A Blow to Currency Derivatives Trading!

 

India’s Forex derivatives market is all set for a profound transformation. According to the notification issued by the Reserve Bank of India on 5^th January 2024, proprietary traders and retail investors will be required to demonstrate contracted or prospective currency exposure to participate in the forex derivatives trading offered by exchanges such as NSE, BSE and MSEI. It effectively means that participation in derivatives trading is henceforth restricted exclusively to hedgers. Initially, this directive was supposed to be effective from April 5, but at the representations made by the market participants, RBI has postponed the effective date to May 3, 2024.

Until now, non-banking participants in exchange-traded currency derivatives were allowed to take positions, be they long or short, without having to establish the existence of underlying exposure, up to a single limit of $ 100 million equivalent across all currency pairs involving INR, put together, and combined across all recognized stock exchanges.

Given this, the stringent notification from the RBI caused a stir in the forex derivatives market. Reports indicate that the daily turnover in the currency derivatives segment of NSE has collapsed to less than one-tenth of the daily average that stood at Rs 1.46 tr since the April circular of RBI that pushed the effective date to May 3. As the market players – predominantly speculators and arbitrageurs – commenced unwinding their positions to comply with the notification, the number of outstanding contracts also has come down substantially. Even the premiums on some option contracts appeared to have surged more than 200%.

The circular had indeed ignited a significant controversy in the market that consists of proprietary traders who accounted for 62% of gross turnover followed by retail investors (19%), others (8.3%), foreign portfolio investors (6.2%), corporates (3.9%) and domestic institutional investors at 0.2%. True, FEMA regulations did say that the participants in the exchange-traded currency derivatives market have to have an underlying exposure. But what the market players arguing is that all along neither the underlying exposure nor contracted exposure was insisted upon to trade in currency derivatives at exchanges up to a limit of $ 100 mn. As a result, currency derivatives market is well established in India with trading volumes reaching $ 5 bn a day. Now with this RBI notification, speculators and arbitragers who contribute a large portion of the volume will be driven out of the market, which means drying up of liquidity.

Theoretically speaking, speculators are important to markets because they bring liquidity while assuming market risk. And, providing liquidity is the essential function of the market which alone enables individual traders, including hedgers to easily enter or exit the market. Secondly, a liquid market reduces the cost of hedging. That aside, derivatives trading in exchanges being well-regulated and transparent helps players in the price-discovery of the underlying asset.

That said, it must also be admitted that speculators, believing that a particular currency is going to increase in value, may choose to purchase it as much as possible even by resorting to high leverage, and in the process can create a speculative bubble by driving the price of a currency above its true value. Conversely, they can go short believing that the asset is currently over-priced and drive the price to fall continuously till the market stabilizes.

Perhaps, it is to avert such unwarranted swings in the currency market, particularly in the light of global uncertainties and the forthcoming entry of the nation’s bonds markets in global indexes from June that the RBI might have issued the notification restricting trading in currency derivatives in exchanges to hedgers alone.

Yet, no one can afford to ignore the unintended consequences of this restriction: one, the relevance of exchanges as facilitators of hedging forex risk without the participation of algorithmic, proprietary and individual traders who typically handle the risk of hedgers will be lost; two, with poor liquidity, hedging becomes costlier; and three, it may finally drive the hedgers to banks that offer costlier over-the counter hedging products leaving exchanges dead. It may even drive traders to shift their operations to the rupee NDF market in Singapore, Hong Kong, or Dubai, which incidentally can result in the same volatility that RBI wanted to check with its latest notification. Over and above all this, it portrays a poor image of India’s regulatory regime.  

As the fact remains that derivatives market needs all kinds of players such as speculators, arbitrageurs and hedgers, RBI may have to recalibrate its exchange rate management techniques and come up with a regulatory framework that ensures liquidity in the derivatives market while managing the swings in currency prices effectively.

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