Moneycontrol Pro Panorama | A death knell for India’s forex derivative market

Market makers, speculators, and arbitrageurs typically contribute the majority of trading volumes in exchanges.

Dear Readers,

In a departure from the foundational principles of exchange operations, the Reserve Bank of India (RBI) has issued a directive permitting exchanges to offer forex derivative contracts involving the rupee solely for contracted exposure or hedging purposes. This move is anticipated to effectively halt trading in the forex derivative market, with reports suggesting a projected reduction in trading volume by over 80 percent.

Within any exchange ecosystem, various participants exist, including market makers, speculators, hedgers, arbitrageurs, and delivery-based buyers. Market makers, speculators, and arbitrageurs typically contribute the majority of trading volumes in exchanges.

According to a publication by the National Stock Exchange (NSE), India's primary exchange for currency derivatives, corporate entities accounted for a mere 3.9 percent of currency derivatives turnover based on notional turnover in February while foreign investors contributed 6.2 percent. Proprietary traders and individual investors dominated the market, responsible for 80 percent of the turnover.

Following the announcement, the open interest for USD/INR April futures plummeted by $833.6 million, representing an 18.5 percent decline on Tuesday.

The RBI's directive to limit the rupee-based derivative forex market to genuine hedgers has significant implications. This unprecedented action is likely to result in increased hedging costs, prompting a potential shift in hedging activity towards local over-the-counter and non-deliverable forward markets and banks.

The exchange-traded rupee derivative market on the NSE has witnessed significant growth, expanding from a daily volume of $142 million to the current level of $5 billion.

Reports suggest that the RBI is aligning with its broader foreign exchange management policy aimed at curbing market volatility, particularly in anticipation of India's bond markets being included in global indexes from June. The rupee has been among the least volatile currencies among emerging market currencies globally.

The RBI has specified that exchanges will only be permitted to offer forex derivative contracts involving the rupee for contracted exposure or hedging purposes, compared to the current allowance of up to $100 million without explicit underlying exposure. This rule will be effective April 5.

The rationale behind the RBI's action is an anticipation of increased volatility following India's inclusion in the bond index. Controlling market volatility would potentially be more challenging with an active derivative market where speculators hold sway.

It is hoped that the RBI will take steps to reinvigorate the market once stability is restored, but until then, the Indian forex derivative market will be all but dead.

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