Participatory notes gained notoriety in the last quarter of 2007 when market regulator SEBI clamped down on the issue of these instruments.

Both the Securities and Exchange Board of India and the Reserve Bank of India (RBI) were then worried about funds from questionable sources entering equity markets through this route.

The turbulence that followed this move eventually led to the reversal of the runaway bull-market.

 But there is scarcely any mention of P-notes or offshore derivative instruments (ODIs), as they are also called, these days. Regulators, both the RBI and the SEBI, also seem more sanguine on this score. The reason is not far to seek.

There is considerable reduction in the outstanding P-notes over the last three years.

According to data published by SEBI, P-notes outstanding is down from the record high of Rs 4,49,613 crore in October 2007 to Rs 1,88,325 crore towards the end of November last year. Share of P-notes in FII assets under management (AUM) is down from the peak value of 51 per cent to 16 per cent.

 P-notes are issued by foreign institutional investors (FIIs) or their sub-accounts registered with SEBI to investors in other countries. The underlying investment could be stocks or derivatives or debt in domestic market.

 These instruments are viewed askance by the regulators because of the anonymity that it provides to unregistered foreign entities that invest in Indian markets through this route.

It may be recalled that excessive FII participation in the derivative market through offshore derivative instruments had made SEBI ban further issue of P-notes with derivatives as underlying in October 2007.

Regulatory changes

 So how did P-notes lose their popularity? There are many factors that contributed to reducing the usage of these instruments.

The most significant was the strong message sent by the regulatory action in October 2007.

When SEBI banned further issue of ODIs with derivatives as underlying and asked FIIs to reduce P-notes to 40 per cent of their assets under custody, it sent the signal that it was not going to allow unbridled inflow of money into equities through this route and was determined to keep a strict vigil on the end-users of these instruments.

SEBI had also then stipulated that stricter KYC norms needed to be followed while issuing P-notes.

Another major regulatory change brought about in 2007 was the order that P-notes should be issued only to entities regulated by the regulatory authority in the country of their incorporation. This change barred many hedge funds that were unregulated entities from subscribing to P-notes.

These regulatory changes had the desired effect and outstanding P-notes declined steadily from the peak value in 2007 to Rs 167,962 crore by August 2008.

The decline was sharper after that as global stock markets crashed following the Lehman debacle. Many hedge funds had to wind down in the last quarter of 2008. This led to the figure declining to Rs 60,000 crore by February 2009.

Alternative avenues

Availability of alternative avenues for playing the India story could also have made P-notes' popularity wane.

It was in late 2007 and first half of 2008 that volumes of Nifty futures traded on the Singapore Stock Exchange (SGX Nifty) recorded a sharp jump.

This implies that former users of P-notes who wished continued exposure to India were shifting to other instruments such as the SGX Nifty.

Many India ETFs (exchange traded funds) listed on exchanges such as New York Stock Exchange, Luxemburg Stock Exchange, Japanese Stock Exchange and so on were also launched and gained popularity in the last three years.

SEBI has also maintained a tight vigil over P-notes in the recent past.

It banned Barclays Capital and Societe Generale from issuing fresh ODIs in January last year for inadequate disclosure and misrepresenting facts regarding the end-users of these instruments.

Though this ban was subsequently revoked, other issuers of P-notes would have got the message that the regulator was serious about filtering the ultimate users of participatory notes.

Again the regulator had ordained FIIs with multi-layered opaque structures to broad-base or increase the number of shareholders to prevent funds from dubious sources from flowing in to the country.

hese measures could have deterred many who would otherwise have thrived in a lax regulatory environment.

P-notes drawn on derivatives also reached alarming levels in mid-2007. The peak for this segment was at Rs 148,000 crore or 22 per cent of FII AUM in June 2007.

P-notes on derivatives

While P-notes in general are undesirable due to their opacity, those drawn on derivatives are even more so. Derivatives allow unregistered external investors to take leveraged exposure to Indian equities.

In other words, the exposure of these investors is many times their outlay comprising mainly of margin payment.

Needless to add, these inflows are extremely short-term in nature and can reverse abruptly, causing violent bouts of volatility in the market.

This figure had reduced to Rs 33,000 crore towards the end of November last year. This is only 3 per cent of the FII assets under management.

FII interest

It would, however, be wrong to extrapolate the declining flow through the P-note route to infer that foreign investors are turning away from Indian shores.

Overseas interest in Indian equities continues to be very strong and FII inflow of $29 billion in the secondary market last year corroborates this view. Assets under FII management have also grown 21 per cent since October 2007.

It is also obvious that many overseas investors have chosen to register with the Indian regulator and invest directly.

Number of FIIs registered with SEBI is up 53 per cent since 2007. Number of sub-accounts has also grown from 1723 to 5561.

Tight regulatory monitoring and availability of alternative investment avenues for India exposure overseas have reduced fund inflows through the P-note route.

But our markets are relatively more insulated from volatile short-term flows now and FII money flowing directly in to India has more than made up for the reduced inflow through the P-note route.

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