Offshore derivatives instruments (ODIs) are investment vehicles used by overseas investors not registered with the SEBI for an exposure in Indian equities or equity derivatives. They may not be registered with SEBI, either because they do not want to, or due to regulatory constraints for which they are not allowed to. It is a registered FII that makes purchases on behalf of these investors and the FII s affiliate issues those ODIs. ODIs include equity-linked notes, capped return notes, participating return notes, etc. Participatory notes are a preferred route for High Net worth Individuals (HNIs) and hedge funds from abroad to make investment in Indian capital market. P-Notes, mostly used by overseas HNIs, hedge funds and other foreign institutions, allow such investors to invest in Indian markets through registered Foreign Institutional Investors (FIIs).
Participatory Notes (P-Notes) is one of the categories of ODIs. The underlying asset class could be stocks, and returns would be directly related to the appreciation in prices of those stocks. India based brokerages to buy India-based securities / stocks and then issue participatory notes to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors. Since international access to the Indian capital market is limited to FIIs. The market has found a way to circumvent this by creating participatory notes.
Here’s how Participatory Notes work:
- The investor deposits money with a registered foreign institutional investor (FII).
- The FII buys the desired Indian security on the investor’s behalf.
- The FII issues a P-note to the investor, which represents their ownership of the Indian security.
- The investor receives dividends, capital gains, and any other payouts from the Indian security.
- The FII reports all P-notes to SEBI on a quarterly basis. They do not have to reveal the identity of the real investor.
Advantages of Participatory Notes:
- The investors in P-notes enjoy the economic benefits of investing in the security which is actually held by the FII.
- Investing through P-Notes is easy and found common amongst FIIs.
- While such FIIs have to mandatorily get registered with SEBI, the other entities subscribing to P- Notes do not require registration and hence can conceal their identity.
- P-notes are easily negotiable by endorsement and delivery.
- Participatory notes yield the advantage of the tax laws of certain preferred nations.
- P-notes reduce the transaction costs and also provide modified tools to manage risk, lower financing costs, and enhance portfolio yields.
SEBI lacks authority over participatory note trading. While foreign institutional investors must register with the Indian regulatory body, participatory notes traded among them remain unrecorded, raising concerns about potential money laundering and illicit activities. The Special Investigation Team (SIT) aims to implement stricter compliance measures for participatory note trading due to the challenge of tracking money flows. The SIT comprises specialized law enforcement officers trained to investigate serious crimes.
Past government proposals to restrict P-notes triggered extreme market volatility. For instance, in October 2007, when the government considered curbing P-note trading, the Sensex index plummeted by 1,744 points in a single session, marking an 8% decline.
Securities and Exchange Board of India (SEBI) regulation for issuance of offshore derivative instruments:
- In 2007, SEBI banned the issuance of new P-notes and required existing P-notes to be wound up within 18 months. This was because P-notes were not regulated. There were concerns about money laundering and other illegal activities.
- In 2008, the restrictions on P-notes were lifted due to the financial crisis. However, SEBI introduced new rules requiring FII to follow KYC norms and submit details of transactions. This led to a decline in the issuance of P-notes.
- In 2016, SEBI mandated that anti-money laundering rules be applied to P-noteholders. It also issued new rules on the transferability of P-notes between two overseas investors. It increased the frequency of reporting requirements for P-note issuers.
- In 2017, SEBI banned FII from issuing P-notes for investments in equity derivatives. It also banned non-resident Indians and residents from investing in P-notes. This was done to prevent round-tripping and money laundering.