Definition and How They Work

What Are Participatory Notes?

Participatory notes also referred to as P-notes, or PNs, are financial instruments required by investors or hedge funds to invest in Indian securities without having to register with the Securities and Exchange Board of India (SEBI). P-notes are among the group of investments considered to be Offshore Derivative Investments (ODIs).

Any dividends or capital gains collected from the securities go back to the investors. Indian regulators are generally not in support of participatory notes because they fear that hedge funds acting through participatory notes will cause economic volatility in India’s exchanges.

Understanding Participatory Notes

Participatory notes are offshore derivative instruments with Indian shares as the underlying assets. Because of the short-term nature of investing, regulators have fewer guidelines for foreign institutional investors. To invest in the Indian stock markets and to avoid the cumbersome regulatory approval process, these investors trade participatory notes.

Foreign institutional investors (FIIs) issue the financial instruments to investors in other countries who want to invest in Indian securities. Brokers and foreign institutional investors registered with the Securities and Exchange Board of India (SEBI) issue the participatory notes and invest on behalf of the foreign investors. Each month, brokers must report their participatory note issuance status to the regulatory board.

This system lets unregistered overseas investors, such as high-net-worth individuals, hedge funds, and other investors buy Indian shares without the need to register with the Indian regulatory body. They provide access to quick money in the Indian capital markets. Investors save time, money, and scrutiny associated with direct registration. These investments are also beneficial to India as they allow for foreign investment into the country.

Advantages and Disadvantages of Participatory Notes

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

However, because of the anonymity, Indian regulators face difficulty determining a participatory note’s original owner and end owner. Therefore, substantial amounts of unaccounted-for money enter the country through participatory notes. This flow of untracked funds has raised some red flags.

Participatory Notes Regulatory Issues

SEBI has no jurisdiction over participatory note trading. Although foreign institutional investors must register with the Indian regulatory board, the participatory notes trading among foreign institutional investors are not recorded. Officials fear this practice may lead to the P-notes being used for money laundering or other illegal activity.

This inability to track money is also why the Special Investigation Team (SIT) would like stricter compliance measures for the trading of participatory notes. The SIT is a specialized team of officers in Indian law enforcement which consists of personnel who have been trained to investigate serious crimes.

However, when the government proposed trade restrictions on the notes in the past, the Indian market became extremely volatile. For example, in October 2007, the government announced it was considering curbing participatory note trading. The announcement caused the Sensex index to plummet 1,744 points during the day’s session, which was more than an 8% drop.

This market disturbance was in response to investor and government worries that the curbing of the P-notes would be a direct hit on the Indian economy. That is because foreign institutional investors help fuel the growth of the Indian economy, industries, and capital markets, and increasing regulation would make it more difficult for foreign money to enter the market. The government ultimately decided not to regulate participatory notes.

Participatory Notes Process

P-notes can be used to purchase any Indian security an investor wants through a series of steps.

An investor deposits funds with the U.S. or European operations of a registered foreign institutional investor (FII), such as HSBC or Deutsche Bank. The investors then inform the bank of the Indian security or securities they wish to purchase

Funds transfer from the investor to the FII account, and the FII issues the participatory notes to the client and buys the underlying stock or stocks in the correct quantities from the Indian marketplace.

The investor is eligible to receive dividends, capital gains, and any other payouts due to stockholders holding the shares of the Indian company. The FII reports all of its issuances each month to the Indian regulators, but as per law, it does not disclose the identity of the actual investor.