Wednesday, October 1, 2008

Participatory Notes

It is Kolkata time now and I am back to understanding market terms ( as well as other things , including my work , at times )


Behind all the hue and cry about Participatory Notes


George Mathew

The Indian Express

Published on October 18, 2007



In the backdrop of a 1,700 point intra-day fall in the Sensex, George Mathew explains the hullabaloo behind participatory notes (PNs or P-Notes)


What are PNs?


Participatory Notes — classified under offshore derivative instruments — are issued by Sebi-registered foreign institutional investors (FIIs) to their overseas investors, who wish to invest in the Indian stock markets without registering themselves with Sebi. Under this system, FIIs route their purchases of shares through brokers and then issue PNs to their overseas clients which indicate the underlying stocks. Foreign clients get dividends or capital gains collected from the underlying securities.


Why do foreign investors come through this route?


Registered FIIs which handle PNs on behalf of their foreign clients do not disclose their client details to Sebi, unless asked specifically by the regulator. Foreign investors who invest through PNs can remain anonymous, they don’t need to register with Sebi. Foreign hedge funds — infamous and feared for their quick entry and exits — normally use PNs to invest in India .


What’s wrong with that?


The biggest problem is their opacity in an era of transparency. Indian regulators don’t have any idea about the source of funds and the identity of foreign investors putting money in PNs. On the other hand, Indian investors have to disclose the full details about their funds and identity while putting funds in the market. So there’s no level playing field. There’s also a fear that PNs bring in hot money which comes into the country suddenly and exits at the same speed.


Finally, the government is worried about whether the PN route is being used to launder money. Earlier, a Sebi investigation exposed how Indian money was routed from India to Mauritius , London , British Virgin Islands and the US and re-entered India as foreign money through the PN route.


How much foreign money has come through PNs?


According to Sebi, the notional value of PNs outstanding, which was at Rs 31,875 crore (20 per cent of assets under custody) in March 2004 has now grown to Rs 353,484 crore —which is 51.6 per cent of assets under FII custody — by August 2007. This means most foreign investment in stocks is through PNs.


Why has Sebi proposed curbs on PNs now?


Sebi wants to encourage foreign investors to register directly with the regulator and bring more transparency on the FII investment front. Another plan of the government is to moderate the copious inflow of foreign funds to the stock market and reduce the upward pressure on the rupee.



 From E-Group, Banking-News



What are ‘Participatory notes’?


D Sampathkumar, The Business Line

Published on October 18, 2007



‘Participatory notes’ are instruments that derive their value from an underlying financial instrument such as an equity share and, hence, the word, ‘derivative instruments’.


When the Indian capital market regulator permitted, back in 1992, foreign institutional investors (FIIs) to register and trade in Indian securities, every one assumed that they would make proprietary investments out of their own capital.


3rd-party investments


There was no question of their trading on anyone else’s behalf. But as it turned out, FIIs were merely acting as a conduit for third-party investments.


But some of these third-party investors had their own preferences in the matter of what Indian stocks that they would like to own with its own risk and reward characteristics. In order to ring fence, each such pool of investments they created accounts or ‘sub-accounts’ in FII parlance.


Sub-account holders


But even sub-account holders, it turned out, were not investing their own money but were in fact raising money from a multitude of high net worth individuals.


They were issued pieces of paper that derived its value from underlying equity instruments of Indian corporates.


The participatory notes were now well truly launched. International investments got a little more complicated with sub-account investment institutions raising loan funds as securitised paper, with a pool of underlying equity shares of Indian companies.


All this leveraged money got further leveraged with the investments going into not just equity shares but derivative instruments (futures and options) of shares of Indian corporates.


Thus one could have a sub account holder of a registered FII investing a combination of subscriptions by a group of investors topped up with funds borrowed by floating yet another piece of tradable instrument using a pool of participatory notes as collateral.


But the tale of leveraged investments became a little more complex with a $100 of such funds getting invested, for example, not in Reliance shares but into futures contract on Reliance shares.


Futures contract


Now, in a futures contract, one did not have to invest the full value of the contract. It is enough if put up a small margin and topped it up each depending on how the share price moved.


The potential of $100 got further magnified.


It is easy to see the super structure of heavily leveraged investments flowing into the Indian stock market. That is without even thinking of whatever private financial arrangements that each one of investors in the original pool of investments that gave rise to the participatory notes.


Global liquidity


All of this became possible when there was a global liquidity thanks to the economic policies of the West and more particularly the US .


A financial distress for one lender who participated in leveraged transaction of investments of a sub-account holder of an FII who had invested in the Indian stock market can cause him to call back his loan.


This could lead to the sub-account holder closing out his futures position in the underlying share which caused the latter’s future price to fall.


Share prices


Since future prices are in turn linked to the spot prices of the same share, there is a price correction in the spot price as well.


The fall in share price erodes not just the overseas investor’s wealth but that of domestic investors as well.


The depreciation of the rupee’s value against other currencies or wiping out huge chunk of the RBI’s currency reserves when the liquidated investments goes out of the country, are the other unintended consequences of the FII play on the Indian stock market


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