Participatory notes

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Participatory notes (PNs / P-Notes) are instruments used by investors or hedge funds that are
not registered with the SEBI (Securities & Exchange Board of India) to invest in Indian
securities. Participatory notes are instruments that derive their value from an underlying
financial instrument such as an equity share and, hence, the word, 'derivative instruments'. SEBI
permitted FIIs to register and participate in the indian stock market in 1992.

Indian based brokerages buy Indian-based securities and then issue PNs to foreign investors. Any
dividends or capital gains collected from the underlying securities go back to the investors.

Participatory notes are instruments used for making investments in the stock markets. However,
they are not used within the country. They are used outside India for making investments in
shares listed in that country. That is why they are also called offshore derivative instruments.

In the Indian context, foreign institutional investors (FIIs) and their sub-accounts mostly use
these instruments for facilitating the participation of their overseas clients, who are not interested
in participating directly in the Indian stock market. For example, Indian-based brokerages buy
India-based securities and then issue participatory notes to foreign investors. Any dividends or
capital gains collected from the underlying securities go back to the investors. According to an
expert group constituted by the finance ministry in India, in August 2004, participatory notes
constituted about 46 per cent of the cumulative net investments in equities by FIIs.[1]

Any entity investing in participatory notes is not required to register with SEBI (Securities and
Exchange Board of India), whereas all FIIs have to compulsorily get registered. Trading through
participatory notes is easy because participatory notes are like contract notes transferable by
endorsement and delivery. Secondly, some of the entities route their investment through
participatory notes to take advantage of the tax laws of certain preferred countries. Thirdly,
participatory notes are popular because they provide a high degree of anonymity, which enables
large hedge funds to carry out their operations without disclosing their identity.

Participatory notes in brief is as follows :

What are participatory notes or PNs? Participatory notes are instruments used by foreign funds
which are not registered to trade in domestic Indian Capital Markets. PNs are derivative
instruments issued against an underlying security permitting holders to get a share in the income
from the security.

How does it work? Investors who buy PNs deposit their funds in US or European operations of
Foreign Institutional Investors (FII) operating in India . The FII uses its proprietary account to
buy stocks.

Why do investors use PNs? Reason for using PNs is to keep investor name anonymous, some
investors have used them to save transaction and overhead costs.

Tax officials fear that PNs are becoming a favourite with a host of Indian money launderers who
use them to first take funds out of country through hawala and then get it back using PNs.

Participatory Notes Crisis of 2007

On the 16th of October, 2007, SEBI (Securities & Exchange Board of India) proposed curbs on
participatory notes which accounted for roughly 50% of FII investment in 2007. SEBI was not
happy with P-Notes because it is not possible to know who owns the underlying securities and
hedge funds acting through PNs might therefore cause volatility in the Indian markets.

However the proposals of SEBI were not clear and this led to a knee-jerk crash when the markets
opened on the following day (October 17, 2007). Within a minute of opening trade, the Sensex
crashed by 1744 points or about 9% of its value - the biggest intra-day fall in Indian stock-
markets in absolute terms. This led to automatic suspension of trade for 1 hour. Finance Minister
P.Chidambaram issued clarifications, in the meantime, that the government was not against FIIs
and was not immediately banning PNs. After the markets opened at 10:55 am, they staged a
remarkable comeback and ended the day at 18715.82, down just 336.04 from Tuesday’s close
after tumbling to a day’s low of 17307.90.

This was, however not the end of the volatility. The next day (October 18, 2007), the Sensex
tumbled by 717.43 points — 3.83 per cent — to 17998.39, its second biggest fall. The slide
continued the next day when the Sensex fell 438.41 points to settle at 17559.98 at the end of the
week, after touching the lowest level of that week at 17226.18 during the day.

The SEBI chief, M.Damodaran held an hour long conference on the 22nd of October to clear the
air on the proposals to curb PNs where he announced that funds investing through PNs were
most welcome to register as FIIs, whose registration process would be made faster and more
steamlined. The markets welcomed the clarifications with an 879-point gain — its biggest single-
day surge — on October23, thus signalling the end of the PN crisis. SEBI issued the fresh rules
regarding PNs on the 25th of October, 2007 which said that FIIs cannot issue fresh P-Notes and
existing exposures were to be wound up within 18 months. The Sensex gave a thumbs up the
next day - Friday, 26 October by re-crossing the 19,000 barrier with a 428 point surge. The
coming Monday (October 29, 2007) history was created when the Sensex leaped 734.5 points to
cross the hallowed 20,000 mark.