PARTICIPATORY Notes (PNs) are instruments held by entities that are otherwise not allowed to invest in Indian markets by the market regulator, the Securities and Exchange Board of India (SEBI). These instruments confer anonymity on those who hold them. PNs are a class of Offshore Derivative Instruments (ODI) and have been the main avenue for the officially barred hedge funds to enter Indian markets.
Brokerages affiliated to foreign institutional investors (FIIs) buy India-based securities and then issue PNs to foreign investors, which are basically in the form of IOUs. Even though PN holders do not own the shares directly, they are able to collect dividends or capital gains that accrue from the underlying assets. Moreover, the velocity of circulation of this instrument is enhanced by the fact that it can be traded in international markets, which is why foreign investors find it attractive.
It is a derivative instrument since it derives its value from an underlying share or security. It allows investors to build portfolios depending on their preference for individual shares. The instrument is issued through the sub-accounts of registered FIIs operating in Indian markets.
Of the little over 1,000 FIIs registered with SEBI only about 34 are both stockbrokers and institutional investors (in March 2004 there were only 14). These are the entities that issue PNs. Hedge funds are reckoned to be among the main holders of PNs. Merrill Lynch, Morgan Stanley, Credit Lyonnais, Citigroup and Goldman Sachs are among the prime issuers of PNs.
According to SEBI, the notional value of PNs outstanding has shot up ten times between March 2004 and August 2007 from Rs.31,875 crore to Rs.3,53,484 crore.
For regulatory agencies PNs are a major irritant because they are opaque instruments belonging to faceless investors. But more importantly, from a wider economic perspective, they amplify the risks associated with volatility in financial markets. For instance, sub-accounts themselves pool the PNs and use them as collateral to raise loans. The scope for such leveraging is amplified when the resulting investments go into other derivative instruments such as futures and options of shares in Indian markets. This kind of leveraging amplifies not only the scope for investing but also the movements of share prices in the markets. The fact that players in the futures market need pay upfront only a small part of the value of the contract as margin money further amplifies the fluctuation in turnover and prices.
The Reserve Bank of India (RBI) has been a consistent opponent of these instruments. In November 2005, it presented a dissenting note to the Finance Ministrys Expert Group on Encouraging FII Flows and Checking the Vulnerability of Capital Markets to Speculative Flows.
The RBI reiterated its stance that the issue of PNs should not be permitted. It pointed out that its main concerns pertained to the regulators inability to know the identity of the owner of the assets or who are the actual beneficial owners of these instruments.
It also pointed out that the instrument encourages multilayering, which will make it difficult to identify the ultimate holder of PNs. This results from the ability of the original PN holder to sell them to other players, whose identity is also unknown. The central bank always regarded the spiralling trade in these opaque instruments as a serious hazard. It also observed that weeding out these instruments would actually enhance the reputation of markets and lead to healthy flows.
The RBI has also reiterated its case that the modus operandi of PNs is a gross violation of the know-your-customer norms, which are a basic requirement for any investor participating in any financial market.
In the past two years, there were several proposals to ban PNs. The S.S. Tarapore Committees report on full capital account convertibility in July 2006 recommended that FIIs be prohibited from investing fresh money through PNs. It recommended that PNs be phased out in a year after providing its holders an exit route.
In fact, a few years ago, under the stewardship of G.N. Bajpai, SEBI itself considered banning PNs. This was based on its investigation of the stock market scam in 2000, orchestrated by the Kolkata-based broker Ketan Parekh. In fact, SEBI admitted, it is not possible to identify the actual beneficiaries of PNs.
The regulator also found that about $2 billion had been brought in and taken out of the country by Overseas Corporate Bodies (OCBs) registered in Mauritius. Although the RBI subsequently banned OCBs from investing in the stock market, the PN game continued with SEBI and the Finance Ministry looking the other way. The Finance Ministrys logic, driven by its overarching interest in wooing foreign investors at any cost, was that PNs provided an opportunity for unregistered investors to invest in India.
The dangers posed by PNs can be disproportionately larger than the actual amounts involved in the transactions. For instance, the Joint Parliamentary Committee (JPC) probe into the stock scam of 2000 (popularly known as the Ketan Parekh scandal) revealed that although only four sub-accounts issued PNs (against shares worth Rs.14,000 crore) involved in the scandal, they were used to rig share prices on a much wider scale, which disrupted the entire system.
Fears have repeatedly been expressed by not only the RBI but also political parties that these opaque instruments pose a serious security hazard. In particular, there is the apprehension that they can be used by drug cartels and terrorist organisations to funnel money into India. While this may be so, the threat perception need not necessarily be based on such fears alone.
For a long time now, PNs have been regarded as a threat to the very integrity of the economic system. Quite apart from the fact they are a prime vehicle for the burgeoning foreign exchange reserves, which has been a worrisome factor for the RBI in the past four years, they pose other systemic risks as well. For one, it is well known that Indian promoters of companies have used PNs to bring in funds parked overseas to fund the creeping acquisition of their companies stock to guard against takeovers. Tax authorities also fear that Indian money launderers use PNs to ship funds out of the country using the hawala route and then get it back into the country posing as PNs.
V. SridharCOMMents
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