Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI, REFI Explained
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Transcript of Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI, REFI Explained
Mrunal http://mrunal.org
[Economy] Participatory Notes (PNotes), Hedge Funds, New Limitson FII, FPI, REFI explained
Posted BySupport StaffOn 18/06/2014 @ 3:27 pm In Economy | 99 Comments
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 (PNotes)?
1. Why Ban Participatory Notes (Pnotes)?2. PNotes, Money laundering & Terror Financing3. Pnotes 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: RegisteredForeign PortfolioInvestor
effective from June 1, 2014 effective fromMarch 19, 2014
Includes
FII: Foreign institutional investor, their subaccountsQFI: Qualified Foreign Investor
same as SEBI
NRI excluded same as SEBICan trade in Indian shares, bonds, debentures, derivatives same as SEBISEBI: investment limit
cannot buy treasury billscan hold maximum 10% shares in a companyDoesn’t apply retrospectively. Example If FII HSBC already owns11% of Infosys shares (before 1/June/2014), they don’t need tosell 1% to get back in 10% limited.(FMC rule) Cannot become board of director in any Indiancommodity exchange.
investment limit
Government bonds: 25billioncorporatebonds: 51billion
have to register themselves as “FPI”, in any SEBIapproved DesignatedDepository Participants (DDP) —
further classification into three categories (Given below) nope
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 government’s financial Institutions (e.g. American equivalents of UTI,EPFO, LIC)This is category 1 because least risky and best KYC compliance in their homecountry.Can issue/buy/sell Participatory Notes (PNotes)
CATII
Foreign country’s Mutual Fund, Pension Fund, University endowment fundCan issue/buy/sell Participatory Notes (PNotes), except certain riskyinstitution listed by SEBI.
CATIII
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 Pnotes 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) classificationAIF
Category Examples impact on Economy
1
1. angel investors2. venture capital
funds,3. small and
mediumenterprises(SME) funds,
4. social venturefundsinfrastructurefunds
Positive. They help new entrepreneurs, startup companiesand infra. Development
2
Those not in thecategory 1 or 2
Private equityfundsdebt funds
Mixed. They use leverage only for day to day requirements.Hence less dangerous than Hedge Funds. (leverageexplained in appendix).
3 Hedge funds They pose systematic risk to Indian market, due to complextrading strategies. (explained in the Appendix)
What are Hedge funds?
You’re 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 tradingtechniques are far more complex than mutual funds, hence Hedgefunds can make money even with sharemarket going down.
Difference between Hedge Fund & Mutual fundHedge 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 fundCategory III.”
registered as “Asset Managementcompanies (AMC)”
They prefer to invest in risky bonds and shares (Becausehigh risk=high return) e.g. Shares of Kingfisher and Cgraded Bonds of Somalian Government.
They usually stick to shares andbonds of reliable companies.
They apply techniques such as leverage, shortselling and arbitrage to make high profit (explainedin the appendix of this article).So, even when sharemarket is going down, HedgeFund would continue giving high return to investor.
Mutual funds provide high returnonly when sharemarket is goingup.
They also play in derivative instruments such as Pnotes (explained after few para.)although hedge funds can no longer play in Pnotes.Because SEBI classified foreign hedge funds intoCAT III FPI.
As such, they don’t play intoPnotes.But if foreign mutual fundgiven CAT II status, theymay play in Pnotes.
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 frominvestors, he can speculate in securities worth 200crores. (Twice the amount)…But for T+2 system only meaning within two dayshe should settle the transaction.
SEBI regulation very strict.A mutual fund managercannot do high levelspeculation like a hedgefund manager.
What is Participatory Note (PNotes)?
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, thenhis 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. They’ll be stored in DEMAT account of HSBC, and won’t begiven to Tom.But HSBC then gives a receipt to Tom listing the shares/bonds purchased on his behalfand stored in HSBC’s DEMAT account.This receipt is called Participatory Note.Technically, it is called “offshore derivative instrument”. Observe the words
OFFSHORE Because foreigner owning something in India, without coming to India oropening office in India.
DERIVATIVE
Because this receipt doesn’t have value of its own.It “derives” its value from the market value of shares/bonds held byHSBC. Today it may be worth $1000, tomorrow $12000 dependingon how the prices of Indian securities move.
INSTRUMENT Selfexplanatory this is one type of financial instrument to invest abroad.
1992: SEBI had permitted Pnotes, to boost foreign investment in India, after BoP crisisof 1991.Pnote owner doesn’t own the shares. (because they’re in the DEMAT account of thatintermediary FII)PNote owner doesn’t have voting rights in the shareholder meetings
Where is the profit in Pnotes?
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 Pnotereceipt to HSBC.
2. Sell this Pnote receipt to another foreigner say Jerry. Then Jerry again has same twooptions.
Why Ban Participatory Notes (Pnotes)?
As of March 2014, Foreigners invested ~Rs. 2 lakh crore in India via Pnotes.(this is 13% of the total FII money coming in India)As such the FII has to disclose Pnote owner data to SEBI on quarterly basis (every 3months). But often, within 3 months the Pnotes would have changed many hands (e.gTom to Jerry to Micky to Goofy).Thus Pnote investments are Anonymous. Hard to trace the owner. Can be used formoney laundering and terror financing.
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 I’ll 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.
PNotes, Money laundering & Terror Financing
Finance Ministry Whitepaper: Indians first send their money to Cayman Islands,British Virgin Islands, Switzerland, or Luxembourg via Hawala operators. Then, theiragents convert rupees to dollars, reinvest it in Indian market through Pnotes. It ispossible to hide the identity of the ultimate beneficiaries, because of these multiple layers.Thus, Pnotes are used in money laundering.ExNational security Advisor MK Narayan: Terrorists are using Pnotes 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 affordcreating volatility in Indian market? Ans. Via printing fake Indian currency, converting itto dollars in a tax haven, to buy Pnotes via a post office company!RBI’s Tarapore Committee: Recommended Banning Pnotes for national securityand to stabilize stock exchanges
Pnotes 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 Pnotes. Observe:
With PNotes Without Pnotes
Tom can buy Indian shares via FII via pnotes.Tom and Jerry have to getPAN+DEMAT. Only then, they canbuy/sell Indian shares.
Tom sells this Pnote to Jerry @profit.Jerry** doesn’t need to pay CGT to IndianGovernment, because we cannot trace whatTom did with that piece of paper in USA!Even if Pnote is sold 10 times to 10 differentpeople, we cannot get CGT.We’ll get CGT only once, when the said pnote owner instructs the FII to sell the sharesfrom its Indian DEMAT account/ portfolio.
If Tom sells his shares to Jerry (andmakes profit), then Jerry** willhave to pay Capital gains tax toIndia.Because Income tax official cantrace it by monitoring the DEMATactivity of both accounts.
**In theory, the seller has to pay the Capital gain tax (Tom Cruz in our case). but inreality the buyer (Jerry) has to cut down the amount from payment to Tom, and givedirectly to government. Recall the Tax deduction at source (TDS) concept in Nokiacontroversy article click me.
ParthsarathiShome
Government must tax such Pnote holders from next budget2014.Shome is a tax expert, he earlier chaired the Committee onGAAR.
Appendix: How Hedge funds make money?
Suppose, Mr.Tom Cruz runs a hedge fund for High net worth Individuals (HNI) ArnoldSchwarzenegger 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; andimmediately sells them in share market.Now, Facebook share price will fall to say $1000 (imagine sudden supply of new onionsin the market)Tom buys 5000 facebook shares @$1000 from another investor, and returns them tobroker Bruce Willis.What’s Tom’s profit here:
Price per sharequantity totalTom Sold 1200 5000 (+) 60,00,000 (because he received $$)Tom bought back 1000 5000 () 50,00,000 (because he paid $$)Tom’s 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(because he’ll 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 shortselling trick to yield result, you need massive quantity of shares. (If I sell 1 kiloonion from my kitchen, it won’t bring down prices in the Mandi. I need atleast a 1000kilo, to change the supplydemand and prices.)Therefore, Hedge funds don’t accept aamadmi in their game. They only allow HighNetworth Individual to join the game, who can finance such large purchases and havedeep pockets to suffer large losses.
#2: Leverage
Suppose Tom has only $500 and wants to bet in $1000 worth shares.
his own pocket $500borrows 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 share’sprice goes up** and Tom is able to sell them @$1200.
What’s Tom’s profit here?
Earned (+) $1200 by selling sharesinvested () $500 from his own pocketborrowed ()$500 principal to friendinterest () $50 interest to friendProfit $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 companyIf Tom himself starts buying large amount of shares (imagine scarcity of onions).
Again, this is a risky game, if Share prices doesn’t rise, Tom will make huge losses (Becausehe’ll 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 today’s date)
Some investor is willing to make “futurecontract”: I’ll buy1000 facebook shares @ $1200 3 months from now.”He wants future contract because right now he doesn’t havemoney or xyz reason.
In this case, Tom will purchase 1000 shares of Facebook from NY and simultaneously make
future contract with Californian investors “ok I’ll sell you the shares @ $1200 after threemonths”.
This Tom’s 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 shareCalifornia: $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 largequantity.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 inNY and $1000.40 in Cali. So, here Tom has to buy even bigger quantity (Ten lakh shares) tosee substantial profit. Tom Cruz may have excellent brain but he’d need High NetworthIndividuals like Arnold & Leonardo to provide him the necessary funding. Thus, Hedge fundsemerged.
Going even complex:
NewYork: $1002 / per Facebook shareCalifornia: $1002 / per Facebook share
How can Tom make money here?
He’ll first apply “Short selling” technique in New York so that Facebook price falls downat 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 portfolioinvestors 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 one3. 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 alternativeinvestment funds by SEBI
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 doesn’t put any restrictions onforeign 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 he’s 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 B4. 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 22. 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 doesn’t permit foreign hedge funds to operate in India.
Which of them are correct?
1. Only 32. only 1 and 23. only 2 and 34. only 1 and 3
Q7. PNotes is a/an ____.
1. Alternative investment instrument2. Alternative derivative instrument3. Offshore derivative instrument4. Offshore equity instrument
Q8. Who uses Pnotes?
1. Entities that want to raise capital from abroad but can’t, due to ADR/GDR/ECB relatednorms.
2. Entities that want to raise capital from abroad but can’t 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 pnotes to invest in India.2. Only NRIs can use Pnotes to invest in India.3. IF a person wants to invest via Pnotes, he needs to get a PAN card first.
Which of them are correct?
1. only 1 and 22. only 2 and 33. 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.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 moneylaundering and terror finance?
2. (interview) SEBI should completely ban Pnotes. What’s your opinion?
Correct Answers for MCQs
1. Answer C only 1 and 3 correct. Alternative investment fund is a different thing2. Answer A. You were required to find the incorrect statement viz. statement #23. 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 funds11. D12. C price difference between two markets.
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