Industry backs SEBI’s FPI commodity push, flags gaps in physical delivery mechanism

The latest market report highlights that Traders at large have backed market regulator’s proposal to allow Foreign Portfolio Market participants (FPIs) to trade physically settled non-agricultural commodity derivatives, but have flagged gaps in the proposed delivery and settlement mechanism, particularly the plan to transfer residual positions to domestic brokers.

The industry and traders at large have urged the Securities and Exchange Board of India (SEBI) to ensure that market-based square-off or rollover stays the primary exit route, with transfer to a designated trading or clearing member used only as a last-resort backstop.

SEBI, in a consultation paper issued on August 11, proposed allowing FPIs to participate in non-agricultural commodity derivatives, including physically settled contracts such as gold, silver, copper and other base metals.

The move is aimed at widening foreign participation, deepening liquidity and improving price discovery in India’s commodity derivatives market.

Exit before delivery should stay the norm

In its comments to SEBI, the IMC Task Force on Capital Markets, headed by former MCX MD and CEO Mrugank Paranjpe, stated the mandatory square-off or rollover requirement should stay the main mechanism for an FPI to exit an expiring contract. Transferring a residual position to a designated trading member or trading-cum-clearing member should only be an emergency backstop and should not replace voluntary or market-based exit options.

Task force additionally stated, the framework should clearly establish that an FPI trading a physically settled derivative and exiting before the tender period does not, merely by trading the contract, create or assume a physical delivery obligation. The clarification, it stated, is important for FPIs as well as custodians, trading members and clearing members.

Who carries the risk if the market freezes?

A key concern boosted by traders at large is the risk that a designated broker could be required to take an FPI’s undelivered position into its own account.  This could be particularly challenging for banks and their subsidiaries, given RBI restrictions on taking such positions, potentially leaving smaller intermediaries to absorb the risk. One market participant stated, “The proposed mechanism requires the broker to take the FPI’s position into its own proprietary book. A significant part of the clearing and broking capacity in this segment sits with banks and with bank subsidiaries, and both are barred by the RBI from doing holding proprietary positions in the commodity derivatives”. The practical consequence is that the institutions best capitalised to absorb a devolved bullion or base metal position are excluded from the role, and it falls to smaller non-bank members.

A commoditywise limit on broker sought

Traders at large have additionally sought commodity-wise limits on the amount of residual positions a designated member can absorb. The FPI’s near-month exposure, they stated, should not exceed the member’s pre-approved absorption capacity. They have additionally sought clarity on the sequence for releasing the FPI’s margin, collecting margin from the designated member and transferring the position. They additionally point out the absence of a clear cap on the risk that can accumulate with a single broker, as well as uncertainty over who owns the margin and bears earnings or loss during the transfer.

Another concern is the potential mismatch between futures and options position limits, which could create difficulties when a residual position is transferred.

They point out to the earlier framework, operational between 2018 and 2022, under which foreign market participants could take physical delivery through authorised brokers. The framework was withdrawn because of low participation. Phased introduction suugested

Traders at large suggest that SEBI should consider an IFSC-first approach, allowing GIFT City-based FPIs to participate initially, followed by a phased expansion into bullion and energy and, later, base metals.

The consultation process closed on September 1. SEBI is anticipated to offering final circular after considering all the feedback from stakeholders.