The Hindu Business Line : What are ‘Participatory notes’?

‘Participatory notes’ are instruments that derive their value from an underlying financial instrument such as an equity share and, hence, the word, ‘derivative instruments’.

When the Indian capital market regulator permitted, back in 1992, foreign institutional investors (FIIs) to register and trade in Indian securities, every one assumed that they would make proprietary investments out of their own capital.

3rd-party investments

There was no question of their trading on anyone else’s behalf. But as it turned out, FIIs were merely acting as a conduit for third-party investments.

But some of these third-party investors had their own preferences in the matter of what Indian stocks that they would like to own with its own risk and reward characteristics. In order to ring fence, each such pool of investments they created accounts or ‘sub-accounts’ in FII parlance.

Sub-account holders

But even sub-account holders, it turned out, were not investing their own money but were in fact raising money from a multitude of high net worth individuals.

They were issued pieces of paper that derived its value from underlying equity instruments of Indian corporates.

The participatory notes were now well truly launched. International investments got a little more complicated with sub-account investment institutions raising loan funds as securitised paper, with a pool of underlying equity shares of Indian companies.

All this leveraged money got further leveraged with the investments going into not just equity shares but derivative instruments (futures and options) of shares of Indian corporates.

Thus one could have a sub account holder of a registered FII investing a combination of subscriptions by a group of investors topped up with funds borrowed by floating yet another piece of tradable instrument using a pool of participatory notes as collateral.

But the tale of leveraged investments became a little more complex with a $100 of such funds getting invested, for example, not in Reliance shares but into futures contract on Reliance shares.

Futures contract

Now, in a futures contract, one did not have to invest the full value of the contract. It is enough if put up a small margin and topped it up each depending on how the share price moved.

The potential of $100 got further magnified.

It is easy to see the super structure of heavily leveraged investments flowing into the Indian stock market. That is without even thinking of whatever private financial arrangements that each one of investors in the original pool of investments that gave rise to the participatory notes.

Global liquidity

All of this became possible when there was a global liquidity thanks to the economic policies of the West and more particularly the US.

A financial distress for one lender who participated in leveraged transaction of investments of a sub-account holder of an FII who had invested in the Indian stock market can cause him to call back his loan.

This could lead to the sub-account holder closing out his futures position in the underlying share which caused the latter’s future price to fall.

Share prices

Since future prices are in turn linked to the spot prices of the same share, there is a price correction in the spot price as well.

The fall in share price erodes not just the overseas investor’s wealth but that of domestic investors as well.

The depreciation of the rupee’s value against other currencies or wiping out huge chunk of the RBI’s currency reserves when the liquidated investments goes out of the country, are the other unintended consequences of the FII play on the Indian stock market.