RBI Circular

RBI Circular on Regulatory Framework on Hedging of Foreign Exchange Risk

The Reserve Bank of India is the central banking authority that regulates and supervises financial institutions in the country. On January 05, 2024, the RBI issued a circular that focuses on the regulatory framework for hedging foreign exchange risk. The circular introduced some important amendments to foreign exchange derivative contracts by emphasizing the essential need for managing foreign exchange risk through hedging strategies.

The circular amended the Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulation, 2000, dated May 03, 2000, after a broad review and a public consultation. However, the revised direction shall come into force from April 05, 2024, replacing the existing directions in Part A of the Master Direction- Risk Management and Interbank dealings dated July 05, 2016. The recent circular 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 and the amendments aim to maintain foreign exchanges with market dynamics and simplify the regulatory framework.

 From April 05, 2024, the existing framework in Part A (Section I) of the Master Direction – Risk Management and Interbank Dealings, dated July 05, 2016, will be replaced by the recent revised direction. The RBI’s circular emphasizes the need for a comprehensive review and link of foreign exchange risk management facilities to keep up with market dynamics. By incorporating the Currency Futures (Reserve Bank) Directions, 2008, and Exchange Traded Currency Options (Reserve Bank) Directions, 2010, into the Master Direction – Risk Management and Inter-Bank Dealings, the regulatory framework aims to simplify and streamline the Foreign Exchange as per the market dynamics. The revised Directions will come into effect on April 05, 2024, signifying the beginning of a new regulatory era. This timeline provides market participants with a clear roadmap for compliance and adaptation to the updated regulations.

The RBI’s circular on hedging foreign exchange risk is aimed at ensuring that various participants in the financial ecosystem are covered under the regulatory ambit. The term Authorized Persons includes Authorized Dealer Category – 1 banks, Recognized Stock Exchanges, and Recognized Clearing Corporations. The circular amends Sections 10(4) and 11(1) of the Foreign Exchange Management Act, 1999, and Section 45W of the Reserve Bank of India Act, 1934¹, which provide a strong legal foundation for the regulatory changes.

The circular provides detailed definitions and explanations of key terms such as anticipated exposure, contracted exposure, currency risk, and others. This is instrumental in ensuring clarity and uniform understanding among market participants and helps to facilitate effective risk management strategies. The main amendments are in the following areas in the recent RBI Circulars:

1. The incorporation of directions from the Currency Futures (Reserve Bank) Directions, 2008 and Exchange Traded Currency Options (Reserve Bank) Directions, 2010.
2. The term Authorized Persons is referred to as the Authorized Dealer Category-1 Banks, which includes Exchange traded currency derivatives, established stock exchanges, etc., which will attract diverse participants in the foreign exchange market.
3. The currency risk arising from the current or capital account transactions is permissible under FEMA, 1999, and the anticipated exposure is stated as a currency risk, which is stated in the circular.  
4. The circular defines several terms related to currency risk and foreign exchange transactions under the FEMA, 1999.
5. Anticipated exposure refers to the currency risk that may arise from future transactions, and this term focuses on the proactive approach to managing potential risks.
6. Contracted exposure refers to the currency risk that arises from transactions that have already been entered into.
7. The currency risk refers to the potential for loss due to the movement in exchange rates of Indian rupees against a foreign currency or the movement in exchange rates of one foreign currency against another. 
8. A Deliverable Foreign Exchange Derivative Contract is an OTC foreign exchange derivative contract where there is actual delivery of the estimated amount of the underlying currencies, excluding non-deliverable contracts. This distinction is essential for understanding the settlement mechanisms in foreign exchange derivative contracts.
9. The Electronic Trading Platform is defined by including Para 2(1)(iii) of the Electronic Trading Platforms (Reserve Bank) Directions, 2018, and it states the increasing role of technology in facilitating foreign exchange transactions. The Exchange Traded Currency Derivative is defined under Regulation 2(xvi) of the Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000, which encompasses derivatives traded on recognized stock exchanges, adding transparency and standardization to currency trading.
10. The term financial contract derives its value from changes in the interest rate of a foreign currency. The inclusion of this term expands the scope of derivative contracts beyond mere exchange rate movements in the country.
11. The circular defines a Foreign Exchange Derivative Contract as a financial agreement that derives its value from the exchange rate of two currencies. This definition is important to understand the nature of derivative contracts that are covered under the regulatory framework.
12. The Non-Deliverable Foreign Exchange Derivative Contract is an OTC derivative in which there is no delivery of the estimated amount of the underlying currencies, and settlement is made in cash. This definition distinguishes non-deliverable contracts from their deliverable counterparts.
13. The term Over-the-Counter (OTC) Derivative refers to a derivative that is traded outside recognized stock exchanges. This definition emphasizes the inclusivity of various derivative transactions taking place outside of formal exchanges.

The RBI’s approach is adaptive to the evolving dynamics of financial markets. The regulator aims to enhance the effectiveness of foreign exchange risk management practices by collecting feedback from market participants and combining various directions from market participants. The regulator is urged to thoroughly review and implement the revised Directions. The circular places a responsibility on market participants to align their practices with the updated regulatory framework. The circular serves as a foundation for promoting stability, transparency, and efficiency in India’s foreign exchange markets. It reflects the regulator’s commitment to fostering a robust financial ecosystem.

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1. https://en.wikipedia.org/wiki/Reserve_Bank_of_India_Act,_1934