SEBI recommendations on P-Notes issuance

Objective
This paper sets out the proposed policy measures on Offshore Derivative Instruments (Participatory Notes).

Background
With a view to monitoring the investment by FIIs through Offshore Derivative Instruments (ODIs) such as Participatory Notes (PNs), Equity Linked Notes, Capped Return Notes, Participating Return Notes etc., SEBI had prescribed reporting of issuance / renewal / cancellation / redemption of the ODIs on a monthly basis since October 2001. The figures submitted by the FIIs on a month to month basis showed an increasing trend.

In the latter half of 2003, a Technical Committee of SEBI Regulated Entities was constituted by the HLCCFM to examine the issues pertaining to P-Notes more closely. The Committee, comprising representatives of RBI, IRDA, SEBI and NSE met in October, 2003 and extensively discussed the issues like:

* Whether PNs should be allowed to be issued at all,

* Whether restrictive use of PNs is possible,

* Monitoring of compliance

* Phasing out of PNs that are non-compliant with new restrictions, etc.

The Committee, having examined the concerns raised by the participants, felt that while these issues and concerns would have to be addressed in the interest of the market, the measures taken should be practical, pragmatic, non-disruptive and enforceable without great difficulty. Recognizing that it may be difficult to enforce a complete ban on PNs, the Committee made certain recommendations which included issuance of PNs only to regulated entities subject to KYC requirements. The same was implemented through suitable amendment to FII regulations.

However, the year on year increase in ODIs, the anonymity that the ODI provides to the investors and the copious inflows into the country from foreign investors has been engaging the attention of the Government and the regulators such as the Reserve Bank of India and SEBI. This has been a topic for discussion in many fora such as HLCC and various committees set up by the Government/ regulators.

Current Scenario:
Currently 34 FIIs / Sub-accounts issue ODIs. This number was 14 in March 2004. The notional value of PNs outstanding which was at Rs.31,875 crores (20% of AUC [1]) in March 2004 has grown to Rs.3,53,484 crores (51.6% of AUC) by August 2007. The value of outstanding ODIs with underlying as derivatives currently stands at Rs1,17,071 crores, which is approximately 30% of total PNs outstanding. The notional value of outstanding PNs, excluding derivatives as underlying as a percentage of AUC is 34.5% at the end of August 2007.

Proposed Measures:
Following consultation with the Government, the following measures are proposed to be implemented urgently:

1) FIIs and their sub-accounts shall not issue/renew ODIs with underlying as derivatives with immediate effect. They are required to wind up the current position over 18 months, during which period SEBI will review the position from time to time.

2) Further issuance of ODIs by the sub-accounts of FIIs will be discontinued with immediate effect. They will be required to wind up the current position over 18 months, during which period SEBI will review the position from time to time.

3) The FIIs who are currently issuing ODIs with notional value of PNs outstanding (excluding derivatives) as a percentage of their AUC in India of less than 40% shall be allowed to issue further ODIs only at the incremental rate of 5% of their AUC in India.

4) Those FIIs with notional value of PNs outstanding (excluding derivatives) as a percentage of their AUC in India of more than 40% shall issue PNs only against cancellation / redemption / closing out of the existing PNs of at least equivalent amount.

chintan

On P Notes from Money control site:

Market watchdog Sebi plans to take the sheen off participatory notes and that too, not by cracking its whip, but by making the instrument lesser attractive to foreign investors. In this exclusive story, CNBC-TV18 finds that the regulator is also trying to use a similar approach to register hedge funds!

White money or black money? Hot money or the money of long term investors? As the debate on the colour of money becomes hotter - regulator Sebi is taking no chances. It plans to bring in more transparency into the foreign flows - and not by tougher regulations, but by better economics! And among the regulator's priority list is Offshore Derivative Instruments, or Participatory Notes.

M Damodaran, Chairman, Sebi calls, "PN route attttractive, because of low costs. Sebi is exploring making investments directly more attractive than PNs for foreign investors."

A participatory note is a derivative instrument issued by a Sebi-registered FII to those foreign investors, who want to buy Indian stocks. It is believed that many hedge funds use the PN route to invest in the Indian market. And so, regulator Sebi is also trying to convince these investors of the benefits of investing directly into the Indian market.

"Sebi is in dialogue with representative organisation that represent such investors. We are trying to tell them that those compying should apply and invest in their own name instead of using PN route. Over time, it will become more expensive to use other routes to invest in India," says Damodaran. That is an issue that many market experts and bankers will be keenly watching.

Many times in the past, the P-note route has been severly criticised for its opacity. That is because investors coming in via this route do not have to declare their identity. And so it is widely believed that the route has also been used to launder money. Many market participants say that while a cost disincetive will help Sebi partly, it may not necessarily control India's big P-note problem.

hi
fiis have to liquidate ,, 34000 million dollars...in 18 months...

exit ,,,from every corner!!!

renu

Consequence will be too high for it to happen, anyway. SEBI doesn't have stomach to go through this. Market may correct for the time being.

pankaj

Excellent & Timely article by Chintam & rkkarnani. Thank u both.
ranga

Dear chintan & rkkarnani,
I have reproduced yr papers in the site "Theindianstock.com ' for the benifit of all.Pl dont mind it.Ofcourse i had clearly mentioned that papers were written by you both in "traderji.com"
ranga

Renuji,
I think its not asking anyone to liquidate.... just want them to change the 'route' and SEBI is trying to make the alternate route as economical as P-notes, the BIG difference would be transparency.

these measures will be good in the larger interest of the country becuse these measures will try and curb money laundering the proceeds of which could be used for antinational activities.

hi all, knee jerk reaction is expected today.. but then this action will benefit in long term... if dollar inflow get reduce than we might see Ruppee depreciating again.... then u ppl know which sector will benefit frm it.

Don't forget tht this is suggestion only right now..... the board meeting is on 25th Oct 2007

hi rkkarnani, karvy, pkjha,renu.. yesterday i had posted the same message of SEBI on moneycontrol also....

today this message is " Message of THE DAY" on moneycontrol.

I can't belive this...