India’s exchange-traded currency derivative market has undergone significant changes following the implementation of new regulatory norms, which have pushed out speculators and mandated that each deal in currency futures and options is based on a genuine, documented exposure.
The new guidelines, introduced by the Reserve Bank of India (RBI) and effective from May 3, require traders to ensure that long or short positions of up to $100 million are taken only against an underlying exposure, with the ability to establish the presence of such exposure if required. Although the RBI maintains that this requirement existed previously, the explicit demand for documentation has deterred many speculative traders from participating, leading to a significant reduction in market activity.
Data from the National Stock Exchange indicates a sharp decline in open interest for currency derivatives. As of the latest figures, open interest in currency derivatives futures contracts has fallen to 4,422,000 from 7,365,00 in March end. Similarly, open interest in currency derivatives options contracts has plummeted to 400,800 from 10,439,200 over the same period. This drop reflects the market’s shift towards genuine hedging transactions, which alone are insufficient to sustain a thriving market.
The changes
The structural change in the market has resulted in an imbalance, with a disproportionately larger number of dollar buyers than sellers. Given India’s economic context—characterised by a current account deficit, higher inflation, and higher interest rates compared to developed countries—the long-term tendency of the rupee is to depreciate. Consequently, most hedging is done to guard against rupee depreciation, primarily by importers and borrowers of foreign exchange-denominated capital.
Even during periods when the rupee is expected to appreciate, the RBI often capitalises on such opportunities to increase its foreign exchange reserves, leaving exporters with little incentive to hedge against rupee appreciation. This skewed market dynamic tends to drive up premiums for dollar/rupee futures or call options, deterring further hedging activities.
Speculators traditionally play a crucial role in maintaining market liquidity by balancing out pricing distortions. Their absence has led to prohibitive premiums and reduced market participation, creating a feedback loop of diminishing liquidity. The stringent documentation requirements for underlying exposures in the currency futures and options market have further complicated participation for genuine hedgers.
As a result, even those eligible to remain in the market have chosen to exit, citing the lack of counterparties and liquidity as major impediments. The once-liquid and transparent market has seen a steady decline in volumes, with many participants now considering over-the-counter derivatives as an alternative for managing their exposures.
