[Kashvi is a second-year law student at National Law University Odisha and Divyansh is a third-year law student at National Law School of India University]
Offshore derivative instruments (ODIs) have been a point of contention in India’s regulatory landscape for over 15 years. These instruments allow foreign investors to trade Indian securities without the need for registration with the Securities and Exchange Board of India (SEBI). However, the increasing complexity of ODIs has raised concerns over regulatory loopholes in international financial regulation. To address these concerns, SEBI recently issued a circular in December 2024 aimed at closing these gaps by standardizing norms for ODIs and segregated portfolios of foreign portfolio investors (FPIs). This move is designed to enhance transparency, ensure better compliance, and align India’s financial market with international standards, thus offering reasonable market access while mitigating risks associated with complex investment structures. The reforms outlined in the circular have far-reaching implications for the country’s financial landscape. Therefore, it is crucial to analyse SEBI’s reforms, which aim to close regulatory gaps, increase transparency, and position India in line with global standards, while unpacking the underlying elements of these regulatory changes.
This post first delves into the key aspects of the circular and the changes it seeks to introduce. It then evaluates the shortcomings and challenges of the circular. Finally, the post offers potential solutions to address these issues.
ODI as a Tool for Regulatory Arbitrage
Despite stricter regulations, ODIs continue to be exploited for regulatory arbitrage. Regulatory arbitrage refers to the strategic practice of taking advantage of differences in regulatory frameworks across jurisdictions, allowing businesses to circumvent unfavourable regulations or reduce compliance costs. Firstly, SEBI regulations require foreign investors to register as FPIs, comply with strict processes, and follow disclosure norms. However, ODIs allow foreign institutional investors to bypass these requirements by trading Indian securities indirectly through FPI-registered entities, avoiding KYC and anti-money laundering checks. Secondly, ODIs often exploit double taxation avoidance agreements, such as those with Mauritius, to minimize tax liability and engage in treaty shopping. Thirdly, this arbitrage weakens market efficiency by fostering speculative and insider trading, as the opaque nature of ODI transactions makes real-time market monitoring highly challenging for regulators.
Lastly, the co-mingling of assets, where FPIs mix ODI-related holdings with proprietary investments, complicates the distinction between funds for hedging ODIs and those for other purposes. Thus, while SEBI’s reforms have significantly improved transparency, ODIs still allow investors to exploit loopholes, emphasizing the need for continuous regulatory innovation to address these challenges.
Unveiling the New Changes: A Shift in ODI Regulations
Disclosure requirements for ODI subscribers
The new circular requires ODI-issuing FPIs to register separately with “ODI” as a suffix, maintaining dual registrations under the same PAN. It also mandates disclosure of ownership and control details when certain thresholds are met. ODI issuers and their designated depository participants must monitor these criteria, submit daily position reports, and oversee group companies with significant control.
The new regulations are pivotal for two main reasons. Firstly, they aim to enhance transparency, as the lack of a disclosure framework for investors using the ODI route allowed subscribers to create a veil of anonymity. This enabled foreign investors to bypass regulatory oversight. SEBI’s analysis found that 35 FPIs manage investments using multiple segregated portfolios across sub-funds or share classes, with eight FPIs having over ten sub-funds each, and one creating as many as 86 sub-funds. This extensive portfolio segmentation raises concerns about regulatory arbitrage, as it suggests that investors could exploit regulatory loopholes. Secondly, the new regulations demonstrate India’s commitment to combating illicit financial flows and aligning with international frameworks such as the FATF standards and the UNCAC. By addressing these issues, India not only meets global standards but also strengthens a secure, trustworthy financial environment, enhancing investor confidence and safeguarding its economic future.
However, this contains several problems. Firstly, excessive disclosure requirements may create challenges in implementation, as auditing and analysing such disclosures could become more complex. Obtaining disclosures at a group level for global ODI subscribers would be difficult for both FPIs and SEBI to correlate effectively. Secondly, for ODI subscribers, the obligation to share investor data with regulators in jurisdictions where they are not registered could raise concerns about confidentiality and the potential for public disclosure in the event of a breach. As a result, non-SEBI-registered offshore entities may resist providing detailed ownership and control information. These new disclosure requirements could ultimately deter existing FPIs from continuing to use the ODI route for investing in Indian securities. Lastly, SEBI’s limited capacity to monitor granular disclosures across FPIs and ODI subscribers could create bottlenecks, reducing market fluidity, discouraging investment, and increasing compliance burdens. These complexities may lead to regulatory gaps as delayed action on issues like undisclosed beneficial owners (UBOs) could distort market transparency, erode investor confidence, and jeopardise financial stability.
Derivative as underlying
The regulations introduced by the recent circular prohibit the use of derivatives as underlying assets in ODIs, a shift from previous practices where derivatives were used for risk management, offering benefits such as lower transaction costs and fewer restrictions. SEBI had initially allowed derivatives for hedging equity shares held by FPIs with a one-to-one ratio in 2017, but by 2019 a separate FPI registration was required for hedging through ODIs, limiting derivative positions to 5% of the market wide position limit.
This measure is expected to foster sustainable market participation by curbing volatility and aligning with SEBI’s broader objective of safeguarding market integrity and investor confidence. Firstly, derivatives are inherently leveraged products that amplify exposure and, when used alongside ODIs, they can magnify systemic risk in the financial market. This combination increases the potential for excessive risk-taking, which could destabilize the market and create vulnerabilities. Secondly, while derivatives play a crucial role in enhancing market liquidity, their use with ODIs may lead to short-term speculative activity rather than long-term, stable investments. This could deter the development of a more robust and transparent financial system.
However, the reduced leverage available to foreign investors due to SEBI’s restrictions on derivatives in ODIs could negatively impact foreign investment inflows. SEBI’s consultation paper indicates that only four ODI issuers are affected and these investors must redeem their existing ODIs within a year. Firstly, derivatives are essential for market liquidity by allowing investors to manage risks. A ban could reduce trading activity in foreign-dominated segments, increasing price volatility, complicating transactions, and diminishing market confidence. Reduced liquidity can lead to mispricing and negatively impact stakeholders. Secondly, derivatives are vital hedging tools for foreign investors. Restricting hedging could cause investors to withdraw capital from India, leading to capital flight. This may destabilize the economy, reduce foreign exchange inflows, weaken the rupee, and increase inflation, potentially limiting business expansion and dampening economic growth.
Proposed Reforms: Solving the Gaps in ODI Regulation
While the circular aims to reduce systemic risks, it also presents several challenges. This section explores the proposed solutions to address these issues.
To address ODI and FPI regulation challenges, SEBI needs a multifaceted approach to ensure transparency, compliance, and competitiveness. Firstly, SEBI’s limitations in monitoring granular disclosures could affect market fluidity and investor confidence. Thus, there should be investment in AI and machine learning-based RegTech platforms that would enable real-time monitoring and detection of irregularities. RegTech platforms such as the FINRA surveillance system is employed by the firms in the United States to identify fraud and compliance.
Secondly, identifying UBOs remains difficult due to complex ownership structures often concealed by trusts, shell companies, or offshore financial arrangements. SEBI could adopt blockchain-based ownership registries, as in the United Kingdom and the European Union, to improve transparency. Integrating AI tools could help uncover hidden ownership patterns, deter financial crimes and restore investor confidence. Independent third-party audits and collaboration with international regulators like FATF, Financial Conduct Authority, and the Securities Exchange Commission could further enhance regulatory capacity and cross-border intelligence sharing.
Thirdly, instead of imposing an outright ban on derivatives, SEBI could explore alternative measures to manage risks. One option could be to mandate higher collateral requirements for derivatives thus mitigating potential losses without entirely prohibiting their use. Another approach could be to limit large positions in derivatives, reducing risk exposure while still allowing their use for risk management. Additionally, SEBI could enforce real-time reporting of derivative trades, providing regulators with better insights and enabling prompt intervention when needed. These measures would strike a balance between mitigating risks and preserving the utility of derivatives in the market.
Lastly, addressing regulatory arbitrage requires aligning India’s tax and regulatory frameworks with global standards to reduce avoidance. Stricter disclosure norms, periodic reporting, and cross-verification with global anti-money laundering databases will enhance compliance. Regulations for segregated portfolios and increased cooperation with bodies like FATF and IOSCO will further strengthen the framework.
Conclusion
SEBI’s circular marks a significant advancement in regulating ODIs and FPIs, reinforcing its commitment to enhancing transparency, accountability, and market integrity. While the new compliance requirements may introduce notable adjustments for market participants, these reforms aim to align Indian capital markets with international standards, fostering growth and development. The creation of comprehensive ODI issuance and subscriber guidelines highlights SEBI’s proactive approach to addressing systemic challenges and strengthening regulatory frameworks.
As the global financial landscape continues to evolve, India has an opportunity to set an example for other emerging economies. Achieving this vision will require collaborative efforts from regulators, policymakers, and industry stakeholders to close existing gaps, create a robust investment ecosystem, and promote innovation and growth while ensuring compliance with global norms.
– Kashvi & Divyansh
