ETCD directives don't go well with RBI's stellar reputation

The recent decisions of the Reserve Bank of India (RBI) to not allow from April 5 transactions in exchange traded currency derivatives (ETCD) without underlying exposure to currency fluctuation risks and  then allowing such trading till May 3, through a press note released after closing hours on April 4, have taken professionals familiar with foreign exchange markets by surprise.

Trading in ETCD without establishing the existence of any underlying exposure has been going on since 2007, when RBI allowed currency futures to be traded on the exchanges approved by the Securities and Exchange Board of India (Sebi).

The RBI’s AP (DIR) Circular no.147 dated June 20, 2014, Master Direction no.1/2016-17 dated July 5, 2016 and AP (DIR) Circular no.29 dated April 7, 2020 were so worded that the market participants, RBI and Sebi believed that underlying exposure was not required. The limit for such trading was $10 million equivalent of notional value (outstanding at any point in time), subject to a single limit of $100 million equivalent across all currency pairs involving Indian rupee (INR), put together, and combined across all exchanges. The trading volumes grew steadily and there was hardly any default. Most participants knew the market intricacies.
 

On January 5, 2024, the RBI’s AP (DIR) Circular No.13 said while the ETCD users are not required to establish the existence of underlying exposure, they must ensure the existence of a valid underlying contracted exposure, which has not been hedged using any other derivative contract and should be in a position to establish the same, if required. This circular was to take effect from April 5, 2024 and so, the traders continued to transact in ETCD without underlying exposures.

On March 27, the RBI told the Commodity Participants Association of India that if any user is undertaking ETCD contract involving INR without an underlying exposure, he is not in compliance with the provisions of Foreign Exchange Management Act (Fema), 1999. That scared the traders who started unwinding by April 4, their positions taken without underlying exposures, some even by taking sizeable losses. However, some traders kept their positions open and probably felt rewarded when at about 5 pm that day, the RBI deferred implementation of its January 5 circular till May 3, 2024.
 

The RBI said that since 2014, the ETCD traders were not allowed to transact without any underlying exposure. If so, why the RBI and the Sebi remained silent for so long and why they have now let it go on till May 3 is difficult to explain. Interestingly, the RBI said that the deadline was extended at the request of some market particip­a­nts. Incidentally, the INR weakened on April 4 and gained the next day. 
 

The standardised currency derivatives traded in exchanges are useful to small exporters/importers because the contract sizes are small and trading is quite transparent. Wider participation in the exchanges from hedgers, individuals and domestic and foreign institutions helped liquidity and price discovery. After the recent RBI directives, the exporters who could hedge their anticipated exposures have lost a useful tool and the premiums they could book. The ETCD markets have now become shallow with only those having underlying exposures trading in the exchanges. The RBI move goes against the trend of allowing more flexibility and therefore, retrograde. The recent developments do not go well with the RBI’s stellar reputation as a prudent regulator.

Email:tncrajagopalan@gmail.com