03 Aug 2015 01:38 IST

What’s the P(ai)N all about?

If money-laundering is to be prevented, the regulator must take a serious look at the rules governing participatory notes

Participatory notes, or PNs, are back under the spotlight thanks to the Special Investigation Team (SIT) on Black Money appointed by the Supreme Court. The SIT, in its latest report, has suggested that PNs are a conduit for laundering black money and that the government should further tighten the rules governing PNs.

The SIT’s recommendation sent shock-waves through the stock market last week and it required an assurance from no less than Finance Minister Arun Jaitley that there would be no “knee-jerk” reaction by the government before calm could be restored.

What exactly is this animal called PN and why does the SIT want the screws tightened on them? And why did the markets react adversely to the SIT’s suggestion?

Underlying value

PNs are derivative instruments used by foreign investors to invest in the Indian stock market. They are issued by Foreign Portfolio Investors (FPI) registered with the stock market regulator, Securities and Exchange Board of India (SEBI). The FPIs issue PNs with specific underlying shares as the asset. For instance, an investor may want to invest in the Infosys share in India; the FPI will buy the share in the domestic market and, based on that, issue PNs to the investor abroad.

The question is: why do foreign investors want to invest through PNs when they can directly invest in the Indian market? There are two reasons. First, the investor has a short-term horizon and does not want to go through the time and effort of registering itself with SEBI, which is a pre-requisite before it can invest in the Indian market. Such investors are typically hedge funds that move money in and out of markets at the blink of an eyelid. These constitute hot capital flows, which is why hedge fund investments are not exactly a desirable class of investors to have.


The second, and main, reason why foreign investors choose the PN route is the anonymity it offers. Such investors are not registered with SEBI and their identity is known only to the FPI. That brings us to why the SIT wants the rules governing PNs tightened further.

The anonymity that PNs offer is very convenient for those who wish to use the route for illegal purposes, such as laundering their black money stashed abroad, or by promoters and businessmen for rigging shares of their companies. Round-tripping — the act of taking unaccounted money out of the country and bringing it back as legal money by investing in the stock market — has been a common practice.

To be sure, this is not the first time that the authorities have tried to rein in PNs. SEBI’s former chairman, M Damodaran, tried banning them in 2007 but had to withdraw in the face of hostile reaction from the stock market. Those were the days when PNs accounted for more than half of the foreign investment in the stock market. Again, in 2011 and later in 2014, SEBI framed tighter regulations to make it difficult for shady investors to use the PN route.

Greater transparency

SEBI decreed that FPIs could issue PNs only to investors who are regulated by the regulators of the country to which they belong; it also said that PNs could not be issued to NRIs or people of Indian origin and further ordered that FPIs had to file a monthly report to it, detailing the beneficial owners of PNs. Yet, despite all these measures, the SIT is of the view that the PN route continues to be used to launder unaccounted money. It has now asked SEBI to take a fresh look at its PN regulations with a view to ensuring that the beneficial owners of PNs are known to it.

The stock market reacted adversely to the SITs suggestions because it feared that an important route for investment by foreign investors would be blocked. Though PNs now account for just 11 per cent of the overall foreign portfolio investment in the country, they are a sizeable investment in absolute terms — at ₹2.75 lakh crore, or $40 billion, as per latest data.

Though SEBI Chairman UK Sinha joined his boss Arun Jaitley in reassuring the market that there were no immediate moves to rein in PNs, the fact is that he and Jaitley have little choice but to take a serious look at the regulations governing PNs if the objective of preventing money-laundering is to be achieved. Genuine investors will have no problem disclosing their identity and those wishing to invest anonymously should be discouraged and put off.

To read more from the GyanGuru section, click here .