SEBI Moves To Plug Regulatory Arbitrage For Offshore Derivative Instruments

Market regulator Securities and Exchange Board of India has floated a consultation paper that seeks to address the regulatory arbitrage available to foreign investors, those investing in India using overseas derivatives instruments or participatory notes as it is commonly called, and those investing in India directly through registration as Foreign Portfolio Investor or its sub accounts.

Offshore Derivative Instrument or P-Note is an instrument which is issued through overseas tax-saving geographies like Mauritius, etc., by a FPI against shares held by it in India as its underlying. While the ODI issuer i.e. the FPI, remains the owner of the underlying securities, the economic benefits of such holdings are transferred to the ODI subscriber.

The route exempts foreign subscriber of the P-Note to avoid registration, though the FPI is registered in India and has to follow KYC norms. Currently, Category-1 FPIs are allowed to issue ODIs against Indian securities.

The regulator had in 2019 tightened the route to disallow ODI issued against derivatives for speculative purpose, unless the derivative position was taken by the FPI on the Indian stock exchange to hedge equity shares held in India on a one-on-one basis and the hedge limited for the ODIs referencing equity shares, subject to a position limit of 5% of marketwide position limits for single-stock derivatives. The regulator allowed permissible position limit for stock index derivatives at higher of Rs 100 crore or 5% of the open interest.

In August 2023, the regulator issued a circular that required enhanced disclosure, allowing granular disclosure on a full look-through basis if any foreign investor holds more than 50% of its asset under management in a single India corporate group or if they hold more than Rs 25,000 crore of their equity AUM in Indian markets. A non-compliance would require the FPI to liquidate the position and exit the Indian market.

SEBI has now applied the same compliance and concentration disclosure standard to ODIs. Further, the proposal tightens the disclosures at the segregated fund level for ODIs and the FPIs.

The market regulator observed that as of July, 35 FPIs held investments through multiple segregated portfolios with different sub-funds or share-classes. Out of these, eight FPIs maintained 10 or more sub-funds each, through which such segregated portfolios with one of them having as high as 86 sub-funds or share classes.

The responsibility of providing this information will be with the ODI issuing FPI and the designated depository participants.

Use Of Derivatives By ODIs

The regulator allowed hedging of ODI positions against Indian stock derivative or index derivative shares in the domestic market. This exception allowed in 2017 is now proposed to be withdrawn. ODI issuing FPIs will not be allowed to issue ODIs with derivatives as an underlying or hedge their position using derivatives in India.

Further, existing ODIs with derivatives as underlying will be required to be redeemed within a period of one year from the date of issuance of the proposed framework. As per the regulator, only four ODI issuers have outstanding ODIs worth Rs 3,075 crore that are hedged with derivatives.

The regulator has also proposed to mandate issuance of ODIs only through a separate dedicated FPI registration where no proprietary investments shall be permitted.