RBI defers exchange traded currency derivatives norms

Table of Contents☰

What’s in today’s article?

Why in News?
What are Exchange Traded Derivatives (ETD)?
Exchange traded currency derivatives norms deferred
Background: New norms published by RBI
What was the practice till now?
Why traders are opposing this move?

Why in news?

RBI has deferred the implementation of its new norms for exchange traded currency derivatives (ETCD) market to May 3 from April 5.

This comes after market participants raised concerns over participation in the ETCD market. As the April 5 deadline approached, there was a sharp rise in volatility in the forex market.

What’s in today’s article?

Exchange Traded Derivatives (ETD)

Exchange Traded Derivatives (ETD)

About
- An Exchange Traded Derivative is a standardized financial contract that is traded in stock exchanges in a regulated manner.
- These contracts derive their value from the performance of an underlying asset, such as stocks, bonds, commodities, or currencies.
- They are subject to the rules framed by market regulators such as the Securities and Exchange Board of India (SEBI) in India.
Examples
- Futures Contracts
  - Futures contracts are a type of exchange-traded derivative.
  - They involve an agreement to buy or sell an asset, like wheat or oil, at a predetermined price on a specified future date.
  - For example, a farmer might use a futures contract to lock in a price for their wheat crop before it’s harvested.
- Options Contracts
  - Options contracts give the holder the right, but not the obligation, to buy or sell an asset at a specific price within a certain time frame.
  - For instance, an investor might purchase a call option on a stock, giving them the right to buy it at a set price within the next six months.
- Exchange-Traded Funds (ETFs)
  - ETFs are investment funds traded on stock exchanges, and they often hold a portfolio of assets such as stocks, bonds, or commodities.
  - ETFs can be considered exchange-traded derivatives because their value is derived from the value of the underlying assets they hold.
Types
- Stock ETDs:
  - The first in the list of Exchange Traded Derivatives is the stock segment.
  - The Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) deal exclusively in stock derivatives in India.
  - The types of stock derivatives are Stock Forwards and Stock Options.
- Index ETDs
  - These types of Exchange Traded Derivatives trade on the major stock indices.
  - One can purchase or sell both index forwards and index options.
  - However, unlike stock options where one can opt for settlement either in cash or via delivery of stocks, index options have to settle in cash.
- Currency ETDs
  - Here, one has the option to trade as per the price movement of the currencies in the stock exchange.
  - Unlike OTC(Over the counter) derivatives trade in currency, ETDs allow for standardized contracts only across the specified pairs of currencies.
  - Every country has a currency, and its value fluctuates based on the value of other countries’ currencies.
  - For example, the price of INR keeps fluctuating compared to USD.
  - Exchange-traded currency contracts work on the same principle of buying at a low price and selling at a higher price.
  - However, exchange-traded currency contracts are always bought in pairs. E.g., Indian Rupee vs United States Dollar, Indian Rupee vs Euro etc.
- Commodity ETDs
  - These types of Exchange Traded Derivatives are traded on the price fluctuations of scores of commodities.
  - In India, one can trade in commodities futures at the Multi Commodity Exchange of India Ltd (MCX).
  - Some of the examples of standardized contracts on commodities include gold, crude oil, silver, natural gas, copper, zinc, etc.
- Bond ETDs
  - These types of Exchange Traded Derivatives involve trading in bonds.
  - For instance, the NSE has an exclusive platform to trade in bond derivatives products.

Background: New norms published by RBI

In January 2024, the RBI introduced a new set of rules for managing foreign exchange risks, which were set to start on April 5, 2024.
The new norms said that only traders with an underlying forex exposure can trade in currency derivatives.
- Underlying in derivatives contracts refers to the order bill or receipt in the case of exporters or importers, and documents to support the transaction in the case of remittances.
- For instance, if an Indian exporter expecting payment in US dollars in three months. This can be used as an underlying contracted exposure.
  - Traders use currency futures to mitigate potential losses from adverse exchange rate movements.
  - By entering a futures contract to sell US dollars at a predetermined rate, the exporter locks in a viable exchange rate.
It said users must ensure the existence of a valid underlying contracted exposure which has not been hedged using any other derivative contract, and they should be in a position to establish the same if required.
- The circular, issued on Jan 5, retained most of the earlier regulations, including a requirement that trades over $100 million would require proof of exposure.
  - Earlier, this requirement of proof for higher value trades was being interpreted to mean that those who did not have any exposure could participate in lower value transactions.
  - However, the Jan 5 circular carried a footnote requiring exchanges to ask clients to trade only against exposures.

What was the practice till now?

Till now, currency traders were free to trade in the derivative market, by either declaring or not declaring underlying exposure.
Currency derivatives are a tool for hedging forex risk.

Why traders are opposing this move?

Exchange traded derivative volume is going to dip
- So far, most transactions on exchanges were done by clients from the retail segment who could not transact in the OTC (over the counter) market as banks asked for the underlying and the users did not have it.
- Now, after the new norm, the exchange traded derivative volume is going to dip by nearly 80 percent as most of the volumes are coming from proprietary desk and retail which hardly have any underlying exposure.
Potential to virtually kill trading on exchanges
- Experts claim that by the above circular RBI has decided to curb trades on exchanges, and this had the potential to virtually kill trading on exchanges since the liquidity came from retail.
Aimed at maintaining a tight leash on the markets
- Dealers feel that RBI’s move to curb speculation is aimed at maintaining a tight leash on the markets.
- However, speculation is needed in a market if the objective is to:
  - move toward fuller capital account convertibility,
  - increase rupee’s influence globally, and
  - prevent investors from moving to unregulated markets like cryptocurrency.

Q.1. What is Securities and Exchange Board of India (SEBI)?

SEBI stands for the Securities and Exchange Board of India. It is a statutory regulatory body established by the Government of India in 1992 to protect the interests of investors investing in securities, along with regulating the securities market.

Q.2. What is Exchange-Traded Fund (ETF)?

An exchange-traded fund (ETF) is a collection of investments such as equities or bonds. ETFs will let you invest in a large number of securities at once, and they often have cheaper fees than other types of funds. ETFs are also more easily traded.