What are offshore derivative instruments (Odis)? Why sebi banned it?

Introduction

There has been a Sebi’s circular Issued on December 17, 2024The circular was titled “Measures to address regulatory arbitrage with respect to offshore derivative instruments (Odis) and Foreign Portfolio Investors (FPIS) With Segregated Portfolios Vis-Vis-Vis-Vis fepis, You can read the sebi’s original circular here,

Sounds like a sentence full of jargons, right? Don’t worry, I’ll declutter it down for you and also explain the significance of it for we small retail investors.

So, as the topic is complicated, I would take a step-by-step Approach to clear the topic. I’ll first explain the basics related to Offshore derivative instruments (odis) And Risk Hedging. When these concepts become clear, I’ll explain what the sebi’s circular is saying (or controlling).

Finally, I’ll also share my views on how this sebi circular is effecting our whole stock market in general and also individual stocks.

So, Stay put. This might look like a boring topic to start with, but if you read it through, i’m sure you will certain a lot of new things in this one Single Piece. Let me also assure you this, my explanations will be simple and easy to understand.

1. What are offshore derivative instrument (ODI)?

Let’s see how a typical offshore derivative instrument (ODI) Comes Into Being.

First up, The ODI Deal Happens Across Borders (Not in India – offshore).

Consider a Foreign Investor Who is Someone Based in London. Say, He Wants to Tap into the Indian Stock Market but do the Get into the hassle of directly buying shares on the nse or bse. Maybe they want to avoid the registration formalities, directly paying taxes, or the paperwork that come with investment in India as a foreigner. This is where an FPI (Foreign Portfolio Investors) Steps in.

FPIS are global financial players, alredy registered with sebi, who are allowed to trade in Indian markets. They know the sebi rules and sebi knows them. These FPIS are often a big bank or investment firm like Goldman Sachs or CITI, with offices in and outside India.

The Story Starts When a Foreign Investor Approaches the FPI (Say in London). The Investor Says, “I want to profit from Indian stocks say tcs, but I don’t want to own them myself.”

The FPI Agrees and Creates an OdieWhich is essentially a Contract or Certificate. This contract promises to mirror the performance of Specific Indian Assets. This asset can be eather tcs stocks directly, or a derivative contract like futures tied to the tcs stock.

In the next step, fPI goes to the Indian Market (their Indian Office), Buys the Underling Assets (Say, TCS Shares or Foughtrs), and holds them on the foreign investor.

Now, this is that part that I would like you to read carefully and remmber for future reference. The Foreign Investor Doesn’t Any Shares or Derivatives, only the FPI has the Holding in India. The ODI is Ised offshore, meaning it’s a deal struck outside India. It is governed by the laws of that Foreign Country, Not India Directly. They do not fall under the Ambit of Sebi.

Now, The Investor Pays The FPI for this Odi. In return, they get the financial outcome – profits if the stock rises, losses if it falls. Recall, they are able to get this without evr touching the Indian market themselves. So they are not bothered about how FPIS (in India) are managing these investments. They will only know or are bothered about, who they have made money from Odi or not. If they make money they may invest against or else say bye-bye to the FPI.

Whereas, in India, FPIS are not ok to loose money in their ODI Contract. So they get creative and they use “other derivatives” This is what is called Hedging.

Again Remember this point, in all this derivative transactions Happy in India (related to derivatives), the Originator of these activities (the foreign investor) is sitting in London who Ider the Wraps.

Now we have reacted a state where we must know the next intricate part of this complex story, Hedging.

I would like to remove you that all i’m explaining you here are related to the sebi’s new circular. To understand its implications we must first know these basics.

2. What is Hedging?

Let’s undersrstand how FPIS Use “Other derivatives” to Hedge his “derivatives tied to the odi” and limit their risks.

Imagine an FPI Issues an Odi based on a derivative, like a futures contract on tcs stock. The FPI buy this future contract in India.

This futures continued promises the FPIS (and hence the Foreign Investor) The Gains is TCS Price Goes Up and Losses in the price Goes Down.

But here is the problem. The FPIS are ready to pass on the loss to the foreign investment, but they want themselves to stay protected (in some case they can also offer offer this capital protective investor). How to get the protection?

If the tcs’ price drops, the futures contract will also also lose value. To protect themselves from this loss, the FPI use “other derivatives” as their heedge.

They will buy another derivative called an options contract. For example, they might buy a “put option” on tcs, which gives them the right to sell tcs shares at a fixed price. If tcs’ price crashes, as fpis have also boght a put-options, they can sell their contrast at a higher pre-deefined Fixed Fixed Price. This gain from the put-option will offset the loss from the futures contract.

[You can ask, what happens to the Put Options if the TCS’ price goes up? The FPI won’t exercise their right to sell at the fixed price since the stock price is higher, so the put option contract expires worthless, without causing any additional loss to the FPI beyond the premium they paid for the option.]

This Balancing Act of Using One Derivative (The Put Option) to Counter The Risk of Another (the futures), is called Hedging. It limits the FPI’s risk of loss in case the price acton of the stock is not as expected.

3. What the new sebi circular, dated December 17, 2024, is saying?

This circular has brought the following main changes:

1. First, FPIS can no longer issue odis based on derivatives like futures or options.
2. INTEAD, must use actual stocks.
3. They also can’t use derivatives to protect (or heedge) their odis almore. They have to hold the exact matter stocks as the odis, one-to-one, all the time.
4. Next, FPIS Issuing Odis need a separete registration just for that, with “Odi” in the name.
5. FPIS Can’t mix their own investments in that account.
6. If Big BIG ODI users Hold too much in one Indian company group (over 50%) or have a huege stake in the Indian market (over Rs.25,000 current), they must share more details about why are and what they haven.
7. FPIS are getting one year, until December 16, 2025, to follow these new rules if they’re already using odis with derivatives.

Sebi is doing this to stop tricky loopholes, make the market fairer, and keep a closer eye on foreign money coming into India.

4. How is this sebi’s new Odi Rule Cold Effect the Indian Stock Market?

The new shift would reduce the overall activity of FPIS in the Indian Market.

Why? BeCause odis with derivatives were a flexible, low-cost way for foreign investors to bet on Indian stocks without directly out Removing this option might make India less attractive for some fipis, especially that who released on derivatives for Quick, Speculative Trades.

If Fewer FPIS PARTICIPATE, The Market Could See Less Foreign Money Flowing in. This might lead to lower trading volumes and liquidity in the overall market. Lower liquidity often means more valati, stock prises

There could also be effects on individual stocks, especially that with derivatives like futures and options (Example, HDFC Bank, Reliance, TCS, ETC)

Before this circular, fipis could issue odis based on derivatives of these stocks. They could also hedege their risk using other derivatives (like a put option) on Indian Exchanges.

This created a lot of trading activity in the derivatives market, which influenced the underlying stock prices in the cash market as well due to sentiments (Read this article to know the difference between cash market and derivative market,

With the new rules, FPIS Can’t Use Derivatives for Odis Anymore. Now, they have to buy the actual stocks. This might reduce trading in the derivatives segment for these stocks. This single makes their futures and options less active.

Less activity in derivatives can lead to wider bid-steps (the gap between buying and selling pris), Making it Costlier for traders to take positions. This single further dampen speech spectative trading, potentially stabilizing the stock pristed in the short term. But on the downside, it will also reduce the overall buzz Around these stocks.

5. It will build trust in the stock market

The sebi circular will also also brings transparency. It requires FPIS with Large Stakes (Over Rs.25,000 Crore or more than 50% in one corporate group) to disclose more details. This type of step might build trust in the market over time.

If FPIS has to hold actual stocks instead of derivatives, their investments might become more long-term and less speculative. It will reduce Sudden Sell-Offs that Crash Stock Pries.

However, in the short term, as FPIS Adjust to these rules by December 2025, some might choose to exit or scale back their positions, especially if they find the new requirements! This could put downward pressure on stock prisles, particular for large-cap stocks where fipis have big stakes, like there in the nifty 50 or senses.

6. Effect of the Odie Rule on Indian Rupee

If FPIS sell off stocks to complete with the new rules, they’ll convert rulers to dollars. This will increase the demand for foreign currency (Say Usd, Euro, etc.). Such High Demand for a Foreign Currency could also also alsowal weaken the rupee.

What is the impact of a weak rupee? It will make imports costlier and adding inflationary pressure.

In an inflationary market, stock prises get hurt ultimately dampening the economic growth.

Conclusion

Is it a good step or a bad step.

On the face of it, it looks like a very positive step. But honestly, it’s a Mixed Bag,

• On one hand, I like that sebi’s trying to Make the market more transparentWhen Foreign Investors Play by CleareR Rules, IT’s Less Likely We’ll See Sudden Shocks, like a big FPI Dumping Stocks BeCause of Some Hidden Derivative Mess. That’s good for us small investors who just want a stable market to grow our savings.
• But on the other hand, I wonder if this might scare off some foresign moneyMore Rules mean more paperwork, and not every FPI might want to deal with that hassle. India’s been a hot spot for foreign investment, will this cool things down? Only time will tell.

While Sebi Says Odis with derivatives was Barely Used (Just Rs.75 Crore in Mid-2023), so why make such a big fuss now? Maybe they just getting getting ahead of a problem before it grows. Or, there are things that they do not want us to bother about but anyways were the feel. For example, recently there has been Allegation of Stocks Pries Staying Artificically Inflated. Maybe, sebi has found out it has something to do with odis (i’m only speculating).

For us, The takeaay is simple, we only know the stock market from the percective of “Cash Market.” Buth More Trading Happens in the derivative market. Moreover, there is also some something called odis which are operated remotely using both stocks and derivatives as their instruments.

I hope I was alive to explain the topic in a simple way to you. If did like my effort, may i request you to Kindly post your feedback in the comment section below,

Have a happy investment.