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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RBI’s Master Directions on Bharat Bill Payment System: A Progressive Leap in the Bill Payment Landscape

[By Karthika S. Babu] The author is a student of Gujarat National Law University.   Introduction The Reserve Bank of India (“RBI”) has recently released the  Reserve Bank of India (Bharat Bill Payment System) Directions, 2024, the Master Direction for the regulation of Bharat Bill Payment System (“BBPS”). The Directions are set to supersede RBI’s earlier Implementation of Bharat Bill Payment System (BBPS) – Guidelines in an attempt to further enhance participation and consumer protection by streamlining the bill payment process under the payment system. BBPS, operated by National Payments Corporation of India (“NPCI”), is a dedicated payment system designed specifically for recurring bill payments across various utility services. The BBPS framework was proposedby RBI in 2014 to unify and consolidate the electronic payment system by creating a single brand image for bill payments in the country.   The recent Master Directions are in line with the broader attempt of RBI for the regulation of the payment systems, reflecting a concerted effort to strengthen the interoperability of the payments sector. Through the directions, RBI has shifted its focus to promoting growth and innovation in the payment system by balancing the interests of various stakeholders. The extant regulatory framework aims to encourage a second wave of boom in the bill payment landscape by largely stimulating the participant units. This blog post is aimed at analysing the key features, ambiguities and the potential cocerns that needs to be addressed by the Directions while highlighting the cascading effect the regulations would have on the technological advancements in the sector.    Key features of the Framework  The recent developments in the payments sector demand for a dynamic regulatory regime. The RBI has so far adopted a balanced approach in harmonizing the sectoral growth with the consumer needs through minimal regulatory intervention and self-regulatory mechanisms. The Directions, by regulating the primary players in the payment system, NPCI Bharat Bill Pay Limited (“NBBL”) and Bharat Bill Payment Operating Units (“BBPOUs”), aim to do the same by creating a level playing field in the payment ecosystem by allowing entry of new players while providing for enhanced consumer redressal mechanisms.   NBBL, is the authorized Bharat Bill Pay Central Unit (“BBPCU”) which operates the payment system in addition to setting industry standards and undertaking clearing and settlement functions. Whereas, BBPOUs are the system  participants in BBPS which may function either as a Biller Operating Unit (“BOU”) or a Customer Operating Unit (“COU”) or both. A BOU onboards billers to BBPS while a COU provides customers the digital/physical interface through which the customers can access the billers in the payment system. The primary responsibility of BOUs as per the Directions is to ensure the regulatory compliance of the onboarding merchants in accordance with the guidelines as prescribed by the RBI or NBBL. On the other hand, COUs have to undertake the responsibility of providing for an inbuilt system for raising disputes in addition to ensuring consumer access to the billers. Moreover, the COUs must also take complete responsibility for the actions of agent institutions which are contracted for providing the interface services to the customers in the payment system.   Further, one of the key aspects of the Master Direction is the relaxation of regulatory requirements for the entry of non-bank payment aggregators (“PAs”) into the BBPS framework. Once a non-bank PA is authorized to operate as a PA under The Payment and Settlement Systems Act, 2007 or under the in-principle authorisation, additional licensing requirements for operating in the BBPS framework are done away with. However, an additional mandate is placed on the non-bank PAs to maintain escrow accounts with a Scheduled Commercial Bank exclusively for the purposes of BBPS transactions. The escrow accounts of the BOUs and COUs are to maintain the credit of funds collected from the customers, due to the biller, the credit/debit of disputed payments and the recovery of charges or commissions on the payment. In addition to the provisions provided in the directions, the management of the BBPS escrow account will be governed by the RBI guidelines on payment aggregators and gateways as applicable.   Finally, NBBL is required to establish a centralized dispute resolution framework as per RBI guidelines which will integrate all participating COUs and BOUs, allowing customers and billers to raise and resolve disputes effectively.   Analysis   RBI, through the Master Directions has introduced further regulatory mandates on an otherwise well-regulated payment system. Although the earlier guidelines provided for extant directions on the various aspects on the interoperability of BBPS, the new directions attempt to provide further clarity by simplifying and consolidating  the existing RBI regulations into the BBPS framework.   In contrast to previous guidelines, the Directions have further streamlined the settlement and consumer grievance mechanism by integrating BBPOU and BBPCU into an end-to-end complaint management system. Moreover, BBPOUs functioning as COUs are required to establish an inbuilt system for raising disputes; however, no such mandate is provided for BOUs. This creates ambiguity regarding how the disputes would be resolved internally between billers and biller aggregators within BOUs before it is escalated to the regulator or the relevant authority. This lack of a mandated dispute resolution system for BOUs may result in inconsistencies in the services of the BBPS system, significantly impacting the participants and the costumers.   Moreover, as per the previous guidelines for the purposes of settlement, the transactions were categorized as ON-US and OFF-US transactions. The difference between an ON-US and OFF-US transaction is that, in the former the biller and the payment collection agent belong to the same BBPOU whereas in the latter they belong to different BBPOUs. The settlement in the ON-US transactions is carried out completely by the BBPOUs whereas OFF-US transactions are settled by the BBPCU. It is pertinent to note that there is no mention of this bifurcation or settlement mechanism in the current framework except for the mandate on COUs to take responsibility for the actions of their agent institutions. Though doing away with this bifurcation has simplified the management and settlement process in the payment system,  it is imperative for

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The NPA Conundrum: Evaluating the Bad Bank Approach

[By Shubham Nahata]   The author is a student at Hidayatullah National Law University, Raipur Introduction One of the most drastic and disastrous impacts of the economic slowdown induced on account of COVID-19 will be seen on the balance sheets(“B/S”) of banking and financial institutions. As the availability of easy credit will become the norm in the post COVID-19 society, banking institutions will need to deal with the herculean task of resolving stressed assets on their B/S. According to the Financial Stability Report, published by the Reserve Bank of India, scheduled commercial banks (“SCBs”) account for almost 9.3% of Gross Non-Performing Assets (“NPAs”) in the economy. Almost 85% of these stressed assets can be traced to the B/S of Public Sector Banking institutions (“PSBs”). One of the prospective solutions on cards for resolving the banking crisis is the creation of a ‘Bad Bank’ that would take over NPAs from banking and financial institutions. Unlike traditional banking institutions, it does not engage in credit lending functions, however, it assists in the recovery of stressed assets in the financial sector. The soundness of the credit infrastructure of an economy is largely dependent on the recovery and resolutions mechanism in place for dealing with stressed assets. This blog post maps the growth of different regulatory practices adopted overtime to deal with NPAs and analyses the viability of a Bad Bank structure based on the experiences of different jurisdictions. Mapping the Trajectory Different strategies have been adopted over time in order to deal with stressed assets in the banking infrastructure. It includes measures like corporate debt restructuring, recapitalisation of banks etc. in order to improve the capital adequacy and keep NPAs in control. However, the overtime rise of NPAs in an economy is a signal for the need for a robust and effective resolution and recovery infrastructure. Neo-liberal banking reforms introduced in the first decade of the 21st century although increased the credit flow in the economy but it also led to a steep rise in bad loans as well. In order to portray the sound health of the banking industry, drastic measures like Corporate Debt Restructuring (“CDR”) were taken. It involved complete overhaul strategies like conversion of debt into equity, reducing interest, or extending the maturity to maintain the soundness of B/S.  One of the benefits that restructuring offered was that it exempted banks from creating provisioning for stressed assets. However, the Reserve Bank of India (“RBI”) prescribed stricter norms for classifying and recognition of stressed assets in the economy after the Asset Quality Review of 2015. This led to a steep increase in the ratio of NPAs in the banking sector. In order to deal with the ‘twin balance sheet problem’, the Insolvency & Bankruptcy Code (“IBC”) was enacted in the year 2016 which provided an effective avenue for financial lenders to undertake the resolution of stressed assets. The Banking Regulation (Amendment) Act, 2017 also empowered the RBI to issue directions to the banks to undertake resolution process against defaulters under the IBC. Similarly, under the framework of Joint Lenders Forum, the Reserve Bank empowered the banks to undertake measures like Corporate Debt Restructuring, Strategic Debt Restructuring and, the Scheme for Sustainable Restructuring of Stressed Assets (“S4A”). S4A offered an opportunity to the lenders to identify the sustainable level of debt for the borrowers and convert the unsustainable part of debt into equity instruments. However, these policies were discontinued after the RBI notified Prior Framework in March 2018. The prior framework was struck down by the Supreme Court in Dharani Sugars and Chemicals Limited v. Union of India, for being violative of Section 35AA of the Banking Regulation Act, 1949. Hence, on June 7, 2019, the RBI notified Prudential Framework for Resolution of Stressed Assets (Prudential Framework) which prescribes an incentive-based approach for resolution of stressed assets to improve the resilience of the credit infrastructure of the economy. Bad Bank Economics Asset quality, capital adequacy, liquidity and, responsiveness to the market are considered to be the key indicators of the financial health of a banking enterprise. Overtime rise in the ratio of NPAs not only affects the asset quality of banking institutions but also affects its capital to asset ratio, in turn, fracturing its ability to lend swiftly in the market. Bad Bank is a special purpose vehicle constituted as an Asset Reconstruction Company (“ARC”) tasked with the objective of acquiring and managing stressed assets of banking and financial institutions. It acquires discounted stressed assets from banks by upfront payment of a certain proportion in cash and issuing security receipts for the rest of the amount. Bad Banks are tasked with the responsibility to uniformly carry out resolution and recovery steps in respect of stressed assets and increase the return on such assets. Generally, such a form of entity is funded by the government and banking institutions in order to carry out its activities. Bad Bank structure for resolution of NPA can be effective as compared to the recapitalisation of banks, as the latter increases the burden on the taxpayers to provide for weak recovery infrastructure for banking institutions.  Global Experience Different jurisdictions around the globe have found recourse in a Bad Bank framework in order to deal with the problem of mounting stressed assets in the banking industry. Sweden during the financial crisis of 1992, formed a state-owned company (‘Securum’) tasked with the objective of acquiring stressed assets from its banking institutions. Securum was successful in resolving banking crisis in the economy and was able to return a substantial amount of government funding. Similarly, the Korean Asset Management Corporation of South Korea was formed in order to deal with stressed assets lying with banking and financial institutions. It was successful in reducing the ratio of NPAs in the economy from 17% in 1998 to 2.2% in 2002. It also introduced and developed the market for asset-based securities which attracted investments from both domestic and foreign investors. After the global financial crisis of 2008, the United States of America also formulated

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