In this session, we will look into Participatory Notes(P-Notes): An Offshore Derivative Instrument. In 1992, SEBI had allowed P-notes to increase Foreign Investment in India after 1991 Balance of Payment Crisis. P-notes are offshore derivative instruments(ODI) issued by registered Foreign Portfolio Investors(FPIs) to overseas investors who want to Invest in Indian Stock Market without registering themselves with SEBI. We will look into the advantages and disadvantages of using P-notes in India. Also we will see the main concern related to Participatory Notes(P-Notes).

Participatory Notes(P-Notes): An Offshore Derivative Instrument

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What is Derivative

A derivative is a Financial Instrument which derives its values from underlying assets. The important derivatives are Forward, Futures, Options and Swaps and the underlying assets includes stocks, commodities, bonds, interest, rates and currencies.

What are Foreign Institutional Investors(FIIs)

Foreign Institutional investors (FIIs) are the institutional investors established outside India responsible for making investment proposals in India. They play an important role in the economy of a country. There are over 1400 FIIs registered under the Securities and Exchange Board of India (SEBI).

What are Participatory Notes(PNs)

Participatory Notes are also Known as P-notes are the financial instruments issued by registered FIIs(Foreign Institutional Investors). PNs are issued for the overseas investors who want to invest in the stock markets in India without being registered under SEBI. They are used by the clients of Foreign Institutional Investors(FIIs) who do not wish to participate directly in the Indian Stock Market.

Advantages of Using Participatory Notes

• PNs plays an important role in the Indian Economy as large investments are done in the share market through FIIs every year.
• Ease of Investment in Indian Stock Market.
• No registration required with SEBI.
• Allows Large Hedge Funds to invest without disclosing their Identity.

Disadvantages of Using Participatory Notes

• A large investment is happening in Indian Stock Market every year via P-notes with no knowledge about the source of investment.
• P-notes are being used in Money Laundering by wealthy Indians.
• It is possible to evade Capital Gain Tax via Participatory Notes(P-notes).

Main Concerns

The main concern in using P-notes is the anonymity lies around the foreign investment in India. Terrorist are using P-notes to invest in Indian Stock market and using its profit to finance their terrorism activities across the country. Due to this, RBI Tarapore Committee recommended to ban the P-notes completely from Indian Stock Market.

Regulation by SEBI

In order to ensure transparency and in light of various recommendations of Special Investigating Team (SIT) on black money, appointed by the Honorable Supreme Court of India, SEBI has been constantly tightening norms for taking exposure in Indian Capital Markets through ODI/ PN route. Some of the recent steps taken by SEBI are as follows:-

• In terms of SEBI (FPI) Regulations, 2014, ODIs/ PNs can be issued only to those entities which are regulated by the appropriate regulatory authority in the countries of their incorporation, after compliance with “Know Your Client” (KYC) norms. Further, only Category (I) and Category (II) FPIs can issue/subscribe or otherwise deal in ODIs/PNs whereas none of the Category (III) FPIs can deal in ODIs.
• In terms of SEBI (FPI) Regulations 2014, an FPI shall ensure that transfer of ODIs/PNs are done to persons which are regulated by the appropriate regulatory authority in the countries of their incorporation, after compliance with “Know Your Client” (KYC) norms and prior consent of the FPI is obtained for such transfer, except when the persons to whom the ODIs/PNs are to be transferred to are pre-approved by the FPI itself.
• In terms of SEBI circular dated November 24, 2014 the applicable eligibility norms between Foreign Portfolio Investors (FPI) regime and subscription through the ODIs have been aligned.
• In terms of SEBI circular dated June 10, 2016 FPIs are required to maintain the BO information of its ODI subscribers in line with the Rule 9 of PMLA, i.e., BO information is to be furnished in case the holding of natural person(s) is above specified thresholds.
• In terms of SEBI (FPI) Regulations, 2014 Resident Indians/NRIs or the entities which are beneficially owned by Resident Indians/NRIs cannot subscribe to Offshore Derivative Instruments.
• In terms of SEBI (FPI) Regulations, 2014, an ODI issuing FPI is required to collect regulatory fee, as specified in Part C of the Second Schedule, from every subscriber of offshore derivative instrument (ODI), issued by it and deposit the same with the Board.
• In terms of SEBI circular dated July 7, 2017 the ODI issuing FPIs were advised that from the date of the circular, they shall not be allowed to issue ODIs with derivative as underlying, with the exception of those derivative positions that are taken by the ODI issuing FPI for hedging the equity shares held by it, on a one to one basis. More on PIB.