Rules of Participatory Notes (P-Note) SEBI

On 30^th May, SEBI put out a proposed report to regulate Participatory Notes (P-Notes) more closely. It may be recollected that when SEBI permitted Foreign Institutional Investors to invest in India, these FIIs were required to register with SEBI by going through the stringent KYC and other reporting and compliance requirements. However, many smaller investors abroad and even institutions did not want to go through these rigorous processes and wanted an easier route to invest in India. Hence these foreign investors were permitted an additional route called as P-Notes. Under this mechanism, the investor could invest in the Indian markets by opening a P-Note account with a registered FII. The advantage was that the process was simpler and at the same time they could participate in the Indian markets.

Why SEBI was worried over P-Notes…

The big worry that SEBI had over P-Notes was that the P-Note issuing FII was not required to disclose complete details of the eventual beneficiary. In many cases, the institution that had originally opened the P-Note with a registered FII had sold the P-Note to another entity. As a result, the FII itself did not have an idea of the end client. This created a major compliance issue for the regulator in India. Secondly, there were fears that the P-Notes were being used to round-trip funds. What that means is that money that had illegally gone out of India was coming into India legitimately through the P-Note route. The third worry was that slush money generated from drugs and arms was also being routed into markets using P-Note route. While there was no evidence on these areas, this was a concern that many centrals banks and capital market regulators around the world had expressed. This had led SEBI to further tighten P-Note norms requiring much greater levels of transparency and disclosure. As a result the share of P-Note in total foreign portfolio investments, which was as high as 51% in 2007, had come down to just about 6% by the year 2017.

Gist of the new P-Note regulatory model proposed by SEBI…

In addition to the disclosure and compliance requirements, SEBI has additionally stipulated two additional measures, and these are open to public comments…

1. Effective April 01^st 2017, SEBI proposes to levy a regulatory fee of $1000 on each Foreign Portfolio Investor (FPI) issuing Overseas Derivative Instruments (ODIs). This levy of $1000 will be on each ODI subscriber who comes via an FPI. This will have 4 key implications. Firstly, the cost of $1000 itself will be prohibitive for most ODI subscribers and may discourage them. Secondly, most ODI subscribers have multiple ODI accounts through multiple FIIs. Hence tracking the final beneficiary becomes quite difficult. This will be difficult since they have to pay the levy for each account with each FPI and it will have to be paid once in three years. Thirdly, this levy will encourage ODI subscriber to directly invest by registering under the FPI route. This process has become much simpler after the 3 categories of FPIs were introduced in 2014. Last, but not the least, since the payment of $1000 will have to be done via banking channels; it establishes a clear audit trail covering the banking and the investment transaction. This will make round tripping much more difficult and complicated.
2. The second restriction that SEBI proposes to introduce is to prohibit ODIs being issued against derivatives unless it is for hedging purposes. Currently, FPIs are permitted to issue ODIs against equity, debt and derivatives. Under the new rules, if the FPI has taken positions in the derivative market purely for speculative purposes, then they cannot issue ODIs against that. This is critical because ODIs on derivatives account for nearly 1/4^th of all ODIs issued by FPIs. The onus will be on the FPIs to ensure that when ODIs are issued against derivatives, they are only issued against positions that are marked for hedging and not those positions that are speculative in nature. This will ensure that all ODI positions are either linked to equity or debt or a protective position underlying one of these positions.

The SEBI proposals need to be seen in the light of the following scenario…

• The current government has taken rapid strides in controlling the generation and circulation of black money through the demonetization route. The tighter regulation of P-Notes takes the fight against black money one step further.

• This move by SEBI will add substantially to the transparency and disclosure standards in the market. While disclosure standards have improved sharply in the last few years, this was one major missing link in the entire thrust on disclosure standards. Globally, institutional investors have preferred markets that are well regulated and have higher standards of transparency and disclosure. It will also go a long way in enhancing the trust of investors in the integrity of the equity market mechanism.

The special status for global portfolio investors in the form of ODIs was accorded at a time when India relied largely on FPI flows to bridge the fiscal deficit and to buoy the markets. A lot has changed since then. The fiscal deficit is well in control, domestic investors have become sizable investors in Indian equities and India has become the largest recipient of Foreign Direct Investment (FDI) in the world. Under these circumstances, SEBI is right in initiating one more step towards the gradual and eventual phasing out of P-Notes altogether.