P-notes at 3-year high

Even as stock prices have been spinning lower this year, unregistered overseas investors have been showing a greater interest in our equity markets. Participatory notes outstanding by the end of May crossed Rs 2,00,000 crore, recording a 36-month high.

P-notes as a portion of total FII assets in India ranged between 15 and 18.1 per cent for most of 2010, but jumped to 19.5 per cent in May 2011. In contrast, the value of FII investments in Indian markets have declined around 7 per cent in the first five months of this year to Rs 10,82,000 crore.

Participatory notes (p-notes) gained notoriety in late 2007 when over half of FII investments into Indian equity were routed through this channel. Fears of investors with an extremely short-term perspective such as hedge funds entering through this route had made SEBI clamp down on p-notes in October 2007.

Suspicion about money laundering through this channel was another reason why regulators frowned at p-notes.

Regulating p-notes

SEBI has been addressing the issue of transparency over the last couple of years by improving the monthly disclosures by p-note issuing FIIs and asking FIIs with opaque structures to broad-base so that the ultimate buyer of p-notes does not stay hidden.   

The availability of offshore derivative products such as the SGX Nifty and various India-focused ETFs has also rendered p-notes less attractive off late.

But despite this strict regulatory vigilance, participatory notes outstanding have been steadily rising since the beginning of 2011.

According to data published on SEBI Web site, monthly average of these instruments is up from Rs 1,31,000 crore in 2010 to around Rs 1,80,000 crore  in 2011, with p-note assets rising as a proportion of outstanding FII assets.

Why more p-notes

So what could be the reason behind p-notes edging higher? One reason could be the heightened volatility in Indian market attracting hedge funds and other global speculators. The Indian benchmark index, Sensex was down 10 per cent between January and May this year making it one of the worst performers among its global peers.

This pronounced downtrend could have attracted funds that prefer to short such markets. Such funds are constantly scouting for opportunities across the globe, and could prefer the p-note route to move in and out of the market easily.

Another reason for the increase in p-notes could be the SEBI ban on FIIs with multi-layered opaque structures such as protected cell companies and multi-class share vehicles.

Over 180 FIIs and 330 sub-accounts were asked not to make any further purchases in Indian equity markets last September. Some of these investors could have started using the p-note route to buy Indian stocks.

The number of FIIs registered with SEBI is down from 1,741 towards the end of last October to 1,716 in May.

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