Over-the-counter derivatives: Whose wings is the central bank targeting?

The Reserve Bank of India (RBI) has revised the guidelines for over- the- counter (OTC) foreign exchange derivatives and overseas hedging of commodity and freight risks through its December 28, 2010, circular.

It seeks to rein in unbridled speculation, ensure that smaller entities don’t gamble in the name of risk management and banks are made more accountable for the appropriateness of the product they sell to customers. It appears that the RBI is trying a tightrope walk between flexibility and restriction.

The suite of products available to hedge any contracted exposure is more than what is available for probable exposures. (See Table 1)
A clear mandate goes out to bankers and corporates that the RBI is not happy with the unbridled speculation indulged in by corporates using unsuitable products eagerly sold by profit hungry bankers.

Wild strategies like hedging a potential purchase over the next two years with an option contract on the dollar rupee at the end of two years coupled with a digital option betting on the range in which dollar Libor or euro/dollar exchange rate would lie are ruled out.
In this regard, an additional condition of quarterly certificate from statutory auditors is mandated.

Non-production of underlying exposure documents would result in contract being cancelled, loss recovered from the customer, but profit on cancellation would not be passed on to them. If on three occasions documents are not produced corporates are denied the flexibility of producing them later. What is not clear is whether the restriction lies only for the said financial year or for all subsequent years.

The RBI continues to permit the choice of currency to hedge irrespective of the currency of underlying exposure.  Thus an exposure to the dollar can be converted into an exposure to the euro with a euro/dollar forward. However, now it requires that the risk management policy of the corporate should specifically permit the same.

The RBI seems to be creating some confusion by stating that the right to cancel and rebook forward contracts for exposures of less than one year is not available for forward contract booked on the basis of anticipated exposure.

By introducing this under the contracted exposure section, is it signaling that such exposures based on average past imports and exports are to be treated as contracted exposure?

Further simultaneous cancellation and booking with another bank for a specified forward contract is permitted. But the condition that they be done simultaneously on maturity date is not clear. How can there be cancellation on maturity date? Further it has cast responsibility on banks to ensure that rebooking is based on cancellation with another bank without any requirement that bank be informed of such rebooking.

In a clear confirmation of earlier stand taken by many bankers, the RBI has made it clear that companies can enter into a foreign currency to rupee swap to move from rupee liability to foreign currency liability, subject however to certain prudential limits.

Even now companies try to reduce cost of funding by attempting this. However, this may impact the reported earnings as queried one leading company recently.  In yet another tightening move the possibility of entering into cost reduction option structures is restricted to companies with a net worth of Rs100 crores.

Further such companies are required to follow the mandates of Accounting Standards 30 and Accounting Standards 31 as they apply to derivative contracts.  In a clear blow to bankers the rules now clearly prohibit leveraged structures, digital options, barrier options, range accruals, and any other exotic product.

It appears that range accruals with does not have any leverage impact will be permitted so long as there is a net premium payable by the customer or it is a zero cost structure with a purchase and sale of a plain vanilla option call or put.  The logic mandating banks to report the delta of the option in the term sheet is not clear for it does not serve any purpose.

A chance to introduce mandatory clearing of all OTC derivatives through CCIL or similar organisation is not exercised.  Such a move would have taken care of margining and information of market activities.

It would also provide for netting cross the market where possible.
A benevolent RBI certainly goes out to favour the statutory auditors with mandated certification. They can smile all the way to the bank.

Ramesh Lakshman is a practicing chartered accountant. He can be reached at rlmail@rlco.biz.