New FX exchange derivatives rules in India may increase OTC activity
India’s new rules on the use of FX exchange derivatives came into force in May, prompting much speculation on the effects of this “new” policy.
Up until recently, investors had read a stipulation that allowed transactions of up to $100 million without providing proof of foreign-currency exposure as a tacit acceptance of speculative trade in these instruments. But at the beginning of this year, India’s central bank indicated a crackdown on the practice.
Impacts on liquidity
The Reserve Bank of India reaffirmed an existing rule for FX exchange derivatives, that they were only to be used to hedge actual foreign currency exposure. In April, six brokers told Reuters that the move was likely to push out up to 80% of the market.[1]
"The unintended consequence of this will be that liquidity will dry up significantly and the small and medium sized companies - the hedgers - will lose access to risk management tool," Anindya Banerjee, head research in FX and interest rates at Kotak Securities told Reuters.
The NSE’s February Market Pulse publication estimated that corporates account for just 3.9% of the currency derivatives turnover while foreign investors contributed 6.2%. Proprietary traders and individual investors were responsible for 80% of the turnover.[2] But these smaller traders likely won’t be able to meet the hedging specification.
A boom in OTC?
The rules may shift hedging activity for foreign investors to local OTC and non-deliverable forward (NDF) markets, an NSE official told Reuters.[3]
Reuters also separately reported that the RBI is easing restrictions on banks' arbitrage trades between the outright FX OTC and the NDF markets.[4] The RBI had imposed an informal ban on dollar/rupee arbitrage trades in August 2023, when it was intervening to prevent the rupee from slipping to a record low, and banks were taking advantage of price differences between the OTC and NDF markets. But the central bank was now slowly allowing more of these trades again.
According to an International Swaps and Derivatives Association (ISDA) report, India’s OTC derivatives market has grown at a CAGR of 6.4% from 2010 to 2022, reaching a $9.3 trillion market in 2022.[5] In India’s OTC derivatives market, FX is the dominant asset class, followed by interest rates. India does not have a domestic OTC equity and commodity derivatives markets as they are not covered in the list of permitted derivatives in the RBI’s Market Makers in OTC Derivatives Directions.
Parameta Solutions, interdealer broker TP ICAP’s data and analytics business unit, has an evaluated pricing solution that aims to deliver transparent and observable prices for foreign exchange derivatives securities globally, using a proprietary data model to give frequent and transparent indications. The FX Evaluated Pricing (FEP) service, which provides coverage for G10 and emerging market currency pairs and includes FX Forward instruments as well as FX volatility surfaces, aims to enable price discovery, valuation of portfolios and the meeting of regulatory reporting requirements.
Bibliography
[1] Reuters India's FX exchange derivatives volumes to plummet on mandatory exposure rule
[2] NSE Market Pulse - A monthly review of Indian economy and markets
[3] Reuters India's FX exchange derivatives volumes to plummet on mandatory exposure rule
[4] Reuters Exclusive: India cenbank lifting curbs on forex non-deliverable forward arbitrage by banks, sources say
[5] ISDA Charting the next phase of India’s OTC derivatives market
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