What are Participatory Notes?


  •  Setting at rest the uncertainty about overseas investments, finance minister Pranab Mukhrjee has said those investing in stock markets through participatory notes (P-notes) will not have to pay tax in India, an assurance that pushed up the markets.
 What are Participatory Notes? 

  •  Participatory notes (P-Notes) are derivative instruments issued by FIIs on Indian shares, but at a location outside of India.
  • The investors, who buy P-Notes, deposit their funds in the US or European operations of the FII, which also operates in India. The FII then uses its proprietary account to buy stocks in India.
  • Other types of P-Notes include equity-linked notes, capped return note, participatory return notes and investment notes. 
 Why do investors use P-Notes? 
  • While one reason for using P-Notes is to keep the investor's name anonymous, some investors have used the instrument to save on transaction costs also. 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 P-Notes, and when their positions become larger, they find it advantageous to shift over to a full-fledged FII structure. 
 What is the problem with the instrument? 
  • It is difficult to establish the beneficial ownership or the identity of the ultimate investor, and hence cannot be taxed. It is feared that FIIs, which have to comply with know-your customer norms, know the identity of the investor to whom P-Notes are issued.
  • Tax officials also fear that P-Notes are increasingly becoming a favourite among a host of Indian money launderers, who use the instrument to first take funds out of the country through the hawala route, and then get it back using P-Notes.

Functioning of Participatory Notes

Participatory Notes, somewhere down the line, hide in themselves the functions and properties of Hedge Funds. Although SEBI, as a regulator had issued KYC (Know Your Client) guidelines, which include that, FIIs must know all the requisites details about their client and be able to furnish the details of the same, as and when demanded or asked by the regulator, to which there should be strict compliance, failing which they have to face the wrath of the regulator. UBS Securities case was on this basis, they were barred from trading in Indian markets by SEBI on this premise only as they failed to furnish the information regarding their clients. Contrary to the fact that SAT reversed the SEBI’s order.

The bigger question after the debate is about hedge funds and why regulators like SEBI and RBI are wary of them. Hedge funds are those funds which are not defined in any legislation in this world and have been deliberately excluded from trading in stock markets and are not allowed to function or work in any stock market of the world on paper. Hedge funds are generally recognized by their characteristics, rather than any term or legislation. Rapid growth, big money, market manipulators, etc. are some of the popular terms related to them. They don’t advertise in papers, they cannot be registered under any statute. Yet they function and extremely popular because of the attention they grab and the limelight they find in the local and national newspapers of all the emerging and developed economies of the world.

Retail investors are not their clients. Market players or high net worth individuals (HNIs) or

professional investors (pension funds or mutual funds) are their clients. However, US Securities Exchange Commission (SEC) provides some clarity on the issue. They are approximately 8000 hedge funds, operating globally, with the major chunk of them operating in USA, and few hundreds are in UK and the other lot of few is disseminated across the globe. Hedge funds promise hefty profits, with the hedge fund manager taking the percentage of the profits as his fees for managing the funds. Generally the rate is 20%, which the hedge fund managers charge for their services in addition to 1%, which they charge as fixed management fee.

Speculative funds managing investments for private investors (in the US, such funds are

unregulated if the number of investors does not exceed one hundred). These are funds usually used by wealthy private investor or institutions. Hedge funds are restricted by law to no more than 100 investors; the minimum contribution is typically $1m. The first hedge fund started in New York on 1 January 1949. Hedge fund managers sell stock short and trade in options of the shares they hold.

Funds that are extremely flexible in their investment options because they use financial instruments generally beyond the reach of mutual funds, which have SEC regulations and disclosure requirements that largely prevent them from using short-selling, leverage, concentrated investments and derivatives. This flexibility, which includes use of hedging strategies to protect downside risk, gives hedge funds the ability to best manage investment risks.

A hedge fund can be classified as an alternative investment. Alternative investments are investments other than stocks and bonds. A U.S. “hedge fund” usually is a U.S. private investment partnership invested primarily in publicly traded securities or financial derivatives. Because they are private investment partnerships, the SEC limits U.S. hedge funds to 99 investors, at least 65 of whom must be “accredited.” (“Accredited” investors often are defined as investors having a net worth of at least $1 million.) A relatively recent change in the law (section 3(c)) allows certain funds to accept up to 500 “qualified purchasers.” In order to be able to invest in such a fund, the investor must be an individual with at least $5 million in investments or an entity with at least $25 million in investments. The majority of hedge funds employ some form of hedging – whether shorting stocks, utilizing “puts,” or other devices.

In the past, hedge funds had been blamed largely for the sudden sharp falls or volatile sessions in indices. Hedge funds are not directly registered with SEBI, but they can operate through subaccounts with FIIs. These funds are also said to operate through the issuance of participatory notes.

SEBI keeps a close watch on the activities of FIIs. As it is believed that nearly 30% of the money is coming from hedge funds through FII route. Hedge funds by their very nature hold stocks for short duration, and exit markets after booking profits, which upsets the sentiments of the market.

Hedge funds make money by identifying imbalances in the prices of asset classes, whether it isequities , debt or forex. These overseas funds enter and exit markets based on arbitrage

opportunities in different markets. Usually they cover their exposures in one market by taking a

countervailing exposure in another. For example, they could go long in one scrip in the US and

short it in India.

Participatory notes are normally subscribed by investors who want to get rid of all the regulatory processes, so that they are adhered to minimum level of disclosure. But the FII with whom they are functioning are required to comply with KYC guidelines of SEBI.

Hedge funds are mostly short-term funds and they rarely buy and hold any stock for long periods.

In April 2003, Infosys witnessed a crash because of weak guidance, due to sharp drops and spurt in prices.

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