Indian Economy, 5th edition (69 page)

The speedier moves in the area of promoting higher foreign investment (FIs) in India should be seen in the light of two broad perspectives –

(i)
India’s rising current account deficit (which crossed an all-time high of 6.7 per cent by
March 2013
) which is creating heavy drain of foreign exchange; and

(ii)
The objective of attracting more FIs while the Western economies are under the spell of recession (cashing in the opprtunity).

PARTICIPATORY NOTES (PN
s
)

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), against Indian securities – the Indian security instrument may be equity, debt, derivatives or may even be an index. PNs are also known as
Overseas Derivative Instruments
,
Equity Linked Notes
,
Capped Return Notes,
and
Participating Return Notes
, etc.

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.

Reasons for the popularity of PNs

The reasons why PNs became such a popular ruote for foreign investors to invest in the India security market may be understood through the following points:

•
One of the primary reasons for the emergence of the PN (an ‘off-shore derivative instrument’, i.e., an ODI) is the restrictions on foreign investments. For example, 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
, The 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.

•
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.

•
And
lastly
, it was a highly ‘safe and lucrative route’ to invest the ‘unaccounted’, ‘even illegal’ money into the Indian security market for huge profits (during the booming market). Experts even imagined that it may be allowing the ‘black money’ of India (stashed away from India through ‘hawala’ kind of illegal channels and deposited in the tax havens of the world in ‘Swiss Bank’ kind of financial institutions) to get invested back in the market! Again, ‘terrorist organisations’ might have been using this route, too.

PNs are
thus
issued, 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 (fro example, title and voting rights) whilst also assuming other risks.

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 regulated, as SEBI does – 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 (1994) – they were not specifically dealt with under the regulations until 2003. According to the
SEBI Regulation, 2004
(and further amended in 2008) with the
objective
of tightening regulations in this regard –

(i)
PNs can be issued only to those entities which are regulated by the relevant regulatory authority in countries of their incorporation and are subject to compliance of ‘know your client’ (KYC) norms.

(ii)
Down-stream issuance or transfer of the instruments can also be made only to a regulated entity.

(iii)
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.

(iv)
In addition, SEBI can call for any information from FIIs concerning off-shore derivative instruments (ODIs) issued by it.

(v)
In order to monitor the investment through these instruments, SEBI on
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.

(vi)
FIIs cannot issue PNs to non-resident Indians (NRIs) and those issuing PNs are required to give an undertaking to the effect.

(vii)
SEBI has also mandated that QFIs (qualified foreign investors), the recently allowed foreign investor class, shall not issue PNs.

SEBI in consultation with the Government had decided in
October 2007
, to place certain restrictions on the issue of 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 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.

The Concerns related to PNs

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 of India, these transactions are outside the purview of SEBI’s surveillance and it is the FII which acts as mini-exchange overseas. The actual transactions in the underlying securities 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 the FIIs who were non-compliant and those who had misreported offshore derivatives [as happened when SEBI took actions against two FIIs –
Barclays
in December 2009 and
Societe Generale
in January 2010]

At present, 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.

International Situation

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, the 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 (as the Ashok Lahiri Committee Report says).
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 having no reporting requirements in this regard.

Hedge Fund

This term has come up from another term
hedging
,
a process by which businesses insulate themselves from the risk of price changes.
14
Hedge funds are the lot of investible (free floating capital) capital which move very swiftly towards the more profitable sectors of an economy.

At present, such funds easily move from the stock market of one economy to the other—away from the low profit fetching to high profit fetching ones. As stock markets fall and rise such funds change markets accordingly. By nature they are temporary. The period for which they continue flowing into an economy there is naturally a boom time. But when they quit for a more attractive economy, the same economy might not be able to manage the accelerated foreign currency outflow and there are chances of imminent foreign currency crisis. This has been in news for the last two years in India where stock market has been in boom, riding on the FIIs inflow via Participatory Notes (PNs).

Short Selling

Sale of a share which is not owned. This is done by someone after borrowing shares from stockbrokers promising to replace them at a future date on the hope (speculation) that the price will fall by then. He fetches profit if price of the share really fell down by the future date of replacement and sustains a loss if the price increased. Recently, short selling has been allowed in India by SEBI.

Bear and Bull

A person who speculates share prices to fall in future and so sells his shares and earns profit is a
bear
. He earns profit out of a falling market. Basically, here he is short selling the shares.

Opposite to bear, bull is a person who speculates share prices to go up in future so either stops selling the select group of shares for that time to be reached (he is basically taking long position on those shares) or starts purchasing that select group of shares.

Thus, a bear increases the number of shares in a stock market activating a general fall in the index—a bearish market. Opposite to it, a bull creates a scarcity of shares in the stock market activating a general rise in the share prices and the index—a bullish market.

Brokers play as a bear for some stocks and as a bull for some other stocks.
w
hile a bear broker is a non-entity, a bull is remembered for long time to come—Harshad Mehta was known as the Great Bull.

Book Building

A provision allowed by the SEBI to all Initial Public
o
ffers (IPOs) in which individual investors are reserved and allotted shares by the company. But the issuer has to disclose the price (at which shares have been allotted the size of the issue and the number of shares offered to the public).

IPO