The issue of offshore derivative instruments (ODIs) such as participatory notes (PNs) have been the subject matter of regulatory controversy for some time now. These are instruments issued by foreign institutional investors (FIIs) (now foreign portfolio investors (FPIs)) to investors overseas that mimic the risks and rewards on underlying securities held by the FIIs/FPIs in Indian companies. These instruments have caused difficulties from a regulatory standpoint as they have been issued overseas within limitations on the long-arm jurisdictions of SEBI. These issues have been discussed in a previous paper.
Yesterday, SEBI issued a circular that imposes significant restrictions on the issue of ODIs by FPIs. In a measure intended to align the applicable eligibility and investment norms between the FPI regime and the ODI route, SEBI has prescribed that an FPI can issue ODIs only to subscribers that meet the eligibility requirements under the SEBI (Foreign Portfolio Investor) Regulations, 2014. These eligibility criteria include that fact that the applicant is resident in a country whose securities markets comply with IOSCO requirements, or a bank falls within the framework of BIS. It excludes investors from countries that have been shortlisted for failing to comply with transparency requirements. Furthermore, FPIs are not allowed to issue ODIs to subscribers that have opaque structures as defined in the FPI Regulations.
The above circular effectively curbs a fairly significant market for ODIs. Investors find reason to invest in ODIs only if they otherwise do not wish to register themselves as FPIs and invest directly into the Indian markets. One of the reasons why ODIs are attractive is because of the relative opacity it offers. The risk accompanying ODIs is that it may be misused for money-laundering and for round-tripping by Indian investors. SEBI’s circular effectively curbs such activity and makes the ODI process more transparent as only investors that qualify to register as FPIs would be entitled to take up ODIs. In other words, SEBI has in one fell swoop eliminated the regulatory arbitrage that was available to foreign investors who wish to remain opaque. This is indeed a welcome move from the perspective of transparency. It also puts a significant onus on FPIs to ensure they issue ODIs only to qualifying investors, which might mean tightening of the KYC norms.
There has been some tightening on other incidental aspects as well. For instance, ODIs will be counted (in terms of beneficial ownership) for determining the maximum limits for investment by FPIs in Indian companies. It would not be possible to circumvent the investment limits through indirect routes such as participation in ODIs.
This measure might likely result in a significant reduction in the use of the ODI structure. This is relevant given the substantial increase in ODI activity in recent times. While this may affect investment flows in the short run, SEBI’s approach is necessary and timely from a regulatory perspective.