What are 'Participatory Notes'?

Participatory notes, also referred to as "P-notes," are financial instruments required by investors or hedge funds that are not registered with the Securities and Exchange Board of India (SEBI) to invest in Indian securities. Any dividends or capital gains collected from the securities go back to the investors. Indian regulators are against participatory notes because they fear that hedge funds acting through participatory notes will cause economic volatility in India's exchanges.

BREAKING DOWN 'Participatory Notes'

Foreign institutional investors (FIIs) provide quick money to the Indian capital market. Because of the short-term nature of investing, regulators have fewer guidelines for FIIs. To invest in Indian stock markets and to avoid the cumbersome regulatory approval process, FIIs trade P-notes.

What Are Participatory Notes?

P-notes are offshore derivative instruments with Indian shares as underlying assets. Brokers and FIIs registered with the SEBI issue the instruments and invest on the FII’s behalf. Brokers must report their P-note issuance status to the SEBI each quarter. The notes allow foreign investors with high net worth, as well as hedge funds and other investors, to invest in Indian markets without registering with the SEBI. Investors save time, money and scrutiny associated with direct registration.

Pros and Cons of Participatory Notes

P-notes are easily traded overseas through endorsement and delivery. They are popular because investors anonymously take positions in Indian markets, and hedge funds anonymously carry out their operations. Some entities route their investments through P-notes to take advantage of certain countries’ tax laws.

However, because of the anonymity, Indian regulators face difficulty determining a P-note’s original and end owner. Therefore, substantial amounts of unaccounted for money enters the country through P-notes. In addition, SEBI has no jurisdiction over P-note trading. Although FIIs must register with SEBI, the P-notes trading among FIIs are not registered. For this reason, India’s government is concerned that P-notes are being used for money laundering.

For this reason, the Special Investigation Team (SIT) would like stricter compliance measures for P-note trading. However, when the government proposed trade restrictions on P-notes in the past, the Indian market became extremely volatile. For example, around the time the government began to discuss curbing P-note trading in October 2007, the market dropped 1744 points. Because FIIs help fuel the growth of the Indian economy, industries and capital market, and because increasing regulations on P-notes would increase the difficulty of foreign money entering the market, the Indian government and investors reacted with fear. The government decided not to regulate P-notes.

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