In today’s Finshots, we talk about the rising value of participatory notes and if these financial instruments should be a cause of worry for Indian markets.

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The Story

In 2001, a massive financial scam rocked the Indian stock market. Ketan Parekh, a smart Chartered Accountant, swindled a whopping ₹40,000 crores by artificially inflating stock prices and then selling them at their peak.

One of his tricks was using Participatory Notes or P-Notes. Think of P-Notes as a way for foreign investors to anonymously invest in the Indian stock market.

Here's the deal. If you want to invest in stocks, you just sign up with a broker, set up a demat account to hold your investments, and start trading. Easy, no?

But for foreign investors, it’s a hassle. They need to register with SEBI (Securities and Exchange Board of India), which can be a complicated process.

P-Notes on the other hand make it simple. Foreign investors can go to a registered entity or bank and say, “Hey, invest in some Indian stocks for me. Here’s the money.” The entity issues them a P-Note (as proof of their participation) and invests in the Indian market on their behalf. The investment is under the entity’s name, keeping the real investor anonymous.

This anonymity worked perfectly for Parekh. He set up accounts with registered foreign investors and funneled money into select stocks via P-Notes. This drove up stock prices, attracting more Indian investors.

Since P-Notes are tied to these stocks, Parekh could use his highly valued P-Notes as collateral to borrow money from foreign banks. He’d then secretly reinvest this borrowed money into the market, driving prices even higher and sparking off a vicious stock market rally.

But this rally came to a screeching halt when the US dot com bubble burst. Stock prices of massively overvalued technology companies nosedived when they failed to deliver profits. When this resulted in a domino effect on global markets, India was no exception. Parekh’s investments began to plummet too, translating into massive debt defaults.

Now you’re probably wondering “Why is Finshots talking about a scam that happened over two decades ago?”

Well, the reason is simple. The value of P-Notes or the nefarious instruments behind the Ketan Parekh scam, have been rising of late. In fact, these investments have now reached a staggering ₹1.49 lakh crores! And the last time Indian markets saw P-Note investments like that, was way back in 2017.

Yeah, that may sound a bit worrisome. But here’s the thing.

P-Notes aren’t pure villains. They were actually devised as a tool to encourage foreign investments way back in FY92. At the time, India was low on foreign exchange reserves barely sufficient to meet 3 weeks worth of imports. Thanks to excessive agricultural subsidies and the global oil crisis. And ever since, P-Notes have made India an attractive destination for foreign capital.

But over the years, these instruments also gave foreign as well as Indian investors a back door entry into the Indian markets. Investors enjoyed the anonymity and ease with which P-Notes could be transferred. And this translated into illegal practices.

For instance, wealthy Indians with a lot of unaccounted income found clever ways to send their money to tax havens like Cayman Islands and Mauritius. They’d then round trip that money into the Indian markets via P-Notes, and make more money off of it. That wouldn’t attract any tax either, simply because these profits would be taxed in a foreign jurisdiction. And if that country had a zero tax policy for profits on investments like these, these disguised Indians investors would get away without paying taxes too.

Not just that, P-Notes easily became a way for terrorists and money launderers to park their money in India. And that’s exactly what gave P-Notes their bad reputation.

The problem worsened in 2007, when P-Notes made up for over half of the total foreign investments India received. And this miffed regulators like the SEBI and RBI (Reserve Bank of India) who advocated banning P-Notes altogether.

These attempts only backfired as stock markets crashed whenever new rules to tame P-Notes came about. On the 17th of October, 2007, for instance, the government’s intention to ban P-Notes dragged down Indian markets by close to 10%, even prompting stock exchanges to suspend trading for a while.

That’s when regulators realised that P-Notes were not just a sensitive investment but a conundrum for them too. Nevertheless, they took up the challenge and began tweaking the rules. Slowly but steadily, they tightened KYC (Know Your Customer) norms, stopped P-Note issuances to investors in countries not compliant with Anti Money Laundering regulations and even got P-Note issuing entities to frequently disclose any unusually high investments that came in.

And you could say that this worked. For context, the share of P-Notes in India’s foreign investments has drastically dropped from over 50% in 2007, to about 10% in 2015 and just about 2% now.

And the rise that P-Notes investments are witnessing at the moment is well within that 2% threshold. If you try to reason it out, they could be largely driven by weaker global markets and western investors who are looking to reduce their exposure to China's industrial stocks. India’s economic growth and booming stock markets are probably their best bet right now.

So yeah, rising P-Note investments shouldn’t be too much of a problem.

But before you think it’s over, here’s a little secret. When Hindenburg Research released its controversial report about the Adani Group’s business last year, it said something about P-notes too. It alleged that the Adani Group used P-Notes to invest anonymously in its own stocks and artificially inflate its businesses’ stock prices.

Although unproven, this could mean that a small but good chunk of astute investors are still camouflaging their way into the Indian stock market.

And unless that loophole is plugged, you can't really give P-Notes a clean chit.

Until then…

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