Informist, Friday, May 3, 2024

By Pratiksha

NEW DELHI – It was only today that the Reserve Bank of India's much-talked about norms on exchange-traded currency derivatives formally came into effect, but nearly a month has passed since the new guidelines caused devastation in the market.

The guidelines, which mandated that every trade must be backed by an underlying exposure, essentially made exchange-traded currency futures and options a hedgers-only market and showed the door to speculative traders. It turns out that even the hedgers are hardly any better off, as they are left stranded in a market devoid of liquidity that was earlier provided by the speculators.

The RBI's directions, notified on Jan 5, said that traders need to ensure the existence of an underlying exposure that backed long or short positions of up to $100 mln. Though traders are allowed to take such positions without having to establish the existence of the underlying exposure, as has been the case till now, the RBI has now said that they should be in a position to establish the same, if required. Flouting of the norms may be seen as non-compliance under the stringent Foreign Exchange Management Act.

Since traders taking positions of up to $100 mln account for almost 70-80% of the volume on the exchange-traded derivatives platform, their exit has left a serious void in the currency futures and options market. Consequently, even those who need to hedge genuine exposures no longer have access to a fully functional market.

"If you stop the entry of speculators, arbitrageurs, who are providers or creators of liquidity, even the hedgers who actually want to go and hedge for genuine hedging requirements, how will they hedge without liquidity?" said Ritesh Bhansali, director at Mecklai Financial Services. "You need clean entry and exit without high impact costs. Any illiquid market cannot function effectively."

Market participants said that hedging has become more painful in the currency options segment, since proprietary and retail traders were more active in this segment before the RBI norms were announced.

According to National Stock Exchange data, open interest currency derivatives futures contracts has fallen to 32,63,467 as on Tuesday, from 52,48,022 as on April 2. Meanwhile, open interest currency derivatives options contracts has fallen to 8,72,412 as on Tuesday, from 69,41,316 as on April 2.

"95% volume happens in options on the trading side, and on the futures, it might be 80%. With the churn and no liquidity, volumes in both have dried out, and options is the first casualty," Sajal Gupta, executive director and head of forex and commodities at Nuvama Institutional Desk said.

Hedgers accessing the market now bear a higher execution cost because it is tough to find a counterparty at all price points. What is worse, illiquidity begets illiquidity.

"Spreads have increased as there are not enough counterparties for a trade and people don't want bad deals. Once all the issues come to the forefront, trading may come down more and then spreads may increase more," said a dealer at a brokerage firm.

"Execution costs are higher because of higher spreads. One of my clients had a $10 million position in October executed in just one day. He wants to cut that position but is getting just 30-40 lots at higher spreads to cut it," said Anil Kumar Bhansali, head of treasury and executive director at Finrex Treasury Advisors LLP.

Trading activity has taken a hit in the long-term future contracts more as compared to the near-term future contracts, as traders are uncertain about adequate liquidity in the market on a sustained basis.

"No trades happen beyond 3 months. For example, the quote for November (futures contract) is 83.91/84.30 (a dollar). Looking at such levels, a person cannot do anything on both sides," Bhansali from Finrex Treasury Advisors LLP said.

Poor market liquidity has forced some of the traders with genuine hedging requirements to move to the dollar/rupee forwards market, participants said. Volatility has picked up in the dollar/rupee forwards and spot market since April due to this, according to dealers.

"Corporates have shifted to banks. They have liquidated their positions. They are not doing active ETCD (exchange-traded currency derivatives) now. The impact is evident," Bhansali from Mecklai Financial Services said.

Some market participants also flagged that the RBI's death-knell of the currency futures and options market may spur illegal foreign exchange trading activities. "People will now move to illegal platforms or overseas trading platforms to trade FX. If you don't get liquidity and the pricing is lost, then why should even corporates look at this platform?" said Gupta.

Average daily turnover for currency futures and options, including notional turnover for currency options, on the National stock exchange was at 103 bln rupees in April, from 780 bln rupees in March, exchange data showed.

A section of the market is hopeful that looking at the state of trading in the currency derivatives market, the central bank may take stock of the situation and provide some respite.

However, the hopeful lot is a very small chunk, given that RBI Governor Shaktikanta Das at the April post-policy conference, pretty much denied the possibility of a rethink.

At the post-policy conference, Das had said the master directions will not be reviewed. "This has been a consistent position and this is a legal requirement as per FEMA (Foreign Exchange Management Act) regulations, so where is the question for review of that?" he said.

The question then arises, will the market eventually adjust to the new norms and rebuild itself with just hedgers alone? Unlikely so. The number of transactions backed by genuine exposures will never match up to that of speculative trades. Nor will the spontaneity.

Given that India is an emerging market as well as a foreign exchange deficit country structurally, and much of the hedging requirement tends to be against rupee depreciation. Counterparties will always be heavily skewed towards one side of the trade.

The RBI's new directives may have been guided by noble considerations of financial stability, but one can't help but wonder if the central bank foresaw the extent of collateral damage. End

US$1 = 83.42 rupees

Edited by Aditya Sakorkar

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