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RBI Committee Recommends Steps To Curb Dominance Of Offshore Rupee Markets

The committee has suggested longer trading hours among other measures.

A pedestrian walks past the Reserve Bank of India building in Kolkata (Photographer: Brent Lewin/Bloomberg)
A pedestrian walks past the Reserve Bank of India building in Kolkata (Photographer: Brent Lewin/Bloomberg)

A committee appointed by the Reserve Bank of India has suggested a host of measures to curb the rising influence of the offshore rupee markets.

The committee, headed by former Deputy Governor Usha Thorat, has suggested longer trading hours, permission to undertake currency derivative transactions upto a limit without underlying exposure and aligning tax and documents with international centres.

The committee, however, does not believe that Indian banks should be allowed to participate in the non-deliverable forwards markets just yet as the risks outweigh the benefits. While backing an expansion of the product suite, the committee said that this should be done within the existing principle that these products should not “create risk” for the user but only “hedge risk.”

Data published by the Bank of England’s semi-annual survey of foreign exchange volumes show that average daily Rupee NDF trading volumes in London have gone up sharply from $7.9 billion in October 2016 to $23 billion in October 2018. A similar survey conducted by the Federal Reserve shows that daily average NDF volumes for Rupee traded in New York have gone up from $2.8 billion to $4.5 billion over the same period.

The Bank of International Settlements’ latest triennial survey which details a broader picture of the NDF markets is due this year.

Opinion
Tackling The Growing Influence Of The Offshore Rupee Market

Key Recommendations

The committee, in its report, said that the sharp growth in offshore trading volumes in the rupee non-deliverable forwards markets has raised concerns around the forces that are determining the value of the rupee. This increase in offshore markets can also hamper the ability of authorities to ensure currency stability.

In order to give a fillip to the onshore markets, the committee recommends measures including the following:

  • Extend onshore market hours to improve access of overseas users.
  • Banks should be allowed to freely offer prices to global clients around the clock.
  • Enable rupee derivatives (settled in foreign currency), to be traded on exchanges in the International Financial Services Centers in India.
  • Allow users to undertake forex transactions up to $100 million in the over-the-counter currency derivative market, without the need to establish underlying exposure.
  • Allow any product to be offered to non-residents, within the principle that these products be used to hedge risk and not create risk.
  • Align the tax treatment of foreign exchange derivatives with that in major international centres.
  • Centralise the KYC requirements across financial markets with uniform documentation requirement.

The proposal to allow rupee derivatives (settled in foreign currency) to be traded on exchanges in IFSC could be a useful change, said Ananth Narayan, professor at SP Jain Institute of Management and Research. The proposal to increase market timings—a long standing demand by participants—will also be a positive step, he added.

In addition, allowing transactions upto $100 million in the over-the-counter market, without underlying exposure, could also make a dent in the offshore markets, Ananth Narayan added. The flip side of this recommendation could be an increase in arbitrage trades between the NDF and onshore markets.

The committee, however, recommends that Indian banks should not be permitted to deal in the offshore rupee derivative market for now as the risks outweigh the benefits.

In Times Of Stress, NDF Drives Spot Markets

The recommendations from the committee follow a detailed study of the relationship between the NDF market and the local spot currency market. In times of stress, such as the 2013 taper tantrum, it was felt that excessive speculation in the NDF market was driving down spot rupee markets. The regulators, at the time, felt hamstrung in curbing the rupee weakness because of this.

The committee’s research suggested that while both spot and NDF markets influence each other over a long period of times, in periods of stress, it is the offshore markets that tend to set direction for the onshore markets.

During the last two stress episodes (the taper tantrum and the 2018 emerging market crisis), the relationship turned unidirectional, with the NDF market driving onshore spot and forwards.
Usha Thorat Committee On Offshore Rupee Markets

One of the reasons for this is that the NDF market is 24-hours. As such, onshore rates were influenced by overnight developments, showed a study of the 2013 taper tantrum period. This also reduced the impact of any regulatory intervention taken during the Indian trading hours, the committee found.

A study of the 2018 period of volatility also threw up the same results. Once again, in that period, it was the NDF rate that was driving the local spot markets.

A study of the two periods reinforces “the presumption that volumes rise sharply in NDF markets during periods of stress, which then become the hub of price discovery and influences onshore rates”. The report added that the impact of the spillover from the offshore markets lingered for a longer period of time compared to any impact of the onshore markets on overseas markets.

Volatility, too, seemed to increase first in the offshore markets before it did in local markets. “There is, however, an interesting asymmetry. There is evidence of rise in volatility spillover from onshore to offshore market in case of rupee appreciation while the opposite happens in the episodes of rupee depreciation.”

All told, as NDF volumes have increased, they have begun to play an important role in both price discovery and driving volatility, particularly during heightened uncertainty periods.
Usha Thorat Committee On Offshore Rupee Markets

The Thorny Issues

The committee addressed a few thorny issues such the regulatory implications of allowing rupee derivatives (settled in foreign currency), to be traded on exchanges in the IFSC.

Since the IFSC functions as an offshore jurisdiction, a shift in volumes to these exchanges would still mean a loss of regulatory influence on the overall currency markets. After studying the pros and cons, the committee recommended that non-deliverable rupee derivatives should be introduced on the IFSC in a phased manner. This could start with introduced such derivatives on exchanges first and then in the over-the-counter segment.

The committee stayed away from recommending stricter RBI control over IFSC traded rupee derivatives as it felt that India needed to integrate more with the global financial markets.

The committee also debated whether Indian banks should be allowed to participate in the NDF markets. “The onshore Rupee derivatives market is currently more deep and liquid as compared to the offshore Rupee market and participation of the Indian banks in the offshore market might, over time, take away this advantage,” the committee said.