Rising speculative bets stoke RBI crackdown on currency derivative

Volumes up 3x post Covid; 2/3rd participation by prop traders

Excessive speculative bets in the domestic currency derivatives market is perceived as the primary catalyst behind the Reserve Bank of India’s (RBI’s) decision to clamp down on those engaging without any underlying exposure.

According to sources familiar with recent central bank norms on exchange-traded currency derivatives (ETCDs), the Foreign Exchange Management Act (Fema), 1999, prohibits speculation against the Indian currency.

“Will the Government of India permit speculation against the rupee? Is India prepared to endorse policy-driven speculation surrounding the rupee?” asked a source elucidating the central bank’s stance.

Last week, the RBI deferred the implementation of norms on ETCDs linked to the Indian rupee until May 3, citing investor concerns that the move could drain liquidity.

The norms were initially slated to take effect on April 1.

Rupee-denominated currency derivatives contracts are actively traded on the National Stock Exchange (NSE), the BSE, and partially on the Metropolitan Stock Exchange of India.

In principle, all trades necessitate an underlying exposure. However, traders are not mandated to furnish evidence of underlying exposure for positions up to $100 million; they must confirm the existence of such exposure.

Following the press conference after last week’s monetary policy, the RBI censured investors for “misusing” the guidelines.

Data highlights a sharp rise in the average daily trading volume (ADTV) in the ETCD segment during the post-pandemic era. The ADTV in 2021–22 surged to Rs 1.41 trillion, up from Rs 70,470 crore in the preceding year, according to combined data from the NSE and BSE. The majority of the volumes stemmed from NSE trades.

However, ADTV came off the cliff in April amid uncertainties over open positions lacking underlying exposure. ETCDs have won investor favour in recent years, whereas products like credit default swaps and interest rate futures have yet to gain traction.

Data from the Securities and Exchange Board of India revealed that proprietary trades accounted for two-thirds of the turnover in 2022-23 on the NSE, with foreign portfolio investor shares comprising roughly 9.5 per cent.

Market observers note that a major portion of options interest stems from intraday traders, indicating speculative activity in the ETCD market. This, they argue, complicates rupee management for the RBI.

“Lately, concerns have arisen regarding the escalating use of algorithmic trades in the ETCD market. Foreign trading firms operating from tax-friendly jurisdictions have become increasingly active. These participants add little value to the ecosystem and exert pressure on the rupee,” commented an official from a brokerage.

The RBI said that the regulatory framework for participation in ETCDs involving the rupee is governed by the provisions of Fema. Regulations mandate that currency derivative contracts involving the rupee — both over-the-counter and exchange-traded — are permitted solely to hedge exposure to foreign exchange (forex) rate risks.

Sources indicated that whenever the Indian currency faces pressure, it is primarily from the ETCD and non-deliverable forwards markets. Historically, the central bank has intervened in the spot, forwards, and currency futures markets to alleviate volatility.

The RBI has been proactive in managing the exchange rate, contributing to the rupee’s status as the most stable emerging market currency in 2023–23. The central bank, which has allowed the currency to depreciate gradually, has also succeeded in amassing forex reserves, now at a record high of $645.5 billion.