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What's allowed and what's not in forex trading

Akhil Nallamuthu BL Research Bureau | Updated on June 05, 2021

Unlike equities and fixed income, currencies don’t classify as investments and are more suited for trading/hedging purposes. Also, investors can fall foul of the law if unaware of rules

Advertisements that pop up online about people making a quick buck through forex trading are very tempting. However, you need to tread carefully as there are do’s and don’ts in forex trade. Sidestepping rules will not only land you on the wrong side of the law but also expose you to a huge risk of losses. So, if currency trading interests you, here’s a lowdown on how you should go about it:

What’s allowed?

Exchange Traded Derivatives

Based on the report of the RBI-SEBI (Securities and Exchange Board of India) Standing Technical Committee on exchange traded currency derivatives, SEBI, in August 2008, came up with a circular enabling recognised exchanges in India to launch currency derivatives. Following this, currency derivatives were launched by both the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE).

Currencies against which the Indian rupee (INR) can be traded include US Dollar (USD), Euro (EUR), British Pound (GBP) and Japanese Yen (JPY). Thus, currency pairs on which derivatives contracts are present now include USD/INR, EUR/INR, GBP/INR and JPY/INR. Besides, cross currency pairs viz. EUR/USD, GBP/USD and USD/JPY were introduced in February 2018. So essentially, for now, any person who is resident in India as per Foreign Exchange Management Act (FEMA), 1999, is permitted to trade only in these seven currency pairs through the domestic exchanges. Additional currency pairs, as and when introduced by the exchanges in future, can also be traded.

Like every other derivatives contract, traders should maintain enough margin to initiate trades in currency derivatives as well. It will be SPAN (standardised portfolio analysis of risk) margin plus ELM (extreme loss margin) margin as prescribed by the exchanges for both futures and options. These are monthly contracts, and the expiry will be two days prior to the last business day of the month. But the contracts expire by 12:30 pm on the expiry day, unlike equity and commodity derivatives, which expire at the end of the expiry day. All these contracts are cash-settled in INR — daily settlement will be on a T+1 day basis whereas final settlement will be on a T+2 day basis. Size of the contract will be 1,000 units for all currency pairs except for JPY/INR, whose contract size is 1 lakh units. Final Settlement Price (FSP) will be the RBI reference rate on expiry day.

While individuals can use the exchange derivatives route for currency trading, businesses can use it for hedging foreign exchange risk too. This apart, individuals and businesses are allowed by the RBI to enter into forward contracts with banks for the purpose of hedging forex risk with respect to transactions for which forex is permitted to be used.

What’s prohibited?

Overseas forex trading

According to the latest triennial report of the Bank for International Settlements (BIS), released in 2019, the daily turnover of the foreign exchange market hit $6.6 trillion in April 2019. The size of the market ensures wafer-thin spreads. In addition, the global FX market is up and running 24*5. The amount of leverage offered is enormous too, making this market appealing for traders.

Forex being a decentralised market, you might be of the impression that your broker has connected you to the actual market liquidity. However, rules in many countries permit brokers to run two types of brokerages, which are commonly called A-book and B-book. In A-book model, brokers earn only through spreads i.e., transaction charges and all their clients’ trades are passed on to the ultimate liquidity provider, which are generally big multi-national banks. On the contrary, in the B-book model, bid/ask spreads can be wider comparatively, and the counter party is the broker himself. Simply put, clients’ losses are brokers’ gains. You may have noticed advertisements like 1,000 times leverage, ‘welcome bonus’ amounting to few hundred dollars, etc. Such offers will most likely come under B-book model.

Leverage of 500 and 1,000 times are common in overseas FX market. As we know, leverage is a double-edged sword; such massive leverage can prompt anyone to trade unnecessarily more, increasing the likelihood of losing money.

There are many ponzi schemes on offer, promising very high returns and referral benefits, which encourage people to recommend such schemes to their friends and relatives. This can land you in serious trouble.

Brokers are also providing binary options, which are not like the equity or commodity options that Indian exchanges provide. As the name suggests, the outcome is all-or-nothing. By entering these contracts, you are predicting that a currency pair will reach a particular level within a particular time. If it does, you make money; if not, the entire money that you bet will be gone in a few minutes or hours. These options encourage gambling, which can lead to big losses and therefore many regulators across the globe have banned this product.

However, the point to note here is that even experienced financial market participants who understand the above mentioned risks should abstain from trading in overseas forex market as regulations in India bar the same.

Blanket ban

Anyone residing in India is prohibited from trading in overseas foreign exchange market and the RBI has repeatedly warned banks against transactions made to fund such trading. The RBI has clarified that any person resident in India collecting and effecting/remitting payments directly/indirectly outside India towards overseas foreign exchange trading through electronic/internet trading portals would make themselves liable to be proceeded against for contravention of the Foreign Exchange Management Act (FEMA), 1999, besides being liable for violation of regulations relating to Know Your Customer (KYC) norms/Anti Money Laundering (AML) standards.

While funding through wire transfers and credit card transfers are difficult these days, many have looked into other means to transfer money — through money transfer intermediaries like Skrill and Neteller or routing through personal overseas bank account. But be warned because, according to the RBI, transferring indirectly outside India towards overseas foreign exchange trading through electronic/internet trading portals is also forbidden.

Worryingly, many are being misguided that a resident Indian can transfer up to $2,50,000 per year as per the Liberalised Remittance Scheme (LRS), irrespective of the purpose. This is not true as the scheme disallows remittance from India for margins or margin calls to overseas exchanges/overseas counterparty and remittance for trading in foreign exchange abroad. Those who continue to trade, bending the rules, should keep in mind that they are not only in violation of laws but they also run into other risks.

While brokers that you are dealing with may be regulated by monetary authorities of other countries. it does not mean you are allowed to trade. As regulations prohibit Indian residents to trade in overseas forex market, should you face any issues with respect to fund payout, etc., there is no one you can turn to for redressing your grievance. In case litigation arises, you may need to travel to the country whose monetary authority has supervisory control over that broker. Even if you manage to win such litigation and gain monetary benefits, you will be questioned for the source and reasons for the same by the Indian authorities and unfortunately, you are already in violation of FEMA Act by trading in forex.

Rules to remember

Trading in seven currency pairs allowed through exchange traded derivatives

Close monitoring of global macro-economic indicators, a must

For better liquidity, INR pairs can be used to construct cross pairs

Don’t fall for high leverage, welcome bonus, referral benefits in overseas forex trading

A how to guide for navigating the currency market

Now that you know you can trade in certain currency pairs through the exchange traded derivatives route in India, how do you decide which one to trade in? Enter fundamental and technical analysis.

Irrespective of the financial asset, methods in technical analysis remain the same.In the end, it all comes to charts and patterns, candlestick patterns and four key price points on which one can work around — open, high, low, and close.

However, when it comes to fundamental analysis,to make better decisions in currency trading, one should understand the global macro-economic picture and follow macro-economic indicators closely. Keeping track — of global economic cycles, policies of major central banks like interest rate decisions and unconventional measures like asset- purchase programmes, inflation and inflation rate differential between countries, external trade balance, external debt, foreign exchange reserves, decisions by global institutions like the International Monetary Fund (IMF) and the World Bank etc. — is imperative.

For instance, the US releases Non-Farm Payroll (NFP) data on the first Friday of every month. Whenever the data is released, all currency pairs containing USD will see above-average volatility.

The data becomes more significant especially when the central bank uses employment numbers as one of the important inputs in policy decision-making process. Another example is the inverse relationship of INR and crude oil price. Since India largely depends on imported crude, an increase in price is detrimental to INR and vice-versa.

EUR/USD and USD/JPY are the most traded currency pairs globally. However, the liquidity in these cross-currency pairs is very low in the domestic exchanges. That is, it is difficult for traders to capitalise on the outcome of the price swings in cross currency pairs. But to address this, traders can construct these currency pairs using INR pairs, which have sufficient liquidity.

To create net long in EUR/USD (when you forecast EUR will strengthen against USD more than any other currency), traders can go long in EUR/INR and short USD/INR. Buying EUR/INR means you are buying euros by selling rupee and shorting USD/INR means you are selling dollar and buying rupee. Here, rupee in both the trades get cancelled out and you have net EUR/USD long.

Similarly, one can create several currency pairs like USD/JPY, GBP/USD, EUR/GBP, EUR/JPY, GBP/JPY. Additional transaction charges are the cost that you pay for better liquidity.

Above all, one should understand that currencies may not be suitable for wealth creation, on the lines of equities and fixed income investments. Currencies are to preserve wealth and are used primarily as a trading product.

Published on June 05, 2021

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