Participatory note volumes on the rise but Sebi isn't worried

After a lull of three years, the volume of participatory notes (P-notes) in the stock market is again on the rise. The proportion of P-notes in assets under management by foreign institutional investors (FII) rose to 19 per cent in November 2011. They had averaged around the 15 per cent mark between October 2008 and September 2010. For market regulator Securities and Exchange Board of India (SEBI), that could be a cause for worry. At a time when the markets are struggling, the possibility of foreign investors taking the P-note route to make a quick buck cannot be ruled out, says the head of a Mumbai-based domestic broking firm. 

P-notes are derivative instruments issued in foreign jurisdictions by an FII or its associates, against underlying Indian securities. Under this mechanism, FIIs buy shares in India and issue P-notes to overseas investors with the shares as the underlying security. SEBI's principal worry around FII investments has always been over the proportion of P-notes in their assets under management.

In June 2007, at the peak of the bull market, investments through P-notes touched an all-time high, accounting for 55.7 per cent of FII assets under management. The high volumes were a concern, especially because there were no rules in place then to ascertain the identity of the investors. "Transparency was a critically missing factor then," says the representative of US-based FII, on condition of anonymity. 

Critics said the P-note route could be used to bring illicit money into the country and influence the markets. In January 2004, SEBI amended norms and made it compulsory for FIIs to disclose details about participatory notes issued by them, including the names of the subscribers. In October 2007, the regulator also instituted a ceiling of 40 per cent on the volume of P-notes an FII could issue as a proportion of its assets under management.

In 2009, the regulator banned two FIIs, Barclays Bank and Societe Generale, from issuing fresh P-notes on account of their inability to provide accurate details of onward issuances of these instruments.

Former SEBI Chairman M. Damodaran, who was instrumental in cracking the whip on P-notes during his tenure (2005-2008), believes the regulator needs to keep a close eye on the recent increase.

In May 2011, the volume of P-notes accounted for 19.5 per cent of FII assets under management and their absolute value was at a 36-month high of Rs. 211,199 crore. But even at the current peak, absolute volumes are less than 50 per cent of those reported in 2007. "And first-level checks are also in place," says Tejesh Chitlangi, Senior Associate at Fin Sec Law, a Mumbai-based law firm floated by Sandeep Parekh, a former Executive Director on the SEBI board.

The market regulator isn't unduly worried either. "We have strong disclosure mechanisms in place now," says SEBI Chairman UK Sinha, referring to the strict know your customer (KYC) rules governing P-notes.