What are participatory ratings?
Participating notes, also called P-Notes, or PN, are financial instruments required by investors or hedge funds to invest in Indian securities without having to register with the Securities and Exchange Board of India (SEBI). P-Notes are part of the group of investments considered to be offshore derivative investments (ODI). Citigroup (C) and Deutsche Bank (DB) are among the largest issuers of these instruments.
Any dividend or capital gain received on the securities is returned to the investors. Indian regulators generally do not support equity notes because they fear that hedge funds acting through equity notes will cause economic volatility in Indian trade.
Explanation of the participatory notes
Foreign institutional investors (FII) issue financial instruments to investors in other countries who wish to invest in Indian securities. An FII is an investor or an investment fund registered in a country other than that in which it invests.
This system allows unregistered foreign investors to buy Indian stocks without having to register with the Indian regulator. These investments also benefit India. They provide quick access to money in the Indian capital market. Due to the short-term nature of the investment, regulators have fewer guidelines for foreign institutional investors. To invest in the Indian stock markets and avoid the cumbersome regulatory approval process, these investors trade equity notes.
Key points to remember
- Foreign brokers and institutional investors (FII) must register with the Securities and Exchange Board of India.
- Participating notes allow unregistered investors to invest in the Indian market.
- Equity Notes, called P-Notes or PN, are derivative instruments of underlying Indian assets.
- Participatory notes are popular investments because the investor remains anonymous.
How do participatory ratings work?
Participating notes are offshore derivatives with Indian stocks as underlying assets. Foreign brokers and institutional investors registered with the Securities and Exchange Board of India (SEBI) issue participating notes and invest on behalf of foreign investors. Dealers must report their participating issue status to the regulatory board every quarter. The Notes allow high net worth foreign investors, hedge funds and other investors to participate in Indian markets without registering with SEBI. Investors save time, money and scrutiny associated with direct registration.
Advantages and disadvantages of participatory notes
Participating tickets are easily exchanged abroad by endorsement and delivery. They are popular because investors anonymously take positions in the Indian markets and hedge funds can conduct their operations anonymously. Certain entities channel their investments via participatory notes in order to take advantage of the tax laws available in certain countries.
However, due to anonymity, Indian regulators find it difficult to determine the original owner and the final owner of the participatory notes. Consequently, large sums of unrecorded money enter the country through participatory notes. This flow of unmonitored funds raised alarm signals.
Participatory note Regulatory issues
SEBI has no jurisdiction over participatory ticket trading. Although foreign institutional investors must register with the Indian regulator, exchanges of participating notes between foreign institutional investors are not recorded. Officials fear that this practice could lead to the use of P-Notes for money laundering or other illegal activities.
This inability to track money is also the reason why the Task Force (SIT) would like to see tougher compliance measures for the exchange of participating tickets. SIT is a specialized team of Indian law enforcement officers which consists of staff trained to investigate serious crimes.
However, when the government has proposed commercial restrictions on banknotes in the past, the Indian market became extremely volatile. For example, in October 2007, the government announced that it was planning to limit participatory ticket trading. The announcement lowered the Indian market by 1,744 points.
This market disruption was in response to investor and government concern that the reduction in P-Notes would have a direct impact on the Indian economy. Foreign institutional investors are helping to fuel the growth of the Indian economy, industries and capital markets, and increased regulation would make it more difficult for foreign money to enter the market. The government finally decided not to regulate the participatory ratings.
Current status of the participating tickets regulations
Participatory ratings remain vulnerable to regulatory decisions. At the end of 2020, Indian regulators determined that P-Notes could not take any derivative positions on the Indian markets for reasons other than hedging. As reported by EconomicTimes.IndiaTimes.com, this rigorous regulatory intervention caused investments to drop via P-Notes throughout 2020, ultimately reaching a low of more than 9-1 / 2 years in November 2020. However, investments rebounded in December 2020 after regulators relaxed some of the more restrictive requirements.
Example from the real world
P-Notes can be used to buy any Indian security an investor wants through a series of steps.
An investor deposits funds with US or European operations from a registered foreign institutional investor (FII), such as HSBC or Deutsche Bank. Investors then inform the bank of the Indian security or the securities they wish to buy. Transfer funds from the investor to the FII account, and the FII issues the participating notes to the client and purchases the underlying stock (s) in the correct quantities in the Indian market.
The investor is eligible to receive dividends, capital gains and any other payment due to the shareholders holding the shares of the Indian company. The FII reports all of its issues quarterly to the Indian regulatory authorities, but according to law, it does not disclose the identity of the actual investor.