All the speculation regarding the introduction of currency futures in India ended on 6 August, with the Reserve Bank of India (RBI) publishing directions on them. Much interest has been spawned in relation to these products since they have been on the regulatory horizon for the past two years, and directions relating to them have been debated by both the Securities and Exchange Board of India (SEBI) and the RBI.
The introduction of currency futures signals the dawn of a new era in the Indian derivatives market, as until now, very limited hedging opportunities were available to traders and others aiming to hedge their currency-related risks.
Currency futures serve the purpose of regulating the exchange rate without intervention by the central bank. The advent of currency futures will lead to effective exchange rate discoveries, mitigating exchange rate volatility, which has singed importers and exporters alike with broad swings either way (the rupee appreciated against the US dollar by around 11% in a less than a year and has again depreciated close to the same percentage in less than eight months).
The RBI has defined currency futures under the Currency Futures (Reserve Bank) Directions, 2008, as “a standardized foreign exchange derivative contract traded on a recognized stock exchange to buy or sell one currency against another on a specified future date, at a price specified on the date of contract, but does not include a forward contract.”
One of the salient features of the directions is that currency futures are permitted in US dollar-Indian rupee or any other currency pairs, as may be approved by the RBI. However, it appears for the time being, that only dollar-rupee futures will be available for trading.
The directions also specify that only “persons resident in India” (as defined under the RBI’s exchange control regulations) may purchase or sell currency futures to hedge an exposure to foreign exchange rate risk or otherwise.
Further, the RBI and SEBI have tightened the regulatory reins over the participation of the other entities such as banks, as banks and other financial institutions cannot participate in the futures market without obtaining the approval of the concerned regulator.
All foreign participation in such transactions has been effectively prohibited. The rationale for this might be a general aversion to foreign participation in derivative products (structured or simple, other than those with the underlying as a share of a listed company) in the aftermath of the sub-prime crisis.
These instruments will initially be traded on designated exchanges. The justification behind this is discernible. An exchange-traded mechanism offers the advantages of a seamless settlement, efficient price discovery, reduced costs, transparency, and an overall tightly regulated environment for the trading of these products, as opposed to a bilateral over-the-counter product.
Other features include a maximum maturity period of twelve months, a fixed contract size of US$1,000 and a settlement rate equal to the RBI’s reference rate, a day prior to the settlement date.
Separate memberships are envisaged for the currency futures market relating to the clearing and settlement of these derivative products. At the time of writing, two exchanges have been granted permission by SEBI in relation to the setting up of such markets: the National Stock Exchange and the MCX Stock Exchange, a subsidiary of the Multi Commodity Exchange of India.
Banks fulfilling certain criteria have also been granted permission to obtain the membership of such exchanges. A bank can become a trading or a clearing member of such an exchange provided it has capital and reserves worth Rs5 billion, maintains a 10% capital adequacy ratio, 3% or less net in non-performing assets and a three-year profit record.
The road ahead
With the introduction of currency futures, the RBI and SEBI have taken yet another step towards fuller capital account convertibility and have also offered an effective hedging tool to investors seriously affected by exchange rate volatility. However, things aren’t as simple as they appear.
Issues which require resolution and further thought include the role of the RBI and SEBI in relation to the regulation of these instruments, and the introduction of currencies other than the dollar, in a global scenario where the might of the dollar is decreasing by the day.
Clearly demarcated roles between the RBI and SEBI would benefit all involved parties and would significantly enhance the effectiveness of the system.
Sawant Singh is a partner and Arun Madhu is an associate at Trilegal in Mumbai. Trilegal is a full service law firm that advises on corporate and commercial law in India and provides commercially oriented legal advice in relation to all sectors of the economy. The firm has offices in Delhi, Mumbai, Bangalore and Hyderabad and have over 80 lawyers, some with experience at law firms in the US, the UK and Japan.
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