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Of Participation of Foreign Entities in Commodity Derivatives

May 29, 2018

On May 18, 2018, the Securities and Exchange Board of India (SEBI) released a consultation paper to propose the idea of allowing foreign entities to participate in the commodity derivatives market through an appropriate regulatory mechanism. Although the proposal is open to public comments only now, the same has been deliberated upon previously by the regulator, when it constituted a Commodity Derivatives Advisory Committee. The Committee recommended opening the commodity derivatives market in a phased manner, starting from Category III Alternative Investment Funds, portfolio management services, mutual funds, and foreign investors having exposure to commodities to banks, insurance companies, foreign portfolio investors, and pension funds.

 

Dealing in commodities could take various forms. Importantly, there could be a spot trade, entailing immediate buying and selling of commodities, or a trade in derivatives, entailing trade in financial instruments based on such commodities. Under the Securities Contracts (Regulation) Act, 1956 (Act), a commodity derivative is defined as a contract for differences, which derives its value from the value of the underlying goods, activities, services, rights, interests or events.[1] Since the value of these instruments is based on commodities, the term excludes from its ambit derivatives based on shares, debt instruments, loans or other forms of securities. The Act allows trading in derivatives, provided the same is carried out on a recognized stock exchange, settled in the clearing house of such stock exchange or in accordance with its rules and bye-laws, and conducted between such parties as are notified by the Central Government.[2]

 

The Proposed Framework

 

Currently, foreign entities are not allowed to trade in commodity derivatives, unless they do so through a subsidiary resident in India. However, operating through an Indian subsidiary itself is not a feasible option for small foreign entities and, in order to ensure that they, too, have access to this segment, it becomes pertinent to usher in a regulatory framework allowing for direct foreign participation therein. With this in view, and considering the increasing importance being accorded to foreign investment in the country, SEBI has proposed that foreign entities which have actual exposure to commodities in India may be allowed to directly participate in commodity derivatives trading. Such Eligible Foreign Entities (EFEs) must be resident in a country whose securities market regulator and/or commodity derivatives market regulator is a signatory to the Multilateral MoU of the International Organisation of Securities Commissions or to a bilateral MoU with SEBI. Moreover, such a country must not be identified by the Financial Action Task Force (FATF) as a jurisdiction having deficiencies in addressing money laundering issues or a jurisdiction which has not committed itself to the action plan developed by the FATF in this regard. SEBI has further proposed a minimum networth requirement for such EFEs to be $1 million with the suggestion that the same may be reviewed in due course.

 

In order to take hedge positions on commodity derivatives platforms, the EFEs will be required to approach Authorized Stock Brokers (ASBs) who shall not only be registered under the SEBI (Stock Brokers and Sub-brokers) Regulations, 1992, but also be authorized by the commodity derivatives exchanges in this behalf. Thereafter, trading in commodity derivatives shall be allowed through a single trading account alone. In this regard, responsibility is placed on the ASBs to conduct due diligence and ensure that the EFE participation is in compliance with the relevant laws. The ASBs shall, wherever required, obtain necessary declarations and undertakings from the EFEs.

 

The participation of an EFE shall be subject to hedge limits for a commodity, which limits shall correspond to the EFE’s physical exposure to the commodity. This requirement has been prescribed in order to ensure that the EFEs do not undertake speculative transactions. The EFE shall be required to approach the ASB of the concerned commodity derivatives exchange for hedge limits, and the limits, once approved, shall be monitored by the exchange.

 

Observations

 

Companies, such as Vedanta, which hedge their position in commodities markets worldwide, may now have a chance to do the same in India. Indeed, permitting foreign entities would provide more liquidity to the commodity derivatives market. Facilitating these entities to hedge their price risks would, in turn, strengthen the import/export market for the underlying commodities. The objectives intended to be achieved through the proposed framework are in tune with certain other measures taken by SEBI of late to create a robust framework for commodity derivatives trading, one of which is to integrate the commodity derivatives platforms with the regular stock exchanges and, therefore, provide a boost to trading volumes for commodities and a better risk management mechanism of larger exchanges.

 

While these measures are being taken, efforts should be made to ensure that the interests of producers and consumers of commodities are taken care of. This necessarily implies building a reliable infrastructure for commodities.

 

 

[1] The Securities Contracts (Regulation) Act, 1956, section 2(bc).

[2] Ibid, section 18A.

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