Exchange-traded currency derivatives had been flourishing in India for more than ten years, driven by retail investors and proprietary traders. However, the situation took a turn when the central bank intervened.
Traders had been freely speculating on the movements of the rupee without holding actual underlying assets. They interpreted a rule allowing transactions up to $100 million without proof of foreign-currency exposure as implicit approval of speculative trading by authorities.
In late March, the Reserve Bank of India dealt a severe blow to the booming market, reaffirming a rule permitting the use of rupee forex derivatives solely for hedging purposes. This effectively sidelined traders and speculators who constituted the bulk of trading volume.
This incident underscores the uncertainty surrounding regulations and their interpretation in India, tarnishing the nation’s reputation as an attractive investment destination. Despite foreign investors flocking to India’s equities and pouring billions into sovereign debt, the ambiguity surrounding regulations poses a challenge.
“There seems to be some disconnect between what the regulator thought was very clearly mentioned in the laws and how the market perceived it,” remarked Smrithi Nair, a partner at Juris Corp., a legal advisory firm. “This sort of confusion creates a negative image at a global level for India as a jurisdiction.”
The RBI insists that its regulations have always mandated participants in the exchange-traded currency derivatives market to have genuine exposure. Deputy governor Michael Patra, in unusually firm remarks on April 5, accused some users of “misusing” the facility.
However, traders argue that the market’s understanding was that underlying exposure was not required for deals below $100 million.
Despite a January circular by the RBI instructing exchanges to inform traders of the need for a valid contract for all trades, unhedged trades persisted. The circular set April 5 as the deadline for the new rules to take effect.
The directive did not fully register until later. Most brokers and industry bodies only sought clarification from regulators and exchanges at the last minute.
The Securities and Exchange Board of India (SEBI) did not receive formal representation from the industry until late March, according to a person familiar with the matter. It forwarded a petition from the brokers’ association to the RBI, which oversees foreign-exchange management.
Exchanges reaffirmed the RBI’s January circular on April 1, days before the deadline, catching many traders off guard with unhedged positions.
Open interest in rupee currency futures has halved since end-March, while premiums on some options contracts surged more than 200%.
Zerodha Broking Ltd. advised its clients to close open positions and warned about dwindling liquidity. The RBI postponed the implementation of the rule until May 3, stating that there was no change in its regulatory approach.
The authority has not clarified the motive behind the move, but some analysts speculate that it aligns with the broader goal of reducing volatility in the currency market. The RBI has utilized its record forex reserves to keep the rupee’s volatility among the lowest in emerging markets.
“It’s a surprise move when the country’s economy is the fifth largest, has robust forex reserves and the currency volatility is well managed,” said Ashish Barua, a former banker and a trader in rupee derivatives on the National Stock Exchange.
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While currency derivatives fall under the joint oversight of the markets regulator and the RBI, it remains unclear how the gap between the market’s interpretation of the rules and the regulator’s enforcement persisted for so long, especially considering that proprietary deals constituted two-thirds of the trading volume on the NSE.
