April 23, 2024


Is India’s foreign exchange derivatives market in danger?

A piece of news from a few weeks ago went under the radar. It had to do with the country’s foreign exchange (forex) derivatives market. The derivatives market in India for exchange-traded currency has flourished for over a decade thanks to retail investors and proprietary traders. The Reserve Bank of India (RBI) then stepped in.

As this market was booming, the RBI reaffirmed a rule that permitted the use of rupee forex derivatives only for hedging. The RBI has deferred the implementation of the rule till next month at the request of some participants. Some of the RBI’s previous circulars on the matter have caused enough confusion that there’s concern that this thriving market could soon be obliterated. Would this happen?


First things first. There are a few terms here that might seem alien so let’s go through them. Derivatives are financial instruments whose value depends upon or is derived from underlying assets like gold or financial assets like interest rates. A derivative doesn’t have a physical existence. It’s the result of a contract between the buyer and seller of the derivative instrument.

There are a few different types here. The first is a “forward contract”, or simply forward. It’s an agreement to buy or sell an asset at a predetermined value at a future date. Then there’s a “futures contract” or future. It involves the purchase or sale of an asset or instrument at a future date at a specified price. These are standardised and not custom deals.

Currency derivatives are traded over the counter. It’s a collective term used for futures and forwards. They’re used for hedging, which involves a future payment or receipt in a foreign currency. In the currency derivative market, one can trade through foreign trading contracts of different foreign currencies.

Most people who participate in the futures market take bets and speculate. They’re not involved in any business that needs foreign currency, like imports or exports. It’s just a way to make some extra money.

In 2008, the National Stock Exchange (NSE) opened its forex currency derivative trading platform. Through brokers registered with the NSE, it allowed individual traders to trade in new forex pairs using the rupee as the base currency. The RBI had stated that these trades should have some underlying exposure, like through imports or exports. The NSE didn’t inform anyone.

In the years that followed, trading in currency derivatives flourished. Later, the RBI allowed individual traders to keep open positions of up to $10 million, which was later increased to $100 million. Trading volumes skyrocketed to $5 billion recently.

The RBI then wanted people to sign a declaration that they had exposure to the currency. The intent was to confirm that the trade was a genuine foreign exchange transaction and not speculative. That was bad news since most people in this market just speculate. There was an immediate response, and the RBI has decided to defer till next month. Could this permanently damage the currency derivatives market?

VIEW: The RBI’s being cautious

The rule the RBI has outlined lines up with its broader foreign exchange management policy. The central bank is being very careful about the rupee as the country’s bond market prepares to be included in the global indexes from June. Thanks, in part, to the RBI’s policies, the rupee has been among the least volatile currencies among emerging market currencies globally.

The RBI had made it clear that anyone with rupee-based contracts below $100 million on the NSE needed an underlying exposure. If not, they would be in violation of foreign exchange rules. The RBI is trying to curb volatility in the currency market as foreign funds have poured money into India’s bond market. It has over $640 billion as a buffer against external shocks.

Ultimately, the RBI isn’t the one to blame here; it’s the exchanges since they hadn’t communicated the rules to the traders. Its January 5th circular reiterated its policy and asked the exchanges to inform users. RBI Deputy Governor Michael Debabrata Patra defended the central bank, saying its policy of forex risk management has remained consistent.

COUNTERVIEW: It could be disastrous

The booming market where volumes reached billions of dollars per day could come crashing down thanks to the RBI’s rule. It effectively exposes traders and speculators who make up nearly 70% of the market. What this shows is the uncertainty concerning regulations and how they’re interpreted. Apart from being disastrous for the derivative market, it undermines India as an investment destination.

The news of being included in the global bond market set off a frenzy as foreigners began flocking to domestic equities lured by high-growth prospects. According to the traders, the understanding was that underlying exposure wasn’t needed for deals below $100 million. Just days before the initial April 5th deadline, things went haywire. Zerodha Banking Ltd cautioned its clients about low liquidity.

The unintended consequence of the RBI’s rule will be small and medium-sized companies – the hedgers – won’t have access to risk management tools. Many have asked why the RBI took this decision on an active market that was operating smoothly. The hope is that the RBI will reinvigorate the market once stability has been restored. Until then, the domestic forex derivative market will be in bad shape.

Reference Links:

  • MC Explainer: What’s all the fuss around RBI’s Jan 5 circular on currency-derivatives trading? – Moneycontrol
  • Controversial RBI Action in Currency Markets Raises Eyebrows. Did it Unduly Benefit a Select Few? – The Wire
  • RBI defers exchange traded currency derivatives norms – The Indian Express
  • ‘No change in RBI’s policy on exchange traded currency derivatives’: Governor Shaktikanta Das – Business Today
  • India’s FX derivatives market faces crushing blow – The Economic Times
  • FX derivatives fiasco puts spotlight on regulatory risk in India – The Economic Times

What is your opinion on this?
(Only subscribers can participate in polls)

a) India’s foreign exchange derivatives market isn’t in danger.

b) India’s foreign exchange derivatives market is in danger.


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