By Shubham Dimri, Law Graduate, Gujarat National Law University, Gandhinagar
The NSE IFSC and BSE’s INX have started offering rupee linked derivatives on their platforms after receiving the approval from the Reserve Bank of India(RBI) and the Securities and Exchange Board of India(SEBI) early this year. This expands the bouquet of financial products offered in IFSC along with allowing for hedging of currency rate risk to prospective participants. The process of developing IFSC into a place, where rupee derivatives are traded, received a boost after the Task Force on Offshore Rupee Markets recommended that to prevent exchange rate shocks, currency rupee derivatives are needed to be brought within the ambit of domestic regulators. This was necessitated by the fact that non-deliverable forwards contracts in Rupee traded in foreign exchanges had a higher value and volume turnover than domestic exchanges which impacted the domestic macro-economic scenario. Following this recommendation, RBI and SEBI have framed rules for the segment in GIFT IFSC to start the process of developing the currency derivative market.
What was the position till now?
Rupee derivatives are traded on both onshore and offshore exchanges. The volume of contracts on offshore exchanges has been very high compared to onshore exchanges because of its speculative demand.India has a high share of around 18% in non-deliverable forwards which shows the global interest in the Indian economy.In India, the restrictions imposed bythe Foreign Exchange Management Act, 1999 (hereinafter “FEMA”)ensure that only persons with underlying risk can hedge their positionin the foreign exchange segment. This is complemented by giving power and responsibility tobanks to verify the risk and accordingly allow for taking positions. On the other hand, the offshore market is mainly dominated by Non-deliverable forwards (NDF). NDF contracts entail a settlement on a cash-only basis and are settled in a foreign convertible currency since Rupee is non-deliverable offshore.
Apart from the speculative demand, there are various reasons for the existence of huge offshore Rupee derivative contracts.These include factors like capital controls, position limits,frequent and significant changes in regulations and guidelines in the domestic exchanges,the OTC markets, and short trading hours.
Why there is a need to change the status quo?
The primary reason behind bringing the currency derivative segment to IFSC is to bring it under the Indian regulatory ambit. The idea is to effectively manage currency rate shocks. Further, different onshore and offshore markets create fragmentation thereby impacting the domestic economy. One primary example is the existence of SGX Nifty futures which affect the indigenous Nifty index because of longer market timings and a liberal regulatory environment. Similarly, the non-deliverable forwards traded in foreign jurisdictions have an impact of currency stability in India. As the High Powered Committee has noted, the stability of Rupee can be enhanced by bringing the offshore market within the purview of Indian regulators.
Besides this, when offshore traded derivatives are larger in value and volume, the price discovery becomes inefficient as it is not necessary that domestic and foreign investors think on the same lines about the economy. The existence of a larger offshore market also comes with an opportunity cost for onshore market. This opportunity cost is in the form of premium collection and revenue loss for domestic financial firms.
What has been done?
The primary objective as outlined by the High Powered Committee is to bring the currency derivative segment into the onshore market.This is to be done by liberalising the onshore market with respect to market hours, servicing to non-residents, and providing flexible position limits. At present, in pursuance of RBI’s objective of currency stability, restrictions are imposed in free trading of Rupee in onshore markets. The start of trading in Rupee linked derivatives in IFSC is a step forward and can be seen as a pilot project before expanding the regulations into onshore markets. This is because IFSC for all reasons and purposes isconsidered offshore entity.
The currency derivative segment received a boost with Non-Resident Participation in Rupee Interest Rate Derivatives Markets (Reserve Bank) Directions, 2019. Under the directions, non-residents have been allowed to undertake both hedging and non-hedging transactions in interest rate risk. However, residents are not permitted to participate in IFSC activities. The regulations concerning IFSC are drafted on the principle of keeping residents out of its ambit so as not to impede the progress of onshore markets. In addition to this, since IFSC is an offshore entity, the domestic capital restrictions apply when dealing in currencies.
Continuing with the trend, RBI has issued the Currency Futures in IFSC Directions, 2020explicitly barring residents from undertaking currency futures contracts unless permitted by RBI. Under the directions, the contracts have to be settled in a denomination other than Rupee since Rupee is non-deliverable under FEMA. The positional limits under the SEBI circularare 15% of total open interest or $1 billion, whichever is higher. This limit is applicable for trading members, institutional investors and eligible foreign investors. For other clients, the gross open position across all contracts should not exceed 6% of the total open interest of $100 million, whichever is higher.
In March, RBI allowed banks which are Category-IAuthorized Dealers under FEMA to offer non-deliverable futures to non-residents. In addition to this, the hedging of exchange rate risk under the voluntary retention route was also permitted. Voluntary Retention Route is a mechanism to allow FPIs to invest in debt markets and keep a portion of investment in India for a period of time. Allowing for currency hedging in this channel limits risk for both investors and domestic economy.
IFSC greatly benefits from these reforms. It increases the market volume in IFSC propelling it towards becoming a world-class institution. Moreover, it also increases the number of financial services offered by the IFSC thereby cementing its position in the derivatives market.
These reforms are a welcome step forward. Until now, the currency derivative regime in India was highly restricted. This brings a highly impactful sector under the watchful eyes of RBI. This is complemented by the establishment of IFSC authority which has members from all the financial sector regulators of India.
However, the inception of currency derivatives in IFSC does not solve the problem of market fragmentation. This is because IFSC is for all objects and purposes treated as an offshore unit. Transactions undertaken at IFSC are treated differently and this creates a separation between onshore and offshore regulatory frameworks. Further, there are concerns regarding offshore transactions eating into the onshore markets because of the liberal compliance and tax laws. However, to limit the spillover effect,ring-fencing has been done by allowing only non-residents to take services.The spillover effect of volatility which is a serious concern is also not adequately redressed. Any volatility has a high voltage impact on domestic bonds and other instruments, thereby having a substantial impact on macro-economic policies. The spillover effect can be controlled by developing and liberalizing onshore market. One of the ways is through increasing the trading hours of exchanges. This is because the value of the exchange is highly susceptible to global events which can happen at any time. Rather than having a drastic change in value on the opening of market, it is better to account for events in a longer time frame.
Currency is a sovereign instrument. The Balance of Payment crisis forced India to open up its economy and according toIMF’s Articles of Agreement the exchange rate ismarket-determined. Any exchange rate volatility has a high impact, both on domestic firms and macro-economic environment. Given the relevance of inter-connected world economies, it is prudent to have regulatory control over such sovereign instruments. A multi-pronged approach shouldbe taken to stabilize wild swings in Indian currency. Recently local banks have been allowed to participate in off-shore non-deliverable forwards market. Until now they were not allowed to do this because the participation of local banks would have meant increased liquidity in offshore exchanges thereby encouraging trading in those exchanges. While this goes against the recommendations of Task Force on Offshore Rupee Markets, the benefits are to be seen.
In essence, it seems like India is following the dictum of ‘if you cannot beat them, join them’. However, to be an attractive option liquidity is sine-qua-non. This means that the numbers of participants at GIFT need to increase. Appropriate regulatory framework, tax breaks and incentives are needed to be offered to firms. While this process will take time, reforms must be timely, need-based and above all must keep interest of participants paramount.