[By Vaibhav Kesarwani & Rudraksh Sharma]
The authors are students of Gujarat National Law University, Gandhinagar.
Introduction
The issues related to Offshore Derivative Instruments or Participatory Notes commonly known as P-notes have been under discussion in the Indian regulation system for more than a decade and a half now. These instruments enabled the foreign investors to trade in the Indian securities without the requirement of obtaining registration from the Securities and Exchange Board of India. However, this mechanism has also attracted criticisms in terms of regulatory arbitrage, opaqueness, and potentially used for activity for suspicion arousing purposes like manipulation and gambling.
The recent consultation paper released by SEBI in regards to investment by Foreign Investors through Segregated Portfolios/ P-notes/ Offshore Derivative Instruments on 6th August, 2024 points to such issues and recommends stricter measures in this regard. This article delves into the key discussions and proposals made by the consultation paper, specifically the proposed dis-allowance of existing exceptions related to use of derivatives by ODI issuers, including the use of ODI with derivatives as underlying as well as hedging of the ODIs with derivative positions on stock exchange.
The Evolution of ODI Regulations in India
Before SEBI’s circular on Offshore Derivative Instruments under the FPI regulations 2014, Participatory Notes were a common channel for foreign investors to invest in Indian market. However, the absence of registration and associated regulation prior to 2014 raised concerns of abuse, such as round-tripping of funds, money laundering, and tax evasion.
In 2017, SEBI barred the extension of ODIs for the purpose of trading in derivatives for the speculative purposes with an exception in the case of hedging. In 2017, SEBI barred the extension of ODIs for the purpose of trading in derivatives for the speculative purposes with an exception in the case of hedging. Subsequently, in 2019, restrictions were imposed on the issuance of ODIs referencing derivatives by FPIs. ODIs could only be hedged with derivative positions on Indian stock exchanges for two purposes: first, to hedge equity shares held by the FPI on a one-to-one basis; and second, to hedge ODIs referencing equity shares, within market-wide position limits, subject to a 5% limit for single stock derivatives.
Due to these stringent conditions, the total value of ODIs as a percentage of the Assets Under Custody of FPIs has dropped significantly, from 44.4% in 2007 to just 2.1% in the current year i.e. 2024. Despite this decline, the consultation paper has highlighted two major potential loopholes with the regulatory framework which are discussed below:
Firstly, the additional disclosure requirements introduced by the FPI Regulations, 2019, and the SEBI Circular dated August 24, 2023, for large and concentrated investments by FPIs, are not directly applicable to ODI subscribers. This opens up the window for foreign investors to avoid detailed disclosure requirements through taking positions through the ODI channel.
Secondly, that the ODIs are not governed in the same manner as direct investments made by FPIs especially with regards to the disclosure of ownership and control. This divergence opens up a fair amount of scope for regulatory arbitrage and this is something that SEBI seeks to counter with the measures under consideration.
Proposed Regulatory Changes
The consultation paper proposes several key changes to the ODI framework to enhance transparency and reduce regulatory arbitrage. These changes, including new disclosure requirements, mandatory separate registration for ODI issuance, and a ban on ODIs with derivatives as underlying, could significantly impact the Indian economy by affecting market liquidity, foreign capital inflows, and the overall growth of the ODI system. The changes are discussed in detail henceforth:
- Applicability of Disclosure Requirements to ODI Subscribers: SEBI’s August 2023 circular requires FPIs to disclose ownership and control information if they exceed concentration and size thresholds. These disclosure requirements will now apply directly to ODI subscribers as well. This would involve ODI issuers and their DDPs regulating as well as reporting on the achievement of these criteria at the ODI subscriber level. For concentration criteria, it is recommended that the ODI issuer and the DDP of the issuer should closely monitor each ODI subscriber. The ODI issuer should provide daily reports on the positions taken by the ODI subscriber(s) to the custodian or DDP. In terms of size criteria, monitoring should be carried out by the ODI issuers, their DDPs, and depositories. This should cover ODI subscribers and their related group companies, meaning any ODI subscriber with 50% or more voting rights or control, over such companies.
- Mandatory Separate Registration for ODI Issuance: In order to facilitate better compliance with the one to one hedging requirement and to enhance monitoring SEBI has suggested that ODIs should be issued only through a specially allotted FPI registration. This registration would not allow for any proprietary investments, thereby eliminating ambiguity regarding the issuance of ODIs and their operation as a distinct activity from FPI.
- Prohibition on Issuing ODIs with Derivatives as Underlying: The paper suggests to abolish the current exemptions which have been enabling ODI issuers to issue ODIs with derivatives as underlying. This would mean that ODIs may only make reference to cash equity, debt securities or other acceptable investment and they have to be 100 per cent hedged with the same instrument for the entire life of the ODI. The existing ODIs with derivatives as the underlying are to be closed within period of 1 year from the date of issuance of the proposed framework and the existing ODIs with cash positions as the underlying but hedged with derivatives are to be either closed or hedge with the said cash position on one-to-one basis in a period of 1 year from the date of issuance of the proposed framework.
Although the first two proposals can strengthen the regulatory framework for Offshore derivative instrument and align the Indian regulation with overseas jurisdiction, the proposed prohibition for ODIs with derivatives as underlying is an extreme step that needs to be scrutinized before implementation. Even if it will benefit to prevent regulatory arbitrage, it can have a reverse effect to prevent the Indian ODI system to grow as its counterparts and impact market liquidity, potential for capital flight. This will be further analysed in the next section.
Analysis of the proposals for prohibition on issuing of ODIs with Derivative as underlying
While the proposed solution for additional disclosures as specified in August 2023 circular applying directly to ODIs, as well as mandating separate registration for ODI issuance is in tune with the international best practice. More emphasis should be placed on strict scrutiny of proposed prohibition of issuance of ODIs with derivative as underlying. While it is a fact that derivatives are inherently leveraged products which amplify exposure, and when used in conjunction with ODIs can increase systemic risk in the financial market. Therefore, though SEBI’s proposed ban on hedging ODIs with derivatives is a strategic step towards protection and increase in transparency, there are some important factors which must be considered before totally prohibiting the use of ODIs for hedging of derivatives:
1. Impact on Market Liquidity: Derivatives are essential tools that help providing liquidity to the market by allowing investors to manage their risks effectively. If SEBI decides to ban derivatives in ODIs, it might unintentionally reduce the amount of trading activity, especially in areas where foreign investors are highly active. This drop in liquidity could lead to several issues for instance, increased price volatility, difficulty in buying or selling of assets and eventually reduced confidence in the market. When the number of trades is less, there is more possibility of widening the gap between the actual buying price and selling price of the securities. This leads to higher costs for trading, which could discourage the people from trading, and thus slows down the markets.
Also, when the market has less liquidity, it can be more volatile. Price Fluctuations can significantly affect trades, causing a certain level of apprehension among investors who seek stability. In the situations, when liquidity decreases, it may become even more challenging to provide accurate market prices for the assets. This contributes to mispricing which will cause problems to all the stakeholders.
2. Potential for Capital Flight: Derivatives are used by foreign investors for hedging purposes so if SEBI’s regulations make it too hard for them to do this, they may prefer to withdraw their capital from the Indian market. This could have some serious consequences and will eventually result in capital fight. Investors may consider the new rules as cumbersome and can move their investment somewhere else. This could mean that, less foreign exchange inflows into India which is a critical factor for the country’s economy.
If a large number of investors withdraw their money, it could hurt the economy, causing the Indian rupee to lose value. A weaker rupee would make imports more expensive, which could drive up inflation. As a result, Indian companies might find it harder to finance new projects or expand due to reduced foreign investment. This could in turn slow down economic growth and make it more expensive for businesses to operate.
Instead of an outright ban of the usage of derivatives in ODIs, SEBI may consider other solutions that can help curb the risks involved. SEBI can mandate that more collateral be put up, particularly when derivatives are used in ODIs. This would help to mitigate losses without out rightly eliminating the derivatives. One possibility could be to restrict the activity of having large positions in derivatives. This would assist in minimizing risk exposure and enable investors to use derivatives for controlling the risk. SEBI could also demand real time reporting on derivative trades. This would enhance the understanding of the market by the regulators and provide avenues for their intervention where deemed necessary.
Conclusion
While SEBI’s emphasis on transparency and risk mitigation is commendable, an outright ban on derivatives could have unintended consequences, such as reduced market liquidity and potential capital flight. Derivatives play a crucial role in risk management and market liquidity, and their absence could make the Indian market less attractive to foreign investors. There is a need for careful consideration to keep the Indian market attractive to foreign investors while maintaining the highest standards of transparency and risk management.
Therefore, rather than imposing a blanket prohibition, SEBI may consider more nuanced measures, such as enhanced collateral requirements or stricter limits on derivative positions. These alternatives could help manage risks without stifling the growth and competitiveness of the Indian financial markets. As India continues to integrate with global markets, finding the right balance between regulation and market freedom will be the key to sustain investor confidence and economic growth.