Ah, this Sensex fever! What are these PNs anyway

What is Participatory Notes?

Participatory Notes (PNs) are nothing but financial instruments which are generally used by investors or hedge funds that are not registered with the Securities and Exchange Board of India or Sebi to invest in Indian securities.

That means if you are a foreign investor not registered with Sebi, you can still invest in Indian markets through PNs and how? In such cases, Indian-based brokerage houses will buy the securities on your behalf and then issue PNs to you. Any dividends or capital gains collected from the underlying securities will keep going back to you.

PNs along with other instruments like Equity Linked Notes and Capped Return Notes are called Offshore Derivative Instruments or ODIs. ODIs are generally issued to overseas investors and they are so called as they derive their existence from the ownership of underlying shares in an Indian company.

Equity Linked Notes or ELNs are instruments whose return is determined by the performance of a single equity security, a basket of equity securities or an equity index. Capped Return Notes, as the name suggests, have a pre-established profit cap.

Simply speaking, all these are bilateral contracts between FIIs and investors for taking exposure in specific stocks without registering themselves with SEBI.

What is Sebi's concen about Participatory Notes?

Sebi is calling the FII fund flow to the markets in the recent time as 'copious'. "Our assessment tells us that Sensex is driven by copious inflow of funds," Union Finance Minister P Chidambaram said last week.

The Sebi and GOI are specifically concerned that the year-on-year increase in ODIs, the anonymity that ODIs provide to investors and the copious inflows into the country from foreign investors may be creating a bubble in the Indian markets.

For instance, the notional value of PNs outstanding shoot up over 10 times from from Rs 31,875 crore in March 2004 to Rs 3,53,484 crore in August this year. Similarly the number of FIIs and their agents issuing ODIs has increased to 34 from 14 in March 2004.

Which means the recent surge in the market is almost entirely driven by the FIIs with little involvement of retail investors. This has also allowed some people to take speculative positions. These inflows are also contributing to a steep rise in the rupee, which has hit Indian exports very badly.

What is the Sebi planning to do now?

The Sebi is proposing to bar the FIIs and their agents from issuing or renewing ODIs such as Participatory Notes, Equity Linked Notes and Capped Return Notes. The suggestion, as of now, is that Sebi will ask the FIIs to wind up their current positions over the one-and-a-half year, during which the regulator would review the position from time to time.

What do the experts say?

RH Patil, Managing Director, National Stock Exchange (NSE): The move is good but untimely, It came too late. Had the SEBI acted earlier, the stock market bubble would not have built.

P Chidambaram: We are not in favour of banning Participatory Notes. We have simply placed a cap on the proportion of money coming through PNs vis-a-vis overall assets under management or overall derivative position.

Adrian Mowat of JPMorgan" Sebi’s move is negative for FII inflows. As per the move, new money will have to register afresh and that will take time. The process of registering as FIIs is a legal, regulatory burden.

Uday Kotak, VC and MD, Kotak Mahindra Bank: In the medium-term, the P-Notes proposal is a right move. But it may hold short-term pain. The direction of proposals does not go against capital flows. Sebi will encourage direct FIIs to register and may give FII registrations much faster than before.

(All reactions from www.moneycontrol.com)