PNs (Participatory Notes)

Participatory notes (PNs) are instruments used by investors or hedge funds that are not registered with the SEBI (Securities & Exchange Board of India) to invest in Indian securities. Indian based brokerages buy Indian-based securities and then issue PNs to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors.

Investopedia Says:
"In many ways, this is similar to an informal ADR process, where brokerages hold on to stocks for foreign investors. However, Indian regulators are not very happy about participatory notes because they have no way to know who owns the underlying securities. Regulators fear that hedge funds acting through participatory notes will cause economic volatility in India's exchanges."

Participatory notes are instruments used for making investments in the stock markets. However, they are not used within the country. They are used outside India for making investments in shares listed in that country. That is why they are also called offshore derivative instruments.

Like any other derivative instruments, their value is determined on the basis of the underlying asset. In the case of participatory notes, the underlying assets are shares listed on the stock exchanges.

In the Indian context, foreign institutional investors (FIIs) and their sub-accounts mostly use these instruments for facilitating the participation of their overseas clients, who are not interested in participating directly in the Indian stock market. For example, Indian-based brokerages buy India-based securities and then issue participatory notes to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors According to one estimate, participatory notes constitute more than 25% of the cumulative net investments in equities by FIIs.

Any entity investing in participatory notes is not required to register with SEBI (Securities and Exchange Board of India), whereas all FIIs have to compulsorily get registered. Trading through participatory notes is easy because

• They are like contract notes transferable by endorsement and delivery.
• Some of the entities route their investment through participatory notes to take advantage of the tax laws of certain preferred countries.
• They are popular because they provide a high degree of anonymity, which enables large hedge funds to carry out their operations without disclosing their identity.

Participatory notes in brief is as follows :
Participatory notes are instruments used by foreign funds which are not registered to trade in domestic Indian Capital Markets. PNs are derivative instruments issued against an underlying security permitting holders to get a share in the income from the security.

How does it work?
Investors who buy PNs deposit their funds in US or European operations of Foreign Institutional Investors (FII) operating in India . The FII uses its proprietary account to buy stocks.

Why do investors use PNs?
Reason for using PNs is to keep investor name anonymous, some investors have used them to save transaction and overhead costs.

What is the problem with PNs?
Tax officials fear that PNs are becoming a favourite with a host of Indian money launderers who use them to first take funds out of country through hawala and then get it back using PNs.

Some FIIs issuing PNs:
Citigroup, Goldman Sachs, Merrill Lynch, Morgan Stanley.