Will RBI's new currency derivatives norms wipe out most exchange traded volumes?

Rupee

The Reserve Bank of India’s (RBI) latest norm on the currency derivatives trades, which will be implemented on April 5, may impact liquidity on the exchanges as users will not be able to meet the underlying exposure requirement stipulated by the central bank, experts said.

What did the RBI say?

In a circular dated January 5, the central bank said users must ensure the existence of a valid underlying contracted exposure which has not been hedged using any other derivative contract, and they should be in a position to establish the same if required.

What is an underlying in derivatives?

Underlying in derivatives contracts refers to the order bill or receipt in the case of exporters or importers, and documents to support the transaction in the case of remittances.

“Importers or exporters should have a receipt or payment of USD, EUR, etc,” Dilip Parmar, a foreign exchange analyst at HDFC Securities, said.

Also read: Bourses ask brokers to ensure compliance with RBI directive on currency derivatives' trading

What was the practice till now?

Till now, currency traders were free to trade in the derivative market, by either declaring or not declaring underlying exposure. Currency derivatives are a tool for hedging forex risk.

Experts said most transactions on exchanges were done by clients from the retail segment who could not transact in the OTC (over the counter) market as banks asked for the underlying and the users did not have it, they added.

The RBI’s directive came to the limelight three months from its release when on April 1 the National Stock Exchange (NSE) and the BSE Ltd directed their members to take note of this circular.

“The exchange traded derivative volume is going to dip by nearly 80 percent as most of the volumes are coming from proprietary desk and retail which hardly have any underlying exposure,” Parmar from HDFC Securities said.

The Average Daily Turnover (ADT) in currency futures dropped to a 29-month low of Rs 23,200 crore (-20.5 percent MoM) in February 2024, significantly lower than the average recorded during FY23 and FY24 (April 2023 to February 2024), according to the NSE's Market Pulse report published in March.

The report added that the proportion of proprietary traders’ turnover in currency derivatives based on notional turnover dropped 171 basis points on-year to 62.1 percent in the last fiscal (as on February 29, 2024), as compared to the corresponding period in the previous fiscal year.

Anil Kumar Bhansali, Head of Treasury and Executive Director, Finrex Treasury Advisors LLP said these (retail) trade formed 90 percent of the total transactions and were a source of liquidity in exchange traded currency futures.

What is the RBI’s January 5 circular?

As per the January 5 RBI circular, a user is allowed to take positions (long or short) without having to establish the existence of underlying exposure, up to a single limit of $100 million equivalent across all currency pairs involving the rupee, put together, and combined across all recognised stock exchanges.

But in the note, the central bank said that recognised stock exchanges shall inform users that while they are not required to establish the existence of underlying exposure, they must ensure the existence of a valid underlying contracted exposure which has not been hedged using any other derivative contract and should be in a position to establish the same if required.

Bhansali added that by the above circular RBI has decided to curb trades on exchanges, and this had the potential to virtually kill trading on exchanges since the liquidity came from retail and may not be available henceforth as retail does not have underlying.

Also read: Popular FX derivatives market faces crushing blow in India

When did the market find out about circular?
Money market experts said most brokers have asked their clients to comply with the RBI’s regulations and also informed them to square off positions without underlying before the implementation of the circular.

“Most of the brokers have informed the changes to their clients and told them to comply with the RBI mandate. They also informed to square off position without underlying exposure to respective clients before April 5,” Parmar added.

Bhansali said the stock exchanges have meanwhile sought clarifications from the RBI on the above circular but have completely stopped new trades without underlying or certificate of having an underlying which needs to be produced when an exchange asks for it.