Inclusion of Foreign Exchange Interest Rate Derivative Contract (“FX-IRD”): Derivatives Directions permits MMs to offer FX-IRD contracts as a hedging option to users. Previously, only FXD contracts could be offered. While FXD was used to hedge the exchange rate risk arising out of two currencies, FX-IRD widened this scope to provide a hedge for risks arising out of change in the interest rate of a foreign currency also. The introduction of FX-IRD gives more options to a user to the hedge foreign currency exchange rate risk.

Change in eligibility and classification criteria for users and expanded list of products: As was the case under the previous regime, even under the present Derivatives Directions, MMs are required to classify users as retail and non-retail user. As a general principle, non-retail users are regulated financial institutions and non-residents. Users not eligible to be classified as non-retail users are considered retail users. Main difference between non-retail and retail user is that a non-retail user is allowed to deal in sophisticated products, which require better risk management capabilities.

Previously a resident could get classified as non-retail user, only if its net worth was more than INR 500 crores. Under the present Derivatives Directions, this criteria has been widened and a resident is also eligible to be classified as a non-retail user if its turnover is more than INR 1000 crore. Also, under the previous regime, non-retail users had the option to be classified as a retail user but a retail user could not get classified as a non-retail user. While the former condition continues, under the present Derivatives Directions, even a retail user has the option to get itself classified as a non-retail user without having the prescribed net worth or turnover, if the MM is satisfied that the user has the risk management capabilities. While this imposes significant burden of check on the MM, it helps users with large turnovers to classify themselves as non-retail users and therefore manage their risk more efficiently by having access to a wider array of derivative products. Additionally, non-retail customers are now permitted to cancel the FXD contracts, which was not allowed under the previous regime, thereby providing more flexibility to users.

Purpose of the contract can be beyond hedging: Under the Derivatives Directions, contracts not involving INR can be offered by MMs categorised as Authorised Dealer Category – I, for purposes which can be other than hedging. Under the previous regime, all FXD contracts could be offered only for hedging (with certain exceptions for non-residents being permitted). This is probably the most significant step in OTC derivatives reforms. Other relaxations in relation to hedging are provided in FX-IRD contracts, which can be entered for purposes other than hedging. Also, non-retail users are allowed to use currency swaps for converting their INR liability into a foreign currency for any purpose, which is also wide in its ambit. These relaxations effectively give more flexibility to users in devising their risk management strategy without being constrained by the requirement of having an actual hedge while entering into a derivative contract.

Non-deliverable derivative contracts can be offered to residents: In the Derivatives Directions, NDDCs involving INR can be offered even to retail users for the purpose of hedging. Earlier only resident non-retail users could enter NDDC for the purpose of hedging. Further, NDDCs not involving INR can be offered to both retail and non-retail users for any purpose other than hedging. This allows broader participation in the market, making it more dynamic and user friendly. Given the overall sensitivity of RBI in dealing with NDDCs and keeping in mind that this was once a frowned upon product many moons ago, it is apparent that the RBI has come a long way by not only recognizing that such a product exists, but also permitting it, albeit in a controlled environment. This step is important for the OTC Derivatives market as a whole, as when analysed with other products like IRDs, credit derivatives, etc. it is quite evident that the intention of the regulator is to move with the market participants and go beyond acknowledgement and actually recognize these products as instruments of change in the Indian OTC derivatives world.

Adjustment and cancellation of contracts: Under the Derivatives Directions, MMs can allow users to take positions upto USD 100 million without the requirement to establish the existence of underlying exposure. Under the earlier regime, this amount was USD 10 million. Another important change in relation to this condition is that MMs have been given the responsibility of informing the user that there should be underlying exposure, which has not been hedged using any other derivative contract. The users continue to have the responsibility of being able to establish the existence of underlying exposure, whenever required / requested by the market maker. While this condition has generally been controversial in the Indian OTC Derivatives market, the fact that the RBI has increased the limit significantly, gives impetus to the market to take comfort from the fact that, what has probably evolved as market practice would now pass the muster with MMs and RBI.

Standalone primary dealers specifically included as market makers: Standalone primary dealers (“SPD“) authorised as Authorised Dealer Category – III have been specifically included as MMs in the Derivatives Directions. Even though SPDs were already permitted to offer FXD contracts, they were not included as MMs in the earlier regime, causing a legal ambiguity. Specific inclusion of SPDs provides needed clarity on their role in the FXD market and the products that they can offer.

Conclusion

It is apparent from the changes summarized above that the current Derivatives Directions has significantly liberalized the OTC FX derivatives market in India. It specifically provides users with more product options and MM with greater flexibility. By allowing users to hedge a broader range of risks, simplifying user classifications, and expanding the scope for entering contracts without strict hedging requirements, the Derivatives Directions is likely to foster greater market participation and operational efficiency. As a regulator, RBI has always watched this space closely and has continuously played a balancing act of recognizing (and introducing) new OTC products in India and keeping the market cautiously conservative. The RBI certainly does not want to relive the days of derivatives disputes or mis-selling claims. A classic example of how far the RBI has come is evident from how the market for structured derivatives has been evolving organically in a regulated environment. The sophisticated products used by banks, foreign portfolio investors, alternate investment funds, insurance companies, mutual funds are testament to the fact that this is a growing market and certainly an interesting space to watch out for in the coming days!

This article was originally published in Mondaq on 13 January 2025 Co-written by: Veena Sivaramakrishnan, Partner; Sumant Prashant, Counsel. Click here for original article

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