economy participatory notes p notes h

7/25/2019 Economy Participatory Notes p Notes h

1/12

[Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI,REFI explained

1. Foreign Investment rules: SEBI Vs RBI1. SEBI new classification of FPI2. SEBI: Alternative investment fund (AIF) classification

2. What are Hedge funds?3. Difference between Hedge Fund & Mutual fund4. What is Participatory Note (P-Notes)?

1. Why Ban Participatory Notes (P-notes)?2. P-Notes, Money laundering & Terror Financing3. P-notes and CGT evasion

5. Appendix: How Hedge funds make money?1. #1: Short selling2. #2: Leverage3. #3: Arbitrage

6. Mock Question7. Correct Answers for MCQs

FII rules: SEBI Vs RBI

SEBI RBI

FPI: Foreign portfolio investorReFI: Registered ForeignPortfolio Investor

effective from June 1, 2014effective from March 19,

2014Includes

FII: Foreign institutional investor, their sub-accounts QFI: Qualified 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 HSBCalready 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 Indiancommodity exchange.

investment limit

Governmentbonds:25 billion

corporate bonds:51 billion

have to register themselves as FPI, in any SEBI-approvedDesignated Depository Participants (DDP)

further classification into three categories (Given below) nope

Page 1 of 12Mrunal Explained: Participatory Notes (P-Notes) mechanism, Money laundering

14-Aug-14http://mrunal.org/2014/06/economy-participatory-notes-p-notes-hedge-funds-new-limits-f...


2/12

SEBI new classification of Foreign investors

Foreign Portfolio Investors (FPI), New classification is based on two criteria:

1. Risk profile: less risky means better category2. KYC compliance: better Know Your customer compliance means better category

FPI: Classification

CAT I

Foreign government. Foreign governments financial 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)

CAT II

Foreign countrys Mutual Fund, Pension Fund, University endowment fund Can issue/buy/sell Participatory Notes (P-Notes), except certain risky institution

listed by SEBI.

CAT

III

Not in CAT I and CAT II. Example Hedge funds (also known as alternativeinvestment 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

AIF

CategoryExamples impact on Economy

1

1. angel investors2. venture capital funds,3. small and medium

enterprises (SME)funds,

4. social venture fundsinfrastructure funds

Positive. They help new entrepreneurs, startupcompanies and infra. Development

2

Those not in the category 1or 2

Private equity funds debt funds

Mixed. They use leverage only for day to dayrequirements. Hence less dangerous than HedgeFunds. (leverage explained in appendix).

3 Hedge fundsThey pose systematic risk to Indian market, due tocomplex trading strategies. (explained in theAppendix)




3/12

What are Hedge funds?

Youre aware of the mutual funds (MF): you invest money in MF, they invest money inshare market and give you profit, after cutting their commission.

Hedge fund is a similar investment game, where High net worth individuals (HNI) pooltheir 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 down.

Difference between Hedge Fund & Mutual fund

Hedge Fund Mutual fund

Only High Net worth Individual (HNI) can enter thisgame

Indian hedge fund: 1 crore rupees (SEBI rule) Foreign (offshore) hedge fund: 5 lakhs dollars

Any investor welcome.e.g. SBImutual fund Rs.100 minimuminvestment required!

SEBI registers them Alternative Investment fund-Category III.

registered as Asset Managementcompanies (AMC)

They prefer to invest in risky bonds and shares(Because high risk=high return) e.g. Shares ofKingfisher and C graded Bonds of SomalianGovernment.

They usually stick to shares andbonds of reliable companies.

They apply techniques such as leverage, shortselling and arbitrage to make high profit(explained in the appendix of this article).

So, even when sharemarket is going down,Hedge Fund would continue giving high return toinvestor.

Mutual funds provide high returnonly when sharemarket is going up.

They also play in derivative instruments such asP-notes (explained after few para.)

although hedge funds can no longer play inP-notes. Because SEBI classified foreign hedgefunds into CAT III FPI.

As such, they dont play intoP-notes.

But if foreign mutual fundgiven 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 mutualfund etc.

SEBI regulation not strict. If Hedge fund manager pooled 100 crore from

investors, he can speculate in securities worth200 crores. (Twice the amount)

But for T+2 system only meaning within twodays he should settle the transaction.

SEBI regulation very strict. A mutual fund manager cannot

do high level speculation like ahedge fund manager.




4/12

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 find risky securities (shares/bonds) in third world countries,

then invest money from one country to another quickly, depending on how sharemarketmoves.

In India, no one can invest in sharemarket without getting PAN card + DEMAD accountfirst. Other nations too have similar mechanism.

But if Tom tries to get PAN card and DEMAT account in each third world country, then

his profit will decline- given the cost of running branch office, staff salary, DEMAT feesetc. in each country.

So, to take a shortcut, Tom will contact some middleman who is already registered as anFII, has PAN card & DEMAT in India. e.g. HSBC.

Tom gives money to HSBC, with instruction buy A, B and C shares/bonds in X, Y and Zquantity.

HSBC buys Indian shares. Theyll be stored in DEMAT account of HSBC, and wont begiven to Tom.

But HSBC then gives a receipt to Tom listing the shares/bonds purchased on his behalfand stored in HSBCs DEMAT account.

This receipt is called Participatory Note. Technically, it is called offshore derivative instrument. Observe the words

OFFSHOREBecause foreigner owning something in India, without coming to India oropening office in India.

DERIVATIVE

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 dependingon how the prices of Indian securities move.

INSTRUMENT Self-explanatory- this is one type of financial instrument to invest abroad.




5/12

1992: SEBI had permitted P-notes, to boost foreign investment in India, after BoP crisis of1991.

P-note owner doesnt own the shares. (because theyre in the DEMAT account of thatintermediary 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. HSBCreturns principal + profit to Tom, after cutting commission. Tom returns the P-note receiptto HSBC.

2. Sell this P-note receipt to another foreigner say Jerry. Then Jerry again has same twooptions.

Why Ban Participatory Notes (P-notes)?

As of March 2014, Foreigners invested ~Rs. 2 lakh crore in India via P-notes. (this is13% of the total FII money coming in India)

As such the FII has to disclose P-note owner data to SEBI on quarterly basis (every 3months). But often, within 3 months the P-notes would have changed many hands (e.gTom to Jerry to Micky to Goofy).

Thus P-note investments are Anonymous. Hard to trace the owner. Can be used for moneylaundering and terror financing.




6/12

Hot Money: can leave Indian market very soon based on just one phone call from TomCruz to HSBC. Hot money creates heavy rise or fall in share market, so even genuineinvestors 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 profit.

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 first send their money to Cayman Islands, BritishVirgin Islands, Switzerland, or Luxembourg via Hawala operators. Then, their agentsconvert rupees to dollars, re-invest it in Indian market through P-notes. It is possible tohide the identity of the ultimate beneficiaries, 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 inIndian stockmarket, and using the same profits to finance terror operations against India.They may use this mechanism to first boost Indian stockexchage, then collapse it byquickly 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 itto dollars in a tax haven, to buy P-notes via a post office 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 profit 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 getPAN+DEMAT. Only then, they canbuy/sell Indian shares.

Tom sells this P-note to Jerry @profit. Jerry** doesnt need to pay CGT to Indian

Government, because we cannot tracewhat Tom did with that piece of paper inUSA!

Even if P-note is sold 10 times to 10different people, we cannot get CGT.

Well get CGT only once, when the saidp-note owner instructs the FII to sell theshares from its Indian DEMAT account/

portfolio.

If Tom sells his shares to Jerry (andmakes profit), then Jerry** will haveto pay Capital gains tax to India.

Because Income tax official can traceit 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 realitythe buyer (Jerry) has to cut down the amount from payment to Tom, and give directly togovernment. Recall the Tax deduction at source (TDS) concept in Nokia controversy articleclick me.




7/12

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 willapply 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 profit here:

Price per sharequantity total

Tom Sold 1200 5000 (+) 60,00,000 (because he received $$)

Tom bought back 1000 5000 (-) 50,00,000 (because he paid $$)

Toms profit $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




8/12

(because hell have to buy higher priced shares and return to Broker Bruce Willis.) adBroker Bruce Willis will make profit. (Because he will receive shares whose market pricehas now increased.)

For short-selling trick to yield result, you need massive quantity of shares. (If I sell 1 kiloonion from my kitchen, it wont bring down prices in theMandi. I need atleast a 1000 kilo,to change the supply-demand and prices.)

Therefore, Hedge funds dont accept aam-admiin their game. They only allow High

Networth Individual to join the game, who can finance such large purchases and have deeppockets 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 @$1200.

Whats Toms profit here?

Earned (+) $1200 by selling shares

invested (-) $500 from his own pocket

borrowed (-)$500 principal to friend

interest (-) $50 interest to friend

Profit $150

** Shares price can go up for variety of reasons.

company expected to make good profit (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 (Becausehell have to return $550 to the friend at some point).

#3: Arbitrage

When same thing sells for different rates in two markets, Tom can take advantage of arbitrage,to make profit.

New York stock exchange California Stock Exchange

1 facebook share sells@1000 (on todays date)

Some investor is willing to make future-contract: Ill buy1000 facebook shares @ $1200 3 months from now.

He wants future contract because right now he doesnt havemoney or xyz reason.




9/12

In this case, Tom will purchase 1000 shares of Facebook from NY and simultaneously makefuture contract with Californian investors ok Ill sell you the shares @ $1200 after threemonths.

This Toms profit: $200 x 1000 Nos. = $2 lakh Dollars.

Although in real life, the arbitrage is so narrow Tom will have to apply leverage, to makesignificant profit. Example

NewYork: $1000 / per Facebook share California: $1002 / per Facebook share.

Here only $2 profit per share

If Tom wants to make $2,00,000 profit, 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 seesubstantial profit. Tom Cruz may have excellent brain but hed need High Networth Individualslike 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 first apply Short selling technique in New York so that Facebook price falls down

at 1000. ($2 profit) Then he uses arbitrage between NY and Cali to make additional profit. ($2) So 2+2 = 4$ profit per share. Imagine if he bought 1 lakh shares like this.

Mock Question

Q1. Find correct statements about the new classification of foreign portfolio investors by

SEBI

1. the entities with higher risk profile and lower KYC compliance, are put under categoryThree

2. alternative investment funds are put under category one

3. University endowment funds are put under category Two

Answer choice

1. only 1 and 22. only 2 and 33. only 1 and 34. All of them

Q2. Find the incorrect statements about the classification of alternative investment funds

by SEBI




10/12

1. Entities with positive externality on Indian economy, are put under category three2. infrastructure funds are put under category two3. hedge funds are classified as alternative investment funds category III.

Answer choice

1. only 22. only 1 and 23. only 2 and 34. 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 volatile2. Indian Sensex may become volatile3. India may run into another balance of payments crisis

Answer choice

1. only 1 and 22. only 2 and 33. only 1 and 34. All of them

Q4. Find incorrect statement

1. An foreign portfolio investors can buy only a fixed 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 commoditytrading exchange, if owns sufficient 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 buycorporate bonds

2. An NRI need needs to register himself as a foreign portfolio investors, if he wishes to buygovernment bonds

3. An NRI is prohibited from buying Treasury bills.

Which of them are incorrect?

1. Only 2

2. only 1 and 23. only 2 and 34. 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 profile, SEBI doesnt permit foreign hedge funds to operate in India.




11/12

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 first.

Which of them are correct?

1. only 1 and 22. only 2 and 3

3. only 1 and 34. 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. Profit 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. Profit 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. Profit due to difference between two stock indexes e.g. SENSEX vs NIFTY.




12/12

3. Profit 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 fight against money

laundering and terror finance?

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 find the incorrect statement viz. statement #2

3. D all of them.

4. Answer C. You were required to find 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. D12. C price difference between two markets.

Visit Mrunal.org/EconomyFor more on Money, Banking, Finance, Taxation and Economy.

URL to article: -funds-hedge-notes-p-notes-participatory-http://mrunal.org/2014/06/economyexplained.html-refi-fpi-fii-limits-new

Posted By Mrunal On 18/06/2014 @ 15:27 In the category Economy


economy participatory notes p notes h

Documents