Hedging in Currency Derivatives Market: Is This End of Currency Derivatives?

[By Pranshu Agarwal] The author is a student of Institute of Law, Nirma University.   Introduction  The Exchange-Traded Currency Derivatives (“ETCD”) was introduced with the primary aim to enable traders and members to hedge their forex risk exposure, but they were using the ETCD platform for speculative trading without having any underlying contracted exposure. Although, the Reserve Bank of India (“RBI”) had stated that the Authorised Dealers (“AD”) do not need to establish the existence of any underlying contracted exposure up to $100 million yet, this led to speculative trading by the traders without having any underlying contracted exposure at all.  The RBI on 5th January, 2024, issued a circular titled “Risk Management and Inter-Bank Dealings – Hedging of foreign exchange risk” (“RBI Circular”) and thereafter, the National Stock Exchange (“NSE”) issued circular to the brokers to comply with the RBI Circular by April 5th. Because of these circulars, Market experts are expecting a slump of 80-85% in the volume in the ETCD overnight that is comprised of proprietary traders, retailers and arbitragers. This article seeks to analyses the principle-based regime and RBI’s direction to establish an underlying contracted exposure for ETCD. The article explores the requirement of valid underlying contracted exposure and its implications. It also discusses the effect of the RBI Circular on the derivatives market.  Underlying Exposure for ETCD: The Current Position  ETCDs are financial contracts traded and regulated by the stock exchanges. These contracts are akin to the volatility in international trade and exchange rates, making such contracts exposed to transactional exposure. To ensure stability and exposure against sudden market movements, RBI required the users to have underlying exposure for taking a position in the market. Whereas, for the convenience of the users, RBI allowed them to take up a position of up to $ 10 Million in the market without having to establish the existence of any underlying exposure. Later the limit was increased to $ 100 Million combined across all exchanges.  The RBI Circular, followed by the 1st April NSE’s circular specified that the users are allowed to take a position in the ETCD upto $100 Million without having to establish the underlying exposure, however they have to ensure a valid underlying contracted exposure for the same. What this entails is that before the RBI Circular, the users could trade on the ETCD up to $ 100 Million without having to show any underlying exposure and RBI did not have any authority to ask for the existence of the same. The RBI Circular has granted the RBI the power to inquire the user whether the ETCD units purchased by them have been hedged by a valid underlying contracted exposure. If the users fail to comply with the Circular by 5th April, 2024, they will be held liable for non-compliance under the Foreign Exchange Management Act, 1999 (“FEMA”). The deadline for the compliance has been extended to May 3rd, 2024 in light of numerous requests from members and traders.  Analysis of the RBI’s Circular  A prima facie reading this circular implies that an exemption provided to the users from having an underlying exposure in the ETCD unit upto $ 100 Million. This exemption has been curbed by the RBI Circular, prescribing the users to ensure valid underlying contracted exposure. Due to this, the traders are squaring off their current position in the ETCD market as the circular aim to eliminate speculative trading and various scams in the derivatives market. As per the SEBI report 90% of the traders make loss in the market, the circular will also ensure protection to the traders.  The derivatives market is very volatile for trading purposes, which can multiply your investment or shrink it down to zero in few minutes. Using this speculative and volatile nature of the derivatives market, many traders trade without any underlying exposure. For example, one of the trader keeps on buying derivative units and another trader keeps on selling the same derivative units thereby artificially inflating the price of the derivative unit, and the situation results in significant loss or profit to either of the trader. Such a scenario is not possible in case the users establish an underlying exposure. That is why hedging is prescribed by the RBI under FEMA as it reduces risk and profitability by creating a negative position in the particular unit.  On the close reading of the RBI Circular in line with the RBI’s policy for currency derivatives, it can be said that the RBI Circular does not make any real changes in the hedging requirement for the currency derivatives. The RBI’s policy has always been consistent over the years regarding the hedging requirement. Earlier, the RBI provided exemption from producing evidence of an underlying exposure, but it never intended to allow trading without any exposure. The exposure requirement was always mandatory. The users understood this exemption from producing evidence of exposure tantamounting to no exposure at all. The RBI Circular merely reiterate what was said in the earlier directions and nothing new has been introduced in the RBI Circular.  End of Speculation: Would this serve the RBI’s Purpose?  Speculative trading is often perceived as inherently risky, posing significant risk to traders. However, it is also necessary as it contributes to market volume. Eliminating speculative trading in the market may lead to reduction in market liquidity, issues in finding getting accurate pricing.  The RBI Circular will not affect the hedgers, as they already hedge their investment, but the proprietary traders and retailers were the biggest contributors to the currency derivatives market, liable for more than 80% liquidity in the market. This circular will require these traders and investors to square off their existing positions without having underlying exposure. With all the traders and investors gone, hedgers will not find any liquidity or any counterparty to execute a contract or hedge their securities in the currency derivatives market. However, hedgers have the option to hedge their securities with future contracts through the Over-The-Counter (“OTC”) market with the banks. Still, there

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