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Risk Management and Inter-Bank Transactions: Mitigating Foreign Exchange Risks

The Reserve Bank of India recently issued Master Directions on Risk Management and Inter-Bank Dealings – Hedging of foreign exchange risk vide circular bearing reference number RBI/2023-24/108 A. P. (DIR Series) dated 5 January, 2024 that bring about a significant shift in the risk management practices of banks for both domestic and international borrowers.

This circular amends the Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulation, 2000, dated May 03, 2000, and provides direction under sections 10(4) and 11(1) of the Foreign Exchange Management Act, 1999, and Section 45W of the Reserve Bank of India Act, 1934.

The revised directions define key terms and categorize users into retail and non-retail, outlining the eligibility and access to various derivative contracts for each. Furthermore, comprehensive overview of the various foreign exchange and currency interest rate derivative contracts that Authorized Dealers can offer focusing on their usage for hedging purposes.

Additionally, it also provides clear instructions for managing risks, rebooking of contracts, and maintaining proper documentation, particularly when dealing with users from other countries.

The revised directions further clarify the responsibilities of market-makers, stock exchanges, and clearing corporations in providing and overseeing these derivatives.

The key changes made in the revised direction are in following areas:

  1. The incorporation of instructions from the Currency Futures (Reserve Bank) Directions, 2008 and Exchange Traded Currency Options (Reserve Bank) Directions, 2010.
  2. The term Authorized Persons is used to describe the Authorized Dealer Category-1 Banks, which encompass Exchange traded currency derivatives, established stock exchanges, and other entities that attract a wide range of participants in the foreign exchange market.
  3. The currency risk arising from the current or capital account transactions is allowed under FEMA, 1999, and the expected exposure is mentioned as a currency risk, as stated in the circular.
  4. The circular provides definitions for various terms pertaining to currency risk and foreign exchange transactions as per the FEMA, 1999.
  5. Anticipated exposure refers to the currency risk that may arise from future transactions, and this term emphasizes the proactive approach to managing potential risks.
  6. Contracted exposure is a term used to describe the currency risk that arises from transactions that have already been entered into.
  7. The currency risk pertains to the possibility of incurring losses as a result of fluctuations in the exchange rates between the Indian rupee and foreign currencies, or between different foreign currencies.
  8. A Deliverable Foreign Exchange Derivative Contract involves the actual delivery of the estimated amount of the underlying currencies, excluding non-deliverable contracts. It is an OTC foreign exchange derivative contract. Understanding the settlement mechanisms in foreign exchange derivative contracts is crucial for grasping this distinction.
  9. The Electronic Trading Platform is described as incorporating Para 2(1)(iii) of the Electronic Trading Platforms (Reserve Bank) Directions, 2018, which highlights the growing importance of technology in facilitating foreign exchange transactions. The Exchange Traded Currency Derivative falls under Regulation 2(xvi) of the Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000. This regulation covers derivatives that are traded on recognized stock exchanges, bringing transparency and standardization to currency trading.
  10. The value of a financial contract is influenced by fluctuations in the interest rate of a foreign currency. This term broadens the scope of derivative contracts to encompass more than just fluctuations in the country’s exchange rates.
  11. The circular provides a definition of a Foreign Exchange Derivative Contract as a financial agreement that derives its value from the exchange rate of two currencies. Understanding the nature of derivative contracts covered under the regulatory framework is crucial.
  12. The Non-Deliverable Foreign Exchange Derivative Contract is an OTC derivative where no delivery of the estimated amount of the underlying currencies occurs, and settlement is made in cash. This definition differentiates non-deliverable contracts from their deliverable counterparts.
  13. An Over the Counter (OTC) Derivative is a derivative traded outside of established stock exchanges. This definition highlights the inclusivity of different derivative transactions occurring outside of formal exchanges.

The revised directions bring in important changes and additions to current regulations, creating a comprehensive framework for effectively managing foreign exchange risk through hedging activities and play a crucial role in fostering stability, transparency, and efficiency in India’s foreign exchange markets.

The revised directions shall come into effect from April 05, 202