BackSebi, government should issue FII registration rules soon
The regulator should do more to enhance the attractiveness of the onshore market.
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The Securities and Exchange Board of India (Sebi) has finally decided to do away with direct registration of foreign institutional investors (FIIs). Last week, it accepted the recommendations of the K.M. Chandrasekhar committee, which had said that Sebi should instead delegate the registration process to designated depositary participants and ease know-your-client (KYC) requirements using a risk-based approach.
The exact details of the committee’s recommendations have not been made available, and so it’s still not known to what extent KYC requirements will be simplified. Even so, the fact that Sebi has been willing to get out of the registration process has got market participants excited. Global custodial participants say that market access for FIIs will undoubtedly become much faster. The only hitch is that while Sebi has approved these changes in the FII registration process, it may take a while before this is implemented with actual rules in place. This is because some changes need to be implemented by the government and some of the recommendations will even require legislative changes. What has added to the complication is that not too long ago, Sebi introduced a new route for foreign investors called qualified financial investors (QFIs), who after a distinct registration process can make direct investments in Indian equities, debt and mutual funds (MFs). This category primarily consists of high net worth individuals and family offices. Investments from this segment, however, haven’t taken off. While the direct investment route will always be a fraction of the institutional route in any case, the QFI segment has also been hit by problems on tax treatment.
The Chandrasekhar committee has proposed that the FII and QFI distinction, as well as the FII and FII sub-account separation should be done away with. It envisages one category, called foreign portfolio investors (FPIs). Since the FII and QFI segments are currently being treated differently as far as taxation goes, the income-tax department will need to clarify how this new segment will be taxed. Of course, no one is expecting the government to change its stance on FII taxation after the GAAR (General Anti-Avoidance Rules) fiasco last year. Even so, clear tax rules have to be in place before the new segment (FPI) is made operational to avoid any confusion. In addition, changes may be required in the Foreign Exchange Management Act and Prevention of Money Laundering Act apart from the evident changes in the Sebi Act. All of these need to be done in a coordinated manner to ensure that the transition to the new regime is smooth.
The risk-based approach to KYC will mean that government and government-related entities such as sovereign wealth funds will require the least amount of paper work. Regulated entities such as MFs and pension funds will require a little more paper work than the previous category, but presumably lesser than what is currently required. All other entities such as hedge funds will have to go through a stringent KYC process. Again, since the details of the KYC requirements are not available, it’s difficult to predict if there will be a surge in registrations by non-regulated investors, or entities that fall in the third risk category.
It also needs to be kept in mind here that a number of foreign investors prefer using offshore derivatives instruments (ODIs) and participatory notes (P-notes) because of the flexibility these instruments provide. Investors aren’t allowed to buy structured over-the-counter (OTC) derivatives onshore, while this can be done offshore using ODIs. So even if a hitherto unregistered FII is able to easily register in the new regime, the fact that it cannot buy OTC products onshore will mean that its direct participation will be limited.
Therefore, apart from simplifying the registration process, Sebi should permit OTC derivatives in the onshore market. Considering that the exchange-traded market is now well established, there is hardly any threat of the OTC market cannibalizing it. On the contrary, it will enhance the liquidity of the exchange-traded market. In the current regime, domestic market participants are clearly disadvantaged and are completely shut out from this segment.
Of course, all this does not suggest that Sebi’s decision on the FII registration process isn’t commendable. It is a huge positive. However, it remains to be seen how well the coordination with the government and the central bank goes before this decision translates into new rules. Besides, the regulator should do more to enhance the attractiveness of the onshore market for overseas investors.
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