MC Explainer : What’s all the fuss around RBI’s Jan 5 circular on currency-derivatives trading?

MC Explainer

tvrfinnews.com

MC Explainer : Traders and brokerages believe that the RBI move will kill a market segment that has taken more than a decade to build.

Over the past few days, there has been a lot of discussion about a circular issued by the Reserve Bank of India (RBI) on currency-derivatives trading.

Traders expressed anger that the banking regulator acted abruptly and brokerages claimed that the regulator’s actions would kill a healthy market.

Are their worries warranted? Here’s a quick explainer on what went down. MC Explainer

Which circular started the storm?
On January 5, 2024, the RBI issued a circular titled ‘Risk Management and Inter-Bank Dealings – Hedging of foreign exchange risk’. This innocuously (even boringly) titled circular had a directive for exchange-traded currency derivatives (ETCDs) which led to the current furore.

ETCDs are bought via exchanges while over-the-counter (OTC) currency derivatives are bought as their name suggests.

The deadline for the directives in the January 5 to come into force was April 5. It has now been extended to May 3. MC Explainer

What triggered the outrage?

The exchanges issued a circular to the brokerages on April 1 and the brokerages started contacting their clients, asking them to close their currency-derivative positions if they did not have underlying contracted exposure to currency risk—for example as an importer or an exporter. MC Explainer

Why is that a problem?

A large part of the currency-derivatives market—which is made up of speculators and arbitrageurs—was being asked to close their positions immediately. This was because RBI’s directions meant that people could only use the derivatives to hedge exposure to foreign exchange rate risks. Therefore, only hedgers were being allowed to operate in the currency derivative segment.

Since the rest of the traders had only three days (going by the earlier deadline) to close their positions, they were forced to take exit at whatever price they could find. Option premiums even shot up by 100x in some cases and traders had to absorb losses of lakhs of rupees. MC Explainer

Market participants were under the impression that the central bank had implemented this policy out of the blue. But as a later, April 4, 2024, circular from the RBI clarified, “The regulatory framework for ETCDs has remained consistent over the years and that there is no change in the RBI’s policy approach”. MC Explainer

Market participants were under the impression that the central bank had implemented this policy out of the blue. But as a later, April 4, 2024, circular from the RBI clarified, “The regulatory framework for ETCDs has remained consistent over the years and that there is no change in the RBI’s policy approach”.

Market participants were under the impression that the central bank had implemented this policy out of the blue. But as a later, April 4, 2024, circular from the RBI clarified, “The regulatory framework for ETCDs has remained consistent over the years and that there is no change in the RBI’s policy approach”. MC Explainer

Why didn’t RBI give more time?

RBI did give enough time. In fact, the central bank had this policy—that currency derivatives can only be used for hedging—since 2020. However, the exchanges had not communicated this to the traders. MC Explainer

Through the January 5, 2024, circular, the RBI had only reiterated its policy and asked the exchanges to inform the users of this regulatory requirement and the deadline by which the requirement must be met.

The circular also said that users who took positions up to $100 million did not have to provide documentary evidence but would have to provide the evidence if asked. While this was always the requirement, it wasn’t clearly stated in the earlier circulars. MC Explainer

Market insiders told Moneycontrol that the exchanges were hoping for a rollback of this decision by the RBI and therefore did not tell traders or brokerages to ensure that currency-derivative positions were being taken only as a hedge.

What happened in the following days?

There was not much time left for compliance since the exchanges sent out the circular to brokerages only on April 1, which was just a few days before the earlier deadline of April 5.

Therefore, the brokerages informed their clients that they would need to furnish evidence about underlying foreign exchange rate risk or the brokerages would forcibly square off their positions. Some other brokerages said that they would square off their positions if the clients gave a self-declaration that their currency-derivative positions are against an underlying exposure, without any further evidence.

The latter option only looked better. If clients were tempted to give a false declaration to hold on to their derivative positions, then the clients would have faced serious legal consequences.

What would be the legal consequences of a false declaration?

If positions were being held against the RBI directive, that is, they were being held without an underlying currency-risk exposure, then the clients could be found in violation of the Foreign Exchange Management Act (FEMA).

They could then be investigated and penalised by the Enforcement Directorate.

If they gave a false declaration to the brokerages, and the brokerages faced any penalty or financial loss because of this declaration, then the clients could also be liable to compensate the brokerages or pay the fine/penalty themselves.

Did the RBI extend the deadline?

Yes, to May 3. But as currency dealers, traders and brokers told Moneycontrol, the extension was given at the very last minute—on the evening of April 4. By then, many traders had already closed their positions at big losses.

Will the RBI’s directive mean the end of ETCDs?

Market insiders believe it would. They said that this segment is kept alive and liquid by speculators, arbitrageurs and hedgers. If only hedgers are allowed, liquidity will come to nearly zero.

Zerodha’s co-founder Nithin Kamath tweeted, “The RBI has its own reasons for restricting unhedged currency derivatives, but this means the death of currency derivative trading on stock exchanges by retail traders.”

RBI: The Reserve Bank of India is India’s central bank, responsible for managing the country’s monetary policy and foreign exchange reserves.

Currency Derivatives: These are financial contracts derived from the value of currencies. They allow speculation on future currency exchange rates.

Possible Reasons for the Circular:

  • Curbing speculation: Excessive currency derivative trading can increase volatility in the foreign exchange market. The RBI might be aiming to regulate this activity.
  • Protecting the rupee: The RBI might be trying to stabilize the Indian rupee by controlling speculation and ensuring orderly foreign exchange trading.
  • Market manipulation: The circular could address concerns about practices that artificially inflate or deflate the rupee’s value.

What to Look for in the News:

  • Specific restrictions imposed by the RBI on currency derivative trading.
  • The impact of these restrictions on traders and the forex market.
  • Industry expert opinions on the effectiveness of these measures.

Finding More Information:

  • Search the web for “RBI Jan 5 circular currency derivatives” or similar terms.
  • Look for news articles from reputable financial publications in India.
  • You can also visit the RBI’s website for official announcements and press releases

.

tvrfinnews.com

Leave a Reply

Your email address will not be published. Required fields are marked *