Access To Complex Forex Derivatives Returns For Large Firms

The Reserve Bank of India has revised its rules for hedging foreign exchange risk, allowing larger firms and financial institutions to get access to complex foreign exchange derivative products. Such products were banned in 2008 after incidents of rampant mis-selling came to light and a number of firms found themselves staring at losses related to such products.

More than a decade later, the RBI has reopened access to such complex foreign exchange derivatives with some safeguards in place. In a set of rules released on Tuesday, the RBI created two separate user categories: retail and non retail. The access to products differs for these two segments.

Non-Retail Users

• This category includes regulated financial institutions and agencies like National Housing Bank, NABARD and others.
• It also includes companies with minimum net worth of Rs 500 crore. Persons resident outside India other than individuals can also be categorised as “non retail users.”
• For this category of users, the products allowed include any derivative contract, including covered options.
• These products can be priced by the authorised dealers and valued independently. They must be approved by the board of the authorised dealer.
• However, the authorised dealer must ensure that any potential loss from a proposed derivative transactions should not exceed loss if the position was unhedged.

Retail Users

• The retail category will include any user who isn’t eligible to be classified as a non-retail user.
• Products allowed for retail category include forwards, purchase of call and put options (Only European options), purchase of call and put spreads, swaps.
• All forward contracts with retail clients shall be executed at the ongoing interbank / market rates.

While opening up the set of products available to corporate users, the RBI has cautioned that the transactions must be genuine hedging purposes, which the central bank defines as “the activity of undertaking a derivative contract to offset the impact of an anticipated or a contracted exposure”.

The RBI has also raised the net worth limit for non-retail users from the Rs 200 crore proposed in the draft guidelines released last year. At the time, market participants had believed that the net worth limit was too low.

A Checkered Past

Complex forex derivatives have a chequered past not just in India but across many emerging markets.

In a June 2009 paper, the International Monetary Fund had said that many firms in emerging markets had been drawn into such transactions, which eventually caused losses. “An estimated 50,000 firms in the emerging market world have been affected,” the IMF said in its paper. Countries impacted had included Indonesia, India, Brazil, among others.

In the aftermath of the losses, the Reserve Bank of India banned such complex products and told banks that they should only sell simple rupee-dollar derivative products. It later allowed cross-currency derivatives linked to the Euro, Pound Sterling and Yen.

A number of banks were fined for mis-selling of complex derivatives as well. Penalties had been imposed on 19 banks, including large foreign and domestic lenders like Citibank and HDFC Bank Ltd., among others.