The Reserve Bank of India on Thursday clarified the scope of its recent measures to curb currency risks, specifying which rupee-linked foreign exchange derivative contracts will attract a 20% reserve requirement and exempting certain transactions from the rules.
In frequently asked questions (FAQs) document, the RBI said the Foreign Exchange Risk Reserve (FERR) requirement would apply to specified derivatives undertaken by authorised dealers with users where the user is purchasing foreign currency against the rupee, the contract's notional value exceeds $2 million equivalent and the transaction is intended to hedge current account exposures.
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The clarifications follow a series of measures announced by the central bank since October 10 to manage foreign exchange risks. The measures had raised concerns among market participants over the scope of the reserve requirement and its implications for currency hedging transactions.
The RBI said derivative contracts with a notional value of $2 million equivalent or less would not attract the FERR requirement. However, authorised dealers must guard against attempts to structure transactions to circumvent the threshold.
The reserve requirement will apply only to contracts involving the rupee in which users buy foreign currency against the Indian currency. Transactions in which users sell foreign currency against the rupee, contracts that do not involve the rupee and derivatives undertaken by users to hedge capital account transactions are outside its scope.
The central bank also clarified that the FERR requirement for authorised dealers' own transactions would apply only to foreign exchange derivatives undertaken to hedge currency risks arising from their own assets and liabilities, where they purchase foreign currency against the rupee.
The requirement will not extend to transactions undertaken by authorised dealers for market-making or for assuming proprietary positions, the RBI said.
The reserve will amount to 20% of the rupee equivalent of the notional value of each eligible derivative contract. For instance, for a contract involving $10 million against the rupee at an exchange rate of Rs 95 per dollar, the notional value would be Rs 95 crore and the applicable FERR would be Rs 19 crore.
The reserve must be deposited and maintained in the authorised dealer's current account with the RBI on a daily basis. For each eligible derivative transaction, the reserve requirement will kick in from the working day immediately following the date on which the contract is undertaken. Banks must maintain transaction-level details for audit.
The FERR balance will not earn interest. The RBI also clarified that the minimum daily balance in an authorised dealer's current account must cover its cash reserve ratio (CRR) obligation, the FERR requirement and any other obligation requiring cash reserves to be maintained with the central bank.
FERR balances will not qualify as high-quality liquid assets (HQLA) under the liquidity coverage ratio framework.
RBI clarifies exemptions and applicability
The RBI clarified that certain current account outflows arising from capital account transactions will be excluded from the requirement for users. These include interest payments on external commercial borrowings and other debt instruments, coupons on resident debt instruments held by non-residents, and dividends payable to non-resident investors.
While such payments are classified as current account transactions under the Foreign Exchange Management Act, 1999, they arise from underlying capital account transactions. Derivatives undertaken by users to hedge these flows will therefore be excluded from the FERR requirement. However, authorised dealers hedging their own currency risks on such exposures will remain subject to the requirement.
The rules will apply only to derivative contracts entered into after the respective directions were issued on October 10 and October 12. However, contracts entered into before the directions and subsequently rolled over will attract the requirement if they meet the prescribed conditions, as a rollover is treated as a fresh contract.
Where a contract is partially cancelled, the reserve will be maintained on a pro-rata basis against the remaining notional value from the following day, provided the contract continues to meet the applicable threshold. If the remaining notional value falls below the $2 million threshold following partial cancellation, the FERR requirement will cease from the following day.
Reporting requirements
Authorised dealers must report details of the FERR maintained on a daily basis through the RBI's Centralised Information Management System (CIMS).
The report for a particular day must be submitted by 5 pm on the following working day. It must include details of derivative contracts undertaken on the reporting date as well as all outstanding contracts and their current notional values against which the reserve is maintained.
The reporting requirement covers both derivatives undertaken by authorised dealers with users and those entered into to hedge their own currency risks. The RBI said the reporting format is available on CIMS.
The FERR requirement will not apply to foreign currency derivative contracts involving the rupee undertaken by authorised dealers with the RBI.