: Leverage
3. #3: Arbitrage
6. Mock Question
7. Correct Answers for MCQs
FII rules: SEBI Vs RBI

SEBI
FPI: Foreign portfolio investor
effective from June 1, 2014
RBI
ReFI: Registered
Foreign Portfolio
Investor
effective from
March 19, 2014
Includes
FII: Foreign institutional investor, their sub-accounts
QFI: Qualified Foreign Investor
NRI excluded
Can trade in Indian shares, bonds, debentures, derivatives
SEBI: investment limit
same as SEBI
same as SEBI
same as SEBI
investment limit
cannot buy treasury bills

can hold maximum 10% shares in a company
Doesnt apply retrospectively. Example If FII HSBC already owns
11% of Infosys shares (before 1/June/2014), they dont need to
sell 1% to get back in 10% limited.
(FMC rule) Cannot become board of director in any Indian
commodity exchange.
have to register themselves as FPI, in any SEBI-approved Designated
Depository Participants (DDP)
further classification into three categories (Given below)
Government
bonds: 25
billion
corporate
bonds: 51
billion
nope
SEBI new classification of Foreign investors

http://mrunal.org/2014/06/economy-participatory-notes-p-notes-hedge-funds-new-limits-fii-fpi-refi-explained.html/print/
1/12
6/18/2014
Foreign Portfolio Investors (FPI), New classification is based on two criteria:

1. Risk profile: less risky means better category
2. KYC compliance: better Know Your customer compliance means better category
FPI: Classification
CAT I
Foreign government.
Foreign governments financial Institutions (e.g. American equivalents of UTI,
EPFO, LIC)
This is category 1 because least risky and best KYC compliance in their home
country.
Can issue/buy/sell Participatory Notes (P-Notes)
CAT
II
Foreign countrys Mutual Fund, Pension Fund, University endowment fund

Can issue/buy/sell Participatory Notes (P-Notes), except certain risky institution
listed by SEBI.
CAT
III
Not in CAT I and CAT II. Example Hedge funds (also known as alternative
investment fund).
in otherwords, highly risky and less KYC compliance type FII are put here.
Cannot issue participatory notes by themselves.
Cannot subscribe/buy/sell to P-notes issued by CAT I or CAT II.
cannot do above things even indirectly. (because SEBI order says so)
Donot confuse between these FPI vs alternative investment funds
SEBI: Alternative investment fund (AIF) classification

AIF
Category
Examples
1. angel investors
2. venture capital
funds,
3. small and
medium
enterprises
(SME) funds,
4. social venture
funds
infrastructure
funds
Those not in the
category 1 or 2
Private equity
funds
debt funds
Hedge funds
impact on Economy
Positive. They help new entrepreneurs, startup companies

and infra. Development
Mixed. They use leverage only for day to day requirements.

Hence less dangerous than Hedge Funds. (leverage
explained in appendix).
They pose systematic risk to Indian market, due to complex
trading strategies. (explained in the Appendix)
2/12
6/18/2014
What are Hedge funds?

Youre aware of the mutual funds (MF): you invest money in MF, they invest money in
share market and give you profit, after cutting their commission.
Hedge fund is a similar investment game, where High net worth individuals (HNI) pool
their money into high risky games to earn high return on investment.
But their trading-techniques are far more complex than mutual funds, hence Hedge funds
can make money even with sharemarket going down.
Difference between Hedge Fund & Mutual fund
Hedge Fund
Mutual fund
Only High Net worth Individual (HNI) can enter this game
Any investor welcome.e.g. SBI
Indian hedge fund: 1 crore rupees (SEBI rule)
mutual fund Rs.100 minimum
Foreign (offshore) hedge fund: 5 lakhs dollars
investment required!
SEBI registers them Alternative Investment fundCategory III.
They prefer to invest in risky bonds and shares (Because
high risk=high return) e.g. Shares of Kingfisher and C
graded Bonds of Somalian Government.
registered as Asset Management

companies (AMC)
They usually stick to shares and
bonds of reliable companies.
They apply techniques such as leverage, short selling

and arbitrage to make high profit (explained in the
Mutual funds provide high return
appendix of this article).
only when sharemarket is going
So, even when sharemarket is going down, Hedge
up.
Fund would continue giving high return to investor.
They also play in derivative instruments such as Pnotes (explained after few para.)
although hedge funds can no longer play in P-notes.
Because SEBI classified foreign hedge funds into
CAT III FPI.
Indian: Karvi Capital, Motilal Oswald, IIFL,
Edelweiss etc.
Foreign: Goldman Sachs, JP Morgan
SEBI regulation not strict.
If Hedge fund manager pooled 100 crore from
investors, he can speculate in securities worth 200
crores. (Twice the amount)
But for T+2 system only meaning within two days he
should settle the transaction.
As such, they dont play into

P-notes.
But if foreign mutual fund
given CAT II status, they
may play in P-notes.
UTI, Reliance Money, SBI mutual

fund etc.
SEBI regulation very strict.

A mutual fund manager
cannot do high level
speculation like a hedge
fund manager.
What is Participatory Note (P-Notes)?
3/12
6/18/2014
Tom Cruz wants to get maximum return on the investment in quickest possible time.
For this, Tom will have to find risky securities (shares/bonds) in third world countries, then
invest money from one country to another quickly, depending on how sharemarket moves.
In India, no one can invest in sharemarket without getting PAN card + DEMAD account
first. Other nations too have similar mechanism.
But if Tom tries to get PAN card and DEMAT account in each third world country, then his
profit will decline- given the cost of running branch office, staff salary, DEMAT fees etc.
in each country.
So, to take a shortcut, Tom will contact some middleman who is already registered as an
FII, has PAN card & DEMAT in India. e.g. HSBC.
Tom gives money to HSBC, with instruction buy A, B and C shares/bonds in X, Y and Z
quantity.
HSBC buys Indian shares. Theyll be stored in DEMAT account of HSBC, and wont be
given to Tom.
But HSBC then gives a receipt to Tom listing the shares/bonds purchased on his behalf and
stored in HSBCs DEMAT account.
This receipt is called Participatory Note.
Technically, it is called offshore derivative instrument. Observe the words
OFFSHORE
DERIVATIVE
Because foreigner owning something in India, without coming to India or

opening office in India.
Because this receipt doesnt have value of its own.
It derives its value from the market value of shares/bonds held by
HSBC. Today it may be worth $1000, tomorrow $12000 depending on
how the prices of Indian securities move.
INSTRUMENT Self-explanatory- this is one type of financial instrument to invest abroad.

1992: SEBI had permitted P-notes, to boost foreign investment in India, after BoP crisis of
1991.
P-note owner doesnt own the shares. (because theyre in the DEMAT account of that
intermediary FII)
P-Note owner doesnt have voting rights in the shareholder meetings
4/12
6/18/2014
Where is the profit in P-notes?

Tom has two options
1. Wait and watch. If the price of those shares go up, call up HSBC to sell them. HSBC
returns principal + profit to Tom, after cutting commission. Tom returns the P-note receipt
to HSBC.
2. Sell this P-note receipt to another foreigner say Jerry. Then Jerry again has same two
options.
Why Ban Participatory Notes (P-notes)?
As of March 2014, Foreigners invested ~Rs. 2 lakh crore in India via P-notes. (this
is 13% of the total FII money coming in India)
As such the FII has to disclose P-note owner data to SEBI on quarterly basis (every 3
months). But often, within 3 months the P-notes would have changed many hands (e.g Tom
to Jerry to Micky to Goofy).
Thus P-note investments are Anonymous. Hard to trace the owner. Can be used for money
laundering and terror financing.
Hot Money: can leave Indian market very soon based on just one phone call from Tom Cruz
to HSBC. Hot money creates heavy rise or fall in share market, so even genuine investors
money is lost.
e.g. Tom continuously buys Infosys shares, they goup to Rs.3000 per share. So, you
(indian) also buy, thinking Infosys will go even higher to 3500, and Ill make profit.
But suddenly tom sells everything, to invest in China for better return.
Now infosys sells not even for 2000. Then you (Indian investor) lost 1000.
P-Notes, Money laundering & Terror Financing

5/12
6/18/2014
Finance Ministry Whitepaper: Indians first send their money to Cayman Islands, British
Virgin Islands, Switzerland, or Luxembourg via Hawala operators. Then, their agents
convert rupees to dollars, re-invest it in Indian market through P-notes. It is possible to
hide the identity of the ultimate beneficiaries, because of these multiple layers. Thus, Pnotes are used in money laundering.
Ex-National security Advisor MK Narayan: Terrorists are using P-notes to invest in
Indian stockmarket, and using the same profits to finance terror operations against India.
They may use this mechanism to first boost Indian stockexchage, then collapse it by
quickly pulling out money from the market. Doubt: how can a poor Pakistan afford
creating volatility in Indian market? Ans. Via printing fake Indian currency, converting it to
dollars in a tax haven, to buy P-notes via a post office company!
RBIs Tarapore Committee: Recommended Banning P-notes for national security and to
stabilize stock exchanges
P-notes and CGT evasion

Capital Gains tax is a direct tax levied on profit from sale of shares/bonds/gold etc.
It is possible to evade capital gains tax via P-notes. Observe:
With P-Notes
Tom can buy Indian shares via FII via p-notes.
Tom sells this P-note to Jerry @profit.

Jerry** doesnt need to pay CGT to Indian
Government, because we cannot trace what
Tom did with that piece of paper in USA!
Even if P-note is sold 10 times to 10
different people, we cannot get CGT.
Well get CGT only once, when the said pnote owner instructs the FII to sell the shares
from its Indian DEMAT account/ portfolio.
Without P-notes
Tom and Jerry have to get
PAN+DEMAT. Only then, they can
buy/sell Indian shares.
If Tom sells his shares to Jerry (and

makes profit), then Jerry** will
have to pay Capital gains tax to
India.
Because Income tax official can
trace it by monitoring the DEMAT
activity of both accounts.
**In theory, the seller has to pay the Capital gain tax (Tom Cruz in our case). but in reality
the buyer (Jerry) has to cut down the amount from payment to Tom, and give directly to
government. Recall the Tax deduction at source (TDS) concept in Nokia controversy article
click me.
Parthsarathi
Shome
Government must tax such P-note holders from next budget 2014.
Shome is a tax expert, he earlier chaired the Committee on
GAAR.
Appendix: How Hedge funds make money?
6/12
6/18/2014
Suppose, Mr.Tom Cruz runs a hedge fund for High net worth Individuals (HNI) Arnold
Schwarzenegger and Leonardo di Caprio.
To get maximum return in quickest possible time, Hedge Fund manager Tom Cruz will
apply three techniques:
#1: Short selling

Suppose Facebook shares are selling at $1200 dollars.
Tom Cruz borrows 5000 facebook shares from a broker Bruce Willis, for two days; and
immediately sells them in share market.
Now, Facebook share price will fall to say $1000 (imagine sudden supply of new onions in
the market)
Tom buys 5000 facebook shares @$1000 from another investor, and returns them to
broker Bruce Willis.
Whats Toms profit here:
Price per share quantity
total
Tom Sold
1200
5000
(+) 60,00,000 (because he received $$)
Tom bought back 1000
5000
(-) 50,00,000 (because he paid $$)
Toms profit
$10,00,000
You can see this is a risky game. Sometimes share price may not fall down but increase
(because of some other player doing large purchases). In that case Tom will lose money
(because hell have to buy higher priced shares and return to Broker Bruce Willis.) ad
Broker Bruce Willis will make profit. (Because he will receive shares whose market price
has now increased.)
For short-selling trick to yield result, you need massive quantity of shares. (If I sell 1 kilo
onion from my kitchen, it wont bring down prices in the Mandi. I need atleast a 1000 kilo,
to change the supply-demand and prices.)
Therefore, Hedge funds dont accept aam-admi in their game. They only allow High
Networth Individual to join the game, who can finance such large purchases and have deep
pockets to suffer large losses.
7/12
6/18/2014
#2: Leverage
Suppose Tom has only $500 and wants to bet in $1000 worth shares.
his own pocket
$500
borrows from a friend @10% interest $500 ($50 in interest later repaid)
total with Tom
$1000
Tom uses this $1000, to purchase shares from Broker Bruce Willis. Now suppose same shares
price goes up** and Tom is able to sell them @$1200.
Whats Toms profit here?
Earned
invested
borrowed
interest
Profit
(+) $1200 by selling shares

(-) $500 from his own pocket
(-)$500 principal to friend
(-) $50 interest to friend
$150
** Shares price can go up for variety of reasons.

company expected to make good profit (and thereby declare bigger dividends)
there are talks of merger / acquisition of that company
If Tom himself starts buying large amount of shares (imagine scarcity of onions).
Again, this is a risky game, if Share prices doesnt rise, Tom will make huge losses (Because
hell have to return $550 to the friend at some point).
#3: Arbitrage
When same thing sells for different rates in two markets, Tom can take advantage of arbitrage, to
make profit.
New York stock exchange California Stock Exchange
1 facebook share sells
@1000 (on todays date)
Some investor is willing to make future-contract: Ill buy

1000 facebook shares @ $1200 3 months from now.
He wants future contract because right now he doesnt have
money or xyz reason.
In this case, Tom will purchase 1000 shares of Facebook from NY and simultaneously make
future contract with Californian investors ok Ill sell you the shares @ $1200 after three
months.
This Toms profit: $200 x 1000 Nos. = $2 lakh Dollars.
Although in real life, the arbitrage is so narrow Tom will have to apply leverage, to make
significant profit. Example
NewYork: $1000 / per Facebook share
California: $1002 / per Facebook share.
Here only $2 profit per share
If Tom wants to make $2,00,000 profit, he will have to buy 1 lakh No. of shares.
But he may not have that much money in his own pocket, to purchase such large quantity.
8/12
6/18/2014
In that case, Tom will need to borrow additional money from friend to play this game (refer
the Leverage concept again.)
With advent of online trading, the arbitrage has decreased to decimal points. say $1000.38 in NY
and $1000.40 in Cali. So, here Tom has to buy even bigger quantity (Ten lakh shares) to see
substantial profit. Tom Cruz may have excellent brain but hed need High Networth Individuals
like Arnold & Leonardo to provide him the necessary funding. Thus, Hedge funds emerged.
Going even complex:

NewYork: $1002 / per Facebook share
California: $1002 / per Facebook share
How can Tom make money here?
Hell first apply Short selling technique in New York so that Facebook price falls down
at 1000. ($2 profit)
Then he uses arbitrage between NY and Cali to make additional profit. ($2)
So 2+2 = 4$ profit per share. Imagine if he bought 1 lakh shares like this.
Mock Question
Q1. Find correct statements about the new classification of foreign portfolio investors by
SEBI
1. the entities with higher risk profile and lower KYC compliance, are put under category
Three
2. alternative investment funds are put under category one
3. University endowment funds are put under category Two
Answer choice
1.
2.
3.
4.
only 1 and 2
only 2 and 3
only 1 and 3
All of them
Q2. Find the incorrect statements about the classification of alternative investment funds
by SEBI
1. Entities with positive externality on Indian economy, are put under category three
2. infrastructure funds are put under category two
3. hedge funds are classified as alternative investment funds category III.
Answer choice
1.
2.
3.
4.
only 2
only 1 and 2
only 2 and 3
only 1 and 3
Q3. What are the consequences if SEBI/RBI doesnt put any restrictions on foreign
portfolio investors?
1. Dollar to rupee exchange rate may become volatile
2. Indian Sensex may become volatile
3. India may run into another balance of payments crisis
9/12
6/18/2014
Answer choice
1.
2.
3.
4.
only 1 and 2
only 2 and 3
only 1 and 3
All of them
Q4. Find incorrect statement

1. An foreign portfolio investors can buy only a fixed quantity of government bonds in India,
but hes free to buy as many corporate bonds as he wishes.
2. A foreign portfolio investor can demand position in the board of directors of a commodity
trading exchange, if owns sufficient number of shares of the said exchange.
3. Both A and B
4. neither A nor B
Q5. Consider following statements
1. An NRI need not register himself as a foreign portfolio investors, if he wishes to buy
corporate bonds
2. An NRI need needs to register himself as a foreign portfolio investors, if he wishes to buy
government bonds
3. An NRI is prohibited from buying Treasury bills.
Which of them are incorrect?
1.
2.
3.
4.
Only 2
only 1 and 2
only 2 and 3
only 1 and 3
Q6. Consider following statements about Hedge Funds

1. A middle class Indian family cannot invest in Hedge Funds.
2. In theory, Hedge fund can provide good return even during slowdown in sharemarket.
3. Given their risky profile, SEBI doesnt permit foreign hedge funds to operate in India.
Which of them are correct?
1.
2.
3.
4.
Only 3
only 1 and 2
only 2 and 3
only 1 and 3
Q7. P-Notes is a/an ____.

1.
2.
3.
4.
Alternative investment instrument

Alternative derivative instrument
Offshore derivative instrument
Offshore equity instrument
Q8. Who uses P-notes?

1. Entities that want to raise capital from abroad but cant, due to ADR/GDR/ECB related
norms.
2. Entities that want to raise capital from abroad but cant because of ECB norms.
3. Entities that want to invest in a securities market abroad, but want to maintain anonymity.
4. Entities that want to invest in a sector where Foreign direct investment is prohibited.
10/12
6/18/2014
Q9. As per SEBI norms

1. Foreigners are completely prohibited from using p-notes to invest in India.
2. Only NRIs can use P-notes to invest in India.
3. IF a person wants to invest via P-notes, he needs to get a PAN card first.
Which of them are correct?
1.
2.
3.
4.
only 1 and 2
only 2 and 3
only 1 and 3
None of them
Q10. In stockmarket, what do you understand by the term Leverage?

1.
2.
3.
4.
Seeking to increase returns by borrowing funds.

process of selling securitis that the seller does not own.
Profit from the price differentials between the two markets.
Buying securities from the primary market to sell them at higher prices in secondary
market.
Q11. In stockmarket, what do you understand by the term Stag investor?

1.
2.
3.
4.
Seeking to increase returns by borrowing funds.

process of selling shares of a security that the seller does not own.
Profit from the price differentials between the two markets.
market.
Q12. In stockmarket, what do you understand by the term Arbitrage?

1.
2.
3.
4.
A broker offering option on a share selling contract.

Profit due to difference between two stock indexes e.g. SENSEX vs NIFTY.
Profit from the price difference of securities between the two markets.
market.
Mains & Interview

1. (GS3) What is Participatory note? Why does it pose challenge to the fight against money
laundering and terror finance?
2. (interview) SEBI should completely ban P-notes. Whats your opinion?
Correct Answers for MCQs

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
Answer C only 1 and 3 correct. Alternative investment fund is a different thing

Answer A. You were required to find the incorrect statement viz. statement #2
D all of them.
Answer C. You were required to find incorrect statement.
Answer C only 2 and 3 are wrong.
Answer B. 1 and 2 correct.
P note: offshore derivative.
Answer C maintain anonymity.
D none of them correct.
A. increase returns by borrowing funds
D
C price difference between two markets.
11/12
6/18/2014
Visit Mrunal.org/Economy For more on Money, Banking, Finance, Taxation and Economy.
URL to article: http://mrunal.org/2014/06/economy-participatory-notes-p-notes-hedgefunds-new-limits-fii-fpi-refi-explained.html

Posted By Mrunal On 18/06/2014 @ 15:27 In the category Economy
12/12

Mrunal (Economy) Participatory Notes (P-Notes), Hedge Funds, New Limits On FII, FPI, REFI Explained Mrunal

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Mrunal (Economy) Participatory Notes (P-Notes), Hedge Funds, New Limits On FII, FPI, REFI Explained Mrunal

Uploaded by

Copyright:

Available Formats

6/18/2014

FII rules: SEBI Vs RBI

cannot buy treasury bills

SEBI new classification of Foreign investors

Foreign Portfolio Investors (FPI), New classification is based on two criteria:

Foreign countrys Mutual Fund, Pension Fund, University endowment fund

Donot confuse between these FPI vs alternative investment funds

SEBI: Alternative investment fund (AIF) classification

Positive. They help new entrepreneurs, startup companies

Mixed. They use leverage only for day to day requirements.

What are Hedge funds?

registered as Asset Management

They apply techniques such as leverage, short selling

As such, they dont play into

UTI, Reliance Money, SBI mutual

SEBI regulation very strict.

What is Participatory Note (P-Notes)?

Because foreigner owning something in India, without coming to India or

INSTRUMENT Self-explanatory- this is one type of financial instrument to invest abroad.

Where is the profit in P-notes?

Why Ban Participatory Notes (P-notes)?

P-Notes, Money laundering & Terror Financing

P-notes and CGT evasion

Tom sells this P-note to Jerry @profit.

If Tom sells his shares to Jerry (and

Appendix: How Hedge funds make money?

#1: Short selling

(+) $1200 by selling shares

** Shares price can go up for variety of reasons.

Some investor is willing to make future-contract: Ill buy

Going even complex:

Q4. Find incorrect statement

Q6. Consider following statements about Hedge Funds

Q7. P-Notes is a/an ____.

Alternative investment instrument

Q8. Who uses P-notes?

Q9. As per SEBI norms

Q10. In stockmarket, what do you understand by the term Leverage?

Seeking to increase returns by borrowing funds.

Q11. In stockmarket, what do you understand by the term Stag investor?

Seeking to increase returns by borrowing funds.

Q12. In stockmarket, what do you understand by the term Arbitrage?

A broker offering option on a share selling contract.

Mains & Interview

Correct Answers for MCQs

Answer C only 1 and 3 correct. Alternative investment fund is a different thing

URL to article: http://mrunal.org/2014/06/economy-participatory-notes-p-notes-hedgefunds-new-limits-fii-fpi-refi-explained.html

You might also like