FPI participation in commodities

Foreign investors were kept out of Indian commodity derivatives for a long time. SEBI has let them in one step at a time.

Step one, October 2018. Foreign firms that already had a real commodity exposure in India could hedge it. The test was business need. An eligible foreign entity had to have open positions in the underlying commodity in India, arising out of its business obligations.

Step two, 2022. SEBI amended the guidelines. Now foreign investors could come in through the Foreign Portfolio Investor route with no underlying exposure at all. Pure investment became allowed.

Step three, May 2023. FPIs were given direct market access. Their orders can now reach the exchange through a broker terminal without a dealer typing them in.

The door is open, but only part way. FPIs are confined to contracts that settle in cash and are not agricultural.

What FPIs may trade. To begin with, the permission covers cash settled non-agricultural commodity derivative contracts and indices comprising such non-agricultural commodities. Chapter 6 adds the practical detail: in recent years the exposure has been limited to cash-settled non-agricultural contracts, primarily crude oil and natural gas.

Three filters therefore apply at once. Cash settled, so no physical delivery obligation ever reaches an FPI. Non-agricultural, which keeps foreign money out of food prices. And index contracts are allowed, provided the index is built of non-agricultural constituents.

The 2018 test versus the 2022 test. The October 2018 permission was a hedging permission and required an open position in the underlying commodity in India arising out of business obligations. The 2022 amendment removed that requirement for the FPI route. Both routes exist; they are not the same permission and they do not share an entry test.

Direct market access. SEBI's circular of 10 May 2023 allows FPIs direct market access using the broker terminal and broker infrastructure. DMA is an access arrangement, not a wider licence — the product restrictions above still bind.

Risk management. FPIs desirous of participating in ETCDs are subject to the risk management measures applicable from time to time, the same margin and position framework as everyone else.

One wording divergence worth recording. Chapter 1's participant list on page 26 says FPIs may participate only in non-sensitive commodities that are cash settled, including indices, while the same chapter on page 22 and Chapter 6 on page 138 both say non-agricultural. Answer with the workbook's dominant phrasing — non-agricultural and cash settled — and read non-sensitive as the same idea loosely worded.

FPIs sit alongside the other institutional entrants the workbook lists: Mutual Funds from 2019, with a separate pair of SEBI circulars dated 21 and 22 May 2019 for Mutual Funds and PMS respectively, plus Alternative Investment Funds Category III and hybrid and multi-asset schemes.

Northgate Commodity Fund, a Category-II FPI registered with SEBI, wants Indian commodity exposure. Its dealing desk draws up five trades and the compliance officer marks each one against the framework.

Now the money. Northgate holds 8 lots of a bullion index future at an index level of 16,000 with a lot size of 500 units, so the contract value is 16,000 x 500 x 8 = Rs 6,40,00,000. Margins are collected exactly as from a domestic client, because FPIs are subject to the risk management measures applicable from time to time.

Contrast a different applicant. Brightwater Metals Ltd of Singapore has a physical Indian aluminium purchase contract for 2,000 MT and wants to hedge it. It does not need the FPI route at all — it can come in as an eligible foreign entity under the October 2018 permission, because it holds an open position in the underlying commodity in India arising out of a business obligation. Northgate has no such exposure, which is exactly why it needs the 2022 amendment.

Chapter 1 (Introduction to Commodity Markets), section 1.4 on hedgers, where the October 2018 permission, the 2022 amendment and the 10 May 2023 DMA circular all appear, and section 1.6's participant list. Chapter 6 (Trading Mechanism), section 6.8, repeats the FPI entry in its list of participants.

The examinable points are the dates and the product boundary. Expect from which year could foreign investors use the FPI route without underlying exposure (2022), what may they trade (cash settled non-agricultural contracts and indices of such commodities), and what did the October 2018 permission require (an open position in the underlying commodity in India arising out of business obligations). A question on 10 May 2023 and direct market access is fair game too, because it is one of the few dated circulars in Chapter 1.

• October 2018 is the hedging permission; 2022 is the investment permission. The 2018 route needs an underlying Indian commodity exposure; the FPI route after 2022 does not. Two doors, two tests.
• Cash settled and non-agricultural, both. A cash-settled agri contract is still out, and a compulsory-delivery non-agri contract such as gold is also out. Candidates remember one filter and forget the other.
• Indices are allowed, but only indices of non-agricultural commodities. An agri index is not a way round the agri restriction.
• Direct market access is not a product permission. The 10 May 2023 circular changes how orders reach the exchange, through broker terminal and broker infrastructure. It does not widen what may be traded.
• FPIs are not exempt from margins. They are subject to the risk management measures applicable from time to time, like any other client.
• The workbook says non-sensitive in one place and non-agricultural in two others. Page 26 uses non-sensitive commodities that are cash settled including indices; page 22 and Chapter 6 say non-agricultural. Treat them as one rule, and answer non-agricultural.
• Do not lump FPIs in with Mutual Funds, AIF Category III and PMS. Those were permitted separately, mutual funds from 2019, and their conditions are not the FPI conditions.