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Participatory Notes (PNs)

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A Participatory Note (PN or P-Note) in the Indian context, in essence, is a derivative instrument issued in foreign jurisdictions, by a SEBI registered Foreign Institutional Investor (FII) or its sub-accounts or one of its associates, against underlying Indian securities. The underlying Indian security instrument may be equity, debt, derivatives or may even be an index. Further, a basket of securities from different jurisdictions can also be constructed in which a portion of the underlying securities is Indian securities or indices.

PNs are also known as Overseas Derivative Instruments, Equity Linked Notes, Capped Return Notes, and Participating Return Notes etc. In January 2014 when the Indian securities market regulator, SEBI issued the new Regulations for Foreign Portfolio Investors, participatory notes got formally defined under the tag "Offshore Derivative Instrument" (ODIs) in Section 2(1)(j) of the said regulation. As per this definition, participatory notes or ODIs are issued by selected foreign portfolio investors (which is a broad category also including FIIs. Hence, Regulation excludes certain category of Foreign portfolio investors, like individuals, from issuing the PNs) against securities held by it that are listed or proposed to be listed on any recognized stock exchange in India.

The investor in PN does not own the underlying Indian security, which is held by the FII who issues the PN. Thus the investors in PNs derive the economic benefits of investing in the security without actually holding it. They benefit from fluctuations in the price of the underlying security since the value of the PN is linked with the value of the underlying Indian security. The PN holder also does not enjoy any voting rights in relation to security/shares referenced by the PN.

Rationale for issuance of PNs

One of the primary reasons for the emergence of an Off-shore Derivative market is the restrictions on foreign investments. For eg, a foreign investor intending to make portfolio investments in India was required to seek FII registration for which he is required to meet certain eligibility criteria. Lack of full Capital Account Convertibility further enhances the entry barriers from the perspective of a foreign investor. However, Since January 2012, Indian government has taken a decision to give direct access to such prospective foreign individual investors who were hitherto banned to invest in equity of Indian companies.

The off-shore derivative market allows investors to gain exposure to the local shares without incurring the time and costs involved in investing directly. In return, the foreign investor pays the PN issuer a certain basis point(s) of the value of PNs traded by him as costs. For instance, directly investing in the Indian securities markets as an FII, has significant cost and time implications for the foreign investor. Apart from seeking FII registration, he is required to establish a domestic broker relationship, a custodian bank relationship, deal in foreign exchange and bear exchange rate fluctuation risk, pay domestic taxes and/or filing tax return, obtain or maintain an investment identity etc. These investors would rather look for derivatives alternatives to gain a cost-effective exposure to the relevant market.

Besides reducing transactions costs, PNs also provide customized tools to manage risk, lower financing costs, and enhance portfolio yields. For instance, PNs can also be designed for longer maturities than are generally available for exchange-traded derivative.

PNs also offer an important hedging tool to a foreign investor already registered as an FII. For example; an FII may wish to obtain long exposure to a particular Indian security. The FII can hedge the downside exposure to the listed security, already purchased by purchasing a cash settled put option. Although the Indian exchanges offer options contract, these contracts have a maximum life period of three months, beyond which the FII shall have to rollover its positions i.e. purchase a fresh option contract. Alternatively, it can avail of a PN which can be customized to cater to its hedging requirements.

Although PNs are privately negotiated Over-The-Counter (OTC) contracts, the terminology, terms and conditions used in these contracts are standardized and uniform, just as in the case of exchange-traded derivative contracts.

Potential investors who would like to take direct Indian exposure in future, may make initial investments through the PN route so as to get a flavor of future anticipated returns.

Further, trading in ODI/PNs gives an opportunity to offshore entities to have a commission based business model. This route provides ease to subscribers as it bypasses the direct route which may be resource heavy for them. All the above-said points make it a good avenue to take exposure in Indian securities.

PNs are thus issued, inter-alia, to provide access to a set of foreign investors who intend to reduce their overall costs and the time involved in making investments in India. In other words, the attraction of investing in PNs is primarily one of efficiency (from an infrastructure and time perspective) for which they are willing to forego certain benefits of directly holding the local securities (e.g title and voting rights) whilst also assuming other risks.

What Concerns are raised related to Participatory Notes?

Being derivative instruments and freely tradable, PNs can be easily transferred, creating multiple layers, thereby obfuscating the real beneficial owner. It is in this respect that concerns about the identity of ultimate beneficial owner and the source of funds arises.

For the reason that such instruments are issued outside India, these transactions are outside the purview of SEBI surveillance and it is the FII which acts as mini-exchange overseas. The actual transactions in the underlying are executed by the FIIs only at its discretion, as and when necessary and there is no one-to-one correspondence between transactions in the underlying instruments and issuance of PNs.

The ex-post reporting requirement enjoined upon the FII in respect of PNs on a monthly basis effectively keeps the transactions in PNs out of the real time market surveillance mechanism and beyond the enforceability jurisdiction of SEBI.

There are also concerns that some of the money coming into the market via PNs could be the unaccounted wealth camouflaged under the guise of FII investment. However, this has not been proved so far. SEBI has indeed been successful in taking action against FIIs who are non-compliant and those who have misreported off shore derivatives. (See SEBI's orders against the two FIIs issued on December 9, 2009 (Barclays) and January 15, 2010 (Societe Generale))

The Special Investigation Team (SIT) on Black Money mentioned the following in its Third SIT Report (Reference p. 79-81 of Third Report, as given in PIB release dated 24 July 2015):

SEBI has informed that the outstanding value of Offshore Derivative Instruments (ODIs) at the end of February 2015 stood at Rs. 2.715 lakh crores. SEBI has further informed that the top five locations of end Beneficial owner of ODIs were Cayman Islands, USA, UK, Mauritus and Bermuda contributing to 31.31%, 14.20 %, 13.49 %, 9.91 % and 9.10 % respectively of total ODIs outstanding.

It is clear from above than a major chunk of outstanding ODIs invested in India are from Cayman Islands i.e. 31.31 %. This translates to roughly Rs. 85,006 Crores. The Cayman Islands had a population of 54,397 in 2010 according to Wikipedia. It does not seem conceivable that a jurisdiction with a population of less than 55,000 could invest Rs. 85,000 crores in one country.

The main point of the above elaboration is just that it does not appear possible for the final beneficial owner of ODIs originating from Cayman Islands to be from that jurisdiction.

The following recommendations are made in this regard:

- It is clear that obtaining information on “beneficial ownership” of P notes is of crucial importance to prevent their misuse. SEBI needs to examine the issue raised above and come up with regulations where the “final beneficial owner” of P notes/ODIs are known.

-The information of “beneficial owner” with SEBI should be in form of individual whose KYC information is known to SEBI. In no case should the KYC information end with name of a company. In case a company is the holder of P notes/ODIs, SEBI should have information of its promoters/directors who exercise effective control over the company. In case of Companies/Trusts represented by service providers like lawyers/accountants SEBI should have information on the real owners/effective controllers of those Companies/Trusts. not end with name

-P notes are transferable in nature. This makes tracing the “true beneficial owner” of P notes even more difficult since layering of transactions can be made so complex so as to make it impossible to track the “true beneficial owner”. SEBI needs to examine if this provision of allowing transferring of P notes is in any way beneficial for easing foreign investment. Any investor wanting to invest through P notes can always invest afresh through an Foreign Portfolio Investor (FPI) instead of buying from a P note holder. (Source: PIB Release dated 24 July 2015)

Regulation of PNs

PNs are market instruments that are created and traded overseas. Hence, Indian regulators cannot ban the issue of PNs. However, they can only be regulated, and they are indeed being regulated by the securities market regulator in India, SEBI. When a PN is traded on an overseas exchange, the regulator in that jurisdiction would be the authority to regulate that trade.

Participatory Notes have been used by FIIs since FIIs were permitted to invest in the Securities Market. They were not specifically dealt with under the regulations until 2003. According to Regulation 15(A) of the Securities and Exchange Board of India (SEBI) Regulations, 1995, which was inserted later in 2004 and further amended in 2008 with the objective of tightening regulations in this regard, PNs can be issued only to those entities which are regulated by the relevant regulatory authority in the countries of their incorporation and are subject to compliance of "Know Your Client (KYC)" norms. Down-stream issuance or transfer of the instruments can also be made only to a regulated entity. Further, the FIIs who issue PNs against underlying Indian securities are required to report the issued and outstanding PNs to SEBI in a prescribed format.

In addition, SEBI can call for any information from FIIs under Regulation 20(A) of the SEBI (FII) Regulations concerning off-shore derivative instruments issued by it, as and when and in such form as SEBI may require.

In order to monitor the investment through these instruments, SEBI, vide circular dated October 31, 2001, advised FIIs to submit information regarding issuance of derivative instruments by them, on a monthly basis. These reports require the communication of details such as name and constitution of the subscribers to PNs, their location, nature of Indian underlying securities etc.

SEBI in consultation with the Government had decided in October 2007, to place certain restrictions on the issue of Participatory Notes (PNs) by FIIs and their sub-accounts. This decision was taken with a view to moderate the surge in foreign capital inflows into the country and to address the know-your-client concerns for the PN holders. However, it was found that such restrictions were ineffective. Therefore, SEBI in October 2008 reviewed its earlier decision and decided to remove these restrictions in the light of the above factors. Rather more attention is given to effective disclosures.

Now PNs or ODIs are regulated under SEBI Foreign Portfolio Investors Regulations 2014 dated 7 January 2014. SEBI, vide its circular dated November 24, 2014 has further listed set of criteria for the subscribers of PNs.

FIIs cannot issue PNs to non-resident Indians (NRIs) and those issuing PNs are required to give an undertaking to the effect. NRIs/Resident Indians are not permitted to transact in ODIs. SEBI has also mandated that Qualified Foreign Investors shall not issue PNs. After the issue of FPI Regulations in 2014 it is specified that Non-institutional foreign investors - Category III FPIs (such as Endowments, Charitable Societies/ Trust, Foundations, Corporate Bodies, Trusts, Individuals, Family Offices) or sections of Category II FPIs (unregulated broad based funds, which are classified as Category II FPI by virtue of their investment manager being appropriately regulated) - would not be permitted to issue or to subscribe to ODIs.

Vide a circular dated 24 November 2014 SEBI has further tightened the norms, clarifying that any investment limit applicable to foreign Portfolio Investors would take into account their exposure to ODIs also. Further, issue of PNs or ODIs can be done only to those investors who are otherwise eligible as FPIs (i.e. those who are from FATF compliant countries, whose central bank is a member of Bank of International Settlement etc.). In addition, it is specified that PNs or ODIs can be issued only to those subscribers who do not have opaque structures as explained in the said FPI Regulations 2014.The term “Opaque Structure” means any structure such as protected cell company, segregated cell company or equivalent, where the details of the ultimate beneficial owners are not accessible or where the beneficial owners are ring fenced from each other or where the beneficial owners are ring fenced with regard to enforcement.

Subsequent to the SIT Remarks on the matter, SEBI on 19 May 2016 took the following additional safeguard measures.

On 7 July 2017 SEBI declared that P-Note holders won’t be allowed to take naked /unhedged exposure to the derivatives market anymore. All their existing unhedged positions will have to be squared off by the end of 2020 or by the date of maturity of the instrument, whichever is earlier. ODI issuing FPIs will now have to provide a certificate that fresh derivatives positions are only for hedging the equity shares on a one-to-one basis.

Data on PNs

FIIs which have been granted FII registration after ensuring that they meet the eligibility criteria as laid down in the Securities And Exchange Board Of India (Foreign Institutional Investors) Regulations, 1995 are known to be issuing derivative/ financial instruments against underlying Indian securities. As per the PN reports being filed with SEBI, it is observed that PNs are issued by large financial sector conglomerates which not only have strong presence in the global investment banking arena but also have asset management arms which invest across a number of securities markets globally. These entities are originally incorporated in well-regulated and developed jurisdictions like the US, UK etc. Further, these entities also possess the financial wherewithal to issue PNs, complemented by skilled personnel who are adept at risk management and financial engineering activities.

The year wise data on PN’s are available here

International comparisons

PN like products are not necessarily used to invest in restricted markets but also reported to be available in the open developed / advanced economies like Japan, Hong Kong, Singapore, Australia, USA and UK. In response to market manipulation concerns, in December 1999, Taiwan Securities and Futures Commission had amended its FII regulations to require periodic disclosure by FIIs of all offshore derivative activities linked to local shares, but this requirement was subsequently removed in June 2000 (Source: Ashok Lahiri Committee Report). China’s Securities Regulatory Commission requires entities to file reports related to these products with minimal reporting requirements that emphasize only on the quota utilized by them. Other Asian countries like Hong Kong, Singapore and Japan have reportedly no restrictions or requirements on PNs. Malaysia, Indonesia and Philippines which are restricted markets though, are heard to be having no reporting requirements in this regard.

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