[Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI, REFI explainedDevendra Vishwakarma
- Foreign Investment rules: SEBI Vs RBI
- SEBI new classification of FPI
- SEBI: Alternative investment fund (AIF) classification
- What are Hedge funds?
- Difference between Hedge Fund & Mutual fund
- What is Participatory Note (P-Notes)?
- Why Ban Participatory Notes (P-notes)?
- P-Notes, Money laundering & Terror Financing
- P-notes and CGT evasion
- Appendix: How Hedge funds make money?
- #1: Short selling
- #2: Leverage
- #3: Arbitrage
- Mock Question
- 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|
||same as SEBI|
|NRI excluded||same as SEBI|
|Can trade in Indian shares, bonds, debentures, derivatives||same as SEBI|
|SEBI: investment limit
|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:
- Risk profile: less risky – means better category
- KYC compliance: better Know Your customer compliance means better category
Donot confuse between these FPI vs alternative investment funds
SEBI: Alternative investment fund (AIF) classification
|AIF Category||Examples||impact on Economy|
||Positive. They help new entrepreneurs, startup companies and infra. Development|
|2||Those not in the category 1 or 2
||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.
|Hedge Fund||Mutual fund|
|Only High Net worth Individual (HNI) can enter this game
||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.|
||Mutual funds provide high return only when sharemarket is going up.|
||UTI, Reliance Money, SBI mutual fund etc.|
What is Participatory Note (P-Notes)?
- 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.|
|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
- 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.
- Sell this P-note receipt to another foreigner say Jerry. Then Jerry again has same two options.
Why Ban Participatory Notes (P-notes)?
- 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.||
- **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.
Appendix: How Hedge funds make money?
- 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 $$)|
|Tom bought back||1000||5000||(-) 50,00,000 (because he paid $$)|
- 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.
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.