The Securities and Exchange Board of India has initiated a proposal to introduce full fungibility between depository receipts and the underlying domestic shares, without any restrictions whatsoever.

The proposal, which is at a preliminary draft stage, seeks to remove all the conditions limiting the availability of the fungibility clause. Current regulations only allow Indian residents to convert their shareholdings into DRs to the extent that DRs have been converted into domestic equity shares.

According to sources familiar with the development, an internal discussion note has been circulated within Sebi, while discussions are on with market participants and experts with a view to formulating the operational guidelines.

Sources said the current arrangement is 'demand driven', with the process of reconversion emanating from the request for the acquisition of domestic shares by non-resident investors for issue of ADRs and GDRs.

This means that DRs have first to be converted into domestic shares to create the 'headroom' for Indian residents to request that their shares be converted into DRs.

They added that the proposal had to be vetted by several quarters since the move implied a move towards full convertibility. Given the price differentials between foreign and domestic shares, Indian residents can request that all their domestic holdings be converted into DRs.

The impact of full, unfettered fungibility would be that premiums in the depository receipts market will crash. This will reduce the arbitrage opportunity between the overseas markets and the domestic markets.

But more importantly, such a move will fly in the face of sectoral foreign institutional investor caps on individual stocks.

For instance, foreign holdings -- including the GDR holdings --  in the State Bank of India is capped at 20 per cent. But with full fungibility, there is a possibility of all shareholders choosing to convert their shares to DRs.