Issues In Participatory Notes

Introduction

The moment one recalls the word, Participatory Notes, it sends shivers across the mind of any ordinary Indian or an ordinary Indian investor. Participatory notes were one of the reasons for the largest fall witnessed ever in Indian stock markets. Participatory notes had been in news for all the wrong reasons, every second or third day, some or the other controversy associated with them props up. The most important regulators in Indian economy, i.e. SEBI and RBI are also seen in picture, day in or day out, issuing notices or warning signs to the parties concerned or related to this instrument. But the analysts associated with stock markets are not much concerned or bothered about this instrument. As some of them, don’t have any relationship with this instrument. Indeed, this instrument is much talked about when we name or see the Foreign Institutional Investors (FIIs).

Although FIIs have contributed to the Indian economy, in more ways than one, but still they have not been able to earn the respect for themselves as they should be. RBI and SEBI, every now and then, are bothered about their activities and moves that might affect the economy and the markets adversely. The recently out, Lahiri Committee Report, also lays emphasis on participatory notes, its role and functioning. The question that arises in a person’s mind is that what is a participatory note, how it functions, and why is it famous for its notoriety, etc. We will try to seek the answers of the above said questions and various other aspects of participatory notes in the following discussion.

What are participatory notes?

In the magazine, Business World, dated December 15th, 2003, the feature on participatory note stated that, “The past month has seen our stock market regulator, the Securities and Exchange Board of India (SEBI), nervously rattling its sabre against a shadowy enemy - hedge funds that trade in Indian stocks through something called the participatory note (P -note), an offshore financial instrument.”

Participatory notes are instruments used by foreign funds / investors who are not registered with the SEBI but are interested in taking exposure in Indian securities Participatory notes are generally issued overseas by the associates of India-based foreign brokerages.3 FIIs that do not wish to register with the SEBI but would like to take exposure in Indian securities also use the participatory notes. Brokers buy or sell securities on behalf of their clients on their proprietary account and issue such notes in favour of such foreign investors.

Participatory Notes are simple derivative instruments that investors not registered in India or

Mauritius use to trade in Indian markets. These investors place their order through brokerage

houses that have Mauritius-based FII accounts. The brokerage houses then repatriate the dividends and capital gains back to these entities. In this case, the broker acts like an exchange: it executes the trade and uses its internal accounts to settle the trade. They keep the investor’s name anonymous.

That is why capital market regulators dislike P-notes.

What are FII’s?

FII means an entity established or incorporated outside India which proposes to make investment in India. FII work in a very tight and scheduled environment and have to act in parlance with the guidelines framed by SEBI, (Foreign Institutional Investors) guidelines, 1995 and they also have to comply with regulatory notifications of RBI, as RBI acts directly on them, for matters specifically concerning foreign exchange. The SEBI (FII) guidelines, 1995 prescribes

§ Who can register as FII?

§ What are the parameters for their eligibility?

§ What are the requisite fee and how it should be made?

§ What is the process of their registration?

§ What is the validity period and the renewal process?

§ What all are the Pre-Registration formalities?

§ What are the different aspects of sub-account?

§ What are the investment opportunities and investment limits?

§ What are the restrictions on investment?

Above said questions are few of them, which have been answered in the SEBI (FII) guidelines,

1995. 

Functioning of Participatory Notes

Participatory Notes, somewhere down the line, hide in themselves the functions and properties of Hedge Funds. Although SEBI, as a regulator had issued KYC (Know Your Client) guidelines, which include that, FIIs must know all the requisites details about their client and be able to furnish the details of the same, as and when demanded or asked by the regulator, to which there should be strict compliance, failing which they have to face the wrath of the regulator. UBS Securities case was on this basis, they were barred from trading in Indian markets by SEBI on this premise only as they failed to furnish the information regarding their clients. Contrary to the fact that SAT reversed the SEBI’s order.

The bigger question after the debate is about hedge funds and why regulators like SEBI and RBI are wary of them. Hedge funds are those funds which are not defined in any legislation in this world and have been deliberately excluded from trading in stock markets and are not allowed to function or work in any stock market of the world on paper. Hedge funds are generally recognized by their characteristics, rather than any term or legislation. Rapid growth, big money, market manipulators, etc. are some of the popular terms related to them. They don’t advertise in papers, they cannot be registered under any statute. Yet they function and extremely popular because of the attention they grab and the limelight they find in the local and national newspapers of all the emerging and developed economies of the world.

Retail investors are not their clients. Market players or high net worth individuals (HNIs) or

professional investors (pension funds or mutual funds) are their clients. However, US Securities Exchange Commission (SEC) provides some clarity on the issue. They are approximately 8000 hedge funds, operating globally, with the major chunk of them operating in USA, and few hundreds are in UK and the other lot of few is disseminated across the globe. Hedge funds promise hefty profits, with the hedge fund manager taking the percentage of the profits as his fees for managing the funds. Generally the rate is 20%, which the hedge fund managers charge for their services in addition to 1%, which they charge as fixed management fee.

Speculative funds managing investments for private investors (in the US, such funds are

unregulated if the number of investors does not exceed one hundred). These are funds usually used by wealthy private investor or institutions. Hedge funds are restricted by law to no more than 100 investors; the minimum contribution is typically $1m. The first hedge fund started in New York on 1 January 1949. Hedge fund managers sell stock short and trade in options of the shares they hold.

Funds that are extremely flexible in their investment options because they use financial instruments generally beyond the reach of mutual funds, which have SEC regulations and disclosure requirements that largely prevent them from using short-selling, leverage, concentrated investments and derivatives. This flexibility, which includes use of hedging strategies to protect downside risk, gives hedge funds the ability to best manage investment risks.

A hedge fund can be classified as an alternative investment. Alternative investments are investments other than stocks and bonds. A U.S. “hedge fund” usually is a U.S. private investment partnership invested primarily in publicly traded securities or financial derivatives. Because they are private investment partnerships, the SEC limits U.S. hedge funds to 99 investors, at least 65 of whom must be “accredited.” (“Accredited” investors often are defined as investors having a net worth of at least $1 million.) A relatively recent change in the law (section 3(c)) allows certain funds to accept up to 500 “qualified purchasers.” In order to be able to invest in such a fund, the investor must be an individual with at least $5 million in investments or an entity with at least $25 million in investments. The majority of hedge funds employ some form of hedging – whether shorting stocks, utilizing “puts,” or other devices.

In the past, hedge funds had been blamed largely for the sudden sharp falls or volatile sessions in indices. Hedge funds are not directly registered with SEBI, but they can operate through subaccounts with FIIs. These funds are also said to operate through the issuance of participatory notes.

SEBI keeps a close watch on the activities of FIIs. As it is believed that nearly 30% of the money is coming from hedge funds through FII route. Hedge funds by their very nature hold stocks for short duration, and exit markets after booking profits, which upsets the sentiments of the market.

Hedge funds make money by identifying imbalances in the prices of asset classes, whether it isequities , debt or forex. These overseas funds enter and exit markets based on arbitrage

opportunities in different markets. Usually they cover their exposures in one market by taking a

countervailing exposure in another. For example, they could go long in one scrip in the US and

short it in India.

Participatory notes are normally subscribed by investors who want to get rid of all the regulatory processes, so that they are adhered to minimum level of disclosure. But the FII with whom they are functioning are required to comply with KYC guidelines of SEBI.

Hedge funds are mostly short-term funds and they rarely buy and hold any stock for long periods.

In April 2003, Infosys witnessed a crash because of weak guidance, due to sharp drops and spurt in prices.

Role of FIIs in stock market

The past booms in stock market in 2001-02, 2003-04, and 2005-06 have been attributed to the FIIs participation in the Indian stock market. But still FIIs are looked with a word of caution and a sense of worry for market regulators. Black Monday has also been attributed to FIIs, over which the regulatory action also followed on UBS. If we carefully scan the financial newspapers, one can find this term on more than one occasions in almost every edition.

The bottomline is FII are indeed a sought of blessing in disguise for the Indian financial system, although their due credit may not be given to them. The problem with foreign entities is that they want to enter every emerging market in the market and want to leave with plush green bags from that market. India being one of the vibrant and emerging economies of the world is an attractive destination of investment for them.

Indian financial system or regulatory compliance does not allow foreign entities or individuals to directly participate in the capital markets. Foreign entities or individuals cannot invest directly or otherwise in Indian markets. So the only option left before them to enter the markets is the route through participatory notes.

The past trends show a very good picture of FIIs contribution to the Indian stock markets. India has received net FII inflows of over $22 billion in three years (2000-2003). Over 40% of these inflows had come through the route of participatory notes.

On April 25, 2003, the BSE Sensex gave a very dismal picture, nobody could have thought of 5000 mark. And the index had slumped to the levels of 2900, as it was a bear phase and everybody was staying away from the markets.

But still the Sensex closed past the levels of 4500 in the first week of October, which means that the index had jumped 55 percent between April to October, 2003.

What was the force behind this entire bull rally in 2003? No doubt all the fundamentals of the

economy were performing well in the NDA era, but still the biggest factor among them all was the participation seen in the markets from FIIs.

The rally in 2003 was an exception in more ways than one. FIIs were the biggest investors in that rally followed by retail participants. The year 2003 saw the record investments from FIIs which were close to Rs. 14,000 crore (precisely Rs. 13,911 crore) and it was also marked by the entry of a number of new FIIs in the Indian stock markets.

Golden year was the title conferred to the year 2003; by most of the stock market bigwigs as in that year FIIs contributed more than $ 5 billions to the Indian markets.

In that particular year, everybody knew that hedge funds had entered the Indian markets through the FII route and they are here to stay for now. But nobody was making fuss or complaining about the issue, as the markets were rising and economy was booming with the increasing dollar reserves with RBI.

FIIs will continue investing in Indian markets so long as the valuations appear attractive to them.

The second prominent reason was the strengthening of the rupee against the dollar.

Hedge funds use arbitraging techniques, which typically invest through participatory notes, borrow money cheaply in the West and invest it in emerging market equity. This gives them a double advantage -- appreciating stocks in an appreciating local currency.

The contribution of participatory notes in 2003 was estimated to be $ 1.5 billion by the FIIs.

Data provided until August 2005 shows that PN issuance rose dramatically from 30.6% of net FII investment in April 2005 (the Sensex was 6,605 on April 1) to 46.73% in August (the Sensex was 7,805 on August 31). Since then, the Sensex has crossed 9,000 and FII investment is up by at least a billion dollars.

The current bull run of year 2005 is no less than a story, as we have seen that the year started at 6000 levels and is finishing at the 9000 levels, which are historic levels to be witnessed ever in Indian stock markets.

Foreign Institutional Investors (FIIs) recorded net purchases in equities at Rs 15.914 billion (US $365.6 million) for the trading week ended July 15, while mutual funds (MFs) were net sellers at Rs. 3.35 billion.

The latest figures suggest that in the first 27 days of the month of December, 2005, FIIs have

pumped in $ 2 billion alone in this month. So this narrates their confidence in the Indian markets.

The rally of this year is supported by the macro-economic fundamentals plus the huge confidence being showered by FIIs in the Indian growth story, as more than 100 new FIIs registered with SEBI during the current year, which took the total tally to 738. And the participation was not only seen from western experts but also from Japanese, South Asian, Europeans, which indicates that the world is looking at Indian markets from a different perspective as has been the case in the past. Till July FIIs had contributed $ 5.44 billion to the stock markets.

Recent Developments

FIIs have been part of the Indian success story right since the beginning of the current rally. But still the concern over their regulation sends shivers down the spine of the regulators (RBI and SEBI). The latest out Lahiri Committee Report, who had been specifically said to give emphasis on the role and position of participatory notes, as RBI had been howling and growling for not allowing FIIs to enter Indian markets through the route of participatory notes. In the recent press note, RBI had clarified that they do not have anything against the participatory notes, but their concern is that this instrument helps in concealing the original beneficiary of the instrument. It leads to multilayering, which makes it more difficult to find out the beneficiary, when it is subject to inquiry. The RBIs stance is valid as has been seen in the case of UBS Securities, for which SEBI took one full year to investigate the matter, and in the process they almost circumvented the whole world to know who the ultimate beneficiaries were. The capital market regulator couldn’t even achieve success in that stance. As SAT ruled out SEBI’s penalty imposed on UBS. The findings lead to that UBS did not comply with KYC guidelines and basically there were some non-residential Indians (NRI’s), who would have ultimately benefited from the transactions.

SEBI is part of the International Organisation of Securities Commissions (IOSCO) and has signed information-sharing agreements with leading regulators; there is little evidence of any clear benefits. In UBS case, the letter of request for information sharing being sent by SEBI Chairman did not gave any desired results to the regulator. The regulator found itself helpless in such circumstances, that inspite of all its efforts; the results did not bore any fruit. So the only option left was to ban such entity or entities.

The Lahiri Committee Report has given the recommendation of phasing out this instrument from Indian markets in a period of three to five years. The other issue which is concerning RBI is the investment limit to be imposed on FIIs. Currently the investment limit on FIIs is 24 per cent.

Presently, out of the 5499 companies, which have FII investments, only 100 companies have passed resolutions to permit increase in FII holding beyond the limit of 24 per cent. RBI concluded that whether FII beyond 24 % should be allowed in a company or not, that power vests with the particular company and it can pass a special resolution in the annual general meeting (AGM) favouring or rejecting the same concept.

The other issue of contention where the committee and RBI doesn’t seems to agree is the line of argument for enhancing operational flexibility to impart stability to the market. On one hand the members (other than RBI) of Lahiri committee suggest “greater flexibility for FIIs to participate in the bond market will induce more ‘balanced’ strategies, and mixing of equity and debt” and that can be done “if FIIs are able to switch between equity and debt investments in India, depending on their view about future equity returns.”

The Lahiri committee describes PNs as akin to contract notes issued against an underlying security, usually to investors that are not otherwise eligible to invest in India.

RBI reiterates that the stance that issuance of participatory notes should not be permitted. It is at loggerheads with finance ministry on this issue. It further says that by not allowing suspicious funds in the markets, we can enhance the image of the markets, which will ultimately lead us to healthy flows in the economy.

Tax payers’ money lent to businesses by public financial institutions and banks found their way into bank accounts abroad. Exporters too under invoiced to keep part of their proceeds abroad. All this happened in the decades before the 1990s when India was seen as a poor Third World economy with no future.

RBI believes that the money coming through the route of FII’s is hot money, which can become cold at any point of time. More than 40% of FII’s at any given instance comprise of money through participatory notes. RBI feels that even if FIIs take 20% of the total invested money out of India, it might lead to financial crisis or destabilize the economy.

RBI is perfectly right on its stand that the integrity of Indian markets must be maintained at any cost. There is a dire need to address these issues and take necessary measures to address the international concerns pertaining to the origin and source of funds flowing into the country. SEBI in the vague of such situation has increased the disclosure requirements and made necessary changes in the registration process.

Thus the expert committee has recommended that the dubious parties should be phased in a span of three years, but at the same instance they have said that eligible participatory notes should be allowed to continue to operate in the markets for a period of two years. In the same breath they have expressed the fear of a possible market crash in future.

The point of the matter, the committee has not come upto the expectations that the economy was expecting from them. In fact, the committee should have emphasized on how the manipulations being done by FIIs can be reduced in future and also the adversarial impact of such transactions on the monetary policy and the exchange rate system of the economy, over which the RBI has been showing concerns over a period of time. The phasing out scheme or steps should have been clearly reiterated in the report. If the complete ban should have been imposed then some alternative for still allowing them to operate in Indian markets should have been brought on paper.

The committee has further suggested that FDI and FIIs sectoral limits of investment should be separated to help eliminate misuse of the FIIs route by foreign direct investors. It has also said that in a transitional arrangement, the current policy of a composite limit may continue and it should be sufficiently raised to a high level. The composite limits should be immediately broken into specific limits for FDI and FIIs. As the economy is booming, efforts should and must be on to improve and bring forex reserves in the form of projects or some permanent source of income rather than this hot money.

Conclusion

The dubious role of FIIs and participatory notes as has been seen in reports cannot be denied. But yet seeing the bulls taking such a heavy charge on account of huge coming of FIIs can also not be overlooked. Black Monday has been attributed to these participatory notes only, but the very fact remains that FIIs were the net buyers on that particular day. Rather it was the panic or the huge selling pressure witnessed was due to Indian investors, who were busy booking profits on that day.

In 2003 also, after the falling of the bull, FIIs were the net buyers. This very fact has been pointed by finance ministry of India.

The concerns of RBI and SEBI can also not be overlooked, being they the market regulators. The primary purpose of who is to protect the interest of the investors. SEBI should look that the clients must provide all the required details to be submitted to the regulator, as and when sought by the regulator.

At the same instance, it can be said that the Lahiri Committee Report did not achieve the purpose for which it had been constituted. Had it brought some ground breaking facts into picture to address the issues being put up by RBI or a solution to end the dilemma in which the regulators are operating?

The officials of SEBI should carry out raids or go for random or surprise checking of the information to be supplied by FIIs, so that FIIs maintain the proper accounts as to where there funds are being maintained in compliance with the guidelines framed by SEBI.

Interestingly, Section 20 of SEBI’s FII rules clearly says every FII shall, as and when required by the market regulator or RBI, submit as the case may be, any information, record or documents in relation to its activities as required by the regulators. But still the purpose or the integrity of the same is not being maintained.

Looking at the things from other perspective. 

Nowadays FIIs are the major contributors to the stock markets. They are very active on trade, day in and day out, the records are broken and new records are being recorded. Some of them, depict the reason for bullishness is the under valuation of Indian stock markets as compared to markets of the developed nations. Moreover, the volumes they generate are not being traded by Indians in such huge capacity. So it indicates they will certainly trade primarily amongst themselves. So in most of the cases, we have seen that if an FII is selling than another FII is buying the same stocks. The primary concern over the whole issue of participatory notes can be subverted in case we allow foreign individuals/investors of especially non-institutional in nature be allowed to operate freely in Indian markets. Simply banning participatory notes cannot be a solution. If the air is polluted, then we cannot close ourselves in an enclosed box with no outlets, so that the air might not harm us adversely. Under those circumstances, we might run into the risk of dying. But in fact, we can use filters and other gadgets to purify the air and then breathe it, so that even our health is not affected adversely.

Thus it is up to the policy makers of India to allow participatory notes or FIIs to operate and provide them with more opportunities and reasons to invest in Indian markets. And in the process invent a series of check and balances system so as to protect the economy and look over to the fact that the economy works best with such kind of filters system.