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.
Photo: Mumbai skyline Carter Road Bandra by Wander-earth, licensed under CC BY-SA 4.0, via Wikimedia Commons.
