India’s Forex derivatives market is all set for a profound
transformation. According to the notification issued by the Reserve Bank of
India on 5th 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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