[Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI, REFI explained

Participatory Notes P Notes explained

[Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI, REFI explained

  1. Foreign Investment rules: SEBI Vs RBI
    1. SEBI new classification of FPI
    2. SEBI: Alternative investment fund (AIF) classification
  2. What are Hedge funds?
  3. Difference between Hedge Fund & Mutual fund
  4. What is Participatory Note (P-Notes)?
    1. Why Ban Participatory Notes (P-notes)?
    2. P-Notes, Money laundering & Terror Financing
    3. P-notes and CGT evasion
  5. Appendix: How Hedge funds make money?
    1. #1: Short selling
    2. #2: Leverage
    3. #3: Arbitrage
  6. Mock Question
  7. Correct Answers for MCQs

FII rules: SEBI Vs RBI

FPI: Foreign portfolio investor ReFI: Registered Foreign Portfolio Investor
effective from June 1, 2014 effective from March 19, 2014

  • FII: Foreign institutional investor, their sub-accounts
  • QFI: Qualified Foreign Investor
same as SEBI
NRI excluded same as SEBI
Can trade in Indian shares, bonds, debentures, derivatives same as SEBI
SEBI: investment limit

  • cannot buy treasury bills
  • can hold maximum 10% shares in a company
  • Doesn’t apply retrospectively. Example If FII HSBC already owns 11% of Infosys shares (before 1/June/2014), they don’t need to sell 1% to get back in 10% limited.
  • (FMC rule) Cannot become board of director in any Indian commodity exchange.
investment limit

  • Government  bonds: 25 billion
  • corporate bonds: 51 billion
have to register themselves as “FPI”, in any SEBI-approved Designated Depository Participants (DDP)
further classification into three categories (Given below) nope

SEBI new classification of Foreign investors

Foreign Portfolio Investors (FPI), New classification is based on two criteria:

  1. Risk profile: less risky – means better category
  2. KYC compliance: better Know Your customer compliance means better category
FPI: Classification
  • Foreign government.
  • Foreign government’s financial Institutions (e.g. American equivalents of UTI, EPFO, LIC)
  • This is category 1 because least risky and best KYC compliance in their home country.
  • Can issue/buy/sell Participatory Notes (P-Notes)
  • Foreign country’s Mutual Fund, Pension Fund, University endowment fund
  • Can issue/buy/sell Participatory Notes (P-Notes), except certain risky institution listed by SEBI.
  • Not in CAT I and CAT II. Example Hedge funds (also known as alternative investment fund).
  • in otherwords, highly risky and less KYC compliance type FII are put here.
  • Cannot issue participatory notes by themselves.
  • Cannot subscribe/buy/sell to P-notes issued by CAT I or CAT II.
  • cannot do above things even indirectly. (because SEBI order says so)

Donot confuse between these FPI vs alternative investment funds

SEBI: Alternative investment fund (AIF) classification

AIF Category Examples impact on Economy
  1. angel investors
  2. venture capital funds,
  3. small and medium enterprises (SME) funds,
  4. social venture funds infrastructure funds
Positive. They help new entrepreneurs, startup companies and infra. Development
2 Those not in the category 1 or 2

  • Private equity funds
  • debt funds
Mixed. They use leverage only for day to day requirements. Hence less dangerous than Hedge Funds. (leverage explained in appendix).
3 Hedge funds They pose systematic risk to Indian market, due to complex trading strategies. (explained in the Appendix)

What are Hedge funds?

  • You’re aware of the mutual funds (MF): you invest money in MF, they invest money in share market and give you profit, after cutting their commission.
  • Hedge fund is a similar investment game, where High net worth individuals (HNI) pool their money into high risky games to earn high return on investment.
  • But their trading-techniques are far more complex than mutual funds, hence Hedge funds can make money even with sharemarket going down.
Difference between Hedge Fund & Mutual fund
Hedge Fund Mutual fund
Only High Net worth Individual (HNI) can enter this game

  • Indian hedge fund: 1 crore rupees (SEBI rule)
  • Foreign (offshore) hedge fund: 5 lakhs dollars
Any investor welcome.e.g. SBI mutual fund Rs.100 minimum investment required!
SEBI registers them “Alternative Investment fund- Category III.” registered as “Asset  Management companies (AMC)”
They prefer to invest in risky bonds and shares (Because high risk=high return) e.g. Shares of Kingfisher and C graded Bonds of Somalian Government. They usually stick to shares and bonds of reliable companies.
  • They apply techniques such as leverage, short selling and arbitrage to make high profit (explained in the appendix of this article).
  • So, even when sharemarket is going down, Hedge Fund would continue giving high return to investor.
Mutual funds provide high return only when sharemarket is going up.
  • They also play in derivative instruments such as P-notes (explained after few para.)
  • although hedge funds can no longer play in P-notes. Because SEBI classified foreign hedge funds into CAT III FPI.
  • As such, they don’t play into P-notes.
  • But if foreign mutual fund given CAT II status, they may play in P-notes.
  • Indian: Karvi Capital, Motilal Oswald, IIFL, Edelweiss etc.
  • Foreign: Goldman Sachs, JP Morgan
UTI, Reliance Money, SBI mutual fund etc.
  • SEBI regulation not strict.
  • If Hedge fund manager pooled 100 crore from investors, he can speculate in securities worth 200 crores. (Twice the amount)…
  • But for T+2 system only meaning within two days he should settle the transaction.
  • SEBI regulation very strict.
  • A mutual fund manager cannot do high level speculation like a hedge fund manager.

What is Participatory Note (P-Notes)?

Participatory Notes P Notes explained

  • Tom Cruz wants to get maximum return on the investment in quickest possible time.
  • For this, Tom will have to find risky securities (shares/bonds) in third world countries, then invest money from one country to another quickly, depending on how sharemarket moves.
  • In India, no one can invest in sharemarket without getting PAN card + DEMAD account first. Other nations too have similar mechanism.
  • But if Tom tries to get PAN card and DEMAT account in each third world country, then his profit will decline- given the cost of running branch office, staff salary, DEMAT fees etc. in each country.
  • So, to take a shortcut, Tom will contact some ‘middleman’ who is already registered as an FII, has PAN card & DEMAT in India. e.g. HSBC.
  • Tom gives money to HSBC, with instruction “buy A, B and C shares/bonds in X, Y and Z quantity.”
  • HSBC buys Indian shares. They’ll be stored in DEMAT account of HSBC, and won’t be given to Tom.
  • But HSBC then gives a receipt to Tom listing the shares/bonds purchased on his behalf and stored in HSBC’s DEMAT account.
  • This receipt is called Participatory Note.
  • Technically, it is called “offshore derivative instrument”. Observe the words
OFFSHORE Because foreigner owning something in India, without coming to India or opening office in India.
  • Because this receipt doesn’t have value of its own.
  • It “derives” its value from the market value of shares/bonds held by HSBC. Today it may be worth $1000, tomorrow $12000 depending on how the prices of Indian securities move.
INSTRUMENT Self-explanatory- this is one type of financial instrument to invest abroad.
  • 1992: SEBI had permitted P-notes, to boost foreign investment in India, after BoP crisis of 1991.
  • P-note owner doesn’t own the shares. (because they’re in the DEMAT account of that intermediary FII)
  • P-Note owner doesn’t have voting rights in the shareholder meetings

Where is the profit in P-notes?

Tom has two options

  1. Wait and watch. If the price of those shares go up, call up HSBC to sell them. HSBC returns principal + profit to Tom, after cutting commission. Tom returns the P-note receipt to HSBC.
  2. Sell this P-note receipt to another foreigner say Jerry. Then Jerry again has same two options.

Why Ban Participatory Notes (P-notes)?

How to use P-Notes for money laundering

  • As of March 2014, Foreigners invested ~Rs. 2 lakh crore in India via P-notes. (this is 13% of the total FII money coming in India)
  • As such the FII has to disclose P-note owner data to SEBI on quarterly basis (every 3 months). But often, within 3 months the P-notes would have changed many hands (e.g Tom to Jerry to Micky to Goofy).
  • Thus P-note investments are Anonymous. Hard to trace the owner. Can be used for money laundering and terror financing.
  • Hot Money: can leave Indian market very soon based on just one phone call from Tom Cruz to HSBC. Hot money creates heavy rise or fall in share market, so even genuine investors’ money is lost.
  • e.g. Tom continuously buys Infosys shares, they goup to Rs.3000 per share. So, you (indian) also buy, thinking “Infosys will go even higher to 3500, and I’ll make profit”.
  • But suddenly tom sells everything, to invest in China for better return.
  • Now infosys sells not even for 2000. Then you (Indian investor) lost 1000.

P-Notes, Money laundering & Terror Financing

  • Finance Ministry Whitepaper: Indians first send their money to Cayman Islands, British Virgin Islands, Switzerland, or Luxembourg via Hawala operators. Then, their agents convert rupees to dollars, re-invest it in Indian market through P-notes. It is possible to hide the identity of the ultimate beneficiaries, because of these multiple layers. Thus, P-notes are used in money laundering.
  • Ex-National security Advisor MK Narayan: Terrorists are using P-notes to invest in Indian stockmarket, and using the same profits to finance terror operations against India. They may use this mechanism to first boost Indian stockexchage, then collapse it by quickly pulling out money from the market. Doubt: how can a poor Pakistan afford creating volatility in Indian market? Ans. Via printing fake Indian currency, converting it to dollars in a tax haven, to buy P-notes via a post office company!
  • RBI’s Tarapore Committee: Recommended Banning P-notes for national security and to stabilize stock exchanges

P-notes and CGT evasion

  • Capital Gains tax is a direct tax levied on profit from sale of shares/bonds/gold etc.
  • It is possible to evade capital gains tax via P-notes. Observe:
With P-Notes Without P-notes
Tom can buy Indian shares via FII via p-notes.
  • Tom and Jerry have to get PAN+DEMAT. Only then, they can buy/sell Indian shares.
  • Tom sells this P-note to Jerry @profit.
  • Jerry** doesn’t need to pay CGT to Indian Government, because we cannot trace what Tom did with that piece of paper in USA!
  • Even if P-note is sold 10 times to 10 different people, we cannot get CGT.
  • We’ll get CGT only once, when the said p-note owner instructs the FII to sell the shares from its Indian DEMAT account/ portfolio.
  • If Tom sells his shares to Jerry (and makes profit), then Jerry** will have to pay Capital gains tax to India.
  • Because Income tax official can trace it by monitoring the DEMAT activity of both accounts.
  • **In theory, the seller has to pay the Capital gain tax (Tom Cruz in our case). but in reality the buyer (Jerry) has to cut down the amount from payment to Tom, and give directly to government. Recall the Tax deduction at source (TDS) concept in Nokia controversy article click me.
Parthsarathi Shome
  • Government must tax such P-note holders from next budget 2014.
  • Shome is a tax expert, he earlier chaired the Committee on GAAR.

Appendix: How Hedge funds make money?

Hedge fund functioning

  • Suppose, Mr.Tom Cruz runs a hedge fund for High net worth Individuals (HNI) Arnold Schwarzenegger and Leonardo di Caprio.
  • To get maximum return in quickest possible time, Hedge Fund manager Tom Cruz will apply three techniques:

#1: Short selling

  • Suppose Facebook shares are selling at $1200 dollars.
  • Tom Cruz “borrows” 5000 facebook shares from a broker Bruce Willis, for two days; and immediately sells them in share market.
  • Now, Facebook share price will fall to say $1000 (imagine sudden supply of new onions in the market)
  • Tom buys 5000 facebook shares @$1000 from another investor, and returns them to broker Bruce Willis.
  • What’s Tom’s profit here:
Price per share quantity total
Tom Sold 1200 5000 (+) 60,00,000 (because he received $$)
Tom bought back 1000 5000 (-) 50,00,000 (because he paid $$)
Tom’s profit $10,00,000
  • You can see this is a risky game. Sometimes share price may not fall down but increase (because of some other player doing large purchases). In that case Tom will lose money (because he’ll have to buy higher priced shares and return to Broker Bruce Willis.) ad Broker Bruce Willis will make profit. (Because he will receive shares whose market price has now increased.)
  • For short-selling trick to yield result, you need massive quantity of shares. (If I sell 1 kilo onion from my kitchen, it won’t bring down prices in the Mandi. I need atleast a 1000 kilo, to change the supply-demand and prices.)
  • Therefore, Hedge funds don’t accept aam-admi in their game. They only allow High Networth Individual to join the game, who can finance such large purchases and have deep pockets to suffer large losses.

#2: Leverage

Suppose Tom has only $500 and wants to bet in $1000 worth shares.

his own pocket $500
borrows from a friend @10% interest $500 ($50 in interest later repaid)
total with Tom $1000

Tom uses this $1000, to purchase shares from Broker Bruce Willis. Now suppose same share’s price goes up** and Tom is able to sell them @$1200.

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