Another half-measure

The Securities and Exchange Board of India’s consultation paper on tightening the rules governing Offshore Derivative Instruments is yet another piecemeal effort that stops short of taking the key decision — whether the country needs these instruments or not. There is a unanimous view that the opacity provided by these instruments leads to the misuse of this route by money-launderers; past investigations have shown that large corporate houses have used these to round-trip funds. But SEBI could not close this route earlier because a large chunk of foreign fund flows into the stock market came through offshore derivative instruments; more than 50 per cent of FII assets were accounted by ODIs in 2007. Closure of this channel then could have had a destabilising effect on the stock market. With the foreign capital flows helping bridge the current account deficit, the Centre was also hesitant about plugging this route earlier. But the threat has dwindled significantly over the years with ODIs accounting for just 6 per cent of foreign investors’ assets towards the end of April 2017.

This has been thanks to a series of measures taken by SEBI over the years such as restricting the transfer of ODIs to unregulated entities, making it mandatory that the entire trail of transfers be reported to the regulator, seeking additional information from foreign investors who were issuing the ODIs and prohibiting resident Indians and NRIs from subscribing to them. These measures have helped bring down the usage of this route significantly in recent times; outstanding offshore derivative instruments are down 27 per cent since the beginning of 2016. SEBI is now seeking to push through two more measures — imposing a regulatory fee of $1,000 on each foreign investor for every ODI client once every three years, and prohibiting issuance of ODIs on derivatives unless it is for hedging purposes. All outstanding ODIs drawn on derivatives have to be wound down by December 2020.

These ongoing tweaks mean that misuse of offshore derivative instruments continues despite the regulator’s ceaseless efforts. However, the two additional measures proposed by the regulator are unlikely to bring the misuse to a halt. One, the fee proposed is too low to deter money-launderers. Two, round-tripping can continue through ODIs issued on equity and debt. The hesitation of the regulator to ban these instruments outright is hard to understand. The declining proportion of ODIs in foreign investors’ assets implies that most of them now prefer to register with SEBI. The interest of Indian markets can be better served by encouraging long-term investors such as pension, insurance and sovereign wealth funds, instead of hedge funds who are the principal users of the ODI route.

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