FPIs are currently permitted to participate in Exchange Traded Commodity Derivatives (“ETCDs”), restricted to cash-settled non-agricultural commodity derivative contracts and indices comprising such non-agricultural commodities. Since the introduction of the current framework in 2022, SEBI has noted a considerable rise in liquidity and market depth of the commodities market. In light of these developments and representations received from the exchanges and market participants, the Securities and Exchange Board of India (“SEBI”) has issued a ‘Consultation Paper on FPI participation in ETCDs’ (“Consultation Paper”) to expand Foreign Portfolio Investor (“FPI”) participation into non-agricultural index derivatives contracts and non-cash settled non-agricultural commodity derivatives contracts. The major proposals have been outlined below.
FPI Participation in Non-Agricultural Index Derivatives
Presently, FPIs are only permitted to trade in cash-settled index contracts whose underlying contracts are also cash-settled. However, irrespective of the manner of settlement of the underlying contracts, index derivatives are always cash-settled. Accordingly, SEBI has proposed to permit FPIs to also participate in non-agricultural index derivatives contracts which are non-cash settled.
FPI Participation in Non-Cash settled Non-Agricultural Commodity Derivatives Contracts
Currently, FPIs are only permitted to participate in cash-settled non-agricultural commodity derivatives contracts due to constraints on delivery mechanisms. FPIs cannot take or make delivery in the absence of a permanent establishment in India, and even if SEBI were to permit FPIs to delegate the settlement of goods through a Trading Member (“TM”), FPIs would still be required to obtain Goods and Services Tax (“GST”) registration to buy/sell commodities in India.
SEBI has now proposed to permit FPIs to trade in non-cash settled non-agricultural commodity derivatives contracts. FPIs may now take positions in non-cash based non-agri-commodity derivative contracts available at domestic exchanges. However, FPIs must compulsorily square off or rollover positions before start of the tender period (“T”) i.e. three days before the expiry of the contract. In order to address the issue of physical delivery, SEBI has proposed a two-tier safeguard mechanism. The safeguard mechanism shall stand triggered only where a FPI has not voluntarily squared off or rolled over its open position by the close of market hours on T-3.
For FPIs, all open positions before the start of the tender period need to be compulsorily transferred to the TM / Trading-cum-Clearing Member (“TCM”), in case square-off or rollover of positions is not done voluntarily by the FPI. Where an open position is held by the FPI at the end of T-1, the TM/TCM shall provide a value-added service to the FPI by absorbing the FPI’s open position to its own books, for a service fee. This transfer of the open position would be akin to a sale of the underlying derivative position by the FPI to the TM/TCM. Thus, to ensure that FPI positions are squared off or rolled over before the start of the tender period, the proposed mechanism shall combine (i) a compulsory square-off obligation, backed by (ii) an automatic transfer mechanism that operates only if the FPI does not voluntarily square off or roll over its position.
To give effect to the aforementioned automatic transfer mechanism, SEBI has proposed that FPIs shall enter into either of the following agreements, as applicable to their membership structure:
(i) A tripartite agreement with the Professional Clearing Member (“PCM”) and the TM, or
(ii) A bipartite agreement with the TCM.
The above-mentioned agreements may incorporate a Proprietary Risk Absorption Charge, i.e., a pre-agreed charge payable by the FPI to the TM/TCM for assuming the relevant position, over and above the service fee for the transfer and without prejudice to any penalty that may be leviable by the exchange or clearing corporation for position-limit violations.
Upon intimation of the arrangements by the TM/TCM to the exchanges, FPIs shall be permitted to trade in the relevant commodity contracts. Prior to the tender period, FPIs shall voluntarily exit their positions either by squaring off or rolling over their positions. Although SEBI has proposed T-3 to be the start of the automatic transfer mechanism, FPIs can still exit their positions at any time up to the close of market hours within T-1 day. If such voluntary exit is not undertaken, only then will the automatic transfer mechanism with the designated TM/TCM get triggered.
The square-off of the FPI’s position shall be made into the proprietary account of the TM/TCM and the trade shall be executed automatically post closure of market hours on T-1 day at the Closing Price/Daily Settlement Price as declared by the exchanges on the day of the transfer of the position.
Upon execution of the transfer, all rights and obligations in respect of the FPI’s position shall vest with the designated TM/TCM. The transfer is treated as a normal market trade and attracts applicable turnover fees, commodity transaction tax, stamp duty and GST. It is analogous to the equity market’s ‘Post-Close’ trading window. Notably, the Consultation Paper exempts the transfer from restrictions that would otherwise apply to over the counter derivatives, off-market transfers, client-code transfers and error accounts; the transfer is instead treated as a market trade subject to the applicable statutory levies.
Conclusion
The Consultation Paper represents a welcome and calibrated step towards aligning the Indian commodity derivatives framework with international markets, while addressing the structural constraints that have restricted FPI participation. That said, the practical utility of the framework for FPIs will ultimately depend on the agreements entered into between the TM/TCM and FPIs, compliance and cost implications, including the Proprietary Risk Absorption Charge and the applicable statutory levies triggered on an automatic transfer, as well as the operational burden of monitoring the T-3 exit deadline across contracts and exchanges. It remains to be seen whether these costs will meaningfully temper FPI appetite once the framework is introduced.
