The Securities and Exchange Board of India (Sebi) has barred Foreign Portfolio Investors (FPIs) from issuing Offshore Derivative Instruments (ODIs, which are also known as participatory notes or P-Notes) with derivatives as the underlying or using derivatives to hedge their ODIs in India.

A derivative is a financial contract that derives its value from an underlying asset.

The market regulator took this step as it sought to address the regulatory arbitrage available to overseas investors: those who directly invest in India by registering as an FPI and those investing in the country by issuing ODIs.

An ODI is an instrument which is issued overseas by an FPI against securities held by it in India as its underlying.

While the ODI issuer (the FPI) remains the owner of the underlying securities, the economic benefits of such holdings are transferred to the ODI subscriber. Such ODIs are generally issued by entities based in overseas tax havens.

Earlier, the norms for issuance of ODIs provided that the instruments can be issued subject to certain eligibility conditions and reporting requirements. In terms of Regulation 21 of the FPI Regulations, 2019, ODIs can be issued by Category I FPIs to persons eligible for registration as Category I FPIs after compliance with Know Your Client (KYC) norms. Transfer of ODIs is permitted subject to consent of the ODI issuing FPI.

In a consultation paper released in August, the market regulator had said that the total value of ODIs as a percentage of the AUC (assets under custody) of FPIs had dropped from 44.4 per cent at the end of 2006-07 to 2.1 per cent at the end of 2023-24. As on May 31, 2024, the total value of ODIs or P-Notes were at ₹1,34,633 crore as against ₹1,49,120 crore in 2023-24.

In its circular issued on Tuesday, Sebi said that FPIs cannot issue ODIs with derivatives as the underlying. It mandated that ODIs with derivatives as underlying issued and outstanding as on the date of the circular, shall be permitted to be redeemed within a period of one year from the date of this circular. However, renewal of such ODIs will not be permitted.

Tightening the rules further, Sebi added that an FPI shall issue ODIs only through a separate dedicated FPI registration with no proprietary investments.

It added that such an FPI registration shall be in the name of the FPI with “ODI” as suffix under the same PAN.

The market regulator also strengthened the disclosure rules in line with the circular issued in August 2023. The regulator said the granular details of all entities holding any ownership, economic interest, or exercising control in the ODI subscriber, up to the level of all natural persons, will have to be collected by the FPI from its ODI subscribers.

This will apply to an ODI subscriber meeting certain criteria, for instance, those having equity positions worth more than ₹25,000 crore in the Indian markets. It will also be applicable to those subscribers who have more than 50 per cent of their position (through the ODIs issued by the FPI) in a single Indian corporate group.

Certain entities are exempt from these disclosures. These include government and government-related investors registered under FPI regulations, Public Retail Funds (PRFs), subject to validation and Exchange Traded Funds (ETFs) with less than 50 per cent exposure to Indian equity markets.

Nikunj Saraf, VP, Choice Wealth said Sebi’s “bold” move will reshape ODIs.

“The move aims to boost transparency, reduce systemic risks, and align foreign investments with India’s market conditions while tackling regulatory loopholes. FPIs must now navigate stricter rules, including separate ODI registrations and detailed disclosures. These steps enhance market integrity but limit flexibility and add compliance costs, potentially deterring short-term players,” he said.