PARTICIPATORY NOTES

Participatory Notes are offshore derivative instruments issued by SEBI-registered (FIIs) to their overseas investors. Reasons for their preference by foreign investors. Concerns of Indian regulators. Recent guidelines of SEBI to regulate P-notes .
Participatory Notes are offshore derivative instruments issued by SEBI-registered Foreign Institutional Investors (FIIs) to their overseas investors, who wish to invest in the Indian stock markets without registering themselves with SEBI. The investors, who buy PNs, deposit their funds with offices of the FIIs situated outside India. The FIIs use their proprietary account to buy stocks in India. The FIIs or the brokers act like exchanges since they execute the trade and use their internal accounts to settle this. FIIs issue PNs to their overseas clients which give details of the underlying stocks. Foreign clients get dividends or capital gains collected from the underlying securities. One reason for using PNs is to keep the investors name anonymous. Some investors use the instrument to save on transaction costs, record keeping, overheads and regulatory compliance overseas. Investors often find it expensive to establish broker and custodian bank relationships, deal in foreign exchange, pay taxes and/or filing, obtain or maintain an investment identity or regulatory approval in certain markets, where their total exposure is not going to be very large. Such investors look for derivative solution to gain exposure in individual, or a basket of, stocks in the relevant market. Sometimes, investors enter the Indian markets in a small way using PNs, and when their positions become larger, they find it advantageous to shift over to a full-fledged Foreign Institutional Investors structure. The biggest problem is their opacity in an era of transparency. Indian regulators do not have any idea about the source of funds and the identity of foreign investors putting money in PNs. On the other hand, Indian investors have to disclose the full details about their funds and identity while putting funds in the market. So there is no level playing field. There is also a fear that PNs bring in hot money which comes into the country suddenly and exits at the same speed. Finally, the government is worried about whether the PN route is being used to launder money. Earlier, a SEBI investigation exposed how Indian money was routed from India to Mauritius, London, British Virgin Islands and the US and re-entered India as foreign money through the PN route. Reserve Bank of India, which had sought a ban on PNs, believes that it is difficult to establish the beneficial ownership or the identity of the ultimate investor, which is possible for registered FIIs. It fears that FIIs, which have to comply with the know-your customer (KYC) norms, know the identity of the investor to whom the note was issued. But it is possible for the investor to sell the PN to another player resulting in multilayering. Tax officials fear that PNs are becoming a favourite with a host of Indian money launderers who use the instrument to first take out funds out of the country, through the hawala route, and then get it back using PNs. Over the years, the use of PNs has increased from 17 Foreign Institutional investors issuing it in 2005 to over two dozen funds now in the current year. Merrill Lynch, Morgan Stanley, Credit Lyonnais, Citigroup and Goldman Sachs are the biggest issuers. The total value of underlying investments in equity represented by the PNs was Rs 67,185 crore representing about 25.7% of the cumulative net investments

in equities by FIIs at the end of June, 2005. As of August 2007, the notional value of PNs was Rs 3.53 lakh crore about 51.4% of all assets under all FIIs present in India. Securities and Exchange Board (SEBI) has recently announced the following changes in the PN business. i. There will be no more issues of PNs against underlying derivatives either by FIIs or the sub-account holders. Existing positions will have to be unwound in 18 months.

concerned sectoral regulator) will be allowed to invest through PN. iv. PN issuing FIIs where outstanding PNs are less than 40% of the FIIs assets under custody will be allowed an incremental issuance of 5% a year subject to a cap of 40% of the FIIs assets under custody; FIIs that are already over 40% limit will be allowed to issue/renew fresh PNs only on cancellation/redemption of PNs to an equivalent extent. The sensex initially reacted negatively on the announcement of SEBIs guidelines, but picked up after Finance Minister and SEBIs clarifications. The long-term impact of SEBIs policies would be known only in times to come.

ii.

iii. Only regulated entities ( those subject to oversight in their home country by the