The Union Budget 2023-24 has recognised offshore derivative instrument (ODI) as a valid contract, though this is limited to an ODI issued by a Foreign Portfolio Investor (FPI) in the International Financial Services Centre (IFSC) as regulated by the International Financial Services Centre Authority (IFSCA). This is done to enhance business activities in the IFSC.
As this is a limited recognition, in general, derivative contracts, unless the ones which meet conditions of the Securities Contracts (Regulation) Act, 1956 (SCRA), will continue to be void.
Section 18A of the SCRA only recognises those contracts in derivative that are traded on a recognised stock exchange; settled on the clearing house of a recognised stock exchange or issued in compliance with the rules of such a stock exchange and between such parties and on terms as the central government may notify. A derivative contract that does not meet the conditions is void.
SCRA defines a derivative to include a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; or a contract which derives its value from the prices, or index of prices, of underlying securities; or commodity derivatives; and such other instruments as the central government may declare to be derivatives.
An example of this could be a security issued to an investor the return on which is dependent on other underlying security(ies). The Finance Bill proposes to amend this to provide that a contract in derivative will be legal and valid if the contract is regulated by the IFSCA in IFSC and are issued by an FPI. FPI will continue to have the same meaning as provided in SEBI (FPI) Regulations, 2019 (SEBI FPI regulations).
One category of a derivative security is an ODI, popularly called participatory notes (P-Notes). P-Notes are generally issued by a registered FPI to its clients/investors who wish to participate in Indian capital markets but do not want to be registered themselves in the markets directly.
Currently, SEBI FPI regulations have provisions dealing with ODIs. The regulations define ODI to mean any instrument, by whatever name called, which is issued overseas by a FPI against securities held by it in India as its underlying. P-Notes have always attracted attention from all regulators, especially SEBI. This is because, while they are a huge source of foreign investment into Indian markets, it is difficult to trace their ultimate beneficiaries, a matter of great concern for the Indian regulators.
It is feared that such shadow structures could be used as a fertile ground for money laundering or round tripping activities using the P-Notes. So, any amendments to tweak these P-Notes have always caused markets to react sharply. History is replete with instances of markets crashing whenever P-Notes laws were tampered with.
Interestingly, despite all controversies surrounding them, P-Notes are not completely banned but are regulated by SEBI as ODIs. So could the Budget now be said to be paving way to legalise P-Notes? This doesn’t seem to be the case. As mentioned, P-Notes in the form of ODIs are already regulated by SEBI. Having said that, the Budget has made a specific provision allowing all kinds of derivatives (not necessarily only P-Notes) to be issued by FPI in IFSC.
For this purpose, amendment to SCRA has been proposed so that derivatives can be issued in IFSC. However, the detailed regulations in this regard will be framed by the IFSCA as these contracts will be regulated by it. Therefore, the final regulations will have to be seen on how these contracts will be regulated in IFSC. So, watch out for this space!
Lalit Kumar is Partner at JSA. Views are personal.