Participatory Notes are financial instruments used by investors or hedge funds that are not registered with the Securities and Exchange Board of India to invest in Indian securities. Indian-based brokerages buy India-based securities and then issue participatory notes to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors.
In many ways, this is similar to an informal ADR process, where brokerages hold on to stocks for foreign investors. However, Indian regulators are not very happy about participatory notes because they have no way to know who owns the underlying securities. Regulators fear that hedge funds acting through participatory notes will cause economic volatility in India's exchanges.
Many market participants believe that PNs are bad because they are unregulated. Some key brokers have said the market for P-Notes may become as big a market as the regulated exchanges — BSE and NSE — and end up dictating prices from outside. There is a reason to believe they will not.
Despite the huge growth of P-Notes, the Indian markets remain fundamentally stronger and more efficient compared to almost all other emerging markets. That gives it the power to determine prices of stocks, without being influenced by parallel markets. In this entire hullabaloo over P-Notes, this is a fact that has somehow gone unnoticed.
So how are Indian stock markets able to decide prices? For that one would need to consider the concept of impact costs, a measure of liquidity in the market. Simply put, impact costs are what the investor pays everytime he buys a scrip above the most efficient price of the stock.
In India, impact costs have been declining. As impact costs fall, the market tends to become more efficient. Here’s the evidence: Over a five-year period, impact costs for a portfolio of Rs 50 lakh invested in all Nifty stocks has fallen from 0.17% in December ’01 to 0.06% in August ’06.
At the same time, a broader set of investors such as hedge funds, pension funds, global mutual funds and private equity funds have made a beeline for the Indian market, especially in the past three years. This has helped push up market efficiency a few notches higher. Even stocks with high promoter holding have seen a decline in impact costs.
Consider the example of Wipro, where the promoter Azim Premji and his family control 81.09%. In such cases, a high concentration of shares would allow a set of investors to have an edge over others in terms of information availability. Yet in Wipro’s case, impact costs have fallen from 0.97% in October ’02 to 0.06% now, driven by the fact that an additional 2% of the promoter group’s stake is now with the public.
It works like a virtuous circle. As impact costs crash on the Indian exchanges, more and more FIIs are likely to head here because they would find it cheaper to trade here. Lakshmi Sharma, a professor at TA Pai Management Institute, says that a 1% change in impact cost would cause a 102% change in FII investment. She also says that the higher the quantum of shares with non-promoters category, the higher the FII investment and vice-versa.
A 1% change in the shareholding of non-promoters’ category of shareholders would cause a 0.327% change in FII investment. Like in the Wipro case, the additional liquidity acted as a spur for FII investments. In turn, this would make the stock more efficient and push up the liquidity levels a few notches higher.
P-Notes will always be in a minority and will always take price cues from the main market without affecting it. To paraphrase Mark Twain, the fear of the P-Note may be greatly exaggerated.
Source: Economic Times