The Hindu Business Line : Take note of P-Notes

The restrictions that came as a surprise to many in October last year have now been lifted. Yes, the bar on P-note issues by FIIs was reversed by the Securities and Exchange Board of India (SEBI) early this month. Said to be a move to boost liquidity, it had great significance for the markets. But what are these P-Notes? Why the ban and now the reversal?

The backdoor entrants

Foreign Institutions, or FIIs as we refer to them, are overseas entities registered with the country’s stock market regulator, SEBI. On registration, these entities can directly invest in Indian stocks, mutual funds, government securities, derivatives and debt. But there is one category of foreign investors who are not under the regulatory purview — investors who buy stocks through Participatory Notes (P-Notes).

P-notes are instruments issued by registered FIIs to other overseas investors for investing in the Indian stock market.

On issuing participatory notes and collecting funds, FIIs invest in the Indian market on behalf of the P-note holders. So, when FIIs buy in their name they might be actually transacting on behalf of an unidentified P-note holder.

Participatory notes serve as a short cut for foreign investors who don’t want to go through the procedural formalities and the process of registering as FIIs. This route also allows participants who are not eligible to trade in Indian markets to ‘participate’, though they aren’t registered with SEBI.

Investors who take the P-note route are often anonymous, with the issuing FII not required to disclose the identity or profile of the P Note holder, unless specifically asked by SEBI. This results in the regulator having no idea of their identity, investment status or objectives.

Why did SEBI step in?

The year 2007 saw a significant rise in India investments by FIIs. By end September 2007, FIIs’ total investments in equities were Rs 51,166 crore when the investment for the whole of the previous year (2006) was only about Rs 36,540 crore.

Investments through participatory notes accounted for a significant chunk of this foreign institutional investment.

Worries that hedge funds and other entities with short-term objectives may be pouring money into Indian stocks, resulting in ‘hot’ flows, prompted the regulator to curtail such investments last year.

Amidst criticism, in October last year, SEBI banned all fresh issue of P-Notes with derivatives as underlying. Outstanding positions were to be wound-up in 18 months. The total amount for which P-notes could be issued by each FII was also capped at 40 per cent of the total assets under the custody of the respective FII.

The objectives behind the new regulation were very clear. SEBI wanted to track and regulate foreign investments coming into the country and stop unhealthy speculation in the market, by unknown investors. By closing the P-Note option, the regulator wanted foreign entities to take the FII route whereby they would have to make full disclosures.

The move, though well thought out, was not all that well received by the market. FII selling sent S&P CNX Nifty plunging 9 per cent in the opening trade on the day following the announcement.

Circuit breakers were triggered and trading was halted on both NSE and BSE for an hour. However, on clarifications from the Finance Ministry, the market recovered subsequently.

Why was the restriction removed?

Despite the P-note ban, Indian indices continued to move northward in the period following this move for a full four months until January 2008. But the rally didn’t extend as financial turmoil in the US escalated into a global credit and liquidity crunch, triggering a reversal in FII flows from the Indian market. As a chain of events unfolded, big investment firms such as Lehman Brothers and Merrill Lynch went bankrupt, even as FIIs continued selling large chunks of their investment in the domestic market.

As a consequence, the rupee started depreciating and the regulators once again had to intervene to make the situation better.

On October 6 this year, SEBI announced the lifting of all its earlier restrictions on p-notes. Foreign institutional investors can now issue P-notes with derivative as underlying.

The 40 per cent cap on P-note issue stands removed and P Note holders are no longer required to wind up their positions in Indian stocks.

The change in SEBI’s stance was to arrest the outflow of money from the markets.

The reversal, though it took immediate effect, hasn’t helped reverse the direction of fund flows. FIIs continue to be net sellers till date.