Popular FX Derivatives Market Faces Crushing Blow in India

A new rule set to take effect on April 5 is expected to force out most of the market’s most active players.

<div class="paragraphs"><p>(Source: 8photo on Freepik)</p></div>
(Source: 8photo on Freepik)

India’s booming market for exchange-traded currency derivatives is headed for a sudden demise.

A new rule set to take effect on April 5 is expected to force out most of the market’s most active players, drying up volumes that reached $5 billion-a-day.

Brokerages have started asking clients to close out contracts after exchanges on Monday reaffirmed the ruling from the central bank that participants must have an actual foreign-exchange exposure. That rules out individual traders and speculators who comprise a large portion of the volume.

“At least 70% or more of the volume will dry up — half the market is arbitragers,” said Sajal Gupta, executive director and head of forex and commodities at Nuvama Institutional. “Those traders won’t take fresh positions and have to square off existing positions.”

Popular FX Derivatives Market Faces Crushing Blow in India

The rule aligns with the Reserve Bank of India’s broader foreign exchange management policy that has seen the authority tamp down on swings in the rupee in the run up to the inclusion of the nation’s bond markets in global indexes from June. The rupee has been one of the least volatile currencies among emerging market currencies globally.

At the heart of the matter is whether rupee-based currency contracts below $100 million traded on the National Stock Exchange and BSE Ltd. need an underlying exposure. The exchanges reaffirmed the RBI’s Jan. 5 circular mandating the requirement on Monday, catching several market participants offguard with unhedged positions.

The clarification followed am email from the RBI to the Commodity Participants Association of India on March 28 that anyone undertaking such contracts without an actual exposure would be in breach of foreign exchange rules, Bloomberg News reported, citing people familiar with the matter. 

Popular FX Derivatives Market Faces Crushing Blow in India

The move has raised concerns about the relevance of exchanges as platforms for hedging currency risk without the participation by algorithmic, proprietary and individual traders who typically manage risk for hedgers, said Kishore Narne, director at Motilal Oswal Financial Services in Mumbai.

Currency futures involving the rupee shed around 1.7 million contracts in open interest to 5.7 million on the NSE, the biggest platform for currency derivatives. The near-month USD/INR contract saw open interest slump by about a fifth from the previous session. The spot rupee was little changed at 83.3838 to a dollar.

Exchange-traded currency derivatives have been one of the successful product offerings of the central bank unlike its other efforts like introducing credit default swaps, interest rate futures and options, and swaptions which have found few takers.

The average daily turnover in currency futures stood at 412.9 billion rupees ($5 billion) in the year ended March 31, 2023, up from 102.9 billion rupees in 2017, according to data from the NSE.

Curbing Volatility

The central bank’s broader objective has been to curb volatility in the currency at a time when foreign funds have been pouring in money into the nation’s bond markets since JPMorgan Chase & Co.’s landmark announcement in September.

The authority has built up forex reserves to a record $643 billion as a buffer against external shocks. It uses all currency platforms including spot, forwards and currency futures to intervene in the currency market. 

The impact of the new rule will be seen over the next month, according to Nuvama’s Gupta. 

“This requirement of underlying will practically kill the volumes in currency derivatives,” said Dilip Parmar, currency strategist at HDFC Securities Ltd.

--With assistance from Ashutosh Joshi and Esha Joshi.

(Updates open interest, rupee pricing at close in 9th paragraph)

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