Investing

Participation Instructions

What is participatory note-taking?

Participating Notes, also known as P-Notes or PNs, are financial instruments for investors or hedge funds to invest in Indian securities without registering with the Securities and Exchange Board of India (SEBI). P-Notes are part of one of the investment groups that are considered Offshore Derivative Investments (ODI). Citigroup (C) and Deutsche Bank (DB) are the largest issuers of these instruments.

Any dividends or capital gains received from securities are returned to investors. Indian regulators generally do not support participatory notes because they fear that hedge funds acting through participatory notes will cause economic volatility on Indian exchanges.

Participation Instructions Explained

Foreign Institutional Investors (FIIs) issue financial instruments to investors from other countries who wish to invest in Indian securities. An FII is an investor or investment fund registered in a country other than the country in which it invests.

The system allows unregistered overseas investors to buy Indian shares without registering with Indian regulators. These investments also benefit India. They provide quick access to capital markets in India. Due to the short-term nature of investments, regulators have less guidance for foreign institutional investors. To invest in Indian equities and avoid the cumbersome regulatory approval process, these investors trade participatory notes.

key takeaways

  • Brokers and Foreign Institutional Investors (FIIs) must be registered with the Securities and Exchange Board of India.
  • Participation Notes allow non-registered investors to invest in the Indian market.
  • Participating Notes, known as P-Notes or PNs, are derivatives of the underlying assets in India.
  • Participatory notes are popular investments because investors remain anonymous.

How does participatory note-taking work?

Participating notes are offshore derivatives with Indian equities as the underlying asset. Brokers and foreign institutional investors registered with the Securities and Exchange Board of India (SEBI) issue participation notes and make investments on behalf of foreign investors. Brokers are required to report their participation in the issuance of notes to the Regulatory Commission on a quarterly basis. These notes allow high net worth foreign investors, hedge funds and other investors to participate in the Indian market without registering with SEBI. Investors save time, money and scrutiny associated with direct registration.

Pros and cons of participatory note-taking

Participating notes are easily traded overseas by endorsement and delivery. They are popular because investors hold positions in Indian markets anonymously, and hedge funds may conduct business anonymously. Some entities invest through participatory notes to take advantage of the tax laws of certain countries.

However, due to anonymity, it is difficult for Indian regulators to identify the original and ultimate owners of the participatory notes. As a result, a large amount of unaccounted for money entered the country through participatory instruments. This untracked flow of money has raised some red flags.

Participatory Bills Supervision Issues

SEBI has no jurisdiction over participatory instrument transactions. Participatory note transactions between foreign institutional investors are not recorded, although foreign institutional investors are required to register with the Indian Regulatory Commission. Officials worry that the practice could lead to P-Notes being used for money laundering or other illegal activities.

The inability to trace funds is also why the Special Investigations Unit (SIT) wants to impose stricter compliance measures on participatory note transactions. SIT is a professional team of Indian law enforcement, consisting of personnel trained to investigate serious crimes.

However, Indian markets have become extraordinarily volatile when the government has placed trade restrictions on the notes in the past. For example, in October 2007, the government announced that it was considering restrictions on participatory bill trading. The announcement sent the Sensex tumbling 1,744 points in the day’s trading, down more than 8% at the time.

The market turmoil was in response to investor and government concerns that restricting P-Notes would hit the Indian economy directly. This is because foreign institutional investors help drive growth in India’s economy, industry and capital markets, while increased regulation will make it harder for foreign funds to enter the market. The government ultimately decided not to regulate participatory bills.

Status of Participatory Description Regulations

Participatory notes remain vulnerable to regulatory rulings. In late 2017, Indian regulators determined that P-Notes could not hold any derivatives positions in Indian markets for reasons other than hedging. According to EconomicTimes.IndiaTimes.com, this tight regulatory intervention caused investment through P-Notes to decline throughout 2018, culminating in a more than 9-1/2-year low in November 2018. However, investment bounced back in December 2018 with some of the stricter requirements after regulators eased.

real world example

P-Notes can be used to buy any Indian securities an investor wants in a series of steps.

Investors deposit funds into the US or European business of a registered foreign institutional investor (FII), such as HSBC or Deutsche Bank. Investors then inform the bank of the Indian securities or securities they wish to buy. Funds are transferred from the investor to the FII account, the FII issues participation notes to the client and purchases the correct amount of underlying stock or shares from the Indian market.

Investors are eligible to receive dividends, capital gains and any other payouts due to shareholders who hold shares in the Indian company. FII reports all its offerings to Indian regulators on a quarterly basis, but by law it does not disclose the identities of actual investors.

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