ETCD guidelines: RBI seeks to balance rupee stability, competitiveness

Postponing the ETCD regulations deadline will reduce volatility in rupee exchange-traded derivatives, particularly options contracts.

Last week, the Reserve Bank of India (RBI) postponed the implementation of new norms for the exchange-traded currency derivatives market, initially set to commence on April 5, to May 3. This deferment came amid market concerns regarding participation in the ETCD market. The original deadline led to increased volatility in the forex market, prompting the RBI to delay the norm implementation.

Global economic fluctuations have a pronounced impact on the ETCD markets, as they are inherently linked to international trade and currency exchange rates. The recent volatility in the forex market, in part a response to global economic uncertainties, reveals the sensitivity of these markets to external shocks. The RBI’s decision to delay the implementation of new ETCD norms reflects a strategic response to these global economic conditions, seeking to provide a buffer against sudden market movements and ensure a stable transition to the new regulatory framework.

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In its announcement, the RBI highlighted that the regulatory framework for ETCDs has been consistent over the years, with no change in policy direction. The delay is meant to alleviate market anxieties and may contribute to stabilising foreign exchange volatility, potentially enhancing trading volumes on these platforms. 

ETCD norms

ETCDs are financial contracts traded on regulated exchanges, akin to stocks or options contracts, but they do not represent any physical asset. Instead, their value derives from the exchange rate between two currencies.

The ETCD market plays a strategic role in India’s broader financial system, providing a mechanism for market participants to hedge against currency risk and facilitating efficient price discovery. This market’s significance is heightened by India’s growing integration into the global economy, necessitating sophisticated financial instruments to manage the associated currency risks.

Drawing on international best practices, effective ETCD regulations often emphasise transparency, risk management, and market integrity. Disclosure requirements for market participants ensure clear visibility into trading activities, while position limits help mitigate excessive concentration and potential manipulation. Regulatory bodies also prioritise risk management frameworks for market intermediaries, including brokers and clearing houses, to safeguard against financial instability. Furthermore, promoting fair and orderly trading practices is crucial, with measures to deter insider trading and market manipulation.

The RBI’s regulatory adjustments in the ETCD sphere are not just technical changes but are part of a broader strategy to enhance the market’s robustness and align it with international best practices. In January, the RBI introduced a rule to mitigate foreign exchange risks, permitting participants to trade in forex derivatives, such as options or futures contracts, up to $100 million across all currency pairs involving the rupee and across all exchanges. This was a significant increase from the previous $10 million limit per exchange. However, contracts denominated in rupees traded on the National Stock Exchange and the Bombay Stock Exchange required underlying exposure.

The revised rule permits market participants to hold positions in the forex derivatives market, long or short, without demonstrating underlying exposure, though a legitimate reason for the trade must be presented if the RBI requests.

Further clarifications from the RBI on Thursday stated that the regulatory framework for ETCDs involving the rupee is governed by the Foreign Exchange Management Act (FEMA), 1999. This framework mandates that currency derivative contracts involving the rupee, both over-the-counter (OTC) and exchange-traded, are allowed solely for hedging foreign exchange rate risks.

Violations of FEMA regulations could result in a penalty thrice the sum involved, or Rs 2 lakh if the amount is indeterminable, with brokers bearing responsibility for any client contraventions post-April 5. This led to concerns among brokers, prompting queries to the Securities and Exchange Board of India and stock exchanges for clarification.

While the regulations necessitate underlying exposure for rupee-based ETCD contracts, the RBI’s previous allowance for positions up to $10 million per exchange without such proof aimed to streamline business operations. However, maintaining valid underlying exposure remains a requisite.

Misinterpretations have arisen among some market participants, equating the relaxation in documentary evidence with a lack of underlying exposure, which contravenes the law, according to RBI deputy governor Michael Patra.

The RBI, in its January 5, 2024, directive, maintained the regulatory framework for ETCD participation involving the rupee. It reaffirmed that participants with underlying exposure could trade up to $100 million without initial documentation. The revised deadline is intended to reduce volatility, following reports of forex brokers urging clients to close positions, which spiked market fluctuations. The rupee hit a record low against the dollar on Wednesday, influenced by these closures.

The recent directive may not immediately affect the market, as the RBI’s policy stance remains unchanged. However, trading volumes might increase after a recent slump caused by position unwinding. The options premium, which had risen to 3.5%, is expected to normalise between 1.5% to 2%.Post-RBI circular, there is optimism among market participants that volatility in rupee exchange-traded derivatives, especially options, will decrease.

Following the new rules, some brokers began liquidating client positions in USD-INR, Euro-INR, GBP-INR, and Yen-INR futures and options contracts, offering an exit before the April 5 deadline. The concern is that a lack of speculators could deplete market liquidity. Speculators are vital for providing the counterbalance to hedgers, ensuring smooth market operations.

The RBI’s approach to ETCD regulation, marked by flexibility and cautious progression, is indicative of a broader objective to balance market stability with international competitiveness. By allowing greater leeway in terms of position limits and documentation requirements, the RBI aims to foster a more dynamic and accessible market. This flexibility is crucial for maintaining the attractiveness and competitiveness of India’s financial markets on the global stage, ensuring they remain resilient in the face of international capital flow volatility.

Retail investors have been active in currency futures markets since their inception in 2008. Unlike in OTC markets, exchanges did not require proof of trading rationale, leading retail traders to drive more than half of all currency futures transactions, thus enhancing market liquidity. Initially, in August 2008, the RBI permitted trading for hedging and other objectives.