Regulating PN routed investments: The Need of the Hour

Regulators of the capital markets in India are worried about possible misuse of P-Notes, including money-laundering. The Tarapore Committee, the Lahiri Committee and Reserve Bank of India have all demanded more transparency on investments via the Participatory Notes (PN) route. due to the heavy involvement of overseas investors

Background:

Participatory notes (PNs) are financial instruments used by investors, foreign funds, or hedge funds that are not registered with the Securities and Exchange Board of India for trading in the domestic market. PNs are issued against an underlying security that permits the holder, to invest in Indian stock market, and get a share/dividend/capital gains in the income from the underlying security.

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. It bars FIIs from issuing P-Notes to Indian nationals, persons of Indian origin or overseas corporate bodies (which are majority owned or controlled by NRIs). Besides, 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.

Mechanism:

These are issued by FIIs (registered with the SEBI and their sub-accounts) to investors abroad with details of scrips that can be bought with expected returns over specific periods of time. If the client approves, they deposit the funds with the overseas branch of the FII. The Indian arm of the FII buys the scrips in the Indian market and settles it on its own account. This has led to a dramatic rise in the stock market and currency, putting the central bank under severe pressure.

The PN-monstrosity

The reason for this apprehension is rooted in the fact that PNs have become an easy way for Indian money launderers who first ship funds out of the country, through hawala, and then get it back using PNs. FIIs which are required to comply with the know-your customer norms, will certainly know the identity of the investor but the same investor might sell the PN to another player resulting in multi-layering. The Reserve Bank of India (RBI) had earlier sought a ban on PNs, owing to the difficulty in establishing the beneficial ownership or the identity of ultimate investors.

Impact on the Indian Stock Market:

The pace at which the Indian markets have moved for the last three years, the Indian stock market has experienced successive highs on a heap of forex inflows. FII investments, directly and through the P-Notes route, have been the biggest contributor to the liquidity support to the bull run.

In the latest instance, market watchdog SEBI (Securities and Exchange Board of India) has proposed restrictions on participatory notes causing panic among investors making investment in Indian equities.

The main stock index, the Sensex, had lost 9.15 per cent after markets opened on October 17 to fall to 17,308 points. But the new PN-regulations may lead to a sharp correction and result in serious bear-market where stock prices correct over 20 per cent.

The situation reinforces how vulnerable over-heated markets across Asia are to any signs of bad news. The Sensex recovered but SEBI as well as Finance Minister P Chidambaram issued assurances.

Though markets scaled to new heights, the overseas investors began to pull out as the markets began to lose steam. The market continued to slide as soon as news of participatory note-related proposals hit the market.

Enormity of the apparent fraud:

JP Morgan Chase estimates that, funds routed through participatory notes are close to $10bn out of the nearly $18bn in total foreign portfolio equity (fdi in Indian equities) inflows so far in 2007.

By August 2007, the notional value of PNs was about 51.4 per cent of all assets under all FIIs present in India, according to SEBI sources. A large number of PN positions must be unwound.

About $88 billion of the estimated $220 billion worth of total FII assets under custody is believed to be PN-related. According to Sebi, the equivalent of $30 billion worth of PNs is parked in F&Os.

Relevance for the small investor:

The message of the dramatic turn of events is that the markets can also be sustained at lower levels provided they match the fundamentals. If you are a small investor the concomitant fluctuations as a result of measures such as regulating PNs should be seen as a minor hiccup but will eventually lead to healthy and assured returns.

Regulating PN routed investments: The Need of the Hour

Return to India

NRI INSURANCE

NRI SERVICES

Indian Cities Guide