Introduction
Derivatives are critical financial instruments used for hedging, speculation, and risk management. In India, the regulatory framework for derivative products is governed by the Reserve Bank of India (RBI) and supported by the Foreign Exchange Dealers’ Association of India (FEDAI). In January 2022, the RBI issued updated Master Directions on OTC derivatives, establishing a modern and comprehensive regulatory structure for market participants. FEDAI, as a self-regulatory organization, issues rules and guidelines primarily applicable to interbank forex dealings and the conduct of member banks.
This article summarizes the key provisions of the 2021 RBI Master Directions and the latest publicly available FEDAI rules (10th edition, April 2024).
I. RBI Guidelines on Derivative Products (Master Directions – 2021, effective January 3, 2022)
The revised directions apply to entities permitted to act as market-makers in Over-the-Counter (OTC) derivatives and outline the regulatory, operational, and governance framework for derivative transactions.
1. Product Approval and Governance
- Market-makers are required to have board-approved policies and frameworks for conducting derivative transactions.
- Any new derivative product must be vetted and approved in accordance with the internal governance mechanism.
2. Restrictions on Unapproved Products
- Market-makers are prohibited from offering or dealing in derivative products that they cannot price independently.
- Derivatives with other derivatives as underlying assets are generally restricted unless specifically permitted.
3. Product Disclosure Statement
- A standard product disclosure statement must be provided to all users, ensuring transparency and enabling informed decision-making.
4. Permitted Transactions
- Market-makers may only engage in derivative contracts involving cash instruments or permitted derivative components.
5. Hedging Provisions
- Derivatives may be used to hedge exchange rate risks, including exposures arising from overseas direct investments.
- Provisions for rollovers and cancellations of hedging contracts are clearly defined.
6. Currency Derivatives on Exchanges
- Residents are permitted to take positions in exchange-traded currency derivatives without underlying exposure.
- A unified limit of USD 100 million equivalent is applicable per user, across all recognized exchanges (NSE, BSE, MSEI) and across all INR currency pairs.
7. Reporting Requirements
- Market participants must report all derivative and foreign exchange exposures of corporate clients as per prescribed formats.
- Timely reporting to the RBI is mandatory to maintain market transparency and regulatory oversight.
8. Alternative Reference Rates (ARR)
- With the phasing out of LIBOR, the guidelines require market participants to transition to ARRs in export/import transactions and derivative pricing.
9. Risk Management
- Institutions must implement robust risk management practices to monitor and control credit, market, and operational risks associated with derivative transactions.
- Risk limits, stress testing, and scenario analyses are encouraged as part of prudent practices.
II. FEDAI Rules (10th Edition, April 2024)
FEDAI serves as a self-regulatory organization and issues guidelines primarily for interbank foreign exchange dealings. While the 11th edition is not publicly available, the 10th edition continues to guide member banks on key operational matters.
1. Self-Regulation
- FEDAI provides a self-regulatory framework for its member banks operating in India’s foreign exchange market.
2. Interbank Transactions
- FEDAI rules govern spot and forward foreign exchange transactions between banks, including procedures for trade execution and settlement.
3. Exchange Rate Determination
- Member banks follow FEDAI guidelines in determining exchange rates such as card rates for customer transactions and interbank rates for forex operations.
4. Customer Transactions
- Although FEDAI does not directly regulate retail clients, its policies indirectly affect public transactions through the practices adopted by member banks.
5. Accreditation and Oversight
- FEDAI accredits forex brokers and intermediaries, issuing operational guidelines to ensure fair practices.
- It also provides training and certification for professionals engaged in foreign exchange dealings.
6. Dispute Resolution
- FEDAI plays an active role in resolving disputes between member banks arising from foreign exchange transactions.
7. Compliance and Audits
- Member banks are obligated to comply with FEDAI rules and are subject to periodic review and audits of their foreign exchange operations.
8. Sources of FEDAI Information
- Official Website: www.fedai.org.in serves as the primary source for circulars, rulebooks, and training materials.
- Member Banks: Employees of member banks have access to additional resources, including e-books and internal guidelines.
- FX Global Code Register: FEDAI maintains a public register of its commitment to the FX Global Code of Conduct.
Conclusion
The regulatory environment for derivative products in India has become more sophisticated and transparent under the revised RBI guidelines and FEDAI framework. These measures aim to ensure sound risk management, protect market integrity, and facilitate responsible participation in the derivatives market. As derivative products continue to evolve, compliance with the prescribed rules and disclosures remains essential for both financial institutions and corporate users.
Disclaimer:
The information provided herein is for educational purposes only and is based on publicly available sources. It is subject to change without notice. Readers are advised to consult financial professionals or regulatory authorities before making any financial or investment decisions. The author shall not be held responsible for any direct or indirect losses arising from the use of this content.
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