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Yash Sharan*
I. INTRODUCTION
Regulatory Arbitrage is the strategic exploitation of variations in regulatory frameworks across markets, enabling firms to bypass unfavourable regulations. The increasing complexity of Offshore Derivative Instruments (“ODIs”) and Foreign Portfolio Investors (“FPIs”), particularly those with segregated portfolios, has raised the question of regulatory arbitrage in international financial regulation. In a move to address this issue, the Securities and Exchange Board of India (“SEBI”) has recently issued a circular to FPIs, Designated Depository Participants and Custodians, Depositories, and Stock Exchanges and Clearing Corporations. The SEBI circular seeks to curb regulatory arbitrage by standardizing norms for ODIs and the segregated portfolios of FPIs, enhancing transparency and compliance. Additionally, it aims at ensuring that FPI is aligned with the international standards to provide reasonable market access and eliminate most of the risks associated with complex structures of the investments. This move comes after a Consultation Paper issued on August 6, 2024, to receive the public’s input. The circular for India – a country that is in the process of liberalising its policies to lure foreign investment while at the same time, desperately trying to prevent its economy from being dominated by any entity – has profound implications on its financial landscape. Thus, it becomes imperative to analyse this circular and SEBI’s reforms that aim to curb regulatory arbitrage, enhance transparency, and align India with global standardsand unpack its ingredients.
Through this article, the author delves into the intricacies of the circular in three major parts. First, the article analyses the major tenets of the circular and the changes it seeks to bring. Second, it highlights the shortcomings and challenges of the circular. Specifically, it delves into the implications of failing to monitor disclosures on financial stability and at last, the essence of identifying Ultimate Beneficial Owners (“UBOs”) is obscured by incorporations and new generation technologies such as a Decentralised Autonomous Organisation (“DAO”). The article concludes with a way forward and the author’s suggestions to resolve the roadblocks.
II. THE EROSION OF MARKET INTEGRITY: HOW ODIS AND SEGREGATED PORTFOLIOS ENABLE REGULATORY ARBITRAGE
ODIs give Foreign Institutional Investors direct and easy access into Indian markets, but cause issues stemming from their lack of transparency. The real owners are not revealed, tax and regulatory evasion are allowed, and manipulations with the help of the ownership. Likewise, FPIs with segregated portfolios offer regulatory uncertainties, because FPIs with segregated portfolios trigger jurisdictional arbitrage, circumvent sectoral limits, and hide ownership making compliance an issue and regulation ridden with loopholes, which allow certain entities to take advantage of jurisdictional gaps and ultimate beneficial ownership, thus posing severe threats to regulation and market fairness.
Regulatory arbitrage in ODIs and FPIs is a complex issue posing several problems. Firstly, the lack of transparency and the veil that hides the actual beneficiaries of companies hinders compliance with Anti-Money Laundering (“AML”) as well as Know Your Customer standards. Secondly, entities use India’s DTAAs with other countries such as Mauritius to avoid taxes hence resulting in revenue losses. India’s DTAA has been abused by entities to route investments so as to avoid capital gains tax and take advantage of more favourable tax treatments resulting in revenue losses, as seen in the Vodafone case. Thirdly, segregated portfolios allow evasion of sectoral investment limits, which is counter to India’s carefully planned regulatory structure. Fourthly, it is evident that there is a lack of a consistent global standardisation of regulations hence enabling what is commonly referred to as jurisdiction shopping enshrinement of operations, especially within regions with lenient regulatory policies. Lastly, such arbitrage undermines the market efficiency by encouraging speculative and insider trading because the transactions under ODI are not transparent in nature and real-time monitoring of the markets becomes extremely difficult for the regulators.
III. LEGAL AND GLOBAL IMPLICATIONS OF SEBI’S REFORMS: AN ANALYSIS OF SEBI’S REGULATORY FRAMEWORK
The legal framework of FPIs in India is mainly defined by the SEBI (Foreign Portfolio Investors) Regulations, 2019, and the Master Circular for FPIs and DDPs. The circular identifies the main changes that are intended to address the issue of regulatory arbitrage together with increasing the effectiveness of ODI issuance in terms of transparency and accountability. It is a further positive development in response to longstanding issues with the management of ODIs and ODI subscribers through the application of governance structures. The provisions are as follows and together provide the parameters for FPIs to issue ODIs as well as the subscription requirements for ODI holders.
Firstly, the circular requires that to engage in the FPI of an ODI, any ODI issuer shall apply for a separate FPI registration specifically for ODI issuance, which must include the suffix “ODI” in its name. As a result, ODI issuing entities will need two distinct FPI registrations – one for proprietary investments and the other for ODI issuance. Interestingly, what used to be two different registrations will both have the same Permanent Account Number. There is an exception to the above requirement in the issuance of ODIs where the underlying securities are in government bonds. This presents myriad implications for the Indian financial market that reverberates internationally. Firstly, separate registrations increase transparency and eliminate the veil of secrecy over ODI transactions, which can contribute to increasing the confidence of international investors. This action takes India to an international standard to ban Illicit Financial Flows (IFFs) and show the world that it is serious about combating the vice. IFFs include illegal capital transfers including tax evasion, money laundering and corruption which deplete resources, erode governance and destabilise the Indian financial system. Secondly, as it is clear that the use of derivatives leads to great fluctuations in the market and increased risk, the prohibition of ODIs with derivatives as the underlying asset also reduces systemic risks.
However, the one-to-one hedging requirement may increase the compliance costs of FPIs and, therefore, discourage small international investors who want to have exposure to the Indian markets. The Indian markets have been funded in the past by small international investors, and if these investors are driven away, the foreign portfolio investments as well as the liquidity could be adversely affected. While promoting transparency and market integrity, investors may be led to other markets with less restrictive rules affecting capital flows. Globally, it may also be a sign for emerging markets to strengthen regulations on ODI, which will help to stabilize a country’s financial market but must be cautiously done not to affect the competitiveness of a country’s economy.
Secondly, the Granular Disclosure Circular proposed thresholds that require realignment or disclosure where an FPI owns over 50% of the total Indian equity AUM invested in a single Indian corporate group. Nevertheless, there was uncertainty about how these thresholds related to FPIs with segregated portfolios, thereby creating a scope for regulatory arbitrage. The circular resolves this matter by requiring that the threshold must be applied on a per-segregated portfolio basis of the FPI. Therefore, any default by a particular segregated portfolio would trigger regulatory action that would only apply to that particular segregated portfolio and not to other segregated portfolios managed by the FPI.
This move has many shades of meaning for India’s financial and regulatory system. On the domestic front, this renders impossible any regulatory arbitrage since each of the segregated portfolios will be held accountable while promoting transparency and compliance without negatively impacting the rest of the FPI entity. It also ensures that FPIs use low-risk management standards on portfolio investments thus lowering systemic risk associated with concentrated portfolios. Higher regulatory attention and compliance obligations may discourage FPIs with complex investment portfolios and cause them to shift to more open jurisdictions. A careful weighing between the two will be necessary in the future, especially for the benefit of both the investors and the firms.
Thirdly, the circular is based on the framework prescribed by SEBI in its Granular Disclosure Circular. These subscribers have to (a) report a change of control or (b) provide details of all ODI subscriber entities including the names of all ultimate natural persons who have an ownership interest, economic interest or control in the subscriber entity, regardless of the thresholds.
This move can greatly improve the level of transparency in India’s financial market. It follows international standards such as the FATF norms with the demand to disclose the ultimate beneficial owners. It increases investors’ confidence in India as increased UBO transparency complies with FATF recommendations, which leads to greater investor confidence from across the world, and improves the solidity of the financial markets. However, it may dissuade FDI from countries with unclear rules regarding compliance due to the put-off effect it has on ODI inflows. Globally, it proves that India is ready to fight against financial fraud but at the same time, raises competitiveness issues with those countries who provide lenient regulations that can potentially shift funds.
IV. STRENGTHENING SEBI’S REFORMS: RISKS, ROADBLOCKS, AND PLAUSIBLE SOLUTIONS
While the circular has been largely applauded, concerns persist over potential risks such as data privacy concerns, enforcement challenges, and others. The circular, while enhancing transparency, poses risks which this section elucidates on.
Firstly, there is the challenge of SEBI’s limited operational capacity to monitor granular disclosures across numerous FPIs and ODI subscribers’ risks creating regulatory barriers, reducing market fluidity, and deterring foreign investment. Due to SEBI’s capacity constraints, it took time to address hidden UBOs, tax evasion, and regulatory arbitrage in ODIs and distort market transparency and investor confidence. Delayed action could undermine India’s financial stability and global investor confidence. To ensure transparency, competitiveness, and robust compliance, SEBI must invest in advanced technologies, strengthen its infrastructure, and reduce over-reliance on self-disclosures. It could also introduce real-time checks and efficient detection of irregularities can altogether transform compliance through a centralized RegTech platform with the help of artificial intelligence (“AI”) and machine learning. AI and Machine learning based RegTech platforms have been adopted, such as the FINRA surveillance system. FINRA is employed by the firms in the United States of America to identify fraud and compliance. Implementation of similar systems improves the credibility of the Indian market. Real-time monitoring for compliance is possible, however, they pose risks with regards to data privacy, algorithm bias and lack of clear understanding when it comes to decision making. Engagement with international organizations such as FATF will improve intelligence sharing while improving SEBI’s enforcement by hiring forensic auditors and IT specialists will improve the capacity of regulation. These steps help make the governance structure strong, bring foreign investment, and enhance the credibility of the Indian economy.
Secondly, the task of identifying Ultimate Beneficial Ownerships (“UBO”) for ODIs and FPIs remains difficult because of the presence of multiple layers of ownership and bearer structures that are often incorporated in the jurisdictions popularly used as offshore financial centers. It is not easy to enforce because entities use trusts, nominee agreements, or shell companies to conceal ownership. New forms of ownership such as DAOs or any other blockchain-based structures might nullify the traditional UBO-centric legislation and widen the existing regulatory divide even more.
This can be resolved by incorporating AI analysis to solve difficult ownership issues, join the data of different jurisdictions, and identify potential criminal organisations. Engaging the international regulatory authorities to develop a blockchain-based global ownership registration system to increase accountability, deter avoidance, and restore confidence in the Indian and international financial systems can be another solution to this quandary. Currently, some countries including the United Kingdom and countries within the European Union have adopted the use of blockchain ownership register to enhance the level of transparency. However, its opponents dispute data privacy, costs, and technical challenges towards its implementation on the international level due to such problems as the inaccurate data and the cross-border regulation.
Additionally, there are plausible solutions to address the plaguing issue of regulatory arbitrage. Firstly, leveraging blockchain and AI can enhance transparency by creating immutable transaction records and detecting suspicious patterns in ODI and FPI operations. Secondly, stricter disclosure norms, including periodic reporting of beneficial ownership and cross-verification with global AML databases, ensure robust compliance. It is suggested that the trade-off is justified, emphasizing stricter norms enhance compliance and mitigate financial crimes effectively. Thirdly, harmonizing India’s tax and regulatory frameworks with global standards eliminates incentives for arbitrage. Fourthly, introducing specific regulations for segregated portfolios treats each as a distinct entity, ensuring compliance with sectoral caps. Finally, fostering international cooperation through FATF and IOSCO promotes a unified approach to regulatory challenges.
V. CONCLUSION
SEBI’s Circular can be seen as a major step forward in the regulation of ODIs and FPIs as it reasserts SEBI’s drive towards the enhancement of transparency and accountability and the protection of market integrity. Although the new compliance obligations may cause significant changes among the market participants, the reforms are expected to improve the Indian capital markets through international standards integration. The formulation of comprehensive ODI issuance and subscriber guidelines indicates that SEBI is keen on tackling potential problems in the system to encourage the development of better regulatory structures.
In the era of an evolving global financial landscape, India has the chance to act as a model for other emerging economies. This means that much work has to be done in the road ahead to align the regulators, the policymakers, and the industry players in order to close the loopholes and build a strong investment environment that encourages more innovation and growth and simultaneously remains compliant.
*Yash Sharan is a student at Hidayatullah National Law University, Raipur
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