Cheat sheet: What are P-notes and why the markets plunged because of them

Participatory notes, or P-notes, is a type of a financial instrument issued by registered foreign institutional investors (FIIs) or hedge funds to overseas investors who wish to invest in the Indian stock market without registering themselves with the Securities and Exchange Board of India (Sebi).

India-based brokerages buy India-based securities and then issue P-notes to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors. It is similar to an informal American depositary receipt (ADR) or global depositary receipt (GDR), which is a simple way for investors to invest in companies whose shares are listed abroad.

Currently, the P-notes system is totally silent as the FIIs issue them to funds or companies whose identity is not known to the authorities. These are address-less funds that could be from dubious sources.
It is for the same reason that regulators fear that hedge funds acting through P-notes would cause economic volatility in India's exchanges.

The Supreme Court-appointed Special Investigation Team on black money last week recommended a host of measures, including suggesting Sebi to tighten norms related to P-notes investments into India. The team has suggested that the market regulator put in place regulations to help identify individuals holding P-notes or offshore derivative instruments (ODIs), among other measures, to curb black money and tax evasion via stock market route.

Reacting to the development, the BSE Sensex and Nifty plunged over 1.5 per cent on Monday with Sensex plunging 550 points and Nifty 160 points.

The market is extremely sensitive to the word P-Note as a lot of investment is riding on these, especially foreign-based investments. Stricter norms on these investment tools will dent India's image as an investment destination, leading investors to offload their positions in the market.

A similar crackdown on P-notes had taken place in 2007 when P-notes at that time accounted for over 50 per cent of total foreign holdings. There was a drop of around 10 per cent within minutes of the market opening for the first time after announcement of the change in norms.

On its part, the government has tried to allay investors' fears, saying it will not react in a "knee-jerk" manner on the report.