Sebi proposes to allow FPIs to participate in physically settled commodity derivatives

The Securities and Exchange Board of India (SEBI) has proposed allowing Foreign Portfolio Investors (FPIs) to participate in non-cash settled, or physically settled, non-agricultural commodity derivative contracts traded on recognised domestic exchanges, subject to a set of safeguards.

The move is aimed at deepening institutional participation and liquidity in India’s commodity derivatives market.

“Based on representations received from stakeholders, deliberations of the Commodity Derivatives Advisory Committee (CDAC), and public comments received on the consultation paper on this subject, and with the objective of deepening institutional participation and liquidity in the commodity derivatives segment, it has been decided to permit FPIs to participate in non-cash (physically) settled non-agricultural commodity derivative contracts, subject to the safeguards specified in this circular,” said SEBI in its latest circular.

Currently, FPIs are permitted to participate in the commodity derivatives segment of recognised stock exchanges through cash-settled non-agricultural commodity derivative contracts and indices comprising non-agricultural commodities, except deliverable options contracts.

Under the revised framework, FPIs will be allowed to participate in deliverable non-agricultural commodity contracts up to the commencement of the tender or staggered delivery period. They will have to unwind or square off their open positions before the commencement of the tender or staggered delivery period.

On the trading day immediately preceding the commencement of the tender or staggered delivery period, no fresh positions that increase an FPI’s existing position in the expiring contract will be allowed.

Two-tier safeguard mechanismSEBI has put in place a safeguard mechanism to ensure that FPIs do not end up with delivery obligations in physically settled contracts.

The primary and preferred mode of exit will be voluntary square-off or rollover. An FPI will be free to square off or roll over its open positions up to the close of market hours on the day preceding the start of the tender period.

However, if an FPI has not voluntarily squared off or rolled over its open position by the close of market hours on T-3, the safeguard mechanism will be triggered.

The FPI’s open position will then be automatically transferred to the proprietary account of a designated Trading Member (TM) or Trading-cum-Clearing Member (TCM) after market hours on T-1, the day preceding the start of the tender period, before the start of end-of-day activities of the clearing corporation.

The Professional Clearing Member will have to inform the designated TM by the end of T-2 about the FPI’s open position that is liable to devolve under the safeguard mechanism. This is intended to enable the designated TM to arrange adequate margin ahead of the transfer.

The transfer will be executed at the closing price or daily settlement price declared by the exchange on the day of transfer. It will be treated as a normal market trade for all purposes, including exchange transaction charges, SEBI turnover fees, Commodity Transaction Tax (CTT), stamp duty and GST on turnover charges.

Once the transfer is executed, the FPI’s open position will be deemed to be closed. The FPI will cease to have any further right, title, obligation or exposure in respect of the position, including in relation to the tender or delivery process. All rights and obligations relating to the transferred position will thereafter vest solely with the designated TM or TCM.

SEBI has also clarified that such transfer of positions from an FPI to a TM under the special arrangement will not be treated as an over-the-counter derivative. Existing provisions relating to transfer of positions between client codes applicable to non-institutional transfers, error accounts or off-market transfers will also not apply to this arrangement. The transfer will instead be considered a trade with applicable statutory levies.

No fresh positions on T-1

No Clearing Member will be permitted to accept or clear any trade that results in an increase in an FPI’s open position in the near-month deliverable contract on T-1, immediately preceding the start of the tender period.

The framework also provides relief to a designated TM or TCM if the transfer of FPI positions causes its proprietary account to exceed applicable position limits.

Such a member will be permitted up to two trading days from the date of transfer to reduce its futures positions and bring them within the prescribed limits, said SEBI.

During this period, the transferred position will not, solely because of the transfer, be treated as a violation attracting penal action under Annexure J of SEBI’s Master Circular for the Commodity Derivatives Segment.

Proprietary Risk Absorption Charge

SEBI has also provided for a “Proprietary Risk Absorption Charge” that may be incorporated into the onboarding agreement between the FPI and the designated TM or TCM.

The charge may be payable by the FPI where its open position is transferred under the backstop mechanism because the FPI failed to voluntarily square off or roll over the position by T-1.

The charge is intended to compensate the TM or TCM for the proprietary risk, margin and position-limit burden it absorbs because of the involuntary transfer. It will be over and above any service fee agreed between the parties for effecting the transfer.

The exchange will prescribe the conditions under which the charge is collected. The quantum and manner of computation of the charge will have to be disclosed to and agreed upon by the FPI at the time of onboarding.

The charge will be without prejudice to any penalty leviable by the exchange or clearing corporation under the existing framework.

Onboarding Requirements

According to the circular, before enabling an FPI to trade in non-cash settled non-agricultural commodity derivative contracts, the Trading Member must put in place either a tripartite agreement among the Professional Clearing Member, Trading Member and FPI, or a bipartite agreement between the Trading-cum-Clearing Member and the FPI, depending on the membership structure through which the FPI operates.

At its discretion, an FPI may enter into an agreement with one TM or TCM across all exchanges and commodities, one TM or TCM per exchange, or one TM or TCM per commodity or group of commodities within each exchange.

The TM or CM will have to inform the relevant exchange or clearing corporation of the arrangement before permitting the FPI to trade in the relevant deliverable commodity derivative contracts. The exchange will enable trading for the FPI only upon confirmation of the arrangement.

SEBI has also asked recognised exchanges having commodity derivatives segments to standardise the format and material terms of the onboarding agreement in consultation with each other, to ensure consistency in safeguards and disclosures applicable to FPIs across exchanges.

The exchange or clearing corporation will also notify detailed schemes or guidelines for a post-closure window between the designated TM and FPI for open positions held by the FPI one day before the start of the tender period, after normal market hours, at the closing price in the commodity derivatives market segment.

SEBI said the move would deepen institutional participation and liquidity in the commodity derivatives segment.

The framework is also expected to broaden the participant base, improve market depth and price discovery, and strengthen convergence between derivatives and physical markets.