Offshore Derivative Instruments (ODI) have been a focal point for the Government in India and over the years, the regulatory boundaries of doing business in this space have been re-aligned by the Securities and Exchange Board of India (SEBI), quite frequently.
As a part of SEBI’s efforts towards increasing transparency and accountability in the ODI space as well as encouraging direct investments through the foreign portfolio investment (FPI) route, the SEBI Consultation Paper of May 29, 2017, titled ‘On streamlining the process of monitoring of Offshore Derivative Instruments (ODIs)/ Participatory Notes (PNs)’, proposed prohibiting the issuance of ODIs against derivatives, except for those used for hedging. SEBI had invited public comments on the matter until June 12, 2017. Thereafter, at a board meeting on June 21, 2017, the SEBI board approved this proposal, with the minutes specifically stating that “The Board has decided to prohibit ODIs from being issued against derivatives, except those which are used for hedging purposes. SEBI will issue a circular in this regard.”
The question now is whether this is the right approach to bringing down volumes in speculative trades being undertaken in the derivatives market.
The New Directives
Since the June meeting, SEBI has issued an ODI Circular dated July 7, 2017 (effective immediately), which provides the following:
- FPIs are not allowed to issue ODIs with derivatives as the underlying instrument, except where the derivative positions have been taken for hedging equity shares held by the FPI, on a one-to-one basis. It is specifically clarified that the phrase “hedging of equity shares” means taking a one-to-one position in only those derivatives that have the same underlying as the equity share .
- All existing ODIs where the underlying derivatives positions are not for the purposes of hedging equity shares will have to be liquidated by the date of maturity of the ODI instrument or by December 31, 2020, whichever is earlier. However, FPIs should endeavor to liquidate such ODI instruments prior to the said timeline.
- To issue new ODIs with derivatives as underlying, the compliance officer of the FPI has to issue a certificate confirming that the derivatives position, on which the ODI is being issued, is only for hedging the equity shares held by it, on a one-to-one basis. This certificate is required to be submitted along with the monthly ODI reports which ODI issuing FPIs are required to file.
How does this Impact Business?
SEBI has always had a rather cautious relationship with participatory notes (P-Notes) and has been circumspect about the market access it provides to overseas entities, which do not hold a licence to participate directly in Indian markets. Over the past decade or so, the ODI route has seen a significant number of changes, not only in terms of tapering down the list of entities eligible to participate in this market, but also on the enhanced compliance, know-your-client (KYC) and reporting obligations cast on the issuer FPIs themselves.
While the nature of changes SEBI has typically introduced pertain to the eligibility of the issuer and the subscriber as well as compliance and reporting obligations, by way of this new ODI Circular, SEBI has set out restrictions around commercial mechanics to whittle down the P-Note market. This change is reminiscent of the measures taken back in October 2007, where foreign institutional investors (FIIs) were prohibited from issuing/renewing ODIs with derivatives as underlyers and given an 18 month grace period to wind up all existing ODI positions. However, almost a year later on October 6, 2008, the SEBI Board decided to do away with the restriction. Although reasons for this reversal were not discussed, the change in 2008 was implemented at a time when the world economy was reeling under the impact of the global financial crisis, making it important for SEBI to take measures to revitalize the markets.
Apart from the above, another notable feature of the ODI Circular is the obligation imposed on the compliance officer. Last year, SEBI introduced a requirement for CEOs to issue confirmations regarding systems and processes that the FPI had in place. In keeping with the trend of affixing personal liability, the ODI Circular requires submission of a certificate by the compliance officer, certifying that the derivatives position is only for hedging the equity shares held by it. These changes under the ODI Circular, contribute towards a gradual rise in the personal liability of key managerial personnel of the FPI and creating greater accountability within the FPI.
Whilst some argue that this move by SEBI should bring down the “inflated” volumes in the derivatives market, there are some (arguably fair) criticisms of the approach that SEBI has taken, by introducing this circular.
- Oversimplified approach: A one-to-one hedging strategy, as advocated by SEBI in the ODI Circular, is over-simplified given that ODIs against derivatives have traditionally been used for long-short strategies, where a participant would go long on one stock and short on another in another sector. The SEBI directive also ignores strategies where an ODI is issued against derivatives to hedge an exposure to market indices, and not specific equity underlyers. The lack of references to ODI subscribers in this ODI Circular is also rather conspicuous, with SEBI stating that the derivatives positions being taken and the corresponding cash hedge must both exist with the same FPI, rather than with the subscriber, who is the ultimate beneficiary of these products. It will therefore, result in a situation where, even if a client were to use the hedging model prescribed by SEBI, he will be compelled to use the same issuer FPI for the equities and the derivatives leg.
- Direct market access: One of the key motives for the steady tightening of the ODI route has been to encourage direct registrations. In addition, moves like the recent decision to impose a fee of USD 1,000 per subscriber, are efforts towards bringing more parity between the direct and indirect access routes. However, certain categories of investors may choose not to invest directly into Indian markets for a variety of reasons including compliance costs, India being a small part of their larger global portfolio, certain types of Indian securities not meeting global accreditation standards, etc. Such entities will find it more complex and unviable to use the ODI route, going forward and may wind down their Indian portfolio completely.
- Robust reporting requirements: The stringency in SEBI’s reporting and compliance mechanism and evaluation criteria for ODI subscribers has seen on a steady increase in the past couple of years, especially after the report of the Special Investigation Team on Black Money in 2015. There is no longer the opacity and anonymity that one historically associated with the overseas derivatives market, because all ODI subscribers are: (i) required to be regulated entities; (ii) subject to stringent KYC and beneficial ownership checks; (iii) mandated to submit information as part of continuous reporting obligations that the FPI has towards SEBI. This, coupled with the international best practices that most ODI issuers are subject to in their home jurisdiction, make the misuse of this route a very challenging proposition.
- Market impact: As a consequence of these changes by SEBI, subscribers with an “unhedged” exposure to derivatives will now be forced to unwind their positions, leading to increased volatility in the markets. In fact, the first trading day after the ODI Circular, saw a fair amount of disruption in the National Stock Exchange of India Limited (NSE), where a technical glitch on July 10th (due to the order book collapsing under a barrage of trade orders) stalled trading in the cash and F&O segments for over three hours. Whilst the exact reasons are now under investigation by NSE’s technical team, reports indicate that this was likely due to a spike in derivative trading volumes that morning, as a result of investors unwinding their positions.
Over the past decade, SEBI has helmed multiple market abuse investigations involving alleged misuse of the P-Note route. Whilst many of these matters continue to remain sub-judice, regardless of their outcome, SEBI remains (rightfully) concerned about the larger market impact of such access products and has been trying to tie up loose ends to make this a more transparent and efficient market. That said, it is important for the regulator to avoid micro-managing market conduct in a bid to compensate for practical hurdles in enforcement. A balance (albeit, delicate) has to be maintained while formulating policies, in order to avoid a situation where the regulations are straitjacketed to an extent that makes them an unsustainable long term formula.
Effective regulation and prompt and decisive enforcement action should be the two-pronged approach for the well-being of any securities market, and is the model that SEBI should strive towards
 Avalanche of P-Notes trade forces 3-hour NSE shutdown, The Hindu, Business Line, July 10, 2017 (available at: http://www.thehindubusinessline.com/markets/sebi-nse-bse-derivative-trade-pnotes/article9758400.ece)
* The author was assisted by Garima Joshi, Principal Associate