Were NSE And BSE Wrong About Currency Derivatives All Along?

Brokerages had misinterpreted regulations laid down by the RBI that it is not mandatory to have an underlying currency exposure at all.

<div class="paragraphs"><p>(Source:&nbsp;<a href=";utm_medium=referral&amp;utm_source=unsplash">Unsplash</a>)</p></div>
(Source: Unsplash)

Over the last two days, currency traders, brokerages and other market participants have been in a tizzy over—what they consider—Reserve Bank of India's new stance on exchange-traded currency derivatives.

Market participants believe that the regulator has effectively shut down the currency derivatives trade, specifically futures market in India. However, these fears might be exaggerated, as speculative currency derivative trades were not covered under RBI regulations in the earlier circular from 2016.

The concerns emerge from a set of master guidelines the regulator issued on Jan. 5, which reiterate that anyone engaging in exchange-traded currency derivatives worth up to $100 million would not need to submit any proof of underlying unhedged exposures.

While the RBI's stance has remained the same for many years, it also told Commodities Participants Association of India that anyone engaging in such trades without adequate underlying unhedged exposures was in violation of Foreign Exchange Management Act, 1999.

Following this clarification, brokerages are now asking their clients to submit proof of their underlying exposures, failing which, they would need to square off their positions.

Brokerages had misinterpreted the stated regulations laid down by the RBI that it is not mandatory to have an underlying currency exposure at all, a senior treasury official with a large private bank said. Whereas, the RBI, in its earlier directions, had allowed positions up to $100 million "for hedging contracted exposure, without the requirement to establish the existence of underlying exposure."

In fact, in the Jan. 5 circular, the RBI put down an additional note as follows:

"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 been not hedged using any other derivative contract and should be in a position to establish the same, if required."

Essentially, the RBI said that it is okay for a user to not provide proof of an underlying exposure while entering into contracts, but they need to have one and provide proof whenever asked.

Speculative activity in the currency futures market amplified when brokerages began proprietary trading, wherein a financial firm chooses to profit from market activities rather than thin-margin commissions obtained through client trading activity.

Entry and exit in futures market is easier than the alternate forwards market, along with greater margin, more liquid, as well as better pricing. 

Over a span of 15 years, the share of arbitrageurs, proprietary traders and retail participants has grown to about 85% of total turnover in the exchange-traded rupee derivatives market, according to Abhilash Koikkara, head of forex and commodities at Nuvama Group.

"Our estimate is corporate hedging is around 6% and FPI volume would be another 7% of the total volume in ETCD," he said. These regulations would fizzle out the liquidity in the currency futures market, which would make it difficult for genuine corporates to hedge, Koikkara said.

On Thursday, the open interest on the most-active dollar/rupee futures contract stood at 2.9 million lots as of 1:40 p.m., from 7.4 million lots on Apr. 1 when the exchanges reaffirmed the RBI's circular.

Even though the RBI reiterated its circular in January, brokerages were awaiting an order from Securities Exchange Board of India, or stock exchanges for a final order with some clarifications. Exchanges, on their part, simply reaffirmed the RBI's circular with no changes, which caused a scramble in the futures market.

Another treasury official with a large corporate said that it was the responsibility of exchanges to educate investors and market participants to clarify the rules of the FEMA Act.

FEMA norms from May 2000 state that any exchange-traded derivatives contracts involving rupee shall be for the purpose of hedging an existing exposure, or one expected in the future.

These users will need to share the details of such exposures when demanded.

Another way to trade in such currency futures market is directly through an authorised dealer. While users can enter into currency derivatives for the purposes of hedging against unhedged exposures. Users can enter derivative contracts where there is no underlying exposures, only if the central bank allows them.

Queries to National Stock Exchange and BSE went unanswered.