What are offshore derivatives instruments?

In the context of the Indian market, offshore derivatives instruments (ODIs) are investment vehicles used by
overseas investors for an exposure in Indian equities or equity derivatives. These investors are not registered with
SEBI, either because they do not want to, or due to regulatory restrictions.

These investors approach a foreign institutional investor (FII), who is already registered with SEBI. The FII makes
purchases on behalf of those investors and the FII's affiliate issues them ODIs. The underlying asset for the ODI
could be either stocks or equity derivatives like Nifty futures.

What are FII sub-accounts?

Sub-accounts are special purpose vehicles floated by foreign funds in which they manage money on behalf of their
overseas clients. FIIs also form proprietary sub-accounts to invest their own money.

What are third party sub-accounts?

This facility has been discontinued by SEBI. Earlier, overseas clients could nominate a fund manager of their choice
to manage their money in a sub-account of an FII to whom they have entrusted the funds.

Are ODIs/P-Notes less transparent?

There are fears that P-Notes are being used as a vehicle by promoters, market operators, politicians to repatriate
illegitimate funds parked abroad. Quite a few promoters are said to be using this route to ramp up their stocks. Then
there is also a concern that terrorist organisations could be channelling money through ODIs and using profits to
fund their nefarious activities.

What are participatory notes?

Participatory notes (PNs) are instruments used by foreign funds, not registered in India, for trading in the domestic
market. They are a derivative instrument issued against an underlying security that permits the holder, some of
whom may not be eligible to trade in Indian stock markets, to get a share in the income from the underlying security.

The investors, who buy PNs, deposit funds in US or European operations of the FII, which also operates in India.
FII uses its proprietary account to buys stocks in India. A government report has said that FII or the broker acts like
an exchange since it executes the trade and uses its internal accounts to settle this. Other such instruments include
equity-linked notes, capped return note, participatory return notes and investment notes.

Why investors use PNs?

While one reason for using PNs is to keep the investor's name anonymous, some investors have used the instrument
to save on transaction costs, record keeping overheads and regulatory compliance overseas. A report said investors
often find it expensive to establish broker and custodian bank relationships, deal in foreign exchange, pay taxes
and/or filing, obtain or maintain an investment identity or regulatory approval in certain markets, where their total
exposure is not going to be very large.

Such investors look for derivative solution to gain exposure in individual, or a basket of, stocks in the relevant
market. Sometimes, investors enter the Indian markets in a small way using PNs, and when their positions become
larger, they find it advantageous to shift over to a full-fledged FII structure.

What is the problem with the instrument?

 RBI, which had sought a ban on PNs, believes that it is tough to establish the beneficial ownership or the identity of
ultimate investors. It fears that FIIs, which have to comply with the know-your customer norms, know the identity of
the investor to whom the note was issued. But it is possible for the investor to sell the PN to another player resulting
in multi-layering. Tax officials fear PNs are becoming a favourite with many Indian money launderers who use it to
first ship funds out of the country, through hawala, and then get it back using PNs.

What is the extent to which PNs are used?

Over the years, the use of PNs has increased from 17 FIIs issuing it in 2005 to over two dozen funds now. Merrill
Lynch, Morgan Stanley, Credit Lyonnais, Citigroup and Goldman Sachs are the biggest issuers. The total value of
underlying investments in equity represented by the PNs was Rs 67,185 crore or 25.7% of FIIs' net investment in
equities in June, 2005. By August 2007, the notional value of PNs was Rs 3.53 lakh crore — about 51.4% of all
assets under all FIIs present in India.