RBI tightens forex derivatives framework to ensure orderly functioning of market

The Reserve Bank of India (RBI) has introduced stringent measures targeting foreign exchange (forex) derivatives contracts, with the aim of maintaining the orderly functioning of the forex market. This comes amid concerns of the rupee weakening against the US dollar, potentially dropping below the 97 mark. The central bank has prohibited Authorised Dealers (ADs) from allowing users to rebook any forex derivative contract involving the Indian rupee (INR).

These contracts, whether deliverable or non-deliverable, will also include those cancelled with any AD after the issuance of new directions. However, rollover of foreign exchange derivative contracts upon maturity remains permissible, provided compliance with existing regulatory provisions. The RBI has also reduced the threshold for undertaking forex derivative transactions to hedge contracted exposures from $100 million equivalent to $5 million equivalent.

Similarly, the threshold for entering exchange-traded currency derivatives involving INR has been lowered from $100 million to $5 million equivalent across all Recognised Stock Exchanges. ADs are now required to obtain and retain a commitment from users entering into forex derivative contracts involving INR, confirming that the underlying exposure was not previously hedged with any other AD.

Furthermore, ADs must maintain a Foreign Exchange Risk Reserve (FERR) in cash, equal to 20 percent of the INR equivalent of the notional amount of each transaction for FX derivative contracts involving INR, exceeding $2 million in notional value. This FERR applies to contracts undertaken to hedge current account exposures where users purchase foreign currency against INR.

Rama Chandra Reddy, Head of Treasury at Karur Vysya Bank, expressed concerns over the additional liquidity cost this measure would impose on covered transactions, discouraging excessive positions. He emphasized the central objective appears to be curbing excessive speculative positions, preventing duplicate hedging of the same exposure, and ensuring that forex derivatives are primarily used for genuine risk management.

While banks may face higher costs and liquidity constraints, customers undertaking genuine hedging may encounter additional documentation and some price adjustments. Reddy acknowledged that these measures could moderate speculative activity and promote orderly market conditions, but cautioned that the rupee's value will continue to be affected by global factors and underlying dollar demand and supply.