A January 5 notification by the Reserve Bank of India (RBI) on hedging of foreign exchange risk caused a stir among stockbrokers as it restricted the use of exchange-traded currency derivatives (ETCDs) offered by stock exchanges such as NSE and BSE for hedging. with effect from April 5. Mint explains what it means for the markets.
What is the matter?
Until recently, users having positions up to $100 million each in any exchange-traded currency derivative contract involving the rupee did not need to have an underlying position. The RBI circular along with a clarification mail last month changed that.
Why brokers are worried
Representations by broker association Commodity Participants Association of India (CPAI) on 22 March were met with a response by RBI’s Financial Markets Regulation Department on 28 March which said that any user participating in exchange-traded currency derivatives without an underlying contracted exposure would be in bad standing. of provisions of the Foreign Exchange Management Act (FEMA), 1999.
A violation of FEMA could involve a penalty of three times the amount of the violation, or ₹2 lakh in case the amount was unverifiable. The duty would fall on the brokers if the customer violates FEMA from April 5 onwards.
Concerned brokers approached market regulator Sebi and stock exchanges late last week to clear the air as till now most of their clients (retail investors) either did not hold any underlying contracted exposure or, if they did, it would be fine. -almost impossible for the brokers to ascertain this. In response, NSE and BSE late on Monday asked all their trading members to take note of the RBI notification, which comes into effect from April 5.
What is the immediate impact of the RBI circular?
Post the circular of the exchanges late on Monday evening, some brokers decided to place open positions of their clients (outstanding buy-sell trades) on USD-INR, Euro-INR, GBP-INR and Yen-INR in square mode from Tuesday. ahead This would make it easier for clients with no underlying exposure to exit before or after the revised rule kicks in on April 5. Those with underlying exposure can continue to add more positions.
However, without speculators, liquidity will dry up, as any market deepens only when a cross-section of participants trades on the segment. That’s because the hedger transfers his risk to the speculator, who takes an informed counter position to profit from the trade.
How does it play?
Suppose an importer expects an inward shipment of USD by the end of April. His risk is the depreciation of the dollar when he receives the remittance. He has the option of selling the dollar forward on the interbank market, controlled by banks, or on the ETCD segment.
Suppose the importer takes a short position on the ETCD, a counterparty, whether a proprietary trader or a retail investor, buys the dollar-rupee futures or options expiring before the end of April, in the hope that it will appreciate before expiration.
How does it affect liquidity?
So, the liquidity is supplied by the counterparty, who, as a speculator, takes an informed decision. If the counterparty were to disappear, a hedger would have to take his place. That hedger may not need the dollar before the end of April, but in mid-May. So, he would make an offer that would be significantly lower than the seller’s asking price.
This would widen the bid spread and increase the impact cost (how quickly an asset could be liquidated for cash), making the market less liquid than the speculators were around. Gradually, participation would thin out and the market would die for lack of participants.
This is what brokers fear would happen to ETCD after the RBI’s January circular. A market that has operated for 16 years, without a license, might begin to see a rapid demise if the speculators were excluded.
The regulator would have its own logic to red flag and prevent uncovered transactions on forex contracts involving the rupee on ETCD.
One of the brokers affected by the circular said that it could be that the regulator wants to prevent excessive volatility in the INR by closing the ETCD to speculators, so it should not intervene in one more market segment, apart from the interbank market. .