Participatory notes are not used within the country. They are used outside India for making investments in shares listed in the Indian stock market
Foreign investment in India can broadly be classified into two categories—Foreign direct investment (FDI) and investment made by foreign institutional investors (FIIs). In both of these cases, foreign money enters the Indian markets and fuels growth of economy, industries and capital market.
However, with the number of increasing regulations in India, it is not easy for foreign money to enter the markets.
There are strict guidelines laid down by market regulator SEBI (Securities and Exchange Board of India) for seeking approvals and documentation for FDI. Also, there are several restrictions laid down on the exit of this money.
On the other hand, FII is mainly characterised as portfolio investment i.e. quick money entering the Indian capital market for short-term. Due to its short-term nature, the regulators have laid down fewer guidelines on FII than on FDI. But, the fact remains that foreign money cannot enter Indian markets without regulatory approvals.
So, what happens to all those overseas investors, who want to invest in the Indian stock markets without getting into the regulatory approval process and other hassles? Well, the answer is participatory notes.
P-notes: Offshore derivative instruments
Participatory notes also called P-Notes are offshore derivative instruments with Indian shares as underlying assets. These instruments are used for making investments in the stock markets. However, they are not used within the country. They are used outside India for making investments in shares listed in the Indian stock market. That is why they are also called offshore derivative instruments.
Participatory notes are issued by brokers and FIIs registered with SEBI. The investment is made on behalf of these foreign investors by the already registered brokers in India. For example, Indian-based brokerages buy India-based securities and then issue participatory notes to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors.
The brokers that issue these notes or trades in Indian securities have to mandatorily report their PN issuance status to SEBI for each quarter. These notes allow foreign high networth individuals, hedge funds and other investors to put money in Indian markets without being registered with SEBI, thus making their participation easy and smooth. P-Notes also aid in saving time and costs associated with direct registrations.
Why are participatory notes used?
Investing through P-Notes is very simple and hence very popular amongst FIIs. Overseas investors who are not registered with SEBI have to go through a lot of scrutiny, such as know-your-customer norms, before investing in Indian shares. To avoid these hurdles, foreign investors take this route. Also, since the end beneficiary of these notes is not disclosed, many investors who want to remain anonymous use it. These instruments aid investors who do not want to register with SEBI and reveal their identities to take positions in the Indian market.
Advantages of participatory notes
Anonymity: Any entity investing in participatory notes is not required to register with SEBI, whereas all FIIs have to compulsorily get registered. It enables large hedge funds to carry out their operations without disclosing their identity.
Ease of trading: Trading through participatory notes is easy because they are like contract notes transferable by endorsement and delivery.
Tax saving: Some of the entities route their investment through participatory notes to take advantage of the tax laws of certain preferred countries.
Disadvantages of P-notes
Indian regulators are not very happy about participatory notes because they have no way to know who owns the underlying securities. It is alleged that a lot of unaccounted money made its way to the country through the participatory note route.