FEMA trouble

Context:

The Reserve Bank of India's (RBI) recent policy reiteration regarding participation criteria for exchange traded currency futures and options contracts has disrupted the functioning of this segment, leading to a significant decline in daily turnover and outstanding contracts.

Impact on Currency Futures and Options Segment:

• Impacted daily turnover: Since the RBI's circular, daily turnover in currency futures and options on the NSE has plummeted to less than one-tenth of the daily average, prompting domestic brokers and foreign portfolio investors to unwind existing contracts.
• Threatened liquidity: The absence of participation from proprietary traders and foreign portfolio investors, who constitute over 65% of the currency derivatives volume, threatens liquidity in the segment, potentially exacerbating volatility in rupee movement and affecting hedging options for market participants.
• Increased volatility: Foreign portfolio investors, unable to trade in currency contracts on domestic exchanges, may shift to the rupee NDF market in overseas financial hubs, potentially leading to increased volatility.

Regulatory Framework and Concerns:

• Exchange traded currency derivatives, governed by FEMA rules, allow small businesses and individuals to hedge their foreign exchange exposure with smaller contract sizes. They have witnessed substantial growth, with volumes increasing nearly six-fold between FY18 and FY24.
• A circular issued in June 2014 allowed trading in currency derivative contracts on exchanges without requiring documentary evidence, but the RBI's recent policy enforcement aims to curb speculation by ensuring adherence to hedging norms.
• Potential Solutions: Collaborative efforts between the RBI and the government to remove foreign currency traded derivatives from FEMA's purview could offer a solution to address regulatory concerns while ensuring a conducive environment for genuine hedging activities.