RBI clarifies forex risk reserve applies only to dollar-buying derivative contracts

The Reserve Bank of India (RBI) on Thursday clarified that its newly introduced Foreign Exchange Risk Reserve (FERR) requirement will apply only to specified derivative contracts involving the purchase of foreign currency against the Indian rupee, providing greater clarity to banks and market participants following its recent intervention in the foreign exchange market.

In a detailed set of frequently asked questions (FAQs), the central bank said the reserve requirement would apply to qualifying foreign exchange derivative contracts with a notional value exceeding USD 2 million or its equivalent.

Contracts in which users sell foreign currency against the rupee will remain outside the scope of the requirement.

The clarification follows the RBI's October 10 announcement of several regulatory measures aimed at addressing risks in the foreign exchange market against the backdrop of significant depreciation in the rupee.

The domestic currency has strengthened against the US dollar since the measures were announced.

𝗥𝗲𝘀𝗲𝗿𝘃𝗲 𝗿𝘂𝗹𝗲 𝗹𝗶𝗺𝗶𝘁𝗲𝗱 𝘁𝗼 𝗳𝗼𝗿𝗲𝘅 𝗽𝘂𝗿𝗰𝗵𝗮𝘀𝗲𝘀

The RBI clarified that the FERR requirement would apply only when a user purchases foreign currency against the Indian rupee through a qualifying derivative contract with an authorised dealer.

It will not apply to transactions in which the user sells foreign currency against the domestic currency.

The distinction is significant because foreign exchange derivatives are used by businesses, financial institutions and other market participants to manage currency-related risks.

Under the new framework, the direction of the transaction determines whether the reserve requirement is applicable.

For instance, a qualifying derivative contract through which a user purchases US dollars against the rupee may attract the requirement if its notional value exceeds the prescribed threshold.

However, a contract involving the sale of US dollars against the rupee by a user will not be subject to FERR.

The central bank's clarification is intended to establish the scope of the measure and remove uncertainty surrounding its application.

𝗪𝗵𝗮𝘁 𝗶𝘀 𝘁𝗵𝗲 𝗙𝗼𝗿𝗲𝗶𝗴𝗻 𝗘𝘅𝗰𝗵𝗮𝗻𝗴𝗲 𝗥𝗶𝘀𝗸 𝗥𝗲𝘀𝗲𝗿𝘃𝗲?

The Foreign Exchange Risk Reserve is a reserve that authorised dealers are required to maintain with the RBI against qualifying foreign exchange derivative contracts involving the Indian rupee.

The requirement covers specified contracts undertaken by authorised dealers with users, as well as qualifying transactions undertaken to hedge currency risks associated with their own assets and liabilities.

For the purposes of the framework, a user is defined as any person, whether resident in India or outside the country, other than an authorised dealer.

The definition establishes the category of market participants whose transactions with authorised dealers fall within the regulatory framework.

The FERR mechanism was introduced as part of the central bank's measures to address risks in the foreign exchange market during a period of pressure on the domestic currency.

𝗧𝗿𝗮𝗻𝘀𝗮𝗰𝘁𝗶𝗼𝗻𝘀 𝘂𝗽 𝘁𝗼 $𝟮 𝗺𝗶𝗹𝗹𝗶𝗼𝗻 𝗲𝘅𝗲𝗺𝗽𝘁

The RBI also clarified that the reserve requirement will not apply to qualifying derivative contracts with a notional value of USD 2 million equivalent or less.

Only contracts exceeding that threshold will come within the scope of the requirement.

"Accordingly, a derivative contract having a notional value of USD 2 million equivalent or less undertaken by an authorised dealer with a user is not subject to the requirement," the RBI said.

The exemption provides clarity for smaller foreign exchange transactions, ensuring that they are not automatically brought under the new reserve framework.

The threshold is determined by the notional value of the individual derivative contract, subject to the central bank's warning against attempts to structure transactions to avoid compliance.

𝗥𝗕𝗜 𝘄𝗮𝗿𝗻𝘀 𝗮𝗴𝗮𝗶𝗻𝘀𝘁 𝗰𝗶𝗿𝗰𝘂𝗺𝘃𝗲𝗻𝘁𝗶𝗼𝗻

While exempting smaller contracts, the RBI cautioned authorised dealers against arrangements designed to circumvent the new provisions.

The central bank said dealers must guard against attempts to structure derivative transactions for the purpose of avoiding the reserve requirement.

The warning is particularly relevant where transactions might be divided into smaller contracts to remain below the USD 2 million threshold.

The RBI's clarification indicates that compliance must take into account the substance of transactions and not merely their individual notional values.

Authorised dealers will therefore be expected to monitor qualifying transactions and ensure that the exemptions are not misused.

𝗠𝗲𝗮𝘀𝘂𝗿𝗲𝘀 𝗳𝗼𝗹𝗹𝗼𝘄 𝗿𝘂𝗽𝗲𝗲 𝗱𝗲𝗽𝗿𝗲𝗰𝗶𝗮𝘁𝗶𝗼𝗻

The FERR framework was among the regulatory measures announced by the RBI on October 10 against the backdrop of significant depreciation in the Indian rupee.

The measures were introduced at a time when movements in the foreign exchange market had drawn attention to currency-related risks and the need for closer regulatory oversight.

Since the announcement, the rupee has strengthened against the US dollar, although the available information does not establish how much of that movement can be attributed specifically to the FERR requirement.

Thursday's FAQs provide additional operational clarity to authorised dealers responsible for complying with the framework.

By restricting the reserve requirement to specified foreign currency purchases above the prescribed threshold, the RBI has clarified the transactions covered by the measure while excluding foreign currency sales and smaller qualifying contracts.

The central bank has also reinforced its expectation that authorised dealers comply with the framework without using transaction structures intended to bypass the rules.