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All you wanted to know about PNs
October, 25th 2007

Now that PNs with underlying derivatives have to be withdrawn in 18 months, it is likely that there may be some choppy sessions ahead but the volatility should pan out very soon.

Mr Sunil Rongala is a Hyderabad-based economist.

A search for PN on yields 37 results, beginning with pain (physiology). The rest include part number, Pitcairn Island, planetary nebulae, pseudo noise, peripheral neuropathy, practical nurse, proton neutron, portable network, primitive notion, and project nothing.

Participatory note or PN was a fairly unknown term to most people, including those who invested in the stock market, observes Mr Sunil Rongala , a PhD in economics, in a discussion with Business Line on the currently hot topic.

It has been about a week since the market regulator SEBI (Securities and Exchange Board of India) decided to crack down on PNs. And suddenly we realised the power that PNs have over the Indian stock market. They (the holders of PNs) decided to go in for a mass sell-off after SEBI decided to impose sanctions on them, recounts Mr Rongala.

Excerpts from an e-mail interview, in which he dwells upon what it is about PNs that has inspired so much fear and loathing.

First, what are PNs? defines participatory notes as Financial instruments used by investors or hedge funds that are not registered with the Securities and Exchange Board of India to invest in Indian securities.

Brokerages buy India-based securities and then issue participatory notes to foreign investors, it adds. Any dividends or capital gains collected from the underlying securities go back to the investors. The kind of people/institutions that can invest in PNs can be found at in/faq.

What is key in the PN definition?

The most important part that needs to be observed in the definition is investors or hedge funds that are not registered with the Securities and Exchange Board of India. This is a big deal.


Imagine you or I try to open a demat or trading account with any firm. When anyone in India tries to open a demat or trading account, they have to give ID proof and address proof. In business its known as KYC, or know your client.

In essence, it means that companies, especially financial entities, should know the character of their client. What it means is that they should know whether their client is real or someone with questionable credentials.

How does that apply to PNs?

When PNs are first sold, they are sold to someone SEBI knows but then they are sold in the market and they can be, and are, purchased by people/institutions that SEBI does not know about. These people, who can trade them, do not have to register with SEBI or anyone. They can participate in the Indian bourses, using FIIs (foreign institutional investors) as intermediaries; but they are essentially faceless and SEBI will never know who these investors are.

Does that create any problems?

Yes, a problem for the integrity of the Indian bourses. Integrity here not only means honesty but also structural integrity.

Hypothetically, people who are against the success of India can invest large sums in the Indian market and then pull them out all of a sudden, causing mass panic.

Now, this is not to suggest that all the investments coming in through the PN route are shady but it does certainly give us food for thought.

Are PNs massive enough to be of concern?

PNs have been exploding in India. SEBI estimates that the total foreign stake in Indian companies in August 2007 was around Rs 6.9 lakh crore, of which Rs 3.53 lakh crore (51.6 per cent of the AUC or assets under custody) is through PNs. Compared to the outstanding PNs of Rs 31,875 crore (20 per cent of total AUC) in March 2004, this is an amazing 11 times growth.

What accounts for the fast growth of PNs in recent times?

One of the reasons why PNs have grown so rapidly in India is because of the regulations that SEBI has imposed on those who can register as FIIs.

The regulations also exclude hedge funds from becoming FIIs. This means that hedge funds see PNs as a perfect conduit to investing in India. As of now there are 34 FIIs that issue PNs.

Another obvious reason for routing money through PNs is the anonymity it affords. Both the above issues have conspired to drive the massive rise in PNs.

Are there different types of PNs?

There are two kinds of PNs spot-based, and derivatives/futures-based (also known as ODIs, offshore derivative instruments), meaning that they are based on other underlying instruments. The latter accounts for around 32-33 per cent of all total outstanding PNs.

Why did SEBI have to do what it did?

Now everyone knows that SEBI placed regulations on PNs. But it must also be stated that it resisted doing so for a while.

What happened, in essence, was that it was under considerable pressure from both the RBI (Reserve Bank of India) as well as the Finance Ministry.


The RBI was and is deeply concerned about the rapid appreciation of the rupee caused by huge net FII inflows. The net FII investment in India in 2007 stands at over $12 billion currently. The Finance Ministry was concerned about the galloping stock market. The Sensex went from 18,000 to 19,000 in four trading sessions and the Finance Minister expressed concern over that.

He cautioned that if there was a break in the stock market bubble, it could and would have catastrophic effects on the real economy. Obviously both were justified in forcing SEBIs hand.

So, the market regulator brought in controls?

Thats right. The changed regulations that SEBI put in place, as you may be aware, were:

FIIs and their sub-accounts shall not issue/renew ODIs with underlying as derivatives with immediate effect. They are required to wind up the current position over 18 months.

Further issuance of ODIs by the sub-accounts of FIIs will be discontinued with immediate effect.

FIIs which are currently issuing ODIs with notional value of PNs outstanding (excluding derivatives) as a percentage of their AUC in India of less than 40 per cent shall be allowed to issue further ODIs only at the incremental rate of 5 per cent of their AUC in India.

Those FIIs with notional value of PNs outstanding (excluding derivatives) as a percentage of their AUC in India of more than 40 per cent shall issue PNs only against cancellation/redemption/closing out of the existing PNs of at least equivalent amount.

What next?

Thats the $64,000 question! We have already seen what will or could have happened. The markets tanked sharply and then rebounded again.

What has fundamentally changed is that it is very unlikely we will see FII inflows the way we have seen them in the past few months. Thats a near given considering that outstanding PNs account for over 51 per cent of foreign money in India. The other fact is that FIIs control most of the floating stock in the bourses.

Do they?

There have been estimates made that show FIIs, including PN-holders, owning around 15-20 per cent of stock of the top 1,000 companies in the bourses. Now consider the promoters; they own over 50 per cent but those shares rarely ever come into the market. That means that the FIIs have had a near ruling of the market. In effect, they control the market because they not only own a chunk of floating shares; they are also the most active.

If you look at the correlation between net FII flows and the market indices, there is a near-perfect positive correlation, suggesting very strongly that FIIs have a tight control on the market, if not a stranglehold.

Will the 18-month Damocles sword impact the markets?

Now that PNs with underlying derivatives have to be withdrawn in 18 months, it is likely that there may be some choppy sessions ahead but the volatility should pan out very soon. The volatility should reduce because derivative-based PNs are highly leveraged something that contributes to volatility.

It should also mean that the hedge funds, which have been fairly responsible for this steep rise in the market, might exit the market because SEBI will never let them register as FIIs.

The RBI can then heave a sigh of relief because the appreciation pressure on the rupee will slacken to a large extent. The Finance Ministry too will heave a sigh of relief because the danger of a full-scale bubble bursting has reduced to a good extent, if not fully.

We had a damage-control exercise a few days ago?

On October 21, SEBI said that sub-accounts (the mechanism through which FIIs issue PNs) could stay, provided they registered and, in effect, surrendered their anonymity. This is, however, a smart move by SEBI that will likely amount to nothing.

Why so?

SEBI knows that PNs are held by hedge funds and SEBI will not register hedge funds even if they wanted to register. (For starters, Encarta defines hedge fund as risk-taking investment company; an investment company that is organised as a limited partnership and uses high-risk techniques in the hope of making large profits.)

Is the move against PNs right?

Whether SEBIs decision to ban PNs was correct or not is a very tricky question. However, at the end of the day, the guiding principle should be whether the decision taken prevented a blow-up of the economy. Everyone will have his or her views but my view is that the decision taken was right. The question is a very philosophical one

Philosophical? Yes, because it comes right down to the heart of the issue of capital controls. Should the Government ban certain type of flows or should there be no capital controls? On a personal level, I believe that there should be no capital controls but that this ideal should not be placed on such a high pedestal that everything else becomes subservient to it. The only thing that should be placed on a pedestal is the macroeconomic well-being of the economy and everything else should become subservient to it.

Is this what you believe weighed the most, in the PN issue?

Yes. SEBI didn't want to ban PNs for several reasons and this let the markets stretch a bit too far. Economic graveyards are littered with the dead bodies of countries that let their stock markets enter a `bubble zone'; a zone where valuations couldn't possibly be justified by fundamentals. The funny thing about bubbles is that they always burst.

What makes PNs capable of hurting the markets?

The main issue or danger regarding PNs is that they are fairly dominated by hedge funds. These funds have only one objective in mind and that is to make lots of money in a short time. I'm not saying that it's a bad objective because the lord knows everyone of us has that objective. However, the key difference is that hedge funds can move a market to their whims while small investors cannot, so there are times that their objective can run opposite to what the regulators would like.

Does India fit in the scheme of hedge fund thinking? How?

Yes, perfectly. A country like India is ideal for hedge funds. Indian bourses are fairly shallow compared to other bigger bourses and that means a relatively less amount of money can move the market. When FIIs come into India with all guns blazing, it generally means that the markets will swing upward and vice-versa causing a lot of volatility. They are not called hot money for nothing. On a comparative basis, India has a very volatile stock market.

So, should India ban FII money?

I am not suggesting for a second that India should ban FII money. They should be let in but there should also be a leash placed on them. The only thing that should matter to regulators should be the well-being of the economy. And an over-inflated market is not conducive to that ideal.


Bio: Mr Sunil Rongala, a PhD in economics, is the co-author of `Asia in the Global Economy: Finance, Trade and Investment' (along with Mr Ramkishen S Rajan of George Mason University, US), a book to be released in 2008 ( Previously the Group Economist in the Chennai-based Murugappa Group, Mr Rongala is currently a research manager in an international partnership firm, in Hyderabad.

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