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Monday, August 10, 2015

Witch hunt against PNs considered harmful

by Susan Thomas.

A slightly different version of this appeared in the Indian Express today.

The Supreme Court appointed SIT on black money has asked that the ultimate beneficiary owner of every Participatory Note (PN) be traced. This brings back an old mistrust from nearly a decade ago, which careful examination suggests is misplaced. PNs help India better integrate into the global financial system. When India fixes her financial systems to become more competitive, these very PN customers will bring their business onshore.

What are PNs? PNs are one way that international investors can invest in Indian assets today. When this investor wants to invest in an Indian firm, they buy a contract from financial firms in their country. In turn, these financial firms may either choose to invest in the Indian asset. Or they can ``replicate'' Indian returns by doing financial engineering using other securities.

The investor buys a PN from a SEBI-registered Foreign Porfolio Investor (FPI). Let us call this registered FPI a "PN seller". Many times, one firm comes to buy a contract from the PN seller, and at the same time another person comes to sell it. The PN seller makes money charging fees to both. No back-to-back transaction takes place in India. The PN seller is "running a book". Sometimes the PN seller sells 100 to one person and buys 80 from another. This leaves an imbalance of 20 on his book. This net imbalance shows up as a trade in India when the FPI sells the security. This imbalance is reported as PN trades to SEBI. The PN seller is continuously selling contracts to end-users and adjusting his position in India reflecting the net imbalance. There are a number of such PN sellers in the world. Their activities are good for India because they connect the world of global finance into India.

So, PNs are a reflection of the world investment community's interest in Indian assets. When India grows, this interest will grow. The puzzle with PNs is why they exist at all. Why does the international financial investor buy a PN and not come into India directly? As with everything in finance, it about getting the best (lowest) price. There are several mistakes in Indian policy where directly trading in India means a higher price.

Three policy mistakes

India has a policy mistake in the form of the securities transaction tax (STT). Trades on Indian exchanges are charged the STT. There is no such cost for the global investor when they buy from their domestic financial firm. PN sellers are domiciled in places like London, New York or Singapore, where tax policy is done correctly and transactions are not taxed. Since the PN seller only sends his net imbalance as trades to India, the burden of the STT is lower. So customers send their orders to PN sellers.

India has policy mistakes in the form of taxation of non-residents, other than the Mauritius/Singapore channel. Some foreign investors invest in India through Mauritius or Singapore to achieve residence-based taxation. Others send their business to PN sellers, who are domiciled in places like New York, London or Singapore, where financial activities of non-residents are tax exempt, and have worked out Mauritius/Singapore vehicles to do trades in India. Hence, the PN business is helping India obtain non-resident participation in the economy, by avoiding the consequences of our flawed approach to taxation of non-residents.

India has policy mistakes on capital controls. For example, India makes it difficult for anyone to take a position on currency futures in excess of $15 million. PN sellers are domiciled in places like New York, London or Singapore, where financial regulation makes no such mistakes. By buying from a PN seller, the customer avoids this problem.

Hankering after the ultimate beneficial owner

Indian authorities want to know the ultimate beneficiary of a PN transaction. This is incorrect for three reasons.

  1. The PN related trades in India are a reflection of a net position between all buyers and sellers, it is impossible to ask who exactly is the ultimate beneficiary owner.
  2. It is when an investigation starts, that the regulator has the ability to trace the links of the chain. This suffices for regulators in 33 of the FATF signatory countries, alongside India. India is the only country asking for information about the ultimate beneficiary owner at all times.
  3. Insisting on the knowledge of the ultimate beneficiary owner will likely cause a push-back against India's attempt at extra-territorial jurisdiction. If a person in India buys a derivative in India and sells it to an investor in London, India does not have the right to ask about the London investor unless in the context of an investigation, and in cooperation with the authorities in London. Strong arm tactics for unreasonable information requests will drive up the cost of doing business in India. This is not in our interest.


To conclude, Indian regulators and Indian tax authorities, amongst others, have long expressed concerns about PN. A better understanding about how the PN market serves India's interest shows that this concern is misplaced. This market provides a valuable service by giving global investors a lower cost channel into Indian investments. Without this market, the cost to the global investment community in Indian investments would go up, their engagement with India would go down. This is not in India's interest. If we do want better knowledge about the beneficiary owner, we would do better to reform our tax policy, our capital controls and our financial regulation to bring the business directly into India. This would be far more effective in strengthing our regulatory control, without hampering much needed global investments into India.


  1. There has been a fixation in the media regarding PN being a vehicle for round tripping by promoters. With SEBI and RBI tightening norms, any attempt for round tripping will be cumbersome and expensive.
    Many PN holders do not have the financial muscle to have a presence in India. They use these brokers to have India exposure in their portfolio.

  2. I have to but point out some very obvious points the author has missed. Firstly, PN holders are subverting KYC requirements of India by investing through PN's, thus circumventing a critical issue of market integrity. We would be naive to assume all the money coming in through PN's is legitimate investment.

    Secondly, foreign investors investing through PN's are adding one additional layer of risk in their investments, that of the PN issuer. This has implications for both liquidity and counterparty risk since it is essentially a Derivative Instrument. I know for a fact, that investment through PN's are not very liquid and can be extremely hard to find good bid/ask spreads. I cant think of a sensible FII who would want to expose their investors to these additional risks.

    That leaves us with the question. Who is investing in these PN's? Question worthy of your next article.


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