Participatory Notes

Participatory notes (PNs) are instruments used by foreign funds, not registered in India, for trading in thedomestic market. They are a derivative instrument issued against an underlying security that permits the holder, some of whom may not be eligible to trade in Indian stock markets, to get a share in the income from the underlying security.

The investors, who buy PNs, deposit their funds in the US or European operations of the FII, which also operates in India. The FII uses its proprietary account to buys stocks in India. A government report has said that the FII or the broker acts like an exchange since it executes the trade and uses its internal accounts to settle this. Other such instruments include equity-linked notes, capped return note, participatory return notes and investment notes.

Q: Why do investors use PNs?

A: While one reason for using PNs is to keep the investor's name anonymous, some investors have used the instrument to save on transaction costs, record keeping overheads and regulatory compliance overseas. An official report said investors often find it expensive to establish broker and custodian bank relationships, deal in foreign exchange, pay taxes and/or filing, obtain or maintain an investment identity or regulatory approval in certain markets, where their total exposure is not going to be very large. Such investors look for derivative solution to gain exposure in individual, or a basket of, stocks in the relevant market. Sometimes, investors enter the Indian markets in a small way using PNs, and when their positions become larger, they find it advantageous to shift over to a full-fledged Foreign institutional investors structure.

Q: What is the problem with the instrument?

A: Reserve Bank of India, which had sought a ban on PNs, believes that it is difficult to establish the beneficial ownership or the identity of the ultimate investor, that is possible for registered FIIs. It fears that FIIs, which have to comply with the know-your customer norms, know the identity of the investor to whom the note was issued. But it is possible for the investor to sell the PN to another player resulting in multi-layering. Tax officials fear that PNs are becoming a favourite with a host of Indian money launderers who use the instrument to first take out funds out of the country, through the hawala route, and then get it back using PNs.