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 investor	ReFI: Registered Foreign Portfolio Investor
effective from June 1, 2014	effective from March 19, 2014
Includes FII: Foreign institutional investor, their sub-accounts QFI: 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 bills can hold maximum 10% shares in a company Doesn’t apply retrospectively. Example If FII HSBC already owns 11% of Infosys shares (before 1/June/2014), they don’t need to sell 1% to get back in 10% limited. (FMC rule) Cannot become board of director in any Indian commodity exchange.	investment limit Government  bonds: 25 billion corporate bonds: 51 billion
have to register themselves as “FPI”, in any SEBI-approved Designated Depository Participants (DDP)	—
further classification into three categories (Given below)	nope

SEBI new classification of Foreign investors

Foreign Portfolio Investors (FPI), New classification is based on two criteria:

1. Risk profile: less risky – means better category
2. 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 home country. Can issue/buy/sell Participatory Notes (P-Notes)
CAT II	Foreign country’s Mutual Fund, Pension Fund, University endowment fund Can issue/buy/sell Participatory Notes (P-Notes), except certain risky institution listed by SEBI.
CAT III	Not in CAT I and CAT II. Example Hedge funds (also known as alternative investment 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

AIF Category	Examples	impact on Economy
1	angel investors venture capital funds, small and medium enterprises (SME) funds, social venture funds infrastructure funds	Positive. They help new entrepreneurs, startup companies and infra. Development
2	Those not in the category 1 or 2 Private equity funds debt funds	Mixed. They use leverage only for day to day requirements. Hence less dangerous than Hedge Funds. (leverage explained in appendix).
3	Hedge funds	They pose systematic risk to Indian market, due to complex trading 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 in share market and give you profit, after cutting their commission.
• Hedge fund is a similar investment game, where High net worth individuals (HNI) pool their money into high risky games to earn high return on investment.
• But their trading-techniques are far more complex than mutual funds, hence Hedge funds can 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. SBI mutual fund Rs.100 minimum investment required!
SEBI registers them “Alternative Investment fund- Category III.”	registered as “Asset  Management companies (AMC)”
They prefer to invest in risky bonds and shares (Because high risk=high return) e.g. Shares of Kingfisher and C graded Bonds of Somalian Government.	They usually stick to shares and bonds of reliable companies.
They apply techniques such as leverage, short selling and arbitrage to make high profit (explained in the appendix of this article). So, even when sharemarket is going down, Hedge Fund would continue giving high return to investor.	Mutual funds provide high return only when sharemarket is going up.
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 into CAT III FPI.	As such, they don’t play into P-notes. But if foreign mutual fund given CAT II status, they may play in P-notes.
Indian: Karvi Capital, Motilal Oswald, IIFL, Edelweiss etc. Foreign: Goldman Sachs, JP Morgan	UTI, Reliance Money, SBI mutual fund etc.
SEBI regulation not strict. If Hedge fund manager pooled 100 crore from investors, he can speculate in securities worth 200 crores. (Twice the amount)… But for T+2 system only meaning within two days he should settle the transaction.	SEBI regulation very strict. A mutual fund manager cannot do high level speculation like a hedge fund 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, then invest 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 account first. Other nations too have similar mechanism.
• But if Tom tries to get PAN card and DEMAT account in each third world country, then his profit 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 an FII, 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 Z quantity.”
• HSBC buys Indian shares. They’ll be stored in DEMAT account of HSBC, and won’t be given to Tom.
• But HSBC then gives a receipt to Tom listing the shares/bonds purchased on his behalf and stored in HSBC’s DEMAT account.
• This receipt is called Participatory Note.
• Technically, it is called “offshore derivative instrument”. Observe the words

OFFSHORE	Because foreigner owning something in India, without coming to India or opening 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 by HSBC. Today it may be worth $1000, tomorrow $12000 depending on how 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 of 1991.
• P-note owner doesn’t own the shares. (because they’re in the DEMAT account of that intermediary 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. HSBC returns principal + profit to Tom, after cutting commission. Tom returns the P-note receipt to HSBC.
2. Sell this P-note receipt to another foreigner say Jerry. Then Jerry again has same two options.

Why Ban Participatory Notes (P-notes)?

• As of March 2014, Foreigners invested ~Rs. 2 lakh crore in India via P-notes. (this is 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 3 months). But often, within 3 months the P-notes would have changed many hands (e.g Tom to Jerry to Micky to Goofy).
• Thus P-note investments are Anonymous. Hard to trace the owner. Can be used for money laundering and terror financing.
• Hot Money: can leave Indian market very soon based on just one phone call from Tom Cruz to 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, British Virgin Islands, Switzerland, or Luxembourg via Hawala operators. Then, their agents convert rupees to dollars, re-invest it in Indian market through P-notes. It is possible to hide 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 in Indian 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 by quickly pulling out money from the market. Doubt: how can a poor Pakistan afford creating volatility in Indian market? Ans. Via printing fake Indian currency, converting it to dollars 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 to stabilize 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 get PAN+DEMAT. Only then, they can buy/sell Indian shares.
Tom sells this P-note to Jerry @profit. Jerry** doesn’t need to pay CGT to Indian Government, because we cannot trace what Tom did with that piece of paper in USA! Even if P-note is sold 10 times to 10 different people, we cannot get CGT. We’ll get CGT only once, when the said p-note owner instructs the FII to sell the shares from its Indian DEMAT account/ portfolio.	If Tom sells his shares to Jerry (and makes profit), then Jerry** will have to pay Capital gains tax to India. Because Income tax official can trace it by monitoring the DEMAT activity of both accounts.

• **In theory, the seller has to pay the Capital gain tax (Tom Cruz in our case). but in reality the buyer (Jerry) has to cut down the amount from payment to Tom, and give directly to government. Recall the Tax deduction at source (TDS) concept in Nokia controversy article click me.

Parthsarathi Shome

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

Appendix: How Hedge funds make money?

• Suppose, Mr.Tom Cruz runs a hedge fund for High net worth Individuals (HNI) Arnold Schwarzenegger and Leonardo di Caprio.
• To get maximum return in quickest possible time, Hedge Fund manager Tom Cruz will apply 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; and immediately sells them in share market.
• Now, Facebook share price will fall to say $1000 (imagine sudden supply of new onions in the market)
• Tom buys 5000 facebook shares @$1000 from another investor, and returns them to broker 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.) ad Broker Bruce Willis will make profit. (Because he will receive shares whose market price has now increased.)
• For short-selling trick to yield result, you need massive quantity of shares. (If I sell 1 kilo onion 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 High Networth Individual to join the game, who can finance such large purchases and have deep pockets 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’s price 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 company
• If 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 (Because he’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, to make 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 buy 1000 facebook shares @ $1200 3 months from now.” He wants future contract because right now he doesn’t have money or xyz reason.

In this case, Tom will purchase 1000 shares of Facebook from NY and simultaneously make future contract with Californian investors “ok I’ll sell you the shares @ $1200 after three months”.

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 make significant profit. Example

• NewYork: $1000 / per Facebook share
• California: $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 (refer the Leverage concept again.)

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

Going even complex:

• NewYork: $1002 / per Facebook share
• California: $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 down at 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 by SEBI

1. the entities with higher risk profile and lower KYC compliance, are put under category Three
2. alternative investment funds are put under category one
3. University endowment funds are put under category Two

Answer choice

1. only 1 and 2
2. only 2 and 3
3. only 1 and 3
4. All of them

Q2. Find the incorrect statements about the classification of alternative investment funds by SEBI

1. Entities with positive externality on Indian economy, are put under category three
2. infrastructure funds are put under category two
3. hedge funds are classified as alternative investment funds category III.

Answer choice

1. only 2
2. only 1 and 2
3. only 2 and 3
4. only 1 and 3

Q3. What are the consequences if SEBI/RBI doesn’t put any restrictions on foreign portfolio investors?

1. Dollar to rupee exchange rate may become volatile
2. Indian Sensex may become volatile
3. India may run into another balance of payments crisis

Answer choice

1. only 1 and 2
2. only 2 and 3
3. only 1 and 3
4. 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 commodity trading exchange, if owns sufficient number of shares of the said exchange.
3. Both A and B
4. neither A nor B

Q5. Consider following statements

1. An NRI need not register himself as a foreign portfolio investors, if he wishes to buy corporate bonds
2. An NRI need needs to register himself as a foreign portfolio investors, if he wishes to buy government bonds
3. An NRI is prohibited from buying Treasury bills.

Which of them are incorrect?

1. Only 2
2. only 1 and 2
3. only 2 and 3
4. 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 3
2. only 1 and 2
3. only 2 and 3
4. only 1 and 3

Q7. P-Notes is a/an ____.

1. Alternative investment instrument
2. Alternative derivative instrument
3. Offshore derivative instrument
4. 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 related norms.
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 2
2. only 2 and 3
3. only 1 and 3
4. 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 money laundering 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 thing
2. Answer A. You were required to find the incorrect statement viz. statement #2
3. 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 funds
11. D
12. C price difference between two markets.

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