Participatory Notes Fall in Popularity

After initially cracking down in 2007 on indirect investment routes such as those using participatory notes (P-notes), SEBI a year later reversed its decision and allowed foreign investors to participate in the Indian markets through P-notes. SEBI’s decision to allow P-notes was the subject-matter of critique on this Blog as it raises questions regarding transparency.

As observed in that post: “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 other words, P-note holders are able to indirectly participate in the Indian markets without being subject to registration and other requirements under Indian regulations.

Critics of P-notes may now rest easy as its market seems to have corrected itself, at least quantitatively. The Economic Times reports that the flow of funds into India through P-notes has substantially reduced. It states:

The value of participatory notes as a percentage of FIIs’ stock investments, which was as high as 50% in a couple of months during the peak of the previous bull run in 2007, has been in the range of 13-15% in the past six months. This is despite the value of FII assets under management rising to `9.7-lakh crore in July 2010, the highest since December 2007, when that bull run peaked.

It is believed that a more streamlined process for registration of FIIs allowed investors that hitherto used derivative instruments such as P-notes to access Indian markets through the front door.

Added to this is another plausible factor. P-notes were largely used by investors such as hedge funds that prefer to offer fewer disclosures to regulators in markets where they invest. However, the recent financial crisis and the resultant tightening of regulation governing such investors have made them somewhat cautious and sluggish as this Economist report observes:

The creep of regulation is one reason why hedge funds increasingly resemble more traditional investment managers. America’s financial-reform bill, passed in July, will require hedge funds with assets over $150m—a low threshold—to register with the Securities and Exchange Commission, to hire or designate a compliance officer and to maintain records on trading positions and leverage. Proposals for new EU regulations would, if adopted, lead to increased oversight of hedge funds by regulators and put limits on funds’ leverage.

The introduction of greater transparency in the affairs of hedge funds and other similar investors will encourage them to invest directly in markets (such as India), which may also partly explain the decline in P-note activity.

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.

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