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Foreign Exchange Hedging – Changing Dynamics

Posted on: October 29, 2021 | By: M Vaseem Sheikh

01st September 2020, marked a special day for Indian Financial Market specially for those who follow Foreign Exchange (FX) markets. The Reserve Bank of India (RBI) heavily liberalized its foreign exchange hedging guidelines, a shift from prescriptive based to principle based!

The recent actions from RBI clearly shows its intent to streamline the FX market activities, right from curbing the volatility caused by external factors, up to providing an operational ease and fair price for the users. It gives a huge respite to all the Offshore investors, Foreign Portfolio Investor (FPI), Alternate Investment Fund (AIF) etc. who for the want of this were always hedging their Indian Rupee (INR) risk at offshore via Non-Deliverable Forward (NDF).

There are 3 specific dimensions to this. Let’s unravel this trinity a bit!

Regulatory Canvass has been repainted with soothing colors to attract more participation in Over the Counter (OTC) FX market for hedging the currency & interest rate risk. Among the methods of booking, while Contracted Exposure method has been retained as such, Past Performance (PP) method has been replaced with Anticipated Exposure (AE) method. While the comfort of not having to submit underlying exposure is retained in AE, the limitation to book up to a maximum amount under erstwhile regulation has been removed. Now, a user can book a hedge for any amount of exposure that they anticipate from their business. So, where is the control? The gain generated out of such hedge can only be passed on by witnessing the underlying exposure or the cash flow. RBI knows, how to do it!

A special USD 10 Million facility window to support and provide all the operational ease to Small and Medium Enterprises (SMEs) has been provided. It can be seen as a replacement for Special Dispensation Facility of the erstwhile regulations. No need to submit underlying exposure as long as you remain under USD 10 Million cap!

A lot of rationalization has been done in who can do what. While the erstwhile regulations were very prescriptive, now 2 broad categories of users, Retail and Non-Retail have been framed. Any entity with a net worth of INR 500 Cr or more are classified as Non-Retail. The product classification permits Non-Retail to use all the products including sophisticated ones. In a way, RBI is ok with the mighty ones taking higher risk.

The product offerings also have been liberalized. While earlier, Forwards, Vanilla Options, Swaps and a handful of Option structures were allowed, now all the products which an Authorized Dealer (AD) Bank can independently price can be offered. Thus RBI has opened the doors for offering all kinds of products in the market, provided relevant controls are in place and importantly to the right set of users.

So, Derivatives are NOT weapons of mass destruction! (If used judiciously)

Price Discovery, has been a persistent problem in FX markets with which RBI has been struggling for past many years. The continuous rise of Non-Deliverable Forward (NDF) market has only multiplied the problem manifold. In NDF markets, a FX trade is net settled in a convertible currency, usually in US dollar, as non-convertible currencies (like INR) are restricted to be delivered offshore. The rising prominence of NDF market can be attributed to restrictions in FX transactions onshore, cumbersome documentation and Know-Your- Customer (KYC) guidelines, restriction of hedging activities by Non-residents and inconvenient market hours for those in other time zones.

The turnover in offshore markets for INR had outpaced that of the onshore market which resulted in fragmentation of price discovery since domestic market price discovery became

vulnerable to influences from price discovery in offshore markets. Also, it dilutes effectiveness of exchange rate management by central bank.

RBI in its recent policy measures has tried to bring in wider integration between the onshore & offshore markets. Onshore FX trading hours has been increased to overlap some of the time zones to take into account of market developments of those geographies (of course COVID is playing a spoilsport currently). The introduction of Rupee derivatives at International Financial Services Centre (IFSC) and permitting Indian Banks to participate in NDF market also will play major role in this. Moreover, RBI also can intervene in NDF market through domestic banks to curb the volatility, if required.

Non-residents are classified as non-retail and permitting hedging via NDF with similar operational convenience also will boost their participation. Many of the AIFs/FPIs, who were hedging their INR risk at offshore can now look to hedge onshore under NDF route. Mark-to- Market (MTM) margining requirements are also made at par with other offshore jurisdictions.

Price Transparency, is another area where RBI is contemplating to increase the participation of user in the market to hedge their FX risks. It is more towards the smaller entities, SMEs (Retail client as per RBI definition) etc. to safeguard their interests. The descriptive guidance on FX mark- up/commissions and recording of market rate along with time stamp are the steps in this direction. The use of FX-Retail, a centralized electronic forex trading platform by Clearing Corporation of India Ltd (CCIL) is also being promoted heavily by RBI. It will also accelerate the regulator’s intent on providing fair price and overall operational comfort to the user.

In summary, FX hedging landscape is revamped with user-friendly ecosystem capabilities to attract higher participation and for sure FX markets will be buzzing in the days ahead. The developments in other markets like debt & equity are also going to increase higher offshore investor participation and hopefully with these simpler hedging norms, the investors will look at India’s FX markets to hedge their FX risk.

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