GS Paper III

News Excerpt:

A notification by the Reserve Bank of India (RBI) on hedging of foreign currency risk caused a stir among stock market brokers as it restricted the use of exchange-traded currency derivatives (ETCD) offered by bourses such as NSE and BSE for hedging with effect from 5 April.

About Exchange-Traded Derivatives (ETD): 

• An Exchange-Traded Derivative is a standardized financial contract that is traded on stock exchanges in a regulated manner. 
• They are subject to the rules drafted by market regulators such as the Securities and Exchange Board of India (SEBI).

Features of ETD: 

• Standardized Contracts: 

• • ETDs are standardized contracts that have a fixed expiration date and consistent trading volume. 
  • They must abide by the guidelines established by the regulatory body and stock market.

• Easy Offsetting Of Previous Contracts: 

• ETDs give traders the ability to offset past contracts, which is a huge convenience. 

• • The following methods can be used to offset an ETD:
    • Dealers can liquidate their open positions in the market.
    • An offset position can be bought by traders at a revised price.

• Presence Of An Intermediary: 

• Unlike OTC derivatives, ETDs don’t have direct counterparty risk. 
• This is because the stock exchange contractually binds the trading parties and acts as a formal intermediary to eliminate any risk of default.
• Subject To Rules And Regulations: 
• The exchange-traded market is subject to the rules and regulations of market regulators. It has to publish information daily, about the major trades being executed. 
• The rules and regulations make it difficult for big players to circumvent the rules via short squeezes and other unfair trade practices.
• Market Depth: 
• Exchange-traded derivative market carries considerable market depth by having high liquidity. This allows traders who want to reverse their positions or sell their stakes to find counterparts easily.

Types of Exchange-Traded Derivatives:

What is the issue?

• Until recently, users having positions up to $100 million each in any exchange-traded currency derivatives contract involving the rupee didn't need to have an underlying position. 
• The RBI circular along with a clarificatory letter last month changed that. 

What is the immediate impact of the RBI circular?

• Post the circulars from the exchanges, certain brokers decided to put their clients’ open positions (outstanding buy-sell trades) on USD-INR, Euro-INR, GBP-INR and Yen-INR in square-off mode;
• This would facilitate clients not having underlying exposure to exit before or after the revised rule sets in on 5 April. 
• Those with underlying exposure can continue to add more positions. 
• However, shorn of speculators, liquidity would dry up as any market gets deep only when a cross-section of participants trade on the segment. 
• That’s because the hedger transfers his or her risk onto the speculator who takes an informed contra position to gain from the trade. 

Why are brokers worried?

• Representations by broker association Commodity Participants Association of India (CPAI) were met with a response by RBI's Financial Markets Regulation Department  
• They said that any user taking part in exchange-traded currency derivatives without an underlying contracted exposure would stand foul of provisions of the Foreign Exchange Management Act (FEMA), 1999.
• Violation of FEMA could involve a penalty of three times the sum of the contravention, or ₹2 lakh in case the amount was unascertainable. 
• The onus would fall on the brokers in case the client is in contravention of FEMA from 5 April onward.
• Worried brokers reached out to markets regulator Sebi and stock exchanges late last week to clear the air as up until now most of their clients (retail investors) either didn't hold any underlying contracted exposure or, if they did, it would be well-nigh impossible for the brokers to ascertain this. 
• In response, NSE and BSE late on Monday asked all their trading members to take note of the RBI notification, which takes effect from 5 April.

How does it play out?

• Assume an importer is awaiting an inward remittance of USD by the end of April.
• His risk is the dollar depreciating by the time he receives the remittance. 
• He has the option of selling the dollar forward on the interbank market, dominated by banks, or on the ETCD segment. 
• Assume, the importer takes a sell position on the ETCD, a counterparty, either a proprietary trader or a retail investor, buys the dollar-rupee futures or options contract expiring by April end, in the hope that it would appreciate before expiry.

How does it affect liquidity?

• The liquidity is supplied by the counterparty, who, as a speculator, makes an informed decision. 
• If the counterparty were to vanish, a hedger would have to take his place.
• That hedger might not need the dollar by April end but by mid-May. 
• So, he would offer a bid that would be significantly lower than the asking price by the seller. 

• This would widen the bid-ask spread and increase the impact cost (how quickly an asset could be liquidated for cash), making the market less liquid than had the speculators been around. 
• Gradually, participation would thin and the market would die for want of participants. 
• This is what brokers fear would happen to ETCD after the RBI’s January circular. 
• A market that ran for 16 years, without let, would possibly begin to see a quick demise if the speculators were to be excluded. 
• The regulator would have had its own logic for red flagging and preventing unhedged transactions on forex contracts involving the rupee on ETCD. 
• One of the brokers impacted by the circular said it could be that the regulator wants to prevent excessive volatility in the INR by closing out the ETCD for speculators, so it doesn’t have to intervene in one more market segment, other than the interbank market.