WHY P-NOTES ARE DYING A SLOW DEATH
Once the most-preferred route for foreign investments, these are dying a slow death due to regulatory tightening
During the raging bull market of 2007, 50 cents on every dollar of foreign investment in domestic stocks came through offshore derivative instruments (ODIs), popularly known as participatory notes (p-notes), an instrument that allows a foreign entity to take exposure to the Indian markets without having to register with the local authorities.
Typically, a vehicle that funnels billions of dollars into the Indian economy should be revered by policymakers but the opposite is true for p-notes. Their opaque nature has always stoked fears of misuse and given them a dubious name. The secrecy around the end-users of p-notes has led to concerns that they could be a go-to instrument for round-tripping, or black money laundering, and also to circumvent the shareholding caps meant for single investors in companies.
However, given the dominance of p-notes among foreign institutional investors’ (FIIs’) — now called as foreign portfolio investors (FPIs) — investment pie, a crackdown on these instruments has always been a touchy subject for policymakers. In October 2007, the Securities and Exchange Board of India’s (Sebi’s) proposed curbs on p-notes saw the worst intraday fall of nearly 10 per cent in the Indian markets.
Nonetheless, Sebi has over the past decade continuously tightened rules governing issues and subscriptions of ODIs. The tightening process got accelerated after a Supreme Courtappointed Special Investigation Team (SIT) on black money made critical observations and recommended more checks and balances on flows through this route. So much so that the eligibility and other criteria for a p-note subscriber are now on a par with that for an onshore investor.
The tightening — and the simultaneous simplification of norms for a direct entry of investors — has dulled the appeal of p-notes, which now account for just 6 per cent, down from 50 per cent in 2007, of FPI assets in the country. Business Standard analyses the recent changes to the ODI framework done by Sebi, starting with the most recent:
May 2017: Ban on derivatives, introduction of issuer fees
Sebi’s latest axe on p-notes has been the proposal to virtually ban p-notes from the derivatives market. The market regulator says issues of ODIs in the derivatives space should only be allowed for hedging purposes. In other words, p-note subscribers will be allowed to deal in the derivatives of a stock only if they own the same stock in the cash segment. The move is aimed at cracking down on speculative trading using these instruments. Currently, a fourth of p-note assets are in the derivatives segment. Starting this fiscal year, Sebi has proposed to levy a ‘regulatory fee’ of $1,000 for every three years on p-note issues of every subscriber. Both the proposals have been flagged by foreign investors. The regulator made the two proposals through a discussion paper on May 29 and is soon expected to take a final call on the matter.
April 2017: No p-notes for Indians and NRIs
Although non-resident Indians (NRIs) and resident Indians were never allowed to take exposure to the domestic market through p-notes, the market regulator gave more sanctity to the issue. The Sebi board reiterated NRIs and resident Indians could neither subscribe to ODIs nor be their end-beneficial owners.
May 2016: KYC norms brought on a par with onshore investors
A year ago, Sebi made one of the most comprehensive changes to the P-note framework. The market regulator said know-your-customer norms and antimoney laundering (AML) applicable to Indians would be made applicable to p-note subscribers. With this, Sebi tried to put an end to the regulatory arbitrage p-note holders enjoyed by not having to register with Indian regulators. Sebi also increased the checks and balances on p-note issuers. It increased the frequency of reporting, and asked FPIs to identify and verify the beneficial owners of their p-note subscribers. Sebi also barred transfers of p-notes from one subscriber to another. The tightening made a substantial dent in p-note investments as p-notes’ share in FPI assets shrank from 10 per cent to 6 per cent within a year. The move also saw top FPIs including HSBC and UBS exit the pnote issuance business.
April 2014: Unregulated entities barred from subscribing to p-notes
In 2014, Sebi enacted FPI regulations by which it merged various foreign investor sub-categories into one and also simplified the entry process. The market regulator tightened the p-note framework. Sebi said p-notes could be issued to only entities that were regulated by an appropriate foreign regulatory authority. It also said p-notes could be issued only after KYC norms had been complied with. Sebi also barred unregulated funds and so-called category III FPIs from dealing in p-notes. (Category-III investors are typically corporate bodies, trusts and family offices). Earlier, in June 2012 and October 2007, Sebi took steps to introduce more accountability for these instruments.