Rupin Chopra and Shantam Sharma
Introduction
The Reserve Bank of India (RBI) has issued a circular[1] on risk management and interbank dealings, marking a significant development in the financial landscape, particularly in interbank transactions and risk management strategies. Effective April 5, 2024, this circular replaces the existing directions provided under Part A (Section 1) of the Master Direction – Risk Management and Interbank Dealings dated July 5, 2016[2]. By focusing on enhancing the resilience of financial institutions against foreign exchange risks, this circular brings a notable shift in the banking sector for both domestic and international borrowers. This article delves into the key highlights of the circular.
Risk Management and Interbank Dealings – Hedging of Foreign Exchange Risk
The RBI’s circular is a critical component of the regulatory framework for hedging foreign exchange risks. Its primary aim is to ensure that derivatives are used exclusively to hedge against exposure to fluctuations in foreign exchange rates, thereby limiting such exposure. The circular consolidates directions for all types of foreign exchange transactions, including cash, tom, and spot transactions. The key highlights are as follows:
- Classification of Users[3]: Authorized dealers have the authority to classify users for offering foreign exchange derivative contracts into retail and non-retail users. Clause 2.1(ii) lists the criteria for non-retail users, while retail users are those who do not meet these criteria.
- Authorized Transactions[4]: Authorized dealers can offer various foreign exchange contracts to both retail and non-retail users, including:
- Foreign Exchange Cash: Immediate exchange of foreign currency for Indian rupees or vice versa.
- Foreign Exchange Tom: Exchange of foreign currency and Indian rupees within two working days.
- Foreign Exchange Spot: Exchange of foreign currency for Indian rupees or vice versa at an agreed exchange rate for a future date. However, money-changing transactions are not governed by this circular.
- Foreign Exchange Derivative Contracts Compliance[5]: Authorized dealers must ensure compliance throughout the lifespan of derivative contracts, avoiding hedging the same exposure with another derivative, ensuring the notional amount and tenor align with the exposure, and adjusting the hedge if the exposure falls below the notional. Users can take positions up to USD 100 million equivalent without underlying exposure verifications.
- Cancellation and Rebooking of Derivative Contracts[6]: Users can cancel and rebook derivative contracts. Net gains (gains over and above losses, if any) on contracts hedging anticipated exposures are transferred at the time of cash flow, with pro-rata distribution for part delivery.
- Transparency in Retail Transactions[7]: For retail transactions, authorized dealers must provide transparency by disclosing the mid-market and ask price of derivatives before entering into contracts. This information must also be included in the deal confirmation.
- Foreign Exchange Derivatives for Non-Residents: Authorized dealers can engage in foreign exchange derivatives transactions with non-resident users directly or through overseas entities, subject to certain conditions:
- The overseas entity is eligible to deal with the product concerned as a dealer/market-maker per the host jurisdiction’s laws and regulations.
- The wholly owned subsidiary/joint venture of the authorized dealer incorporated in India can undertake such transactions, provided they are a banking entity.
- The authorized dealer must ensure that the central treasury/group entity is authorized by the user to deal on its behalf.
- It is the duty of the authorized dealer to provide information, data, or any other particulars required by the RBI for such transactions in the prescribed manner and time[8].
Impact of the Circular
The RBI’s circular aims to bolster risk management practices and enhance transparency in interbank dealings within the Indian financial market. The impacts are:
- Enhanced Risk Management: By consolidating and updating the regulatory framework, the circular enhances the overall risk management capacity of the financial system, making it more resilient against foreign exchange volatility.
- Clarity and Accessibility: Detailed definitions and clear guidelines reduce ambiguity, making it easier for all stakeholders to understand and comply with the regulations.
- Flexibility and Customization: Classifying users into retail and non-retail categories with specific product offerings allows for greater customization of financial products to meet diverse needs, enhancing the effectiveness of risk management strategies.
- Market Development: By updating the regulatory framework and keeping pace with international practices, the circular supports the development of a more robust and sophisticated foreign exchange market in India.
- Regulatory Compliance and Transparency: Emphasizing transparency and compliance throughout the lifecycle of foreign exchange transactions and derivative contracts fosters a more transparent market environment.
Overall, the new guidelines are expected to support the structured growth of the financial markets by providing clearer rules, enhancing risk management practices, and ensuring market participants are well-equipped to manage foreign exchange risks effectively.
Conclusion
In conclusion, the RBI’s circular on risk management and interbank dealings represents a proactive step towards strengthening the resilience of the Indian financial system. By enforcing robust risk management practices, enhancing oversight mechanisms, and promoting transparency in derivative transactions involving the INR, the RBI aims to mitigate systemic risk and safeguard the stability of the financial market. Adhering to this circular will help financial institutions foster a culture of responsible risk management, thereby contributing to the overall resilience and integrity of India’s banking sector.
Ritvik Kashyap (Intern) and Kartikey Maithani ( Associate Advocate) at S.S. Rana & Co. have assisted in the research of this article.
[1] Available at – https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12594&Mode=0
[2] Available at – https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=10485
[3] Available at – https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12594&Mode=0
[4] Clause 2.2 of RBI Circular on Risk Management and Inter Banking Dealing – Hedging of Foreign Exchange Risk https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12594&Mode=0
[5]Clause 3.4 of RBI Circular on Risk Management and Inter Banking Dealing – Hedging of Foreign Exchange Risk https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12594&Mode=0
[6] Clause 2.4 (ii) of RBI Circular on Risk Management and Inter Banking Dealing – Hedging of Foreign Exchange Risk https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12594&Mode=0
[7]Clause 2.4 (v) of RBI Circular on Risk Management and Inter Banking Dealing – Hedging of Foreign Exchange Risk https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12594&Mode=0
[8] Clause 2.4 (vi) of RBI Circular on Risk Management and Inter Banking Dealing – Hedging of Foreign Exchange Risk https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12594&Mode=0
Related Posts
RBI’s New Framework for Self-Regulatory Organizations in FinTech Sector