The Reserve Bank of India’s (RBI) policy of allowing only hedgers with a valid underlying exposure to participate in exchange traded currency futures and options contracts, which it recently reiterated, has disrupted the functioning of this segment. Daily turnover in this segment on the NSE has collapsed to less than one-tenth of the daily average since the April 4 circular, in which the RBI pushed the enforcement by just a month to May 3, 2024. Number of outstanding contracts have also reduced as domestic brokers and foreign portfolio investors have started to unwind existing contracts.

Currency futures and options traded on exchanges play an important role in enabling small businesses and individuals to hedge their foreign exchange exposure, since these contract sizes are much smaller than those in the inter-bank OTC market. The exchange traded instruments are transparent. Besides hedgers, domestic and foreign brokers, institutional investors and individual traders have also been increasing their trading activity in these instruments, based on their view of the rupee and other currencies. This segment has grown strongly, with volumes increasing almost six-fold between FY18 and FY24. Without participation from proprietary traders and foreign portfolio investors, who account for over 65 per cent of the currency derivatives volume, liquidity will vanish, making it difficult for hedgers to take cover with these instruments. If activity in this segment halts completely, it can exacerbate volatility in rupee movement. Sharp rupee movement in the inter-bank market in either direction can be arrested by trading activity on the exchanges.

Exchange traded currency derivatives are governed by rules framed under the Foreign Exchange Management Act (FEMA) which clearly state that such instruments can be used only for hedging. This was the basis for the central bank’s policy, as Deputy Governor Michael Patra emphasised during the monetary policy press conference. A circular issued in June 2014 allowed trading in currency derivative contracts on exchanges up to a certain limit without providing documentary evidence. Through a Master Circular in January 2024, the RBI gave time until April 5 for positions without underlying to be unwound. The fall in trading turnover now is a direct result of speculators disappearing from the market.

The RBI appears aware about the fall in activity in this segment; the Governor recently urged Indian banks to increase their participation in currency derivatives market. But banks are unlikely to do so, given the higher cost of trading on exchanges. Foreign portfolio investors, who will no longer be able to trade in currency contracts on domestic exchanges, may shift to the rupee NDF market in Singapore, Hong Kong or Dubai. Stronger overseas trading in rupee derivatives can again lead to heightened volatility. The central bank should work with the government to remove foreign currency traded derivatives from the purview of the FEMA.