Participatory notes are one of the recent instruments being used in our financial market, which is increasingly opening up to foreign capital. However as with any channel routing foreign money into India, this instrument has also come under suspicion and debate. The cause for concern carries weight and there is some evidence of misuse of P-Notes (as they are popularly called).
Participatory Notes are derivative instruments, which are used by foreign funds wanting to invest in the Indian securities market. The important feature is that these funds are not registered with SEBI. So to invest into the Indian securities market these funds channel their money via a registered Foreign Institutional Investor or any Indian brokerage house having its branches abroad. These brokerage houses invest and trade on behalf of the owners of the funds. The gains and dividends from the trade are repatriated to the owners of the fund by these brokerage houses and financial institutions. Participatory notes, thus allow these unregistered foreign investors to indirectly own the securities in the Indian financial market and order the intermediate P Note issuing brokerage firm to sell or purchase the security. However the brokerage firms keep he names of the investing entities a secret. In fact in many instances the money is routed via such a complex global network that tracking the original investor becomes tough and almost impossible. There in lies the bone of contention.
The problem of secrecy of identity of the actual investor via the Participatory Notes channel has important ramifications. What is feared is that unscrupulous elements might take advantage of this secrecy cloak and use this channel for money laundering. Thus illegal money from India might tour around the world and re-enter the country as foreign inflows. The second fear has been that this channel of foreign money into India makes our financial market very vulnerable to the volatile hedge funds and other such funds that invest just to seek profits in the short run. The secrecy of the investor’s identity would not allow the regulator sitting in India to make an accurate real time judgment if the flows via this channel are speculative and volatile or for a long-term investment purpose.
It is beyond debate that India like all the developing countries needs foreign capital to augment growth and create resources for the purpose of investment. P Notes are a powerful channel to tap such foreign funds. But like any other developing economies, there is a persistent fear of a market collapse and financial crises if these funds were to start moving in the opposite direction and flee the Indian markets in a jiffy. There are also fears of bigger foreign players manipulating the domestic capital markets to make their own gains, rendering the small domestic investor hapless. Most of the foreign money is routed through Mauritius to save on taxes as India and Mauritius have entered into a double tax treaty. This again adds a layer in the channel of global money movement.
These issues with respect to Participatory Notes become more bothersome as increasing volumes of money are being routed via this channel. Participatory Notes have accounted for about 40% of the net FII inflow (about $22 billion) from 2002-2005 in to India. Large volumes have the potential to create large disturbances in the market as the on that happened on Black Monday, the UBS scam.
This UBS Securities scam is a well-cited case to illustrate the problem with P-Notes. On 17th May 2004, FII’s made a sale of about Rs. 188.35 crores in the stock market. This immediately sent shivers into the market and investors especially the small investors upon seeing this sale binge started panic selling their shares too. Like any self-fulfilling prophecy, the stock market plummeted. The Sensex fell by 567.74 points, NIFTY fell by 196.90 points & the Intra-day Sensex fell by 842 points. The estimated loss in the market was about Rupees One Lakh Crores. The stock market had to be closed three times that day and when it reopened the next day it again saw some fall. Upon investigations by SEBI it was found that UBS got its order to sell on its sub account by Swiss Finance Corporation Limited, which was based in Mauritius. This acted on the orders of UBS AG London, which got its orders from its clients including Caxton international, which is a hedge fund based in the British Virgin Islands. This one hedge fund alone had issued sales orders of about Rs. 99 crores. Lo and behold! SEBI further investigated only to find NRI names at the root of this long chain.
It took SEBI almost one full year to get to the bottom of the chain and that too without being able to hold any one person or entity responsible. It meanwhile had stopped UBS from market transactions since UBS was not cooperating in sharing much of the information. This case is a good pointer as how P Note channel is an open invitation to irregular investors. That is why SEBI guidelines to the FII and brokerage houses include KYC or “Know Your Client”. Meaning, the FII should be able to provide information on who is the ultimate investor and beneficiary of the trade to facilitate SEBI to monitor the market closely for unsettling flows but this is rarely followed in its full dimension.
The Reserve Bank of India has been opposing P Notes and vouching for banning P Notes in India since they have the potential to destabilize the market. On the contrary the Ministry of Finance feels that P-Notes are a major source of much needed foreign flows in India and cannot be banned. They can be however monitored closely. RBI may have a point when it argues about improving the quality of flows but to ban the P Notes is just not a solution. What we need is greater transparency on the actual identity of the investor and perhaps stronger regulatory norms to the FII for creating a disincentive to play dirty the Indian market.
The Lahiri Committee (June 2004) on liberalization of FII was expected to throw some light on Participatory Notes and the way to make them a more acceptable and a secure instrument but the report was found wanting on this issue.
So, while the foreign flows are much needed by India, their sudden exodus can cause market destabilization and crises. It is necessary to have some idea about the source of these flows for any regulator to work efficiently. To achieve this there should be better means of information sharing mechanisms installed in place which would allow RBI, SEBI, Government of India and their counterparts abroad to act in unison under full information.
The bottom line is aptly illustrated at Bloomsburg – “As hedge funds from across the world shower riches on Indian stock markets, all that the country's central bank can worry about is how to stop them.”
Participatory Notes are derivative instruments, which are used by foreign funds wanting to invest in the Indian securities market. The important feature is that these funds are not registered with SEBI. So to invest into the Indian securities market these funds channel their money via a registered Foreign Institutional Investor or any Indian brokerage house having its branches abroad. These brokerage houses invest and trade on behalf of the owners of the funds. The gains and dividends from the trade are repatriated to the owners of the fund by these brokerage houses and financial institutions. Participatory notes, thus allow these unregistered foreign investors to indirectly own the securities in the Indian financial market and order the intermediate P Note issuing brokerage firm to sell or purchase the security. However the brokerage firms keep he names of the investing entities a secret. In fact in many instances the money is routed via such a complex global network that tracking the original investor becomes tough and almost impossible. There in lies the bone of contention.
The problem of secrecy of identity of the actual investor via the Participatory Notes channel has important ramifications. What is feared is that unscrupulous elements might take advantage of this secrecy cloak and use this channel for money laundering. Thus illegal money from India might tour around the world and re-enter the country as foreign inflows. The second fear has been that this channel of foreign money into India makes our financial market very vulnerable to the volatile hedge funds and other such funds that invest just to seek profits in the short run. The secrecy of the investor’s identity would not allow the regulator sitting in India to make an accurate real time judgment if the flows via this channel are speculative and volatile or for a long-term investment purpose.
It is beyond debate that India like all the developing countries needs foreign capital to augment growth and create resources for the purpose of investment. P Notes are a powerful channel to tap such foreign funds. But like any other developing economies, there is a persistent fear of a market collapse and financial crises if these funds were to start moving in the opposite direction and flee the Indian markets in a jiffy. There are also fears of bigger foreign players manipulating the domestic capital markets to make their own gains, rendering the small domestic investor hapless. Most of the foreign money is routed through Mauritius to save on taxes as India and Mauritius have entered into a double tax treaty. This again adds a layer in the channel of global money movement.
These issues with respect to Participatory Notes become more bothersome as increasing volumes of money are being routed via this channel. Participatory Notes have accounted for about 40% of the net FII inflow (about $22 billion) from 2002-2005 in to India. Large volumes have the potential to create large disturbances in the market as the on that happened on Black Monday, the UBS scam.
This UBS Securities scam is a well-cited case to illustrate the problem with P-Notes. On 17th May 2004, FII’s made a sale of about Rs. 188.35 crores in the stock market. This immediately sent shivers into the market and investors especially the small investors upon seeing this sale binge started panic selling their shares too. Like any self-fulfilling prophecy, the stock market plummeted. The Sensex fell by 567.74 points, NIFTY fell by 196.90 points & the Intra-day Sensex fell by 842 points. The estimated loss in the market was about Rupees One Lakh Crores. The stock market had to be closed three times that day and when it reopened the next day it again saw some fall. Upon investigations by SEBI it was found that UBS got its order to sell on its sub account by Swiss Finance Corporation Limited, which was based in Mauritius. This acted on the orders of UBS AG London, which got its orders from its clients including Caxton international, which is a hedge fund based in the British Virgin Islands. This one hedge fund alone had issued sales orders of about Rs. 99 crores. Lo and behold! SEBI further investigated only to find NRI names at the root of this long chain.
It took SEBI almost one full year to get to the bottom of the chain and that too without being able to hold any one person or entity responsible. It meanwhile had stopped UBS from market transactions since UBS was not cooperating in sharing much of the information. This case is a good pointer as how P Note channel is an open invitation to irregular investors. That is why SEBI guidelines to the FII and brokerage houses include KYC or “Know Your Client”. Meaning, the FII should be able to provide information on who is the ultimate investor and beneficiary of the trade to facilitate SEBI to monitor the market closely for unsettling flows but this is rarely followed in its full dimension.
The Reserve Bank of India has been opposing P Notes and vouching for banning P Notes in India since they have the potential to destabilize the market. On the contrary the Ministry of Finance feels that P-Notes are a major source of much needed foreign flows in India and cannot be banned. They can be however monitored closely. RBI may have a point when it argues about improving the quality of flows but to ban the P Notes is just not a solution. What we need is greater transparency on the actual identity of the investor and perhaps stronger regulatory norms to the FII for creating a disincentive to play dirty the Indian market.
The Lahiri Committee (June 2004) on liberalization of FII was expected to throw some light on Participatory Notes and the way to make them a more acceptable and a secure instrument but the report was found wanting on this issue.
So, while the foreign flows are much needed by India, their sudden exodus can cause market destabilization and crises. It is necessary to have some idea about the source of these flows for any regulator to work efficiently. To achieve this there should be better means of information sharing mechanisms installed in place which would allow RBI, SEBI, Government of India and their counterparts abroad to act in unison under full information.
The bottom line is aptly illustrated at Bloomsburg – “As hedge funds from across the world shower riches on Indian stock markets, all that the country's central bank can worry about is how to stop them.”
2 comments:
a true knowledge imparting post...learned a lot, good work raghav
will be waiting for more of these
The problems with P-notes is the same as the general fears associated with foreign capital flows in an emerging market like ours. Since these flows are essentially speculative in nature, and dominated by some big players,P-notes or any other instrument, there can't be anything to keep it under control,lest they flee the market.SEBI should come up with guidelines that would make the small investor safe against any major activity by these big fishes. At this juncture I don't think SEBI can actually do something.
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