Introduction:
As we all know, The Reserve Bank of India which is the country’s central banking authority, plays a pivotal role in regulating and supervising financial markets. Yesterday, On January 5, 2024, the RBI issued a crucial circular, numbered RBI/2023-24/108, link provided below for Circular No. 13, which mainly focuses on the hedging of foreign exchange risk.
This circular, issued by the Financial Markets Regulation Department, Central Office, introduces significant amendments and additions to existing regulations concerning foreign exchange derivative contracts. In this comprehensive article, we will delve into the intricate details of the circular, providing an in-depth analysis of the key points and their implications for authorized persons.
Overview of the Circular:
Regulatory Framework and Background:
The circular begins by emphasizing the imperative need for managing foreign exchange risk through hedging activities. It explicitly refers to the Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000, dated May 03, 2000, and subsequent amendments. Additionally, the Master Direction – Risk Management and Inter-Bank Dealings dated July 05, 2016, serves as a foundational document for understanding the regulatory landscape.
Main Changes and Additions to the above circular:
1. Review and Consolidation: The circular underscores the ongoing efforts to enhance the foreign exchange risk management facilities. This includes a comprehensive review based on feedback from market participants and the experiences gained since the implementation of the revised framework.
2. Incorporation of Directions: An important aspect of the circular is the incorporation of Directions from the Currency Futures (Reserve Bank) Directions, 2008, and Exchange Traded Currency Options (Reserve Bank) Directions, 2010, into the Master Direction – Risk Management and Inter-Bank Dealings. This consolidation aims to streamline and simplify the regulatory framework.
3. Effective Date: The circular establishes a timeline for the implementation of the revised Directions. They are set to come into effect from April 05, 2024. This date holds significance as it marks the commencement of the new regulatory regime, replacing the existing Directions in Part A (Section I) of the Master Direction related to Risk Management and Interbank Dealings dated July 5, 2016.
4. Authorized Persons: A critical term introduced in the circular is “Authorized Persons,” referring to Authorized Dealer Category – I banks. Additionally, for exchange-traded currency derivatives, Recognized Stock Exchanges and Recognized Clearing Corporations fall under this umbrella. The definition and inclusion of these entities underscore the diverse participants in the foreign exchange market.
5. Legal Basis: The circular cites specific legal provisions under which it has been issued. Sections 10(4) and 11(1) of the Foreign Exchange Management Act, 1999, and Section 45W of the Reserve Bank of India Act, 1934, serve as the legal foundation for the Directions provided in the circular.
Definitions and Explanations:
To comprehend the circular fully, it is crucial to understand the definitions and explanations provided for key terms. Let’s delve into the definitions and explanations for each term outlined in the circular:
Definitions:
1. Anticipated Exposure: The circular defines “Anticipated Exposure” as the currency risk arising from current or capital account transactions permissible under the FEMA, 1999. These are transactions proposed to be entered into in the future. The inclusion of this term emphasizes the proactive approach to managing potential risks.
2. Contracted Exposure: “Contracted Exposure” refers to currency risk arising from current or capital account transactions permissible under the FEMA, 1999, which have already been entered into. The distinction between anticipated and contracted exposure is crucial for understanding the timing and nature of foreign exchange risk.
3. Currency Risk: The circular defines “Currency Risk” as the potential for loss due to movement in exchange rates of INR against a foreign currency or movement in exchange rates of one foreign currency against another. This definition highlights the multifaceted nature of currency risk.
4. Deliverable Foreign Exchange Derivative Contract: A “Deliverable Foreign Exchange Derivative Contract” is an OTC foreign exchange derivative contract, excluding non-deliverable contracts, where there is actual delivery of the notional amount of the underlying currencies. This distinction is essential for understanding the settlement mechanisms in foreign exchange derivative contracts.
5. Electronic Trading Platform (ETP): The term “Electronic Trading Platform (ETP)” is defined in alignment with Para 2(1)(iii) of the Electronic Trading Platforms (Reserve Bank) Directions, 2018. It signifies the increasing role of technology in facilitating foreign exchange transactions.
6. Exchange Traded Currency Derivative: “Exchange Traded Currency Derivative” is defined in accordance with Regulation 2(xvi) of the Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000. It encompasses derivatives traded on recognized stock exchanges, adding transparency and standardization to currency trading.
7. Foreign Currency Interest Rate Derivative Contract: This term refers to a financial contract deriving its value from changes in the interest rate of a foreign currency. Notably, contracts involving currencies of Nepal and Bhutan do not qualify under this definition. The inclusion of this term expands the scope of derivative contracts beyond mere exchange rate movements.
8. Foreign Exchange Derivative Contract: The circular defines a “Foreign Exchange Derivative Contract” as a financial contract deriving its value from the change in the exchange rate of two currencies, with at least one not being the Indian Rupee. This definition is fundamental to understanding the nature of derivative contracts covered under the regulatory framework.
9. Hedging: “Hedging” is defined as the activity of undertaking a foreign exchange derivative or foreign currency interest rate derivative transaction to offset the impact of an anticipated or contracted exposure. The concept of hedging is central to risk management in the foreign exchange market.
10. Leveraged Derivative: The circular introduces the term “Leveraged Derivative,” defined as an OTC derivative with a potential payout exceeding the notional amount of the contract. This definition sheds light on the risk and reward dynamics associated with leveraged derivatives.
11. Mid-Market Mark: The “Mid-Market Mark” is defined as the price of a derivative free from various costs or adjustments. Understanding this term is crucial for participants to ascertain the fair value of derivatives, devoid of external influences.
12. Net Worth: The circular borrows the definition of “Net Worth” from the Companies Act, 2013. This term is relevant in the context of determining the financial standing of entities participating in foreign exchange transactions.
13. Non-Deliverable Foreign Exchange Derivative Contract (NDDC): A “Non-Deliverable Foreign Exchange Derivative Contract” is defined as an OTC derivative where there is no delivery of the notional amount of the underlying currencies, and settlement is in cash. This definition distinguishes non-deliverable contracts from their deliverable counterparts.
14. Over-the-Counter (OTC) Derivative: The term “Over-the-Counter (OTC) Derivative” refers to a derivative traded outside recognized stock exchanges. The definition underscores the inclusivity of various derivative transactions taking place outside of formal
In conclusion, the RBI’s recent circular on the hedging of foreign exchange risk marks a significant milestone in the regulatory landscape of India’s financial markets. The circular, RBI/2023-24/108 A. P. (DIR Series) Circular No. 13, dated January 5, 2024, introduces crucial amendments and additions to existing regulations, providing a comprehensive framework for managing foreign exchange risk through hedging activities.
The circular’s emphasis on a comprehensive review and consolidation of foreign exchange risk management facilities demonstrates the regulatory commitment to evolving with market dynamics. The incorporation of Directions from the Currency Futures (Reserve Bank) Directions, 2008, and Exchange Traded Currency Options (Reserve Bank) Directions, 2010, into the Master Direction – Risk Management and Inter-Bank Dealings signifies a move towards simplifying and streamlining the regulatory framework.
The effective date of April 05, 2024, for the revised Directions is noteworthy, as it signals the commencement of a new regulatory era, replacing the existing framework in Part A (Section I) of the Master Direction – Risk Management and Interbank Dealings dated July 5, 2016. This timeline provides market participants with a clear roadmap for compliance and adaptation to the updated regulations.
The inclusion of the term “Authorized Persons,” encompassing Authorized Dealer Category – I banks, Recognized Stock Exchanges, and Recognized Clearing Corporations, underscores the diverse entities engaged in foreign exchange transactions. This broad definition ensures that various participants in the financial ecosystem are covered under the regulatory ambit.
The legal basis cited in the circular, invoking Sections 10(4) and 11(1) of the Foreign Exchange Management Act, 1999, and Section 45W of the Reserve Bank of India Act, 1934, imparts a strong legal foundation to the regulatory changes. It establishes the authority of the RBI in issuing these Directions and emphasizes their importance in the broader regulatory framework.
The detailed definitions and explanations provided for key terms in the circular are instrumental in ensuring clarity and uniform understanding among market participants. Terms such as anticipated exposure, contracted exposure, currency risk, and others contribute to a nuanced comprehension of the regulatory requirements and facilitate effective risk management strategies.
In essence, the RBI’s circular on hedging of foreign exchange risk reflects a proactive and adaptive approach to the evolving dynamics of the financial markets. By incorporating feedback from market participants and consolidating various Directions, the RBI aims to enhance the effectiveness of foreign exchange risk management practices.
Market participants, including Authorized Dealer Category – I banks, Recognized Stock Exchanges, and Recognized Clearing Corporations, are urged to thoroughly review and implement the revised Directions. As the circular comes into effect in April 2024, it not only reflects the regulator’s commitment to fostering a robust financial ecosystem but also places a responsibility on market participants to align their practices with the updated regulatory framework. Overall, the circular serves as a cornerstone for promoting stability, transparency, and efficiency in India’s foreign exchange markets.
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