The Securities and Exchange Board of India (SEBI) on Wednesday allowed hedge funds registered as category III Alternative Investment Funds (AIFs) to invest in commodity derivatives as clients, opening up the market to institutional investors for the first time.

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The action by SEBI marks a milestone in Asia`s third-biggest economy, which allowed futures trading in commodities since 2003. But it will still keep out foreign investors, banks, mutual funds and other institutions from investing in derivatives.

The move to open up to category III AIFs, licenses that are mainly granted to hedge funds, could expand liquidity in the market, thus providing companies more hedging opportunities and improving price discovery.

Category III AIFs may participate in all commodity derivative products, but will not be able to invest more than 10 percent of the investable funds in one underlying commodity, SEBI said in a statement.

These investors will also be allowed to use leverage, SEBI said.

"The commodity derivatives markets in India lack the desired liquidity and depth for efficient price discovery and price risk management," SEBI said.

Market participants such as National Commodity and Derivatives Exchange Ltd welcomed SEBI`s plan given volumes in Indian commodity futures have fallen to 67 trillion rupees ($1.04 trillion) in 2015/16 from 170 trillion rupees in 2012/13.

"The presence of AIFs, will spur the infusion of research based information, capital, innovation and new trading strategies in India`s commodity markets," Mrugank Paranjape, managing director of Multi Commodity Exchange Of India Ltd.

Goldman Sachs Investments (Mauritius), Blackstone GPV Capital, Matthews Asia Growth Fund and InterContinental Exchange (ICE) are among foreign investors that hold stakes in Indian commodity exchanges, which would benefit from increased trading.

The move to open up commodity derivatives to hedge funds will now raise hopes India will gradually open commodity markets to other participants.

SEBI Chairman Ajay Tyagi took over in March, pledging to make developing commodity markets a key plank of his tenure. 

"The market regulator has opened window for institutional investors. Gradually we can expect participation of banks and mutual funds," said Harish Galipelli, head of commodities and currencies at Inditrade Derivatives & Commodities.