What are Pnotes and how do pnotes work?

Participatory Notes also known as P-Notes or PNs are derivative instruments(derives values from Stock like Infosys) and are issued by an existing & SEBI-registered foreign portfolio investor to other overseas investors(who do not wish to register with SEBI).

For example, a registered FPI like HSBC can issue a P-note on any traded stocks in Indian Domestic Market (like “Reliance Industry”) to its customers based out of Singapore or any other country.

At a very high level, the entire process works as follows:

  • The client would deposit funds with US or European Operations of an FPI (like HSBC or UBS ) and indicate the shares in Indian Stock market he/she is interested in buying.
  • Upon receiving the funds, FPI would issue the P-notes to the client and buy the underlying stock in appropriate quantity from Indian Stock Market.
  • The client(P-note holder) becomes eligible to dividends, capital gains and other payouts on the underlying securities because he/she owns the stock in Indian Stock market.
  • FPI reports P-notes issuances every quarter to SEBI but uses the option in law to keep the end identity of actual investor hidden.

Hence Pnotes is the route taken by an investor who does not wish to register with SEBI but still wishes to take exposure in the Indian securities markets.

History of Pnotes:

Until the 1990s, India’s development strategy was focused on self-reliance and hence we were not seeking foreign funds for development. However, this changed with financial reforms launched in 1992 by Dr. ManMohan Singh. As a part of these transformative reforms from Sep-1992, India allowed direct investment in Indian Stock Markets by FII ( Foreign Institutional Investors). To further enhance capital by foreign investors, Indian regulator SEBI allowed Participatory notes starting Feb-2000.

Below table outlines Pnotes vs total FPI investments by Foreign investors for last few years.

YearTotal Value of Participatory Notes - FPI's (in Crores)Asset Under Management by FPI's (in Crores)PN's vs AUM Percentage
2008-0969,4453,91,95417.7
2009-101,45,0379,00,86916.1
2010-111,75,09711,06,55015.8
2011-121,65,83211,07,39915.0
2012-131,47,90513,36,55711.1
2013-142,07,63915,93,86913.0
2014-152,72,07824,11,81011.3
2015-162,23,07722,24,53710.0

As you can see, FPI’s investment in participatory notes is gradually reducing and this is because of continuous efforts from SEBI, RBI and Ministry of Finance.

Disadvantages of P-notes.

Pnotes were started for genuine foreign investors who believed in Indian growth story and hence wanted to invest in India without having to go through KYC and other regulatory processes.  However lately, PNotes have become one of the biggest mechanism for money laundering by Indian companies.  Company owners would typically move the black money outside India via hawala channels and later deposit the money with an FPI and then work with the FPI’s to buy stocks of their own company via

However lately, PNotes have become one of the biggest mechanism for money laundering by Indian companies.  Company owners would typically move their black money outside India via hawala channels & deposit the money with an FPI and then work with the FPI’s to buy stocks of their own company via P-notes.

This is the biggest reason because of which SEBI, RBI and Finance Ministry have been making investments via Pnotes more and more difficult.

Conclusion

PNotes were designed to enhance infuse capital in Indian stock market but lately, it has become a tool for money laundering. We are seeing many actions by SEBI & RBI like increasing disclosure requirements and restricting the transfer of Pnotes among investors.

We are hopeful that in a few years, Pnotes would be used only by “real” foreign investors and initiatives by government agencies would result in a cleaner secondary market.