For years, participatory notes (PNs) have been seen as a way for dodgy money to come into Indian capital markets—often enough, it is believed this money belongs to Indians who send it overseas through the hawala route and then bring it back through the stock markets and make it white money. Which is why, in its third report, the Special Investigation Team (SIT) on black money had red-flagged this.
Of the Rs 2.7 lakh crore of PNotes outstanding in February 2015, the SIT found 31% came from the Cayman Islands. In the case of PNotes issued from the Cayman Islands, SIT said, it was impossible that a nation with 55,000 people could possibly invest Rs 85,000 crore in India. While PNotes were difficult to stop at a time when a lot of foreign investment came in through this route, as more FPIs registered with Sebi, it became easier to tackle such inflows. So, over a period of time, Sebi insisted on knowing the name of the end beneficiary of the PNotes and also said that no PNotes could be issued to entities that were not registered with the regulators of the countries they were incorporated in.
While this reduced the amount of money coming in through the PNote route, from Rs 2.3 lakh crore in January 2016 to Rs 1.7 lakh crore in April 2017—in terms of the assets of all FPI, this means a fall from 10.5% to 6%—even this is not enough since, with PNotes freely transferrable, keeping track of the end beneficiary is not easy.
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Going by its latest consultation paper, Sebi seems to be trying to tackle the problem in parts. To begin with, it wants to levy a fee of $1,000 on each participatory note issued. This, Sebi’s consultation paper argues, will discourage investors from coming in via this route and, instead, simply register with Sebi as FPIs. In addition, Sebi also wants to ban participatory notes that are used purely for speculative purposes—according to Sebi data, around a fourth of all PNotes issued fall under this category.
At Rs 40,000 crore, Sebi’s logic is probably that the amount is not large enough to make a material difference to the market—if any Sebi action spooks the market, this will defeat the purpose. And, presumably, when the flow of PNotes also become smaller in both absolute and relative terms—PNotes issued against equity are currently Rs 109,000 crore—Sebi could even think of banning them altogether.