mrunal [economy] participatory notes (p-notes), hedge funds, new limits on fii, fpi, refi explained...

6/18/2014 Mrunal [Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI, REFI explained » Mrunal

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[Economy] Participatory Notes (P-Notes), Hedge Funds, New Limits on FII, FPI,REFI explained

1. Foreign Investment rules: SEBI Vs RBI

1. SEBI new classification of FPI

2. SEBI: Alternative investment fund (AIF) classification

2. What are Hedge funds?

3. Difference between Hedge Fund & Mutual fund

4. What is Participatory Note (P-Notes)?

1. Why Ban Participatory Notes (P-notes)?

2. P-Notes, Money laundering & Terror Financing

3. P-notes and CGT evasion

5. Appendix: How Hedge funds make money?

1. #1: Short selling

2. #2: Leverage

3. #3: Arbitrage

6. Mock Question

7. Correct Answers for MCQs

FII rules: SEBI Vs RBI

SEBI RBI

FPI: Foreign portfolio investorReFI: RegisteredForeign PortfolioInvestor

effective from June 1, 2014effective fromMarch 19, 2014

Includes

FII: Foreign institutional investor, their sub-accountsQFI: Qualified Foreign Investor

same as SEBI

NRI excluded same as SEBI

Can trade in Indian shares, bonds, debentures, derivatives same as SEBI

SEBI: 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 SEBI-approved DesignatedDepository Participants (DDP)

–

further classification into three categories (Given below) nope

SEBI new classification of Foreign investors

http://mrunal.org/



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 (P-Notes)

CATII

Foreign country’s Mutual Fund, Pension Fund, University endowment fundCan issue/buy/sell Participatory Notes (P-Notes), except certain risky institutionlisted 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 P-notes 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) classification

AIFCategory

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 fundsThey 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 trading-techniques are far more complex than mutual funds, hence Hedge fundscan make money even with sharemarket going down.

Difference between Hedge Fund & Mutual fund

Hedge Fund Mutual fund

Only High Net worth Individual (HNI) can enter this game

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 fund-Category 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, 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.

Mutual funds provide high returnonly when sharemarket is goingup.

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.

As such, they don’t play intoP-notes.But if foreign mutual fundgiven CAT II status, theymay play in P-notes.

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 days heshould settle the transaction.

SEBI regulation very strict.A mutual fund managercannot do high levelspeculation like a hedgefund manager.

What is Participatory Note (P-Notes)?



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 & 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 behalf andstored in HSBC’s DEMAT account.This receipt is called Participatory Note.Technically, it is called “offshore derivative instrument”. Observe the words

OFFSHOREBecause 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 depending onhow the prices of Indian securities move.

INSTRUMENT Self-explanatory- this is one type of financial instrument to invest abroad.

1992: SEBI had permitted P-notes, to boost foreign investment in India, after BoP crisis of1991.P-note owner doesn’t own the shares. (because they’re in the DEMAT account of thatintermediary FII)P-Note owner doesn’t have voting rights in the shareholder meetings



Where is the profit in P-notes?

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 P-note receiptto HSBC.

2. Sell this P-note receipt to another foreigner say Jerry. Then Jerry again has same twooptions.

Why Ban Participatory Notes (P-notes)?

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 investors’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.

P-Notes, Money laundering & Terror Financing



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!RBI’s Tarapore Committee: Recommended Banning P-notes for national security and tostabilize stock exchanges

P-notes 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 P-notes. Observe:

With P-Notes Without P-notes

Tom can buy Indian shares via FII via p-notes.Tom and Jerry have to getPAN+DEMAT. Only then, they canbuy/sell Indian shares.

Tom sells this P-note 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 P-note is sold 10 times to 10different people, we cannot get CGT.We’ll get CGT only once, when the said p-note 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 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 article

click me.

ParthsarathiShome

Government must tax such P-note holders from next budget 2014.Shome is a tax expert, he earlier chaired the Committee onGAAR.

Appendix: How Hedge funds make money?

http://mrunal.org/2014/05/economy-nokia-tax-row-royalty-payment-chennai-plant-finland-dtaa-microsoft-takeover-unicitral-tds-withholding-tax-explained.html



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 onions inthe market)Tom buys 5000 facebook shares @$1000 from another investor, and returns them tobroker Bruce Willis.What’s Tom’s profit here:

Price per share quantity total

Tom 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 short-selling 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 1000 kilo,to change the supply-demand and prices.)Therefore, Hedge funds don’t 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.



#2: Leverage

Suppose Tom has only $500 and wants to bet in $1000 worth shares.

his own pocket $500

borrows 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 shares

invested (-) $500 from his own pocket

borrowed (-)$500 principal to friend

interest (-) $50 interest to friend

Profit $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, tomake profit.

New York stock exchange California Stock Exchange

1 facebook share sells@1000 (on today’s date)

Some investor is willing to make “future-contract”: 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 makefuture 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 large quantity.



In that case, Tom will need to borrow additional money from friend to play this game (referthe Leverage concept again.)

With advent of online trading, the arbitrage has decreased to decimal points. say $1000.38 in NYand $1000.40 in Cali. So, here Tom has to buy even bigger quantity (Ten lakh shares) to seesubstantial profit. Tom Cruz may have excellent brain but he’d need High Networth Individualslike Arnold & Leonardo to provide him the necessary funding. Thus, Hedge funds emerged.

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 portfolio investors bySEBI

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 alternative investment fundsby 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 on foreignportfolio 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. P-Notes is a/an ____.

1. Alternative investment instrument2. Alternative derivative instrument3. Offshore derivative instrument4. Offshore equity instrument

Q8. Who uses P-notes?

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 p-notes to invest in India.2. Only NRIs can use P-notes to invest in India.3. IF a person wants to invest via P-notes, 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 P-notes. 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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URL to article: http://mrunal.org/2014/06/economy-participatory-notes-p-notes-hedge-funds-new-limits-fii-fpi-refi-explained.html

Posted By Mrunal On 18/06/2014 @ 15:27 In the category Economy

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