RBI Directive for Currency Derivatives

RBI Directive for Currency Derivatives

Subject: Economy

Sec: Financial Market 

• RBI Directive for Currency Derivatives:
  • Effective from April 5, all market participants, including Foreign Portfolio Investors (FPIs), must declare any underlying position in the currency derivatives market.
  • This declaration is necessary even for a single lot, or else all positions must be squared-off.
  • Previously, FPIs were allowed to participate in Exchange-Traded Currency Derivatives (ETCD) without establishing “underlying exposure” in equities, bonds, or other financial instruments.
  • FPIs could take long or short positions in all currency pairs up to a limit of $100 million across all recognized stock exchanges.
• Impact on FPIs:
  • FPIs, along with other market participants, have been crucial in providing liquidity to ETCD contracts listed on exchanges.
  • Some FPIs and foreign brokers, particularly those engaged in prop trading or high-frequency trading, may now need to square off positions by April 5.
  • Failure to comply could result in penal action.
  • Custodians handling trades for FPIs are seeking clarity from the RBI regarding this directive.
• Concerns and Confusion:
  • The FPI community is confused and uncertain about the necessary actions to take.
  • Large hedge funds and quant-based funds, active in the ETCD market, may have significant positions that require attention.
  • Lack of clarity has led to a situation where many market participants are considering squared-off positions before the deadline.
• Market Outlook:
  • The market anticipates a shift towards a landscape dominated by hedgers, including exporters, importers, and FPIs.
  • Banks and brokers, traditionally market makers, might consider their position in light of the new directive.
  • The circular raises concerns of a reduction in liquidity if banks and brokers withdraw from the market.
• Risk Factors:
  • FPIs’ positioning in the USD-INR pair typically leans towards being long (more foreign currency, less rupee).
  • With positive FPI flows into India and a current account deficit, the risk is perceived as Indian currency depreciation.

ETD – Exchange Traded Derivative:

• An Exchange Traded Derivative is a standardized financial contract traded on stock exchanges in a regulated manner.
• These derivatives are subject to rules drafted by market regulators such as the Securities and Exchange Board of India (SEBI).

Derivatives Overview:

• Derivatives are financial contracts deriving their values from price fluctuations of underlying assets like stocks, currency, bonds, commodities, etc.
• There are essentially two types of derivatives:
• Exchange Traded Derivatives (ETDs):

1. Subject to standardized terms and conditions.
2. Traded on stock exchanges.

• Over the Counter (OTC) Derivative:

1. Traded between private counter-parties.
2. Transactions occur directly between parties without a formal intermediary.

ETD Characteristics:

• ETDs are standardized, meaning they have pre-defined terms and conditions.
• Traded on regulated exchanges, ensuring transparency and market oversight.
• Buyers and sellers of ETDs do not need to know each other, as the exchange acts as the counter-party for both sides.
• Prices and terms are publicly available and visible on the exchange, allowing for price discovery and market liquidity.
• ETDs often include various financial instruments such as futures and options contracts.

Examples of ETDs:

• Futures Contracts: Agreements to buy or sell an asset at a future date for a specified price.
• Options Contracts: Contracts giving the buyer the right (but not the obligation) to buy or sell an asset at a set price within a specific time frame.

Exchange Traded Derivatives play a crucial role in financial markets, providing investors with opportunities for risk management, speculation, and portfolio diversification. Their standardized nature and regulated trading environment contribute to market efficiency and transparency.