What are p- notes ?

Q: What are participatory notes?

A: Participatory notes (PNs) are instruments used by foreign funds, not registered in India, for trading in
the domestic market. They are a derivative instrument issued against an underlying security that permits the
holder, some of whom may not be eligible to trade in Indian stock markets, to get a share in the income
from the underlying security.

.The investors, who buy PNs, deposit funds in US or European operations of the FII, which also
operates in India. FII uses its proprietary account to buys stocks in India. A government report has said that
FII or the broker acts like an exchange since it executes the trade and uses its internal accounts to settle this.
Other such instruments include equity-linked notes, capped return note, participatory return notes and
investment notes.
Q: Why investors use PNs?
A: While one reason for using PNs is to keep the investors name anonymous, some investors have used
the instrument to save on transaction costs, record keeping overheads and regulatory compliance overseas.

A report said investors often find it expensive to establish broker and custodian bank relationships,
deal in foreign exchange, pay taxes and/or filing, obtain or maintain an investment identity or regulatory
approval in certain markets, where their total exposure is not going to be very large.

Such investors look for derivative solution to gain exposure in individual, or a basket of, stocks in the
relevant market. Sometimes, investors enter the Indian markets in a small way using PNs, and when their
positions become larger, they find it advantageous to shift over to a full-fledged FII structure.
Q: What is the problem with the instrument?
A: RBI, which had sought a ban on PNs, believes that it is tough to establish the beneficial ownership or
the identity of ultimate investors. It fears that FIIs, which have to comply with the know-your customer
norms, know the identity of the investor to whom the note was issued.

But it is possible for the investor to sell the PN to another player resulting in multi-layering. Tax
officials fear PNs are becoming a favourite with many Indian money launderers who use it to
first ship funds out of the country, through hawala, and then get it back using PNs.

Q: What is the extent to which PNs are used?

A: Over the years, the use of PNs has increased from 17 FIIs issuing it in 2005 to over two dozen funds
now.

Merrill Lynch, Morgan Stanley, Credit Lyonnais, Citigroup and Goldman Sachs are the biggest
issuers
The total value of underlying investments in equity represented by the PNs was Rs 67,185 crore
or 25.7% of FIIs net investment in equities in June, 2005.
By August 2007, the notional value of PNs was Rs 3.53 lakh crore about 51.4% of all assets
under all FIIs present in India.

Who gets P-Notes?

P-Notes are issued to the real investors on the basis of stocks purchased by the FII. The registered FII looks
after all the transactions, which appear as proprietary trades in its books. It is not obligatory for the FIIs to
disclose their client details to the Sebi, unless asked specifically.
What are hedge funds?

Hedge funds, which invest through participatory notes, borrow money cheaply from Western markets and
invest these funds into stocks in emerging markets. This gives them double benefit: a chance to make a
killing in a stock market where stocks are on the rise; and a chance to make the most of the rising value of
the local currency
What is an FII?

An FII, or a foreign institutional investor, is an entity established to make investments in India.

However, these FIIs need to get registered with the Securities and Exchange Board of India

Entities or funds that are eligible to get registered as FII include pension funds; mutual funds;
insurance companies / reinsurance companies; investment trusts; banks; international or
multilateral organisation or an agency thereof or a foreign government agency or a foreign
central bank; university funds; endowments (serving broader social objectives); foundations
(serving broader social objectives); and charitable trusts / charitable societies

Sebi not happy

However, Indian regulators are not very happy about participatory notes because they have no way to know
who owns the underlying securities. Regulators fear that hedge funds acting through participatory notes
will cause economic volatility in India's exchanges .

Hedge funds were largely blamed for the sudden sharp falls in indices. Unlike FIIs, hedge funds are not
directly registered with Sebi, but they can operate through sub-accounts with FIIs. These funds are also said
to operate through the issuance of participatory notes
30% FII money in stocks thru P-Notes

According to one estimate, more than 30 per cent of foreign institutional money coming into India is from
hedge funds. This has led Sebi to keep a close watch on FII transactions, and especially hedge funds

Hedge funds, which thrive on arbitrage opportunities, rarely hold a stock for a long time.
With a view to monitoring investments through participatory notes, Sebi had decided that FIIs
must report details of these instruments along with the names of their holders.

Sebi has also proposed a ban on all PN issuances by sub-accounts of FIIs with immediate effect.
They also will be required to wind up the current position over 18 months, during which period
the capital markets regulator will review the position from time to time.

Sebi chairman M Damodaran, in a recent interview Business Standard, said that the amount of
foreign investment coming in through participatory notes keeps changing and is somewhere
between 25-30 per cent. "Recent indications are that it has gone up a little but again after the
sub-prime crisis, there have been some exits. But it's a fairly significant percentage, it's not
something you can ignore."