Context

Foreign portfolio investors (FPIs) domiciled at the GIFT International Financial Services Centre (IFSC) and registered with the Securities and Exchange Board of India (SEBI) have been allowed to issue participatory notes (P notes).

IFSCA Permits Non-Bank FPIs at GIFT City to Issue Participatory Notes and ODIs

• Investment Landscape at GIFT City: At present, the International Financial Services Centre Authority (IFSCA), the unified regulator for GIFT City, allows banking units to issue P-notes.
  • Besides offshore bank units investing in securities in Indian stock exchanges, other entities primarily investing in listed markets are the funds in IFSC registered as FPIs.
• Regulatory Changes as per IFSCA Circular: Initially, only banking units registered with SEBI as FPIs were permitted to issue derivative instruments with Indian securities. 
  • Now, non-bank entities registered with IFSCA and SEBI as FPIs are also allowed to issue derivative instruments with Indian securities as underlying, within GIFT-IFSC.
• Need for Tax Relaxations: Although the IFSCA has permitted all IFSC entities to issue Offshore Derivative Instruments (ODIs) to non-resident investors, adjustments in tax regulations would be necessary to extend the exemption to investors from Indian taxation. 
  • There is a need for an exemption of capital gains on transfer of ODIs by the non-resident investors as well as for any distribution by ODI issuers.

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Significance

• Boost to Offshore Derivative Instruments (ODIs) Issuance: Allowing P-Note issuance from GIFT City could potentially enhance their attractiveness, provided that the rules around taxation are eased.
  • Currently, about 46 FPIs are domiciled at the GIFT IFSC. 
• Advantages of ODIs for Non-Banking FPIs at GIFT City: This presents an opportunity for non-banking FPIs located at the IFSC with substantial assets under custody (AUC) to offer ODIs to international investors. 
  • ODIs provide a major benefit of confidentiality to investors, which is highly appealing to many. 
  • When combined with the leverage permitted at the GIFT City, ODIs create a compelling argument for an increase in trading volume among GIFT City FPIs.
•  Expanding Investment Opportunities at GIFT City: AIFs with FPI registration can also issue ODIs. This issuance allows FPIs to hedge their risks and provides ODI holders with exposure to Indian equities and instruments.
  • Recent regulatory changes could give a fillip to FPI activity from the GIFT City.

Foreign investment in India

This can broadly be classified into two categories: Foreign direct investment (FDI) and investment made by foreign institutional investors (FIIs).

• There are strict guidelines laid down by market regulator SEBI for seeking approvals and documentation for FDI. There are several restrictions laid down on the exit of this money.
• On the other hand, FII is mainly characterized as portfolio investment i.e. quick money entering the Indian capital market for short-term.  Due to its short-term nature, there are fewer guidelines on FII than on FDI. 

Foreign Portfolio Investment (FPI)

FPI involves an investor buying foreign financial assets. It involves financial assets like fixed deposits, stocks, and mutual funds.  All the investments are passively held by the investors. 

• Investors who invest in foreign portfolios are known as Foreign Portfolio Investors.

Categories of FPI:

• Category I: This includes investors from the Government sector. Such as central banks, Governmental agencies, and international or multilateral organizations or agencies.
• Category II:This includes regulated broad-based funds such as mutual funds, investment trusts, insurance/reinsurance companies.
• It also includes regulated banks, asset management companies, portfolio managers, investment advisors, and managers.
• Category III: It includes those who are not eligible in the first two categories. It includes endowments, charitable societies, charitable trusts, foundations, corporate bodies, trusts, individuals

Participatory notes/P-notes: Offshore Derivative Instruments

Participatory notes/p-notes are used for making investments in the stock markets. However, they are not used within the country. They are used outside India for making investments in shares listed in the Indian stock market. Thus, they are called offshore derivative instruments.

• Issuance: They are issued by brokers and FIIs registered with SEBI. The investment is made on behalf of these foreign investors by the already registered brokers in India. 
  • For example, Indian-based brokerages buy India-based securities and then issue participatory notes to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors.
• Need for Participatory Notes: Overseas investors who are not registered with SEBI have to go through a lot of scrutiny, such as know-your-customer norms, before investing in Indian shares. To avoid these hurdles, foreign investors take this route.
  • Since the end beneficiary of these notes is not disclosed, many investors who want to remain anonymous use it. 
• Significance: These notes allow foreign high net worth individuals, hedge funds, and other investors to put money in Indian markets without being registered with SEBI, thus making their participation easy and smooth. 
  • P-Notes also aid in saving time and costs associated with direct registrations. 
• Current Market Trend: They were of immense popularity prior to 2007 when nearly half of the foreign flows came through this route.
  • However, they lost their appeal following tightening of norms around identification of their end beneficiaries and easing of FPI registration norms. 
  • Currently, P-notes account for around 2 per cent of the total AUC of FPIs.

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Advantages of Participatory Notes

• Anonymity: Any entity investing in participatory notes is not required to register with SEBI, whereas all FIIs have to compulsorily get registered. 
  • It enables large hedge funds to carry out their operations without disclosing their identity.
• Ease of trading: Trading through P-notes is easy because they are like contract notes transferable by endorsement and delivery.
• Tax saving: Some of the entities route their investment through participatory notes to take advantage of the tax laws of certain preferred countries.

Disadvantages of Participatory Notes

• Regulatory Oversight: SEBI has no jurisdiction over P-note trading and thus, no way to know who owns the underlying securities. 
  • It is alleged that a lot of unaccounted money made its way to India through the P-note route.