[Manya is a student at National Law University Odisha.]
In light of offshore derivative contracts being recognised as valid in Gujarat International Finance Tech (GIFT) City as part of the 2023 budget announcement, participatory notes (P-notes) are set to make a full-fledged comeback in Indian markets after a series of partial bans by Securities Exchange Board of India (SEBI) over the years. This article delves into the laws regulating offshore derivative instruments (ODIs) in India, and its role in Indian markets while tracing its journey since its first ban in 2007. This article also attempts to provide some suggestions which can be implemented under the existing regime, keeping in view the recent developments.
What are Offshore Derivative Instruments?
ODI is a route for foreign investors who are not registered with SEBI to get exposure to Indian securities. These foreign investors do not deal directly in the Indian stock market, as they are not registered with the SEBI, and simply enjoy the lower transactional costs and minimal restrictions as compared to direct participation.
These offshore investors invest via foreign institutional investors (FIIs), who are already registered with the SEBI. The FIIs such as the foreign banks set up in India, issue ODIs to any offshore investor and consequently acquire securities in the Indian market on behalf of the relevant offshore investor. The investor is entitled to receive dividends and capital gains out of the security hedged onshore, or is liable to pay to FII in case of loss. This arrangement between an FII and offshore investor is executed typically by way of total return swap contracts.
In India, P-notes are the most used form of ODIs and these terms are often used interchangeably. P-notes are a great way of increasing foreign investment inflow in the country, without any regulatory hassles. It encourages high net worth individuals, small hedge funds, and other individuals to invest in Indian securities.
ODIs / P-notes provide liquidity since they are transferable instruments. P-note holders are permitted to transfer the instruments to other investors, creating layers of intermediaries. In this manner, the actual beneficial owner remains anonymous. This anonymity allows unregulated activities, such as money laundering, terror funding and round-tripping, that can contribute to high market volatility.
Are P-notes Regulated?
In 2003, SEBI introduced P-notes in India to boost foreign investment inflow. By 2007, SEBI put a partial ban on the issuance of ODIs, after realising certain major loopholes in their trade. SEBI does not have any direct link with the P-note holders, and therefore there are no regulations governing their dealing. However, SEBI regulates the FIIs, commonly foreign banks, that issue the P-notes and hold positions in Indian securities.
In 2017, SEBI banned P-notes carrying derivatives (like futures, options, warrants etc.) as an underlying instrument. It also restricted the use of P-notes to only one-to-one hedging in equity. SEBI is reluctant to put a complete ban on ODIs as it would seriously discourage foreign investments in India. However, SEBI is moving towards implementing a stricter compliance framework with regard to ODIs.
Conditions for the issuance of ODIs were introduced under the SEBI (Foreign Portfolio Investors) Regulations 2019 (FPI Regulations). The foreign portfolio investors (FPIs) must disclose all information about the parties involved and comply with ‘know your client’ rules. The P-note holders are subjected to a diligence process. ODIs can only be issued to entities regulated by a foreign regulatory authority.
Recent Developments
In the 2023 budget, the finance minister announced offshore derivative contracts to be valid. This development in the offshore derivative market is only restricted to the GIFT City, IFSC being developed in Gujarat. Outside the IFSC, the ODIs will continue to be governed by the FPI Regulations.
Recognising offshore derivative contracts as valid will allow full-fledged use of P-notes in the IFSC, including derivatives as underlying instruments and other forms of ODIs. The budget has also announced a tax exemption on the distribution of income received from hedging P-note securities to non-resident investors (restricted only to the offshore banking units set up in the IFSC). Earlier, there used to be a double taxation on the same income on the issuance of ODIs, first on the income received from the position held on securities underlying in P-notes, and second when such income was distributed to the client investor.
Now, FIIs are exempted from taxation on income distributed to non-resident investors. This exemption will attract the foreign banks set up in GIFT City to issue P-notes. The rationale behind taxation for issuance of ODIs in the Indian markets is that they are considered as owners of the underlying securities, and the identity of the actual beneficial owner of the P-notes is unknown due to their anonymity. In order to give effect to these budget announcements, amendments are yet to be brought in the Securities Contract (Regulation) Act 1956 and International Financial Services Centres Authority Act 2019.
Suggestions
The importance of foreign capital inflow cannot be challenged, however, to weed out the illegal channels, some changes in the present regulatory framework may need to be incorporated.
Due to easy liquidity and transferability of P-notes, transfer trails are difficult to track, thereby encouraging round-tripping of fund. It is important to devise a mechanism to track the ultimate beneficial owner. The United States Securities Exchange Commission in order to prevent round-tripping has a ‘distribution compliance period’, wherein the exempted securities cannot be resold to a US person until the said period ends. Such measures are needed to restrict the transferability of ODIs in offshore markets.
The recent developments, even though restricted to the IFSC, may impact the markets as the FIIs will now move to set up in the GIFT City. SEBI and IFSC can create a comprehensive framework for the regulated operation of P-notes in India. Additionally, to achieve the goal of boosting foreign capital inflow in India, SEBI can ease the requirements that will allow more foreign investors to directly register with SEBI. In this manner, investors can directly deal in Indian securities with minimal regulatory hassles.
Conclusion
ODIs are crucial instruments for any financial market, for driving the foreign capital inflows and encouraging investments. However, they are equally difficult to regulate due to the nature of their transactions. SEBI has remained cautious to not introduce any major amendments, to avoid any sharp reactions in the market. This move to recognise ODIs as valid will drive the FPIs to get registered in the GIFT City. While the recent announcement is a welcome step for foreign investors, this move by the government can prove to be counter-productive, if not dealt with caution. The upcoming amendments need to be brought in with a comprehensive approach so as to deal with any undesired activities in the future.