Participatory notes have acquired unparalleled mystique as a market instrument. Their popularity may soon inspire some ingenious film-maker to make a blockbuster. The era of some policeman chasing a gold smuggler in a Bollywood movie is gone. Now, we may instead see our beloved Shah Rukh Khan, in a pinstriped suit, investigating terrorist money being funnelled through participatory notes.
Participatory notes have all the elements it takes to become popular. They invite rapt attention of not only the laymen, but also experts around the world. There is no consensus on their use or misuse. In a short span of less than two years in our country, two expert committees reached two radically different conclusions about their fate. While one committee recommended giving them a lease of life, another recommended ending their life sooner than later.
Today, Jinny is in a mood to unravel some of the mysteries surrounding participatory notes with her buddy Johnny. Let’s see what they are up to:
Jinny: PN… PN tricky star…. I just wonder what you are….
Johnny: Hey, what’s that? New rhyme?
Jinny: No. But it can be a song in a new movie… say ‘Dirty PNs’… starring Shah Rukh, along with a high-voltage team of two expert committees.
Johnny: ‘Dirty PNs’? … What’s that?... Some virus?
Jinny: PNs are participatory notes. I hope you have heard about this term.
Johnny: Aha! Participatory notes. Who hasn’t heard about them? But, I wouldn’t mind if you provided some more insight on participatory notes and how Shah Rukh dealt with the wise men of two expert committees.
Jinny: Let me first introduce you to participatory notes. Participatory notes are instruments used for making investments in the stock markets. However, they are not used within the country. They are used outside our country for making investments in shares listed in our country. That’s why they are also called offshore derivative instruments.
Like any other derivative instruments, their value is determined on the basis of the underlying asset. In the case of participatory notes, the underlying assets are shares listed on the stock exchanges.
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. According to one estimate, participatory notes constitute more than 25% of the cumulative net investments in equities by FIIs.
Johnny: But why are the clients who use participatory notes not interested in participating directly in the market?
Jinny: Several reasons can be cited. The first and foremost reason is convenience. 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.
Johnny: Hedge funds… tax benefits… contract notes… so many complex things. We will talk about them some other time. Tell me what difficulty does anonymous buying and selling pose for the market?
Jinny: It is felt that anonymity can be misused for routing dirty money in the economy. That is why regulators around the world are putting strict disclosure requirements on participants. In India, FII regulations mandate that participatory notes are issued only to a regulated entity and the FII has to ensure that no downstream issuance to any unregulated entity takes place. It is also felt that anonymous traders have a very short-term horizon and most of the money flowing through the participatory notes is hot money chasing some quick returns in the Indian market. Any adverse movements of the capital can destabilize the market.
Johnny: If participatory notes are susceptible to misuse, then why have they not been banned?
Jinny: There is resistance because, ultimately, it is money, stupid! Investment through participatory notes contributes to better participation of FIIs in the Indian market. Investment by FIIs amounts to around 12% of the spot or cash market volumes. Except for 1998-99, the net FII inflow into the Indian stock market has always been positive. Net FII inflow crossed the magic figure of $10 billion (Rs43,000 crore) in 2004-05. The same can be contrasted with 1992-93, when the net FII inflow was only $4 million. High inflows lead to better market capitalization. Nobody is sure what effect the banning of participatory notes will have on the sentiments of FIIs. The whole market may go into a tailspin and that will be our own doing.
Johnny: I get it now Jinny. But enough of this already. Time to check out the real Shah Rukh on Kaun Banega Crorepati.
(Shailaja & Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at email@example.com)