FPIs Get Closer to Physical Commodities: SEBI Greenlights Proposal for Derivatives Market Access

FPIs Get Closer to Physical Commodities: SEBI Greenlights Proposal for Derivatives Market Access​

Securities and Exchange Board of India (SEBI) is set to propose a significant overhaul of commodity derivatives access for foreign portfolio investors (FPIs). The regulator is considering allowing FPIs to trade physically deliverable non-agricultural commodity derivatives, pending the release of a consultation paper. This move represents a substantial step toward expanding commodities market participation for international investors.

The proposed framework introduces a mandatory exit mechanism designed to manage risk associated with physical delivery. Under this model, FPIs would be required to square off or roll over their positions prior to the contract's expiry period. Failure to comply voluntarily mandates automatic transfer of the open position to a designated broker or trading-cum-clearing member.

Mandatory Exit Mechanism for Foreign Investors​

The evaluation currently centers on an FPI being able to trade non-cash settled non-agricultural commodity contracts, mirroring other market participants. While FPIs retain the option to close or roll over their positions before the tender period, they must compulsively complete this action three days preceding the expiry date. If an FPI fails to voluntarily exit, the exchange will trigger the position transfer via its clearing or trading member.

Risk Management Shifts to Designated Broker​

A crucial element of the SEBI proposal is the back-up mechanism for instances where the FPI does not execute a proper exit. Such institutions intending to trade these contracts would need an agreement with a designated broker or clearing member, limited to only one such arrangement. The open position could be carried until market close on the day before the tender period commences.

If the fail-safe mechanism activates, the open position will automatically transfer to the designated broker’s proprietary account. This transaction, which occurs at that day's closing price or daily settlement price declared by the exchange, effectively shifts the delivery risk burden onto the broker.

The Role and Responsibilities of the Brokerage Sector​

The proposed structure dictates that the clearing member must inform the designated broker about the FPI’s open position and the required margin in advance to ensure adequate preparation time. Furthermore, the proposal allows the broker time to reduce a transferred position if it exceeds applicable limits. The assigned broker will then have two trading days to reduce any excess position.

To safeguard market integrity, clearing members are prohibited from accepting trades that would increase an FPI’s open position in the near-month deliverable contract on the day before the tender period. This constraint is designed to prevent FPIs from increasing exposure just prior to the mandatory exit deadline.

Penalties and Transaction Charges for Non-Compliance​

The proposed agreement between the FPI and its designated broker could stipulate a pre-agreed charge or penalty should the FPI fail to square off or roll over the position, thereby forcing the broker to absorb it. This contractual charge would be distinct from any penalties levied by the exchange or clearing corporation for violating position limits.

It is noted that these transfer trades will be treated as standard market transactions and will attract all applicable charges. These include SEBI turnover fees, Commodity Transaction Tax, stamp duty, and GST on turnover charges.

Market Expansion Context​

The proposed policy shift would signify an expansion of commodities market access for FPIs in India. Previously, SEBI allowed FPI participation in exchange-traded commodity derivatives restricted to cash settled non-agricultural commodities and related indices (2022). Under this new proposal, FPIs could potentially take positions in contracts that lead to the physical delivery of the underlying commodity.