P-Notes Norms

Table of Contents
1. Introduction
2. Requirement for Reform
3. Background
4. Definition and Structure of P-Notes / ODIs
5. Why P-Notes Can Be Misused
6. Provisions in the Consultation Paper
7. SEBI Measures Implemented Earlier
8. Significance and Implications
9. Compliance: Practical Points for Market Participants
10. Illustrative Example
11. Conclusion
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Introduction

SEBI recently released a consultation paper proposing tighter norms for the issuance of offshore Derivative Instruments (ODIs), commonly referred to as P-Notes. The consultation seeks to reduce opacity in the P-Note route, curb misuse for money-laundering or tax avoidance, and increase transparency of foreign investment flows into Indian equity markets.

Requirement for Reform

• Because the investment chain for P-Notes can be opaque, these instruments have been used as conduits for illicit funds; therefore, their use needs to be restricted to genuine investors.
• Some ODI subscribers spread their exposures across multiple issuers to avoid detection or regulatory scrutiny; the consultation paper proposes measures to curb such circumvention.

Background

• Approximately 6% of total foreign investment in Indian equities and related instruments has come through P-Notes.
• P-Notes accounted for as much as 50% of foreign investment in earlier years; regulatory steps have reduced their share, but they still represent about a quarter of all ODIs.
• Following directions from the Supreme Court, SEBI issued instructions to strengthen Know Your Customer (KYC) norms for ODI subscribers, restrict transferability of ODIs, mandate reporting of suspicious transactions, and require periodic system reviews by issuers.
• If ODIs are transferred, issuers are required to produce the complete trail of transfers to SEBI on demand to enable audit and investigation.

Definition and Structure of P-Notes / ODIs

• P-Notes (Participatory Notes) are offshore derivative instruments issued by SEBI-registered Foreign Portfolio Investors (FPIs) or their Indian-registered intermediaries to investors who wish to gain exposure to Indian securities without registering directly with Indian regulators.
• Typical parties involved are the ODI issuer (an FPI or its agent), the ODI subscriber (the offshore investor using the P-Note), and the underlying Indian securities (equity, debt or derivatives positions held by the issuer in India).
• P-Notes provide economic exposure to Indian securities; the investor does not hold the securities directly, and the issuer is responsible for complying with reporting and regulatory requirements.

Why P-Notes Can Be Misused

• Opacity: The ultimate beneficial owner of funds invested via P-Notes may remain unidentified to Indian authorities unless the issuer provides full information.
• Layering: Investors can route funds through multiple issuers or jurisdictions, complicating traceability and enabling tax avoidance or treaty-shopping.
• Speculative use: ODIs issued against derivatives can be used for short-term speculative trading rather than genuine hedging or long-term investment.

Provisions in the Consultation Paper

• SEBI proposes a supervisory fee of USD 1,000 to be levied on every FPI that issues ODIs or P-Notes. This fee would be payable once every three years by each SEBI-registered FPI for each of their P-Note subscribers.
• The proposal seeks to prohibit ODIs being issued against derivatives for speculative purposes. Presently, ODIs may be issued against derivatives as well as equity and debt; the consultation aims to limit issuances to legitimate, non-speculative uses.
• The paper gives a deadline-31 December 2020-to wind up ODIs that were issued against derivatives and are not for legitimate non-evading purposes. Issuers would be required to ensure that ODIs are issued only against derivatives used for bona fide hedging or other legitimate economic purposes, and not for speculation or evasion.

SEBI Measures Implemented Earlier

• Mandated stronger KYC norms for ODI subscribers following Supreme Court directions to identify beneficial owners.
• Directed issuers to maintain and make available a complete transfer trail of ODIs to SEBI on request.
• Required reporting of suspicious transactions and periodic reviews of internal systems and controls by ODI issuers.

Significance and Implications

• The measures will discourage investors from using the P-Note route to hide identity or intentions and will encourage direct registration as FPIs where appropriate, thereby increasing transparency.
• Reducing opaque flows is a step towards preventing money-laundering and tackling tax avoidance and treaty-shopping practices.
• The supervisory fee and stricter controls could increase compliance costs for issuers, which may reduce the supply of P-Notes and shift investment flows towards on-shore registered investors.
• Market participants-issuers, subscribers and custodians-will need to strengthen KYC, record-keeping and reporting systems to meet SEBI's requirements and avoid penalties.

Compliance: Practical Points for Market Participants

• Issuers must keep detailed records of each ODI/P-Note subscriber, including beneficial ownership details and the economic rationale for issuance.
• Issuers should assess derivative positions backing ODIs to ensure they are for hedging or legitimate purposes and not for speculative exposure.
• FPIs issuing ODIs should budget for the supervisory fee of USD 1,000 per subscriber every three years and prepare for periodic audits by SEBI.
• Where transfers of ODIs occur, the issuer must retain and be able to produce the chain of transfers to SEBI on demand.
• Prospective ODI subscribers should consider direct FPI registration if they require permanent, transparent access to Indian markets.

Illustrative Example

• An offshore investor wishes to gain exposure to an Indian equity index but does not want to register directly as an FPI. An FPI issues a P-Note to the investor, holding the underlying Indian securities or derivatives. Under the proposed norms, the issuer must verify the investor's identity, record the legitimate purpose (for example, hedging an existing exposure), and pay the supervisory fee; if the ODI is backed by derivatives, the issuer must ensure these derivatives are not held for speculative purposes.

Conclusion

The consultation on P-Notes aims to balance the needs of legitimate foreign investors for efficient market access with the regulator's obligation to prevent misuse. Strengthening KYC, imposing a supervisory fee, restricting speculative derivative-backed ODIs, and requiring full transfer trails are intended to improve transparency, reduce illicit flows, and align offshore investment practices with global standards. Market participants should review their processes to ensure compliance and consider direct registration where appropriate.