A whopping Rs 4,50,000 crore was pumped into the Indian stock markets by foreign investors in 2007 through instruments or products which many view as opaque, but no one, including market regulator Securities and Exchange Board India, seemed to know much about the identity of these investors or the source of the money. There was suspicion of money laundering and round tripping, or simply money which was taken out illegally coming back in legal form.
This money was invested through participatory notes (P-Notes) which are derivative instruments issued in foreign jurisdictions by a foreign institutional investor, its sub-accounts or one of its associates, against underlying Indian securities. P-Notes survived over the years, putting a question mark over the generation and circulation of unaccounted wealth in the economy.
Last week, days after the government announced changes in the Indo-Mauritius Double Taxation Avoidance Treaty or DTAA, Sebi stipulated that Indian KYC (know your customer) norms would be applicable to all issuers of offshore derivative instruments including P-Notes and these rules would be the same as that for all other domestic investors. Earlier, P-Note issuers had the choice of following either Indian or foreign KYC norms. The regulator also wants P-Note issuers to report all transactions that happen during a month (compared to only end of month holdings) in their monthly reports.
P-Notes currently account for about 10 per cent of the total FPI inflows, against 51 per cent in 2007. In absolute terms, investments made through P-Notes during March 2016 were Rs 2.23 lakh crore compared with over Rs 4.5 lakh crore in October 2007. While Indian regulators had very few details about the source of funds and the identity of foreign investors putting money in P-Notes, domestic investors were told to disclose full details about their funds and identity while buying into Indian stocks. In short, there was no level-playing field.
The Special Investigation Team (SIT) on black money, in its third report released on July 24, 2015, said since P-Notes are traded overseas outside the direct purview of Sebi surveillance, there is “apprehension about the beneficial ownership and the nature of funds invested in these instruments”. Some of the money coming into the market through P-notes could be the unaccounted wealth camouflaged under the guise of foreign institutional investor (FII) investment. SIT report said obtaining information on “beneficial ownership” of P-Notes is crucial to prevent their misuse.
The SIT report said that as on February 2015, investment through P-Notes stood at Rs 2.715 lakh crore and the top five locations of end beneficial owner of the outstanding investments were Cayman Islands (31.31 per cent, the US (14.20 per cent), the UK (13.49 per cent), Mauritius (9.91 per cent) and Bermuda (9.10 per cent).
“A major chunk of outstanding ODIs invested in India are from Cayman Islands — i.e. 31.31 per cent. This translates to roughly Rs 85,006 crore. Cayman Islands had a population of 54,397 in 2010, according to Wikipedia. It does not seem conceivable that a jurisdiction with a population of less than 55,000 could invest Rs 85,000 crore in one country. The main point of the above elaboration is just that it does not appear possible for the final beneficial owner of ODIs originating from Cayman Islands to be from that jurisdiction,” the SIT report said.
With P-Notes now becoming transparent, a major loophole for entry of suspected illicit money has been plugged. “The new norms are in line with suggestions made by the SIT report. These changes will not only make the route difficult to access India market but also make it more expensive. Offshore derivative instruments (ODI) issuers will have to put in place a robust mechanism to track end beneficial owner,” said Suresh Swamy, Partner, PwC India.
The government has been seeking to regulate P-notes since the time they were introduced in 1995. The Reserve Bank of India (RBI) has always been opposed to P-Notes as such instruments make it impossible to know the actual beneficiaries.
In 2007, when investments through P-Notes were at their peak, Sebi for the first time attempted to phase out these instruments. P-Notes then accounted for 50 per cent of total foreign holdings. In continuation of its crackdown on P-Notes, the capital markets regulator in 2014 said P-Notes can be issued only to investors coming from jurisdictions that have anti-terror funding norms and anti-money laundering norms.
With Sebi tightening norms last week, money laundering and round tripping through P-Notes investment will be tough. More importantly, it will be a test of the quality of portfolio flows and whether it is of an enduring nature or in other words — money which is for the medium and long haul.