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Last Updated : Aug 08, 2015 01:08 PM IST | Source: CNBC-TV18

P-notes: Should regulators phase it out?

The experts argue that even though there are genuine p-note investors, more transparency needs to be brought in to the whole process.

For the fourth time in last 15 years, financial markets have been faced with a familiar question - should participatory notes be phased out?

Participatory notes or P-Notes are offshore derivative instruments used by foreign investors who are interested in betting on Indian shares but not keen on registering with Securities and Exchange Board of India (SEBI).

Many say the black money stashed overseas is brought back through p-notes to prevent detection. Regulators, RBI and SEBI have always been uncomfortable with p-notes. In 2007, SEBI had banned new issue of p-notes, which was followed by a major crash in the stock market. Since 2011 SEBI has started a renewed effort to force P-Notes issuers to reveal a lot of information on buyers.

Former Sebi Chairman, M Damodaran told CNBC-TV18 that the market regulator must know who is investing in the market lack of which can lead to problem of black money.

However, G Padmanabhan, former Executive Director of RBI said that most of the investors are genuine who is either pension or hedge fund holders. Most of p-note holders are genuine as per the court as well, he said.

Better option is to ensure investors can freely and easily access the Indian market, said Pramod Gubbi, Director-Institutional Sales at Ambit Capital adding that investors will find some other way to enter the market using some other instrument.

Below is the transcript of M Damodaran, G Padmanabhan & Pramod Gubbi's interview with Latha Venkatesh on CNBC-TV18.

Q: Do you think that even without the problem of black money the very fact that we are asking Swiss banks not to encourage the practice of hiding the names of customers. We have no moral right to continue with these notes?

Damodaran: The special investigation team (SIT) said that the market regulator should know who is investing in the market. You should have that information because in the absence of information there is a possibility of black money generation and that is the subject that the SIT is addressing, that is where the SIT's concerns come from. If you look at the history of this - 1992 you started seeing offshore derivative instruments. It continued without any check.

In 2004, SEBI said enough is enough, we gave you five years time - you wind down. Far from winding down, it increased to fairly high numbers, half way down that five year period. Therefore, in 2007, SEBI said no fresh issue and you get in 2009 which is your original timeline - from 2004 if you count then five years, to wind down.

It was intended to be a non-disruptive way of phasing out a non-transparent element from a market where the international community is asking for transparency. You are seeing evidence of it worldwide. Do you really need this instrument and my take on this has always been, if India is a growth story and people are investing in India because it is a growth story and you want to buy into the growth story, then register with SEBI and invest.

Q: In your estimate, who are the people who use P-Notes? At the moment, almost 90 percent or 88 percent of the foreign investment is happening through the Foreign Portfolio Investors (FPI) or the Foreign Institutional Investors (FII) route. Who are the kinds of people who prefer this 11 percent that come through the P-notes? Are they largely pension-funds? What kind of people are they?

Gubbi: They would largely be investors across all spectrums, but certain hedge funds would be the majority hedge funds who operate across different markets for whom getting registration in specific markets might be a course of doing business. Simply to avoid that they would engage with a certain P-Note issuer across multiple markets; just to keep it simple from a transaction perspective and get access to that market.

There is no malignant intention there irrespective of the nature of the fund. Whether, it is a pension fund or a hedge fund, my sense is it is the majority of our hedge funds who are quite nimble by the nature of their operations itself would want to keep it simple in terms of ease of transacting in multiple markets at the same time.

Q: That is one category.

Gubbi: That is right. There is a category of hedge funds who also operate across multiple markets, but some who genuinely choose, even if they could have taken an FII or an FPI route intentionally, a P-Note option to keep their identity anonymous when they are well known by the market and their transactions, when made public can move prices and can have a price impact on their own position building, which is why they would opt to come through P-Notes.

There are other markets globally which provide this anonymity to investors who genuinely want to build positions at very low market impact.

The last one which is what the SIT seems to be intending at is where the source of the money is perhaps not completely above board either through tax evasions or other purposes; who choose to sort of get into financial markets through these structures and genuinely want to keep their identity anonymous.

It is the small minority of such investors which is what the SIT is after. The majority of P-Note issuers are largely alright even from the court's perspective.

Q: The RBI grapples with the Non-Deliverable Forward (NDF) market, but you can't stop it. Do you think that structured products in some form will survive? If you phase out P-Notes then they are likely to continue as structured notes by another name and it will not even be told to the regulator?

Padmanabhan: Let me start by putting across what was Reserve Bank's concern way back when we said, in fact gave a dissent note to a committee set up by the government as to why P-Notes should be discouraged. In any of kind of market to maintain the integrity, there are three things which are important. Firstly, the becoming big issue is the beneficial ownership known.

Secondly, it is the question of market manipulation. The regulators tackle it through a near real-time monitoring. Is that real time monitoring possible as far as the P-Notes are concerned? The third issue is probably specific to India is of the round tripping issue where the tax evasion happens.

At that point of time, when the Reserve Bank objected to this the international scenario, the international rules and regulations were such that possibly all these concerns were genuine concerns. The question that we need to address today is whether we have been able to address this concern little better through various methods?

Thirdly, if we try to do anything to the existing market structure, will the market structure take as such or more because we have internationalised more. The international investor will find some other means to come back into the country through some other instrument call it P-Note, call it something else.

I think one of the lessons that we learnt as far as the currency is concerned which was your question is that probably we need to take measures to make sure that these investors have access to the Indian market more directly, easily, less documentation, less formalities and let them come in directly.

That possibly would be a better option to tackle this entire issue than trying to tackle through any kind of artificial restrictions.

Q: Last thoughts Mr G Padmanabhan, you think p-notes should go?

Padmanabhan: I hold the view that once we have implemented a product unless we find that the monitoring has become impossible, I don’t know whether today system of SEBI collecting this information on a monthly basis would suffice because the problem there would be within a month what happens as far as these transfers are concerned.

Q: Assuming they are able to ask for daily information?

Padmanabhan: Ask for this – if they are able to get that information, if they are able to manage this information then probably that would be the right way forward.

Q: So P-notes with regulation is what you will be comfortable with?

Padmanabhan: I would say that an eternal vigilance and an eternal and continuous improvement on the quality of oversight rather than a roll back would be the way forward as far as I am concerned. 

Q: Mr Damodaran?

Damodaran: I want to put a question to you after hearing all of this? Are we saying that no issuer has an agreement with the party to whom ODI’s are issued regarding protecting their anonymity of that investor? If that issuer has how is that issuer reporting to the regulator that I know to whom I wish would. Because there are there has been a history of issuers when asked saying sorry we can’t reveal because we don’t know. There is a lot of layering involved and we don’t know who ultimately it is. There is a fund that is bringing it to us and all of that.

Are we saying today all of that has been addressed and you will get information at the tap of a button from every jurisdiction, the word, keep p-notes? If that is not happening clearly they will be a small problem residing somewhere and I hope it doesn’t become big and become destabilising in the market. 

Padmanabhan: I also support the view that the destabilisation should not be the concern. I think today the market has the depth; India has the enough deepens to make sure that these blips can be tackled effectively, so that should not be the worry at all?

Q: That was all the market man’s view?

Damodaran: The real issue is as we saw in 2007 and he himself told you that he is from the market; even if you stop this it is not as if everybody will pick up the money and run. There will still be a lot of them that will be in your market. It is at the end of the day buying into the India’s story. That is the story.

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First Published on Aug 3, 2015 09:02 pm
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