- Participatory Note is a significant topic in the Economy Section of the UPSC IAS Exam.
- Participatory Notes, or P-Notes (or PNs), are financial instruments issued by registered foreign institutional investors (FIIs) to international offshore investors seeking to invest in Indian stock markets without registering with the market regulator, the Securities and Exchange Board of India (SEBI).
What are the Participatory Notes?
- P-notes, or Offshore Derivative Instruments (ODIs), are issued by registered Foreign Portfolio Investors (FPIs) to overseas investors seeking involvement in the Indian stock markets without direct registration.
- P-notes are backed by Indian stocks. FPIs, non-residents, invest in various Indian securities such as shares, government bonds, corporate bonds, etc.
- Despite relaxed registration requirements for P-note holders, they must undergo stringent due diligence by the Security and Exchange Board of India (SEBI).
What are the reasons for Declining P- Notes?
- Uncertainty persists regarding inflation levels and the actions of the US Federal Reserve (Fed).
- The decline in P-Notes is attributed to the tightening of monetary policy by the US Fed, which has been actively raising rates to combat inflation.
- Similar actions are being taken by central banks in Britain and the Eurozone.
- Currency correction has occurred significantly.
- In financial markets, a correction denotes a price rebound following a trend impulse. Such corrections bring prices back in line with the overall trend.
- They typically occur due to overselling or overbuying of instruments.
- The reduction in P-Notes is partly attributed to market corrections affecting equity and debt portfolios.
What are the Expectations for P-Notes in the Future?
- Equity markets are presenting enticing valuations currently.
- Supply-chain and inflation concerns are expected to diminish in the upcoming months.
- Markets typically anticipate shifts in the economic cycle.
- It’s anticipated that in the next one to two quarters, Foreign Portfolio Investors (FPIs) will likely reallocate capital toward Indian equities.
Steps were taken by SEBI to regulate participatory notes
- In October 2007, SEBI introduced fresh regulations, barring FIIs from issuing new participatory notes, with existing ones to be wound up within 18 months. A year later, these restrictions were lifted amidst the financial crisis.
- January 2011 saw SEBI implement new rules, requiring FIIs to comply with Know Your Customer (KYC) norms and disclose transaction details, leading to a decline in participatory note issuance.
- April 2014 witnessed SEBI’s ban on unregulated foreign entities from subscribing to participatory notes
- In 2016, SEBI extended anti-money laundering rules to participatory note holders, alongside KYC norms.
- SEBI introduced fresh norms on participatory note transferability between overseas investors and increased reporting frequency in 2017.
- Subsequently, in July 2017, SEBI prohibited foreign portfolio investors from issuing participatory notes for equity derivatives investments, allowing them only for equity hedging.
- In April 2017, as part of efforts to combat round-tripping and money laundering, SEBI barred both non-resident Indians and residents from investing in participatory notes.
Conclusion
Participatory notes continue to face regulatory scrutiny. In late 2017, Indian regulators specified that P-Notes could not engage in derivative positions in Indian markets unless for hedging purposes. This strict regulatory intervention led to a decline in P-Note investments throughout 2018, reaching a more than 9-1/2 year low in November 2018. However, investments experienced a rebound in December 2018 following relaxation of some restrictive requirements by regulators.
FAQs
1. What are Participatory Notes (PNs)?
- Participatory Notes (PNs) are financial instruments used by investors or institutions to invest in the Indian stock market without undergoing the regulatory process. Essentially, they are offshore derivative instruments issued by registered foreign institutional investors (FIIs) to overseas investors, enabling them to invest in Indian securities without direct registration with the Securities and Exchange Board of India (SEBI).
2. How do Participatory Notes work?
- A foreign investor who wants to invest in Indian securities but does not want to go through the regulatory process can do so by purchasing PNs from registered FIIs. The FII holds the underlying securities and issues PNs to the investor, who, in turn, gains exposure to the Indian market without being directly registered with SEBI. The value of PNs is directly linked to the performance of the underlying securities.
3. Are Participatory Notes legal in India?
- Yes, Participatory Notes are legal in India, subject to regulations set forth by SEBI. However, there have been instances where SEBI has tightened regulations surrounding PNs to prevent misuse or speculative activities. SEBI periodically reviews and updates the regulatory framework governing PNs to ensure transparency and mitigate risks associated with these instruments.
4. What are the risks associated with Participatory Notes?
- Participatory Notes carry inherent risks, including market risk, currency risk, and regulatory risk. Since the ultimate beneficiary of PNs remains anonymous, there are concerns about money laundering and market manipulation. Moreover, changes in regulatory policies or market conditions can impact the value of PNs. Investors should thoroughly assess these risks before investing in PNs.
5. How do Participatory Notes impact the Indian stock market?
- PNs can influence the Indian stock market by attracting foreign investments, thereby contributing to liquidity and market depth. However, they can also introduce volatility and speculative trading. Regulators closely monitor the activities related to PNs to maintain market integrity and stability. Overall, PNs play a significant role in channeling foreign investments into the Indian market, but their impact requires careful supervision and regulation.
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