In the Indian context, a Participatory Note (PN or P-Note) is a derivative instrument issued by a SEBI registered FII in foreign jurisdictions against Indian securities—the Indian security instrument could be equity, debt, derivatives, or even an index. Overseas Derivative Instruments, Equity Linked Notes, Capped Return Notes, and Participating Return Notes are all terms used to describe Participatory Notes.
The underlying Indian security, which is held by the FIT that issues the Participatory Note, is not owned by the Participatory Note investor. As a result, Participatory Note investors benefit financially from investing in the security without actually holding it. Because the value of the Participatory Note is linked to the value of the underlying Indian security, they benefit from price fluctuations in the underlying security. In addition, the Participatory Note holder has no voting rights in relation to the security/shares mentioned in the Participatory Note.
Reasons for the popularity of Participatory Notes
The following points can help explain why Participatory Notes became such a popular vehicle for foreign investors to invest in the Indian security market.
Foreign investment restrictions are one of the primary reasons for the emergence of the Participatory Note (an ‘off-shore derivative instrument,’ i.e., an ODI). For example, a foreign investor planning to make portfolio investments in India must apply for FII registration and meet certain eligibility requirements. From the standpoint of a foreign investor, the lack of full capital account convertibility raises the entry barriers even higher. However, since January 2012, the Indian government has decided to grant direct access to such potential “foreign individual investors” who were previously prohibited from investing in Indian companies’ equity.
The off-shore derivative market allows investors to gain exposure to local stocks without the time and expense of doing so directly. In exchange, the foreign investor pays the Participatory Note issuer a percentage of the value of the PNs he trades as costs. For example, investing directly in Indian securities markets as a foreign institutional investor (FII) has significant cost and time implications for the foreign investor.
He must establish a domestic broker relationship, a custodian bank relationship, deal in foreign exchange and bear exchange rate fluctuation risk, pay domestic taxes and/or file tax returns, obtain or maintain an investment identity, and so on, in addition to seeking FII registration. To gain a cost-effective exposure to the relevant market, these investors would rather look for derivatives alternatives.
PNs offer customized tools to manage risk, lower financing costs, and improve portfolio yields in addition to lowering transaction costs. PNs, for example, can be designed with longer maturities than are typically available in exchange-traded derivatives.
A foreign investor who has already registered as an FII can use PNs as a valuable hedging tool. An FII, for example, might want to get ‘long’ exposure to a specific Indian security. By purchasing a ‘cash-settled put option,’ the FII can hedge the downside exposure to the listed security that it has already purchased. Although Indian exchanges offer options contracts, these contracts have a three-month maximum life, after which the FII must roll over its positions and purchase a new option contract. Alternatively, it can obtain a PN that can be customized to meet its hedging needs.
Potential investors who would like to take direct Indian exposure in the future may make initial investments through the PN route so as to get a flavor of future anticipated returns. Furthermore, trading in ODI/PNs allows offshore entities to operate on a commission-based business model. Subscribers benefit from this route because it avoids the direct route, which may be resource-intensive for them.
Finally, investing the ‘unaccounted’, ‘even illegal’ money into the Indian security market for huge profits was a highly safe and lucrative route’ (during the booming period). Experts speculated that it could allow India’s ‘black money,’ which has been stashed away from the country through hawala-style illegal channels and deposited in tax havens around the world in ‘Swiss Bank’-style financial institutions, to be re-invested in the market. This route could have been used by ‘terrorist organizations as well.
PNs are thus issued in order to provide access to a group of foreign investors who want to cut their overall investment costs and time in India. To put it another way, the appeal of investing in PNs is primarily one of efficiency (both in terms of infrastructure and time), for which they are willing to forego some of the benefits of directly holding local securities (such as title and voting rights) while also taking on additional risks.
Regulation of Participatory Notes
PNs are international market instruments that are created and traded. As a result, Indian regulators are unable to prohibit the issuance of PNs. They can, however, be regulated, as SEBI is—for example, if a Participatory Note is traded on an overseas exchange, the regulator in that jurisdiction would be in charge of regulating that trade. Participatory Notes have been used by FIIs since they were allowed to invest in the securities market in 1994, but they were not addressed specifically in the regulations until 2003. The SEBI Regulation of 2004 (as amended in 2008) was enacted with the goal of tightening regulations in this area.
Only those entities that are regulated by the relevant regulatory authority in the country of incorporation and are subject to ‘know your client (KYC) norms are eligible for PNs. Down-stream issuance or transfer of the instruments can also be made only to a regulated entity. Further, the FIIs who issue PNs against underlying Indian securities are required to report the issued and outstanding PNs to SEBI in a prescribed format.
In addition, SEBI can call for any information from FIIs concerning off-shore derivative instruments (ODIs) issued by it. SEBI advised FIIs to submit information on the issuance of derivative instruments by them on a monthly basis on October 31, 2001, in order to monitor the investment through these instruments. These reports require information such as the subscribers’ name and constitution, their location, the nature of the Indian underlying securities, and so on.
FIIs cannot issue PNs to non-resident Indians (NRIs) and those issuing PNs are required to give an undertaking to the effect. SEBI has also mandated that QFIs (qualified foreign investors), the recently allowed foreign investor class, shall not issue PNs.
In October 2007, SEBI, in consultation with the government, decided to impose certain restrictions on FIIs and their sub-accounts issuing PNs. This decision was made in order to control the surge in foreign capital inflows into the country and to address PN holders’ concerns about ‘know-your-client’ issues. However, such restrictions were found to be ineffective. As a result, SEBI reviewed its earlier decision in October 2008 and decided to remove the restrictions in light of the above factors. Instead, more emphasis is placed on effective disclosures. Category III FIIs are not permitted to issue PNs, according to a SEBI decision from October 2013.
Because PNs are derivative instruments that are freely traded, they can be easily transferred, resulting in multiple layers and obscuring the true beneficial owner. Concerns about the identity of the ultimate beneficial owner and the source of funds arise in this context.
Because such instruments are issued outside of India, these transactions are not subject to SEBI’s supervision, and the FII serves as a mini-exchange overseas. The FIIs only execute actual transactions in the underlying securities when and as needed, and there is no one-to-one correspondence between transactions in the underlying instruments and the issuance of PNs.
The monthly ex-post reporting requirement imposed on FIIs in respect of PNs effectively keeps PN transactions out of the real-time market surveillance mechanism and outside of SEBI’s enforceability jurisdiction.
There are also concerns that some of the money entering the market through PNs may be ‘unaccounted wealth’ disguised as FII investment. However, this has yet to be proven. SEBI has been successful in prosecuting non-compliant FIIs and those who misreported offshore derivatives [as happened when SEBI prosecuted two FIIs in December 2009 and January 2010].
PNs are currently issued by large financial conglomerates that not only have a strong presence in global investment banking but also have asset management arms that invest across a variety of global securities markets. These companies were founded in well-regulated and developed jurisdictions such as the United States and the United Kingdom. Furthermore, these entities have the financial means to issue PNs, as well as skilled personnel with experience in risk management and financial engineering.
PN-like products are not only available in restricted markets, but also in open developed/advanced economies such as Japan, Hong Kong, Singapore, Australia, the United States, and the United Kingdom. In December 1999, the Taiwan Securities and Futures Commission amended its FII regulations to require periodic disclosure by FIIs of all offshore derivative activities linked to local shares in response to market manipulation concerns, but this requirement was later removed in June 2000. (as the Ashok Lahiri Committee Report says).
The Securities Regulatory Commission of China requires companies to file reports on these products with minimal “reporting requirements that emphasize only the quota used by them.” Other Asian countries with PN restrictions or requirements include Hong Kong, Singapore, and Japan. Malaysia, Indonesia, and the Philippines, which are restricted markets, have no such reporting requirements.
This term evolved from the term hedging, which refers to the process by which businesses protect themselves from price fluctuations. 14 Hedge funds are pools of investible (free-floating capital) capital that move quickly into more profitable economic sectors.
At the moment, such funds can easily move from one economy’s stock market to another, from low-profit to high-profit investments. As stock markets rise and fall, these funds adjust their investments accordingly. They are, by definition, transient. Naturally, there is a boom period when they continue to flow into an economy. However, if they leave for a more appealing economy, that same economy may be unable to manage the accelerated foreign currency outflow, potentially resulting in a foreign currency crisis. This has been in the news in India for the past two years, where the stock market has been booming thanks to FII inflows through Participatory Notes (PNs).
The ‘automatic route’ and the ‘approval route’ are the two ways a prospective borrower can obtain external commercial borrowings (ECBs). The RBI considers ECBs not covered by the automatic route on a case-by-case basis under the approval route. In September 2011, the High-Level Committee on ECB made a number of decisions to broaden the scope of ECBs, including:
- High net worth individuals (HNIs) who fulfill the criteria prescribed by SEBI can invest in IDFs.
- IFCs have been included as eligible issuers for FII investment in the corporate bonds long-term infra category.
- ECBs would be permitted for refinancing rupee loans for infrastructure projects, provided that at least 25% of the ECBs were used to repay the rupee loan and the remaining 75% was invested in new infrastructure projects (but only under the approval route).
- The use of ECBs to refinance buyer/supplier credit for the purchase of capital goods by infrastructure companies was approved. Only under the approval route would this be possible.
- ECBs for interest during construction (IDC) accrued on a loan during the project execution phase for infrastructure companies would be allowed. This would be contingent on the IDC being capitalized and included in the project cost.
- The Chinese currency, the Renminbi (RMB), was approved as an acceptable currency for raising ECBs up to $1 billion within the existing ECB ceiling (allowed only through the approval route).
- The existing ECB automatic route limits for eligible corporates were increased from US$ 500 million to US$ 750 million. The limit has been raised from US$ 100 million to US$ 200 million for borrowers in the services sector, and from US$ 5 million to US$ 10 million for NGOs engaged in microfinance activities.
The government took the following key efforts to simplify and streamline the ECB rules until April 2020:
- Increasing the maximum for refinancing rupee loans through the European Central Bank from 25% to 40% for Indian power businesses;
- Allowing the ECB to spend money on road and highway toll systems as long as they’re part of the original project and meet certain criteria, as well as low-cost housing projects;
- Reducing the withholding tax from 20 percent to 5 percent for a period of three years (July 2012–June 2015) on interest payments on ECBs;
- Introducing a new ECB scheme of US $10 billion for companies in the manufacturing and infrastructure sectors;
- Allowing the Small Industries Development Bank (SIDBI) to access the European Central Bank (ECB) for on-lending to micro, small, and medium-sized businesses (MSMEs); and
- Allowing the National Housing Bank (NHB) and Housing Finance Companies to use ECBs to finance prospective low-cost/affordable housing unit owners.
- The RBI announced a new ECB framework in December 2015 that was more in tune with the current economic and business environment—from a regulatory standpoint, the ECBs will now fall into three distinct categories—
- Medium-term foreign currency-denominated ECB;
- Long-term foreign currency-denominated ECB (with a minimum average maturity of 10 years); and
- Indian rupee-denominated ECB.
The new lenders include overseas regulated financial institutions, sovereign wealth funds, pension funds, insurance companies, and others, with only a small negative list for long-term foreign currency and INR-denominated ECB.
- In order to facilitate rupee-denominated borrowing from abroad, the government decided to establish a framework for the issuance of rupee-denominated overseas bonds in December 2015. (such bonds have got a popular tag of the masala bonds).
These bonds will have a 5-year minimum maturity. The real estate and capital markets sectors are not eligible for these bonds. Interest income from these bonds will be subject to a 5% withholding tax, but capital gains arising from rupee appreciation will be exempt from taxation.