Reforming India’s Rupee Derivatives: RBI’S 2025 Draft & Future of Capital Account Liberalisation
The Reserve Bank of India (RBI) published the Draft Master Direction – Reserve Bank of India (Rupee Interest Rate Derivatives) Directions, 2025 on June 16, 2025, marking a major step towards strengthening India’s financial markets and gradually advancing capital account liberalization. This draft suggests a liberalised framework for non-resident entities to participate in interest rate derivatives (IRDs) denominated in rupees, including over-the-counter (OTC) instruments such as forward rate agreements (FRAs) and interest rate swaps (IRS), as well as exchange-traded derivatives.
While the draft represents a technical policy shift, its implications are far-reaching. It marks a deliberate attempt to align India’s derivative markets with global standards and signals a forward-looking intent to expand access, deepen liquidity, and internationalise the rupee. However, the proposed framework also raises legal, regulatory, and fiscal questions. This blog explores the RBI’s move through the lens of capital account liberalisation, assesses its alignment with India’s financial strategy, and highlights gaps in regulation, dispute resolution, and cross-border enforcement.
I. CONTEXTUALISING RBI’S 2025 DRAFT: THE EVOLVING REGULATORY FRAMEWORK
Interest rate derivatives (IRDs) are vital tools in global financial markets, enabling participants to hedge rate risks, manage portfolios, and express macroeconomic views. In India, the regulatory treatment of IRDs has historically been conservative, particularly for foreign participants. Under the Master Direction – Reserve Bank of India (Interest Rate Derivatives) Directions, 2019, non-residents were primarily allowed to hedge rupee interest rate exposure linked to Indian securities.
The 2025 Draft marks a decisive shift. It expands eligibility to a broader class of non-resident entities, including Foreign Portfolio Investors (FPIs), foreign banks, and corporate treasury units. These participants may now engage in rupee IRD contracts either over-the-counter (OTC) via Authorised Dealer (AD) banks or through recognised exchanges. Notably, the framework permits proprietary trading by non-residents, subject to compliance requirements such as reporting, margining, and documentation norms.
While technical in form, the draft signals a wider liberalisation intent. It builds upon recent RBI measures like the Special Vostro Accounts (2022), regulatory relaxations at IFSC-GIFT City, and the expansion of the Voluntary Retention Route (VRR) for FPI debt investments.
II. CAPITAL ACCOUNT LIBERALISATION AND INDIA’S FINANCIAL STRATEGY
India’s approach to capital account liberalisation has historically been one of cautious incrementalism. This cautious stance has been reaffirmed through subsequent RBI policy papers and Financial Stability Reports, which advocate for phase-wise liberalisation tailored to domestic macroeconomic conditions. The 1997 Tarapore Committee recommended a calibrated and sequenced framework for opening the capital account, anchored in three core principles: macroeconomic stability, sound financial institutions, and effective regulatory architecture. While full convertibility remains a long-term objective, India has consistently adopted a segmented and risk-sensitive approach, especially when it comes to short-term and volatile capital flows.
The proposed liberalisation of rupee interest rate derivatives for non-residents under the 2025 Draft Directions is consistent with this evolutionary framework. Unlike equity inflows, which are more easily reversible, derivative markets carry embedded systemic risks. As seen during the Mexican (1994), Asian (1997), and Russian (1998) crises, unregulated access to derivatives markets without adequate supervisory capacity can exacerbate capital outflows and market volatility. Derivatives permit not only hedging but also leveraged speculative positions, which can amplify volatility and disrupt monetary policy transmission. It is in this context that the RBI’s design becomes instructive: by requiring all non-resident participation to pass through authorised dealer (AD) banks and recognised exchanges, the framework ensures both visibility and regulatory control.
This move aligns with the larger macro-financial policy goal of promoting the rupee as an international currency. By enabling foreign participation in rupee-denominated risk instruments, India takes a small but significant step toward greater rupee internationalisation. This priority has gained traction in recent years, especially following global de-dollarisation discourse and geopolitical fragmentation of trade finance networks. Allowing non-residents to hedge rupee exposure domestically rather than relying on offshore non-deliverable forwards (NDFs) also deepens the domestic IRD market, improving its pricing efficiency and resilience.
Yet, the liberalisation raises regulatory concerns. Supervisory capacity to monitor cross-border positions, especially when global banks and funds operate across jurisdictions, remains under-tested. Legal uncertainties ranging from sovereign immunity to tax disputes complicate the participation of non-residents in India’s derivatives market. This is further complicated by India’s 2016 Model BIT framework, which restricts access to international arbitration and reinforces domestic remedies, raising enforceability concerns for foreign financial institutions. These unresolved legal issues underscore the need for coherence between the RBI framework and broader fiscal, tax, and securities regulations administered by the Ministry of Finance and SEBI.
Finally, macroprudential implications remain. The draft is silent on how these flows will interact with India’s external account. Without robust CCP access or effective netting, speculative IRD flows could stress the rupee yield curve, undermine bond market stability, or expose gaps in risk transmission.
III. LEGAL AND REGULATORY CHALLENGES OF CROSS-BORDER PARTICIPATION
While the RBI’s 2025 Draft Directions expand access to rupee IRDs, they expose persistent legal and institutional limitations, particularly in the context of cross-border enforcement, tax clarity, and fragmented financial regulation.
(a) FEMA and Taxation Uncertainty
Foreign participation in rupee derivatives falls under the Foreign Exchange Management Act, 1999 (FEMA), which governs India’s capital account regime. However, FEMA provides RBI broad discretionary powers without always specifying procedural standards. The 2025 draft, for instance, is silent on the tax classification of gains from non-resident proprietary IRD trades. Uncertainty remains around whether such income will be treated as business income or capital gains, whether tax withholding applies, and which tax treaties, if any, are applicable. In the absence of clarification from the Central Board of Direct Taxes (CBDT), foreign investors risk exposure to double taxation, retrospective claims, or litigation.
(b) Enforcement of Cross-Border Contracts
The enforceability of derivative contracts, especially OTC transactions, hinges on legal recognition of netting, close-out provisions, and governing law clauses. Although India has enacted the Bilateral Netting of Qualified Financial Contracts Act, 2020, its implementation remains limited in scope, particularly with respect to non-resident counterparties. Moreover, India is not yet a party to the UN Convention on the Assignment of Receivables or other treaties that enhance cross-border enforceability, making litigation or arbitration involving foreign parties potentially lengthy and unpredictable.
(c) Regulatory fragmentation
Oversight of IRD markets remains divided. The RBI governs OTC contracts and AD banks, SEBI supervises exchange-traded derivatives, and the IFSCA regulates similar instruments at IFSC-GIFT City. This fragmented structure risks compliance asymmetries and forum shopping, especially for global participants operating across platforms. Unless harmonised through inter-agency coordination or joint guidance, this siloed approach may undermine investor confidence.
IV. BALANCING LIBERALISATION WITH PRUDENCE
The liberalisation of India’s rupee interest rate derivatives (IRD) market for non-residents marks a pivotal moment in India’s capital account strategy. However, its long-term success will depend on how effectively India balances openness with regulatory depth, institutional infrastructure, and legal predictability.
(a) Codify and Clarify the Legal Framework
There is an urgent need to synchronize FEMA, tax, and securities laws to provide legal clarity for cross-border IRD transactions. Codifying norms related to:
- the tax treatment of IRD gains for non-residents;
- permissible market structures;
- eligibility conditions for netting under insolvency.
through RBI or SEBI circulars or amendments will reduce compliance ambiguity and build investor confidence.
(b) Strengthen Risk Management Infrastructure
Opening IRD markets to foreign players increases the complexity of financial risk management. India must invest in market infrastructure that supports real-time margining, trade reporting, and central counterparty (CCP) clearing to avoid systemic vulnerabilities. Expanding the application of the Bilateral Netting Act to cover a broader array of qualified contracts and encouraging the adoption of internationally accepted standards such as ISDA Master Agreements will be key to ensuring legal certainty. While Indian courts have gradually begun recognising ISDA-based documentation, no comprehensive jurisprudence exists on the enforcement of ISDA close-out provisions post-default.
(c) Enhance Regulatory Coordination
Lack of regulatory harmonisation across RBI, SEBI, and IFSCA undermines supervisory clarity and may disincentivise foreign entry. Establishing a unified regulatory sandbox or inter-agency task force for derivatives regulation could help streamline approval processes, prevent arbitrage, and ensure consistent rule-making across jurisdictions.
(d) Embrace Gradual and Phased Integration
India must continue its phased liberalisation model. The Voluntary Retention Route (VRR) provides a successful precedent, allowing controlled FPI debt flows with regulatory safeguards. A similar approach for IRDs beginning with VRR-compliant entities or restricted exchange platforms would allow the RBI to test market behaviour, manage inflows, and preserve macroprudential stability before scaling access
V. CONCLUSION
The RBI’s 2025 draft on rupee interest rate derivatives is not merely a regulatory update, it is a strategic intervention in India’s capital account architecture. If implemented with legal clarity, supervisory coherence, and infrastructure investment, it can deepen domestic markets, improve monetary transmission, and advance the rupee’s role in global finance. The path ahead demands careful calibration: India must uphold its liberalisation goals without compromising financial stability, ensuring that the next phase of integration is both orderly and resilient.
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Author: Nidhi Bhadauriya, a 4th year B.A.LL.B.(Hons.) student.
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