
Published on April 10, 2024 at 4:06:01 AM
Guarding Against the Winds of Change: Currency hedging for NRIs
Back in 2017, two separate decisions, one by the country’s central bank, the Reserve Bank of India (RBI), and the other by the market regulator, the Securities and Exchange Board of India (SEBI), opened up a new investment avenue for Non-Resident Indians (NRIs).
In February 2017 the RBI allowed NRIs to access the exchange-traded currency derivatives (ETCD) market, to hedge currency risk arising from their investments in India.
Then, four months later, in June 2017, SEBI too allowed NRIs to hedge currency risk by accessing the ETCD market.
Before the two regulators allowed NRIs this option, they were permitted to hedge their rupee currency risk through over-the-counter (OTC) transactions with banks.
To be sure, the clearance given by SEBI was conditional. The market regulator permitted NRIs to trade in the currency derivatives segment of stock exchanges subject to certain terms and conditions. These included mandating NRIs to designate a bank to monitor and report their combined positions in the OTC and ETCD segments.
So, what did SEBI actually say?
“NRIs may take positions in the currency futures/exchange traded options market to hedge the currency risk on the market value of their permissible (under FEMA, 1999) Rupee investments in debt and equity and dividend due and balances held in NRE accounts," SEBI said.
In addition to this, SEBI said that the onus of ensuring the existence of the underlying exposure rest with the NRI concerned. “In case of any contravention, the NRI shall render itself liable to any action that may be warranted by the Reserve Bank of India (RBI) as per the provisions of Foreign Exchange Management Act (FEMA)," SEBI said.
The regulator also asked stock exchanges to take steps to put in place necessary systems for implementation of the new norms. Earlier, the RBI had allowed NRIs to invest in exchange-traded currency derivatives.
But why do NRIs even need currency hedging?
NRIs earn in foreign currency and are prone to currency risk all the time. Therefore, traditionally they had been permitted to hedge their rupee currency risk over the counter (OTC) with authorised dealer Category 1 banks.
Although this did help NRI investors hedge currency risk to some extent, the RBI’s and SEBI’s move to grant them permission to enter ETCD and allowing them access to additional hedging products has helped such investors, many of whom are UHNIs or HNIs, a great deal.
NRIs can access this route subject to the following terms and conditions:
- NRI trading in ETCD has to be mandatorily routed via an Authorised Dealer bank that needs to be designated by the investor.
- The NRI investor can hedge currency risk arising out of permissible investments in Indian rupees that are held in their NRE accounts. These investments can be made in debt and equity, and investors can take positions in currency futures and options. It is incumbent upon the exchange to provide details of all the transactions of an NRI investor to AD bank designated by him or her.
- The designated bank has to monitor and report the combined positions of the investor across both the OTC and ETCD segments, via them or any other AD bank.
- The ultimate responsibility for their exposure however, lies with the NRI investors themselves. The NRI cannot hedge unless they have taken an existing position in that currency and if found doing so, can face action as deemed appropriate by the RBI.
Which currency pairs are permitted?
According to the SEBI circular of June 2017, NRIs are permitted to trade in four currency pairs. These are:
Currency Pair | Position limits |
USD-INR | Gross open position across all contracts shall not exceed 6% of the total open interest or USD 10 million, whichever is higher |
EUR-INR | Gross open position across all contracts shall not exceed 6% of the total open interest or EUR 5 million, whichever is higher. |
GBP-INR | Gross open position across all contracts shall not exceed 6% of the total open interest or GBP 5 million, whichever is higher. |
JPY-INR | Gross open position across all contracts shall not exceed 6% of the total open interest or JPY 200 million, whichever is higher. |
What exactly are currency derivatives?
Currency derivative trading is basically an exchange of two currencies at a mutually agreed price at a future date. The currencies are exchanged by dealing in currency futures or currency options.
But unlike in equity derivative trading, the underlying asset here are the currencies and not stocks. Also, no broker is involved in the process as it is facilitated by AD Category 1 banks.
What are the requirements that an NRI needs to fulfil for trading in currency derivatives?
An NRI needs to fulfil the following requirements for currency derivatives trading:
- They need to designate an Authorised Dealer Category-I bank who is a clearing member of the exchange or the clearing corporation. Often times banks offering NRI accounts also offer such services.
- The NRI investor is required to apply for the Custodial Participant (CP) code through the clearing member. In this case the clearing member is the AD Category 1 bank. To apply for CP code, an NRI is required to provide the copy and details of the PAN, passport no. with its expiry date. The AD bank updates their details and sends it to the clearing corporation for CP code allotment.
- The NRI also need to place a margin with the exchange via the clearing member for trading in currency derivative
So, why should NRIs even consider investing in currency derivatives?
NRIs typically move funds across geographies (mostly from abroad to India) for investment purposes or to support their families back home. At times, they also take back money from India to their country of residence.
This opens an NRI investor to currency risk owing to frequent fluctuations in exchange rates. Investments in currency derivatives allows such investors to hedge currency risk. Apart from this, it also offers them some additional benefits:
- Helps diversify the investment portfolio
- Helps provide a transparent trading platform
- Allows an investor to take greater leverage by paying lower margin costs
- Eliminates counterparty risk, which is common in OTC platforms
Conclusion
The moves by the banking and stock market regulators to allow NRIs to hedge currency risk has opened up a new investment opportunity for them. But this has not gained in popularity yet as not too many NRI investors are yet aware of the new changes. Moreover, banks have also not marketed the new services to their potential customers from among the NRI community. As an NRI investor, you can take advantage of this way of currency hedging by approaching your bank and seeking further information from them.
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