Even as foreign portfolio investors trundled into the Indian stock market, pumping in millions over the last three decades, another shadowy route opened up alongside. Investors in other countries who did not wish to register with the Securities and Exchange Board of India (SEBI) could buy Indian stocks and debt through participatory notes (p-notes) issued by FIIs registered with SEBI.
These p-notes have been both the SEBI and the Reserve Bank of India’s (RBI) bane, due to the suspicion that money launderers are using this channel to bring back the money stashed overseas. Both the regulators have been waging a long-drawn war against p-notes for some time now.
The earlier regime
All FIIs registered with SEBI were earlier allowed to buy Indian stocks, debt or derivative contracts and issue p-notes (also known as offshore derivative instruments) based on these assets to investors residing outside India.
Now, it will not be right to say that all those who bought these p-notes had ulterior motives or a desire to mask their identity. There are many foreign investors, such as hedge funds who invest in many countries, for whom the speed of transaction is of utmost importance. Such investors do not like to waste time registering with the country’s regulator.
But there is no doubt that the opacity provided by p-notes was misused by money launderers. Things came to a head in 2007, when the share of p-notes in FII’s Assets Under Management (AUM) in India exceeded 50 per cent.
A large chunk of these p-notes had equity futures and options as underlying assets. This increased the risk of heightened volatility cause by fund outflow. Therefore, SEBI had clamped down on p-note issuances then. While many of the restrictions were removed in the subsequent months, the threat posed by them has decreased significantly. As of March 2016, p-notes account for just 10 per cent of the FII AUM.
Tightening the screws
A blanket ban of p-notes was thwarted by the stock market that went into a slump every time there was talk of banning p-notes. Nevertheless, SEBI has been gradually tightening the rules dealing with p-note issuances over the years.
In January 2011, monthly reports containing name and jurisdiction of the end beneficial owner were made mandatory. In 2014, it was laid down that p-notes can be issued by or subscribed to only by entities regulated or supervised by the securities market regulator or the banking regulator of the concerned foreign jurisdiction. It was also stipulated that some FIIs such as endowments, charitable societies, trusts, foundations, companies, individuals and family offices cannot issue p-notes.
In November 2014, it was also laid down that p-notes cannot be issued to residents of countries that are identified as having lax anti-money laundering rules by the Financial Action Task Force (an inter-government body set up to combat money laundering and terrorist financing).
Recent changes
Last week, SEBI took additional steps to make sure these rules are watertight.
One, it made it easier to identify the ultimate beneficiary or owner of the p-notes. So far, FIIs resident in India needed to only report the identity of the entity buying the p-notes. Disclosures regarding onward issuances of these notes were not stringent enough and were reported to SEBI only on demand. Now it has been made mandatory for all FIIs to report all the transfers made by p-note subscribers, every month, to SEBI.
Further, all p-note buyers have to seek the p-note issuer’s permission before transferring these instruments. This will ensure that the issuer is also held accountable.
Two, the p-note issuing FIIs have to run KYC checks on those purchasing these instruments that are similar to the checks done on domestic investors. This will, to a large extent, help check money laundering.
Three, issuers have to identify and verify the beneficial owners in companies subscribing to p-notes. Anyone holding more than 25 per cent stake in a company and 15 per cent in partnership firms/ trusts/ unincorporated bodies is a beneficial owner.
Why the kid-glove treatment?
Many think that p-notes should be banned altogether, as their influence on the Indian stock market has whittled down over the years. But that would not be fair to genuine investors who use these instruments for the convenience they offer; it might not be right to throw the baby out with the bath-water. Again, copious outflows triggered by a p-note ban can affect our external balance adversely.
SEBI is, therefore, right in dealing with the issue in a phased manner, plugging the gaps one by one, so that the p-note channel is completely sanitised.