SEBI's mooted curbs on PN (P-Notes) flows causes BSE, Nifty to hit lower circuit

Curbing the flow of hot money into the country has side effects. Bulls discovered this to their cost, when market regulator SEBI placed limits on participatory notes.

What is participatory notes?

Participatory notes (PNs) are instruments used by investors or hedge funds that are not registered with the SEBI (Securities & Exchange Board of India) to invest in Indian securities. Indian based brokerages buy Indian-based securities and then issue PNs to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors.

Participatory notes are instruments 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 that country. That is 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.

Today's fall

India's stock market benchmark Sensex crashed by 1,743 points within the first few minutes of opening this morning (17 October 2007), prompting the suspension of trade for an hour.

This is fallout of market regulator Securities and Exchange Board of India (SEBI) clamping down on anonymous participatory notes (PNs) to arrest the flood of foreign inflows. The fall came just days after finance minister P Chidambaram expressed surprise at shooting stock prices - the Sensex had shot up by 5,000 points in less than two months - and hoped that things would cool down.

Soon after the stock markets closed on hitting the down-circuit, Chidambaram said in a live telecast that the government was neither against PNs, nor was it banning them. Proposals to moderate portfolio investment by foreign investors were part of a series of steps to moderate capital inflows, he emphasised.

Earlier, on Tuesday, SEBI proposed partial restrictions on investment through offshore derivative instruments, including participatory notes (PNs), equity linked notes and capped return notes.

SEBI issued a discussion paper suggesting that FIIs and their sub-accounts should not issue or renew offshore derivative instruments (ODIs) with underlying 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," the paper said, inviting comments from the public about the new proposals.

FIIs currently issuing ODIs the with notional value of PNs outstanding (excluding derivatives) as a percentage of their assets under custody (AUC) in India of less than 40 per cent should be allowed to issue further ODIs only at an incremental rate of 5 per cent of their AUC in India.

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

Though only a proposal, the SEBI move effectively halted the FII-led rally. FIIs invested over $5.45 billion in October alone, taking their total investment for 2007 to $17.69 billion.

The huge inflows have pushed up the value of the rupee against the dollar. The year-on-year increase in ODIs, the anonymity that it provides to investors, and the copious inflows into the country from foreign investors have been areas of concern for the government and regulators like the Reserve Bank of India (RBI) and SEBI.

Earlier, the High Level Committee on Capital Markets (HLCC), as well as various committees set up by the government and regulators had made recommendations that included issuing of PNs only to regulated entities subject to know-your-customer (KYC) requirements.

Main causes for concern

The notional value of PNs outstanding, which was Rs31,875 crore (20 per cent of AUC) in March 2004 has grown over 10 times to Rs3,53,484 crore (51.6 per cent of AUC) by August 2007

The value of outstanding ODIs with underlying derivatives is Rs1,17,071 crore - about 30 per cent of total PNs outstanding

The notional value of outstanding PNs - excluding those with underlying derivatives - as a percentage of the AUC was 34.5 per cent in August 2007

At present, 34 FIIs and sub-accounts issue offshore derivative instruments (ODIs), against 14 in March 2004

-Compiled from various sources