Some Thoughts on the P-Note Volte Face

In an earlier post, Mihir highlighted some key decisions taken by SEBI earlier this week. One decision regarding P-Notes merits greater discussion.

A little less than a year ago (October 16, 2007 to be precise), SEBI introduced bold measures to curb the use of participatory notes (P-notes) and other offshore derivative instruments (ODIs) by foreign investors in the Indian stock markets. In a nutshell, P-notes are instruments that derive their value from an underlying financial instrument such as a share traded on an Indian stock exchange. They are issued by foreign institutional investors (FIIs) to various offshore investors on the strength of underlying equity, derivatives or other securities that are held by the FIIs.

In its October 2007 decision, SEBI adopted a two pronged approach. First, it announced restrictions on the issuance of ODIs by FIIs to investors offshore in respect of underlying securities in the cash market (e.g. by imposing quantitative limit of 40% of assets under custody of the FIIs) and entirely prohibited the issuance of ODIs where the underlying securities are derivatives. Second, SEBI instead encouraged offshore investors (such as hedge funds) to register themselves with SEBI as FIIs or sub-accounts rather than to continue to participate in the Indian stock markets through indirect routes such as ODIs, thereby calling on them to come in through the “front door”.

It appears that one of the key drivers for those changes was the need on the part of the RBI (as the foreign exchange regulator) to stem the flow of foreign exchange into India and to curb the rise of the Rupee against other foreign currencies that was the trend in 2007. Whatever the underlying reason may have been, the changes signalled a move towards engendering a culture of transparency in the markets. In other words, offshore investors in Indian markets were encouraged to invest directly rather than use indirect (and possibly opaque structures) to invest. This objective has been partially achieved as it resulted in several foreign investors (including hedge funds) registering themselves as FIIs or sub-accounts. SEBI data reveal that “391 FIIs and 1160 sub-accounts have been registered since October 31, 2007”. Furthermore, although there was fear initially that these strong measures would cause a flight of foreign capital, newspaper reports indicate that no such thing ever occurred on any significant scale.

However, on Monday (October 6, 2008) the SEBI board decided to remove all the restrictions imposed by SEBI in October 2007. In other words, the position was reverted to that which existed pre-October 2007, whereby P-Notes and other ODIs can be issued by FIIs without any quantitative restrictions. While this move has been hailed in some quarters as enabling a further opening up of the Indian capital markets, it does present several difficulties which cannot be ignored.

First, the timing of the change perhaps partly explains the regulatory motive. Present today is the contagion effect of the global crisis. Not only have the Indian markets been sliding downwards, but there is threat that the global crisis could affect emerging markets such as India in a more acute way. Hence, it appears that both SEBI and RBI have taken measures to revitalize the Indian markets (both on the equity side as well as the debt side), nearly simultaneously. SEBI’s decision to reverse the policy on P-Notes (and hence boost the capital markets) was accompanied by RBI’s decision to reduce the cash reserve ratio (CRR) by 50 basis points (and hence boost the debt markets by making more funds available for lending). Clearly, the decision on P-Notes seems to have been made with a view to attracting more foreign capital. As in October 2007, what drove the decision regarding P-Notes is foreign exchange and capital controls. As an aside, the other instrument which Indian regulators often use to calibrate the flows of foreign exchange is external commercial borrowings (ECBs), which as we have seen a few weeks earlier were further liberalized by the RBI, consistent with the need to activate the debt markets.

The concern that therefore emerges is the constant blurring of the distinction between capital controls and securities regulation. Regulation of instruments such as P-Notes falls within the domain of securities regulation (with SEBI being the regulator on this count). SEBI’s role is to determine the efficacy of such instruments on their merits, such as depending on who the investors are, whether they should be registered with SEBI, what types of disclosure and transparency requirements (fashionably called the KYC-norms) they should be subjected to, and the like. SEBI’s role is that of a stock- or securities-market regulator. But, when decisions are driven by foreign exchange and the need to relax capital controls, and not necessarily with a view to investor-protection, there is a doubt as to the precise nature of the role being played by SEBI. Both in October 2007 as well as now, both SEBI and RBI appeared to have collaborated in decisionmaking, and decisions were arrived at based on foreign exchange requirements and not necessarily with a view to investor protection.

Second, and more importantly, the current proposals signal a move away from transparency. P-Notes enable their holders to obtain economic benefits from (and of course bear the risk of) the Indian markets without actually investing in them. They can (notionally or virtually) enter and exit the Indian markets without being registered with the Indian securities regulator. They are also not subjected to the trading and settlement systems on the Indian stock exchanges. This is all on account of the fact that it is the FIIs that hold the underlying securities on the strength of which P-Notes are issued. When P-note holders are offshore, issues of extraterritoriality are intensified. Without being registered with SEBI, it is not possible to obtain adequate disclosures or information from these entities. These difficulties were experienced in fact by SEBI in the UBS and Goldman Sachs cases (discussed here) where it unsuccessfully attempted to obtain disclosures and undertakings from offshore investors. In this context, it is not entirely clear what the justification for reverting to a more opaque regime is. That too when securities regulators the world over are adopting a more cautious approach in the wake of recent events arising from the global credit crisis, and due to the pervading sense of doubt over the success of free-market capitalism.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.


  • Great post Uma – I think it captures the essence of the issue. It almost begs the question whether this will again get reversed if the markets improve, which makes a mockery of the consistency of our regulation.

  • SEBI’s job is not just protecting investor, ensuring disclosure and transparency. Means SEBI is not just market market development being the essential part of its job. So wht I think is that the action which is taken for bringing more liquidity in the market is taken by keeping in mind the objective of development of market………But of course the action is quite oppose to its fundamental business…..moreover….in this time of credit crunch this also seems to result in a failure

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