Offshore Derivative Instruments (ODIs), also known as Participatory notes (p-notes) are instruments used by the foreign investors to invest in India’s securities markets without getting registered with the SEBI. Securities include shares, bonds and derivatives.
In the article on foreign investment, we learnt that Foreign Institutional Investors (FII) and their sub-accounts have to register themselves with SEBI to invest in India’s markets. And to register, they have to go through regulatory approval processes and fill several know your customers (KYC) forms, provide PAN no. etc.
Through participatory notes, a foreign investor can invest in India’s stock markets and bond markets without these regulatory hassles.
Participatory notes are issued by India-based brokers or Foreign Institutional Investors (FIIs) registered with SEBI, to overseas/ foreign investors. These brokers/ FIIs make investments on behalf of overseas investors.
To illustrate- A registered FII buys Infosys shares from the Indian stock market. It keeps the shares with itself and issues participatory notes based on these shares to interested overseas investors.
Offshore Derivative Instruments/ Participatory notes holder doesn’t own the Infosys shares. The p-note is just a kind of instrument based on the securities. In technical terms, p-note is a derivative. It derives its value from the value of underlying securities. In this case, Infosys shares. Any dividends or capital gains collected from these underlying securities (Infosys) are passed on to the overseas investor.
The participatory notes were introduced to ease the regulatory burden for foreign investors. But, It is difficult to know the identity of the investors as they are outside the reach of SEBI. Hence, the money can be used for terror financing or money laundering.
It was suspected that p-notes were used for round-tripping of domestic black money. Indians took their black money out of the country through channels like hawala and brought it back using the p-notes.
In June 2007, 56 % of the total Foreign Institutional Investment in India was through p-notes.
The SEBI and the Indian Government tried to ban p-notes, but the markets crashed and they had to back down. But, since then, the SEBI has been slowly tightening the regulations on p-notes. As a result, participatory notes investment shrunk to 6 % of FIIs by April 2017. Some of the measures by SEBI have been highlighted below:
- Extended KYC norms to p-noteholders.
- Curbs on transferability of the p-notes.
- Increasing frequency of reporting by registered FIIs to SEBI about the details of p-note transactions.
- Streamlined the FII registration process to make it more attractive.
- Also, Participatory notes can be issued only in those jurisdictions which follow anti-money laundering rule and anti-terror-funding rules
Recently, SEBI banned FIIs from issuing Offshore Derivative Instruments (p-notes) which have derivatives as their underlying security. The exception will be where these derivatives are used for hedging purposes. The existing p-notes on derivatives will have to be liquidated by the year 2020 when it will be completely phased out.
It should be noted that p-notes on shares and bonds have not been banned.
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