What is Participatory Notes? What are the SEBI regulations on them?

 One of the controversial issues related with the participation of foreign investors in Indian stock market is the subscription of Participatory Notes by foreign investors. Participatory Notes (P-Notes) are instruments used by foreign funds and investors not registered with the SEBI to invest in Indian securities. They are generally issued overseas by associates of India based foreign brokerages (FPIs) and domestic institutional investors. Technically, P-Notes are Offshore Derivative Instruments (ODIs) issued by FPIs and their subaccounts against underlying Indian securities (like shares).

What is the controversy behind Participatory Notes?

           A major defect of the P-Notes as instruments to make investment in Indian shares is that it hides the identity of the investor. According to the ‘White Paper’ on black money (2012) prepared by the central government, a considerable portion of PNs are used by wealthy individuals who uses it as a mechanism to channelize black money kept in foreign countries to India. The Special Investigation Team (SIT) on black money also recommended the phasing out of P-Notes.

Recent tighter regulations on P-Notes

           In the background of the hunt for black money, restrictions over P-Notes are tightened. Hence, over the last one decade, SEBI was slowly tightening norms on P-Notes. In May 2016, SEBI has extended the KYC (Know Your Client) norms and anti-money laundering norms to the PN subscribers also. Similarly, back in April 2014, SEBI banned unregulated entities in foreign countries (so called Category III FPIs in India) from subscribing P-Notes.

SEBI bans the issue of Participatory Notes for equity derivatives

           In a recent development, on July 8, 2017, SEBI issued a circular banning FPIs from issuing Participatory Notes for investing in equity derivatives. At the same time, FPIs can issue PNs to overseas investors if the equity derivatives investments are used for hedging the equity shares held by them. This means that a foreign investor can make investment in equity derivatives only if he purchases an equal value of shares in the cash segment. Effectively, this step will help to avoid speculative investment by foreign investors using PN in derivatives. SEBI also instructed ODI-issuing FPIs to liquidate such ODI instruments prior to the timeline of 2020.

           According to market statistics, FPIs hold P-Notes of over Rs 1.9 lakh crore in cash and Rs 40,000 crore in derivatives. This means that banning of PNs for equity derivatives will lead to phasing out of around 25% of investment made through P-Notes.

           The SEBI’s ban on PNs is on those ones where there is investment in equity derivatives. Investment in the cash segment can be continued. But the current move of eliminating derivate investment in equity shares is a step towards minimising the use of PNs by foreign investors.

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