How RBI Diktat May Kill India's Onshore Currency Derivatives Market

Reminiscent of the 1997 Tiger Currency Crisis, where the notorious speculator George Soros broke the Thai Baht leading to the Asian currency crisis, the Reserve Bank of India (RBI) may have inadvertently sounded a death knell for the vibrant currency derivatives market. Brokers fear that from April 5, only those who can "establish" an underlying exposure for hedging foreign currency risk will dare to trade in the currency segment on the Indian exchanges, while the rest would be risking FEMA (Foreign Exchange Management) violations. Such an inference is being drawn from an RBI circular dated January 5 that comes into effect from April.

As a result, if currency trading on Indian exchanges dies, the bets will move to the informal non deliverable forwards market in tax havens, where powerful speculators like Soros hold economies to ransom. But the devil's advocate view also says that RBI's purpose here could be to curb excessive speculation in the Indian currency to arrest wild price moves in case of unforeseen circumstances or events. Yet, that could be the lesser of the risks given the level playing field available to parties on the opposite side of the trade.

Stock exchanges are a pool of liquidity and daily speculators are an essential breed of market makers for that liquidity pool in trading segments like equity, currency, bonds etc. Like in any market, 90 percent of speculators driving the daily volumes do not have any underlying exposure and are just in there to make a quick buck by changes in the price - but they provide liquidity. The average daily turnover of currency futures and options contracts traded on India’s largest exchange NSE is more than Rs 1.5 trillion. The RBI circular may kill this market if it drives away such speculators.  
As per the circular, from April 5, the currency and interest rate derivatives traders "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." It simply means that the authorities have a right to ask any trader in the currency and interest rate derivatives to "establish" an underlying exposure for hedging the currency risk. Brokers say, there has been no such requirement up to now and anybody can trade in the currency and interest rate derivatives market with or without underlying exposure up to a certain limit.

"RBI circular is a U turn on the existing policy of allowing all participants to trade currency derivatives feely on the exchanges subject to certain limits. By putting the condition on every participant to prove underlying exposure for every exchange based trade, or face FEMA action, it will clearly spell the death knell for price discovery and volumes on the exchanges. It is surprising that the exchanges have not issued a circular to highlight this absolute U turn of an existing policy," said Rajesh Baheti, promoter director Corsseas Capital.

 In Baheti's view, the circular means that you don't have to prove any underlying exposure before trading but the field is open for the authorities to raise questions and hold you in violation of laws if you fail to establish underlying exposure -- it's simply illegal to trade on an exchange without currency exposure.

Before India's exchange traded currency derivatives market started gaining traction for the past few years, it was RBI's archaic laws that pushed trading in Rupee to the unofficial NDF market in Singapore and US. It simply meant that speculators could decide the direction of the Indian Rupee in foreign jurisdictions. Such laws that push speculation in a country's currency to foreign jurisdiction was a chief cause for the Asian Currency Crisis.

Derivatives are financial instruments that are used to hedge risks, manage exposures, and speculate on the movements of underlying assets. In the currency derivatives market, the underlying exposure may simply mean exposure to any business or asset in foreign countries that may involve risk of currency price fluctuation. For instance, oil companies that import crude from foreign countries and pay in dollars are prone to currency risks and hence are said to have underlying exposure.