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[Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI, REFI explained
1. Foreign Investment rules: SEBI Vs RBI
1. SEBI new classication of FPI
2. SEBI: Alternative investment fund (AIF) classication
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,
FII: Foreign institutional investor, their sub-accounts
QFI: Qualied 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
Doesnt apply retrospectively. Example If FII HSBC already owns 11% of Infosys shares (before
1/June/2014), they dont 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
have to register themselves as FPI, in any SEBI-approved Designated Depository Participants (DDP)
further classication into three categories (Given below) nope
SEBI new classification of Foreign investors
Foreign Portfolio Investors (FPI), New classication is based on two criteria:
1. Risk prole: less risky means better category
2. KYC compliance: better Know Your customer compliance means better category
FPI: Classication
Foreign government.
Foreign governments nancial 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 countrys 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
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
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?
Youre aware of the mutual funds (MF): you invest money in MF, they invest money in share market and give you prot, 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
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
They prefer to invest in risky bonds and shares (Because high risk=high return) e.g.
Shares of Kingsher and C graded Bonds of Somalian Government.
They usually stick to shares and bonds of reliable
They apply techniques such as leverage, short selling and arbitrage to make high
prot (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
although hedge funds can no longer play in P-notes. Because SEBI classied
foreign hedge funds into CAT III FPI.
As such, they dont 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
SEBI regulation very strict.
A mutual fund manager cannot do high level
speculation like a hedge fund manager.
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 nd 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 rst. Other nations too have similar
But if Tom tries to get PAN card and DEMAT account in each third world country, then his prot will decline- given the cost of running
branch ofce, 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.
Tom gives money to HSBC, with instruction buy A, B and C shares/bonds in X, Y and Z quantity.
HSBC buys Indian shares. Theyll be stored in DEMAT account of HSBC, and wont be given to Tom.
But HSBC then gives a receipt to Tom listing the shares/bonds purchased on his behalf and stored in HSBCs 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 ofce in India.
Because this receipt doesnt 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 nancial instrument to invest abroad.
1992: SEBI had permitted P-notes, to boost foreign investment in India, after BoP crisis of 1991.
P-note owner doesnt own the shares. (because theyre in the DEMAT account of that intermediary FII)
P-Note owner doesnt 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 + prot 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)?
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
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 nancing.
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 Ill make prot.
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 rst 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 beneciaries, 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 prots to
nance terror operations against India. They may use this mechanism to rst 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 ofce company!
RBIs 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 prot 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 @prot.
Jerry** doesnt 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
Well 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 prot), then
Jerry** will have to pay Capital gains tax to India.
Because Income tax ofcial 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
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?
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.
Whats Toms prot here:
Price per share quantity total
Tom Sold 1200 5000 (+) 60,00,000 (because he received $$)
Tom bought back 1000 5000 (-) 50,00,000 (because he paid $$)
Toms prot $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 hell have to buy higher priced shares and return to Broker Bruce Willis.) ad
Broker Bruce Willis will make prot. (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 wont bring down
prices in the Mandi. I need atleast a 1000 kilo, to change the supply-demand and prices.)
Therefore, Hedge funds dont accept aam-admi in their game. They only allow High Networth Individual to join the game, who can
nance 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 shares price goes up** and Tom is able to sell them
Whats Toms prot here?
Earned (+) $1200 by selling shares
invested (-) $500 from his own pocket
borrowed (-)$500 principal to friend
interest (-) $50 interest to friend
Prot $150
** Shares price can go up for variety of reasons.
company expected to make good prot (and thereby declare bigger dividends)
there are talks of merger / acquisition of that company
If Tom himself starts buying large amount of shares (imagine scarcity of onions).
Again, this is a risky game, if Share prices doesnt rise, Tom will make huge losses (Because hell have to return $550 to the friend at some
#3: Arbitrage
When same thing sells for different rates in two markets, Tom can take advantage of arbitrage, to make prot.
New York stock exchange California Stock Exchange
1 facebook share sells @1000 (on
todays date)
Some investor is willing to make future-contract: Ill buy 1000 facebook shares @ $1200 3
months from now.
He wants future contract because right now he doesnt have money or xyz reason.
In this case, Tom will purchase 1000 shares of Facebook from NY and simultaneously make future contract with Californian investors ok Ill
sell you the shares @ $1200 after three months.
This Toms prot: $200 x 1000 Nos. = $2 lakh Dollars.
Although in real life, the arbitrage is so narrow Tom will have to apply leverage, to make signicant prot. Example
NewYork: $1000 / per Facebook share
California: $1002 / per Facebook share.
Here only $2 prot per share
If Tom wants to make $2,00,000 prot, he will have to buy 1 lakh No. of shares.
But he may not have that much money in his own pocket, to purchase such large quantity.
In that case, Tom will need to borrow additional money from friend to play this game (refer the Leverage concept again.)
With advent of online trading, the arbitrage has decreased to decimal points. say $1000.38 in NY and $1000.40 in Cali. So, here Tom has to
buy even bigger quantity (Ten lakh shares) to see substantial prot. Tom Cruz may have excellent brain but hed need High Networth
Individuals like Arnold & Leonardo to provide him the necessary funding. Thus, Hedge funds emerged.
Going even complex:
NewYork: $1002 / per Facebook share
California: $1002 / per Facebook share
How can Tom make money here?
Hell rst apply Short selling technique in New York so that Facebook price falls down at 1000. ($2 prot)
Then he uses arbitrage between NY and Cali to make additional prot. ($2)
So 2+2 = 4$ prot per share. Imagine if he bought 1 lakh shares like this.
Mock Question
Q1. Find correct statements about the new classication of foreign portfolio investors by SEBI
1. the entities with higher risk prole and lower KYC compliance, are put under category Three
2. alternative investment funds are put under category one
3. University endowment funds are put under category Two
Answer choice
1. only 1 and 2
2. only 2 and 3
3. only 1 and 3
4. All of them
Q2. Find the incorrect statements about the classication of alternative investment funds by SEBI
1. Entities with positive externality on Indian economy, are put under category three
2. infrastructure funds are put under category two
3. hedge funds are classied as alternative investment funds category III.
Answer choice
1. only 2
2. only 1 and 2
3. only 2 and 3
4. only 1 and 3
Q3. What are the consequences if SEBI/RBI doesnt put any restrictions on foreign portfolio investors?
1. Dollar to rupee exchange rate may become volatile
2. Indian Sensex may become volatile
3. India may run into another balance of payments crisis
Answer choice
1. only 1 and 2
2. only 2 and 3
3. only 1 and 3
4. All of them
Q4. Find incorrect statement
1. An foreign portfolio investors can buy only a xed quantity of government bonds in India, but hes free to buy as many corporate bonds
as he wishes.
2. A foreign portfolio investor can demand position in the board of directors of a commodity trading exchange, if owns sufcient number
of shares of the said exchange.
3. Both A and B
4. neither A nor B
Q5. Consider following statements
1. An NRI need not register himself as a foreign portfolio investors, if he wishes to buy corporate bonds
2. An NRI need needs to register himself as a foreign portfolio investors, if he wishes to buy government bonds
3. An NRI is prohibited from buying Treasury bills.
Which of them are incorrect?
1. Only 2
2. only 1 and 2
3. only 2 and 3
4. only 1 and 3
Q6. Consider following statements about Hedge Funds
1. A middle class Indian family cannot invest in Hedge Funds.
2. In theory, Hedge fund can provide good return even during slowdown in sharemarket.
3. Given their risky prole, SEBI doesnt permit foreign hedge funds to operate in India.
Which of them are correct?
1. Only 3
2. only 1 and 2
3. only 2 and 3
4. only 1 and 3
Q7. P-Notes is a/an ____.
1. Alternative investment instrument
2. Alternative derivative instrument
3. Offshore derivative instrument
4. Offshore equity instrument
Q8. Who uses P-notes?
1. Entities that want to raise capital from abroad but cant, due to ADR/GDR/ECB related norms.
2. Entities that want to raise capital from abroad but cant because of ECB norms.
3. Entities that want to invest in a securities market abroad, but want to maintain anonymity.
4. Entities that want to invest in a sector where Foreign direct investment is prohibited.
Q9. As per SEBI norms
1. Foreigners are completely prohibited from using p-notes to invest in India.
2. Only NRIs can use P-notes to invest in India.
3. IF a person wants to invest via P-notes, he needs to get a PAN card rst.
Which of them are correct?
1. only 1 and 2
2. only 2 and 3
3. only 1 and 3
4. None of them
Q10. In stockmarket, what do you understand by the term Leverage?
1. Seeking to increase returns by borrowing funds.
2. process of selling securitis that the seller does not own.
3. Prot from the price differentials between the two markets.
4. Buying securities from the primary market to sell them at higher prices in secondary market.
Q11. In stockmarket, what do you understand by the term Stag investor?
1. Seeking to increase returns by borrowing funds.
2. process of selling shares of a security that the seller does not own.
3. Prot from the price differentials between the two markets.
4. Buying securities from the primary market to sell them at higher prices in secondary market.
Q12. In stockmarket, what do you understand by the term Arbitrage?
1. A broker offering option on a share selling contract.
2. Prot due to difference between two stock indexes e.g. SENSEX vs NIFTY.
3. Prot from the price difference of securities between the two markets.
4. Buying securities from the primary market to sell them at higher prices in secondary market.
Mains & Interview
1. (GS3) What is Participatory note? Why does it pose challenge to the ght against money laundering and terror nance?
2. (interview) SEBI should completely ban P-notes. Whats your opinion?
Correct Answers for MCQs
1. Answer C only 1 and 3 correct. Alternative investment fund is a different thing
2. Answer A. You were required to nd the incorrect statement viz. statement #2
3. D all of them.
4. Answer C. You were required to nd incorrect statement.
5. Answer C only 2 and 3 are wrong.
6. Answer B. 1 and 2 correct.
7. P note: offshore derivative.
8. Answer C maintain anonymity.
9. D none of them correct.
10. A. increase returns by borrowing funds
11. D
12. C price difference between two markets.
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Posted By Mrunal On 18/06/2014 @ 15:27 In the category Economy