SEBI's Netting Proposal: A Capital Efficiency Tailwind for FPI Flows

The Securities and Exchange Board of India (Sebi) is moving to address a key operational friction for foreign institutional capital. The regulator is set to release a consultation paper that would allow Foreign Portfolio Investors (FPIs) to net their buy and sell trades, settling only the final difference instead of each transaction separately. This is a high-conviction, structural tailwind aimed directly at improving capital efficiency.

The mechanics are straightforward but impactful. Currently, FPIs must gross-settle every single transaction, meaning they must fully fund every purchase and deliver shares for every sale, even when trading the same stock within a single day. This requirement significantly increases funding needs and transaction costs. The proposed netting framework would allow those offsetting trades to be aggregated, reducing the total settlement amount and freeing up capital. Sebi states the goal is "enhance operational efficiency and reduce cost of funding" for these large global investors.

This reform comes amid severe outflow pressures, lending it immediate urgency. FPIs were net sellers of $2.5 billion in December 2025 and have been net sellers by $18.8 billion for the entirety of 2025. The proposal is part of a broader package of market reforms aimed at attracting overseas investors, which also includes examining a closing auction mechanism to improve price discovery and curb volatility.

Portfolio Allocation and Sector Rotation Implications

The netting proposal directly alters the risk-adjusted return calculus for large FPIs, making India a more competitive destination for institutional capital. By reducing settlement costs and freeing up capital that would otherwise be tied up in gross-margin requirements, the reform improves the operational efficiency of trading. This is a critical factor in portfolio construction, as it effectively lowers the hurdle rate for executing trades and rebalancing positions. For a global fund manager, the ability to net offsetting trades in a single day reduces counterparty risk and funding strain, enhancing the quality of the investment opportunity.

This efficiency gain is likely to influence sector weightings, favoring stocks with higher liquidity and trading volume. Large FPIs often engage in index-rebalancing trades, buying one stock while selling another. The netting framework would make these offsetting moves significantly cheaper and smoother, potentially increasing the turnover and relative weight of large-cap, liquid stocks in FPI portfolios. In contrast, less liquid small-cap or mid-cap stocks, where the cost of gross settlement is a larger relative burden, may see relatively less capital allocated through this channel.

Despite recent outflows, the structural inflow trend from key regions remains intact, providing a foundation for the reform's impact. US investors now hold around 44 per cent of total FPI AUM in India, and European investors from Ireland and Norway have also seen their exposure rise. This sustained long-term interest means the capital efficiency gains from netting are being offered to a group of investors already committed to the market. The reform could solidify their conviction by making India's operational framework more aligned with global best practices, a key consideration in institutional flow decisions.

Viewed another way, the proposal is a direct response to the competitive pressures FPIs face when choosing between emerging markets. By improving settlement efficiency, India aims to reduce a friction that could otherwise push capital toward more streamlined markets. For portfolio allocators, this is a structural tailwind that lowers the cost of ownership and improves the risk-adjusted profile of Indian equities. The bottom line is that the reform doesn't just fix a technical issue; it makes India a more attractive and efficient part of a global portfolio.

Capital Efficiency and Risk-Adjusted Returns

The proposed netting reform directly quantifies the capital drag currently imposed on foreign institutional investors. The gross-settlement requirement forces FPIs to fully fund every purchase and deliver shares for every sale, even when trading the same stock within a single day. This creates a significant operational friction, tying up capital that could otherwise be deployed for investment or hedging. By allowing netting, SEBI addresses this key constraint, improving capital efficiency and lowering the effective cost of participation in the Indian market.

The scale of the opportunity is substantial. With FPIs currently holding about $900 billion invested in Indian markets, even a modest reduction in settlement costs and funding requirements translates into meaningful capital relief for the global investor base. For a large fund manager, the ability to net offsetting trades in a single day reduces counterparty risk and frees up liquidity, enhancing the quality of the investment opportunity. This is a necessary step to make India's operational framework more competitive with global best practices.

Yet, it is critical to contextualize this efficiency gain within the broader drivers of FPI flows. As Sebi Chairman Tuhin Kanta Pandey has emphasized, FPI flows are largely driven by global factors such as returns across markets, earnings growth, currency movements and geopolitical developments. Netting is a structural tailwind that improves the risk-adjusted profile of Indian equities by lowering a specific friction, but it is not a sufficient condition to reverse outflows on its own. The reform lowers the cost of ownership, but the primary decision for capital allocation still hinges on the fundamental attractiveness of Indian assets versus alternatives.

The bottom line is that this reform targets the "quality factor" in portfolio construction. It makes India a more efficient and lower-cost market to trade in, which supports a conviction buy for allocators focused on execution and liquidity. However, the ultimate verdict on India's appeal rests with the earnings trajectory and global capital flows. The netting proposal is a smart, targeted fix to a known constraint, but it operates within a larger cycle where returns and risk premiums remain the dominant forces.

Catalysts, Risks, and What to Watch

The immediate catalyst is the consultation paper's imminent release. SEBI Chair Tuhin Kanta Pandey has signaled it could be out as early as today, with final rules dependent on feedback and potential coordination with the Reserve Bank of India on bond market liquidity. This sets a clear timeline for the reform's next phase. The bottom line is that the structural tailwind is now entering the formal rule-making process, a necessary step before any operational impact can be realized.

A key risk is that the reform may not be sufficient to offset broader macro headwinds. As Pandey himself noted, FPI flows are driven far more by returns, earnings growth and global conditions than by regulatory factors. The netting proposal is a targeted efficiency gain, but it operates against a backdrop of steep U.S. tariffs and muted domestic earnings growth that are primary drivers of recent outflows. In other words, while the reform lowers a specific friction, it does not alter the fundamental investment thesis that determines capital allocation. The risk is that improved settlement mechanics are a secondary factor to primary drivers like global risk appetite and currency moves.

For institutional allocators, the path to confirming the reform's success lies in monitoring specific metrics. The most direct indicator will be FPI net flows in the quarters following implementation. A sustained reversal from outflows to inflows would be the clearest signal that the capital efficiency gain is translating into improved portfolio construction. Complementing this, a rise in secondary market trading volumes-particularly for large-cap, liquid stocks where offsetting trades are common-would provide a leading indicator of the reform's operational impact. This would show that the lower cost of rebalancing is indeed encouraging more active portfolio management.

The bottom line is that this is a high-conviction, structural tailwind, but its impact is conditional. It improves the quality factor by lowering a known friction, but the ultimate verdict on India's appeal rests with the earnings trajectory and global capital flows. The reform is a smart, targeted fix to a known constraint, but it operates within a larger cycle where returns and risk premiums remain the dominant forces. Watch the flow data and volume metrics to see if the efficiency gain is enough to tip the scales.