Kotak Mutual Fund : The P-Note Conundrum – Path Ahead

From Kotak Mutual Fund

What are P-Notes?

Source: Issues in Participatory notes, Arun Gargi

Participatory notes (p-notes) are instruments used by foreign funds /
investors who are not registered with SEBI but are interested in taking
exposure to Indian securities. The associates of India-based foreign
brokerages generally issue p-notes overseas. Institutional investors
that do not wish to register with SEBI but would like to take exposure
in Indian securities also use the pnotes.

Brokers buy or sell securities on behalf of their clients on their
proprietary account and issue such notes in favour of such foreign
investors.

P-note investors place their order through brokerage houses. The
brokerage houses then repatriate the dividends and capital gains back
to these entities.

Participatory notes are popular because they provide a high degree of
anonymity, which enables certain entities to carry out their operations
without disclosing their identity and that is why regulators are not
comfortable with huge funds coming in via the p-notes route.

What has changed?

SEBI released a discussion paper of the proposed policy changes on
p-notes. This will likely cap investor participation via the p-note
route. Accordingly, FIIs and their sub -accounts shall not issue /renew
ODIs with underlying as derivatives with immediate effect. Moreover,
they are required to wind up the current position over 18 months. The
extent of funds via p-notes in the Indian derivatives market is
estimated to be about USD 20 to 30 Billion. Investor sentiment is
likely to weaken considerably as an important source of potential
inflows has likely been plugged. Of the US$17 billion of foreign
portfolio equity inflows this calendar year, close to US$10 billion
have likely been through p-notes (Source: JP Morgan), suggesting a
sizable moderation in portfolio inflows when these proposed policy
changes are implemented.

Implications on markets

We believe this would become a prelude to more investors coming in the
Indian markets as registered FIIs. Although liquidity might slow,
SEBI's move will likely result in transperancy in the markets which is
good for the health of the market. The Ministry of Finance has
expressed concerns of strengthening rupee, which could hurt the
competitiveness of the economy. A cap on p-note inflow would restrict
hot money flowing into the country and thereby stem the rise in the
rupee. It might also leave the markets that much less vulnerable when
outflows of such funds happen. Also with the recent rapid rise in the
markets, the valuations seemed to be rich. With fundamentals being
intact, such corrective dips present opportunities for investors to buy
at relatively cheaper valuations.


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Source: kotak sec