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<ul><li><p>6/18/2014 Mrunal [Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI, REFI explained Mrunal</p><p>http://mrunal.org/2014/06/economy-participatory-notes-p-notes-hedge-funds-new-limits-fii-fpi-refi-explained.html/print/ 1/12</p><p>[Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI,REFI explained</p><p>1. Foreign Investment rules: SEBI Vs RBI1. SEBI new classification of FPI2. SEBI: Alternative investment fund (AIF) classification</p><p>2. What are Hedge funds?3. Difference between Hedge Fund &amp; Mutual fund4. What is Participatory Note (P-Notes)?</p><p>1. Why Ban Participatory Notes (P-notes)?2. P-Notes, Money laundering &amp; Terror Financing3. P-notes and CGT evasion</p><p>5. Appendix: How Hedge funds make money?1. #1: Short selling2. #2: Leverage3. #3: Arbitrage</p><p>6. Mock Question7. Correct Answers for MCQs</p><p>FII rules: SEBI Vs RBI</p><p>SEBI RBI</p><p>FPI: Foreign portfolio investorReFI: RegisteredForeign PortfolioInvestor</p><p>effective from June 1, 2014effective fromMarch 19, 2014</p><p>Includes</p><p>FII: Foreign institutional investor, their sub-accountsQFI: Qualified Foreign Investor</p><p>same as SEBI</p><p>NRI excluded same as SEBI</p><p>Can trade in Indian shares, bonds, debentures, derivatives same as SEBI</p><p>SEBI: investment limit</p><p>cannot buy treasury billscan hold maximum 10% shares in a companyDoesnt apply retrospectively. Example If FII HSBC already owns11% of Infosys shares (before 1/June/2014), they dont need tosell 1% to get back in 10% limited.(FMC rule) Cannot become board of director in any Indiancommodity exchange.</p><p>investment limit</p><p>Government bonds: 25billioncorporatebonds: 51billion</p><p>have to register themselves as FPI, in any SEBI-approved DesignatedDepository Participants (DDP)</p><p>further classification into three categories (Given below) nope</p><p>SEBI new classification of Foreign investors</p></li><li><p>6/18/2014 Mrunal [Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI, REFI explained Mrunal</p><p>http://mrunal.org/2014/06/economy-participatory-notes-p-notes-hedge-funds-new-limits-fii-fpi-refi-explained.html/print/ 2/12</p><p>Foreign Portfolio Investors (FPI), New classification is based on two criteria:</p><p>1. Risk profile: less risky means better category2. KYC compliance: better Know Your customer compliance means better category</p><p>FPI: Classification</p><p>CAT I</p><p>Foreign government.Foreign governments 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 (P-Notes)</p><p>CATII</p><p>Foreign countrys Mutual Fund, Pension Fund, University endowment fundCan issue/buy/sell Participatory Notes (P-Notes), except certain risky institutionlisted by SEBI.</p><p>CATIII</p><p>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 P-notes issued by CAT I or CAT II.cannot do above things even indirectly. (because SEBI order says so)</p><p>Donot confuse between these FPI vs alternative investment funds</p><p>SEBI: Alternative investment fund (AIF) classification</p><p>AIFCategory</p><p>Examples impact on Economy</p><p>1</p><p>1. angel investors2. venture capital</p><p>funds,3. small and</p><p>mediumenterprises(SME) funds,</p><p>4. social venturefundsinfrastructurefunds</p><p>Positive. They help new entrepreneurs, startup companiesand infra. Development</p><p>2</p><p>Those not in thecategory 1 or 2</p><p>Private equityfundsdebt funds</p><p>Mixed. They use leverage only for day to day requirements.Hence less dangerous than Hedge Funds. (leverageexplained in appendix).</p><p>3 Hedge fundsThey pose systematic risk to Indian market, due to complextrading strategies. (explained in the Appendix)</p></li><li><p>6/18/2014 Mrunal [Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI, REFI explained Mrunal</p><p>http://mrunal.org/2014/06/economy-participatory-notes-p-notes-hedge-funds-new-limits-fii-fpi-refi-explained.html/print/ 3/12</p><p>What are Hedge funds?</p><p>Youre 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 trading-techniques are far more complex than mutual funds, hence Hedge fundscan make money even with sharemarket going down.</p><p>Difference between Hedge Fund &amp; Mutual fund</p><p>Hedge Fund Mutual fund</p><p>Only High Net worth Individual (HNI) can enter this game</p><p>Indian hedge fund: 1 crore rupees (SEBI rule)Foreign (offshore) hedge fund: 5 lakhs dollars</p><p>Any investor welcome.e.g. SBImutual fund Rs.100 minimuminvestment required!</p><p>SEBI registers them Alternative Investment fund-Category III.</p><p>registered as Asset Managementcompanies (AMC)</p><p>They prefer to invest in risky bonds and shares (Becausehigh risk=high return) e.g. Shares of Kingfisher and Cgraded Bonds of Somalian Government.</p><p>They usually stick to shares andbonds of reliable companies.</p><p>They apply techniques such as leverage, short sellingand arbitrage to make high profit (explained in theappendix of this article).So, even when sharemarket is going down, HedgeFund would continue giving high return to investor.</p><p>Mutual funds provide high returnonly when sharemarket is goingup.</p><p>They also play in derivative instruments such as P-notes (explained after few para.)although hedge funds can no longer play in P-notes.Because SEBI classified foreign hedge funds intoCAT III FPI.</p><p>As such, they dont play intoP-notes.But if foreign mutual fundgiven CAT II status, theymay play in P-notes.</p><p>Indian: Karvi Capital, Motilal Oswald, IIFL,Edelweiss etc.Foreign: Goldman Sachs, JP Morgan</p><p>UTI, Reliance Money, SBI mutualfund etc.</p><p>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 days heshould settle the transaction.</p><p>SEBI regulation very strict.A mutual fund managercannot do high levelspeculation like a hedgefund manager.</p><p>What is Participatory Note (P-Notes)?</p></li><li><p>6/18/2014 Mrunal [Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI, REFI explained Mrunal</p><p>http://mrunal.org/2014/06/economy-participatory-notes-p-notes-hedge-funds-new-limits-fii-fpi-refi-explained.html/print/ 4/12</p><p>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, theninvest money from one country to another quickly, depending on how sharemarket moves.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, then hisprofit will decline- given the cost of running branch office, staff salary, DEMAT fees etc.in each country.So, to take a shortcut, Tom will contact some middleman who is already registered as anFII, has PAN card &amp; 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. Theyll be stored in DEMAT account of HSBC, and wont begiven to Tom.But HSBC then gives a receipt to Tom listing the shares/bonds purchased on his behalf andstored in HSBCs DEMAT account.This receipt is called Participatory Note.Technically, it is called offshore derivative instrument. Observe the words</p><p>OFFSHOREBecause foreigner owning something in India, without coming to India oropening office in India.</p><p>DERIVATIVE</p><p>Because this receipt doesnt 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 depending onhow the prices of Indian securities move.</p><p>INSTRUMENT Self-explanatory- this is one type of financial instrument to invest abroad.</p><p>1992: SEBI had permitted P-notes, to boost foreign investment in India, after BoP crisis of1991.P-note owner doesnt own the shares. (because theyre in the DEMAT account of thatintermediary FII)P-Note owner doesnt have voting rights in the shareholder meetings</p></li><li><p>6/18/2014 Mrunal [Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI, REFI explained Mrunal</p><p>http://mrunal.org/2014/06/economy-participatory-notes-p-notes-hedge-funds-new-limits-fii-fpi-refi-explained.html/print/ 5/12</p><p>Where is the profit in P-notes?</p><p>Tom has two options</p><p>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 P-note receiptto HSBC.</p><p>2. Sell this P-note receipt to another foreigner say Jerry. Then Jerry again has same twooptions.</p><p>Why Ban Participatory Notes (P-notes)?</p><p>As of March 2014, Foreigners invested ~Rs. 2 lakh crore in India via P-notes. (thisis 13% of the total FII money coming in India)As such the FII has to disclose P-note owner data to SEBI on quarterly basis (every 3months). But often, within 3 months the P-notes would have changed many hands (e.g Tomto Jerry to Micky to Goofy).Thus P-note investments are Anonymous. Hard to trace the owner. Can be used for moneylaundering and terror financing.Hot Money: can leave Indian market very soon based on just one phone call from Tom Cruzto HSBC. Hot money creates heavy rise or fall in share market, so even genuine investorsmoney 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 Ill 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.</p><p>P-Notes, Money laundering &amp; Terror Financing</p></li><li><p>6/18/2014 Mrunal [Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI, REFI explained Mrunal</p><p>http://mrunal.org/2014/06/economy-participatory-notes-p-notes-hedge-funds-new-limits-fii-fpi-refi-explained.html/print/ 6/12</p><p>Finance Ministry Whitepaper: Indians first send their money to Cayman Islands, BritishVirgin Islands, Switzerland, or Luxembourg via Hawala operators. Then, their agentsconvert rupees to dollars, re-invest it in Indian market through P-notes. It is possible tohide the identity of the ultimate beneficiaries, because of these multiple layers. Thus, P-notes are used in money laundering.Ex-National security Advisor MK Narayan: Terrorists are using P-notes 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 it todollars in a tax haven, to buy P-notes via a post office company!RBIs Tarapore Committee: Recommended Banning P-notes for national security and tostabilize stock exchanges</p><p>P-notes and CGT evasion</p><p>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 P-notes. Observe:</p><p>With P-Notes Without P-notes</p><p>Tom can buy Indian shares via FII via p-notes.Tom and Jerry have to getPAN+DEMAT. Only then, they canbuy/sell Indian shares.</p><p>Tom sells this P-note to Jerry @profit.Jerry** doesnt need to pay CGT to IndianGovernment, because we cannot trace whatTom did with that piece of paper in USA!Even if P-note is sold 10 times to 10different people, we cannot get CGT.Well get CGT only once, when the said p-note owner instructs the FII to sell the sharesfrom its Indian DEMAT account/ portfolio.</p><p>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.</p><p>**In theory, the seller has to pay the Capital gain tax (Tom Cruz in our case). but in realitythe buyer (Jerry) has to cut down the amount from payment to Tom, and give directly togovernment. Recall the Tax deduction at source (TDS) concept in Nokia controversy articleclick me.</p><p>ParthsarathiShome</p><p>Government must tax such P-note holders from next budget 2014.Shome is a tax expert, he earlier chaired the Committee onGAAR.</p><p>Appendix: How Hedge funds make money?</p></li><li><p>6/18/2014 Mrunal [Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI, REFI explained Mrunal</p><p>http://mrunal.org/2014/06/economy-participatory-notes-p-notes-hedge-funds-new-limits-fii-fpi-refi-explained.html/print/ 7/12</p><p>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:</p><p>#1: Short selling</p><p>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 onions inthe market)Tom buys 5000 facebook shares @$1000 from another investor, and returns them tobroker Bruce Willis.Whats Toms profit here:</p><p>Price per share quantity total</p><p>Tom Sold 1200 5000 (+) 60,00,000 (because he received $$)</p><p>Tom bought back 1000 5000 (-) 50,00,000 (because he paid $$)</p><p>Toms profit $10,00,000</p><p>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 hell 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 short-selling trick to yield result, you need massive quantity of shares. (If I sell 1 kiloonion from my kitchen, it wont bring down prices in the Mandi. I need atleast a 1000 kilo,to change the supply-demand and prices.)Therefore, Hedge funds dont accept aam-admi in their game. They only allow HighNetworth Individual to join the game, who can finance such large purchases and have deeppockets to suffer large losses.</p></li><li><p>6/18/2014 Mrunal [Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI, REFI explained Mrunal</p><p>http://mrunal.org/2014/06/economy-participatory-notes-p-notes-hedge-funds-new-limits-fii-fpi-refi-explained.html/print/ 8/12</p><p>#2: Leverage</p><p>Suppose Tom has only $500 and wants to bet in $1000 worth shares.</p><p>his own pocket $500</p><p>borrows from a friend @10% interest $500 ($50 in interest later repaid)</p><p>total with Tom $1000</p><p>Tom uses this $1000, to purchase shares from Broker Bruce Willis. Now suppose same sharesprice goes up** and Tom is able to sell them @$1200.</p><p>Whats Toms profit here?</p><p>Earned (+) $1200 by selling shares</p><p>invested (-) $500 from his own pocket</p><p>borrowed (-)$500 principal to friend</p><p>interest (-) $50 interest to friend</p><p>Profit $150</p><p>** Shares price can...</p></li></ul>