The Reserve Bank of India (RBI) has rightly done a rethink on its earlier proposal to ban structured derivatives that aimed to reduce the cost of hedging of Indian companies. In its recently issued comprehensive guidelines on over the counter (OTC) foreign exchange derivatives, RBI has permitted listed companies and unlisted companies with a minimum net worth of Rs100 crore to use cost reduction structures.
A little over a year ago, in its draft guidelines on OTC derivatives products, the central bank had considered banning these products. Cost-reduction structures involve a long and a short options position, where the premium received by writing one option offsets the premium required to buy the second option.
One concern related to such structured derivatives is that they can be misused and there can be an attempt to speculate rather than hedge risk. This isn’t merely a theoretical concern, but one that was evident during the financial crisis, when a number of Indian companies reported large losses on their structured forex derivatives exposure.
Despite these concerns, it’s heartening to note that the central bank has taken on board feedback from Indian companies and multinational companies that these products serve effectively in hedging currency risks. Of course, there is always the chance that some companies would misuse them. But clamping down on these products clearly isn’t the solution, since some firms would require non-standard products to effectively hedge their risks.
In the past two years, this market has diminished greatly, with RBI getting more watchful after large forex related losses came to light in 2008. There was almost an impression that selling structured products involved getting into the regulator’s bad books. RBI’s clearly stated policy and guidelines should put some life into the market for non-standard derivative products.
The new guidelines, however, fail to address the need for a more comprehensive risk management system. Post the financial crisis, the world is headed towards centralized clearing and daily mark-to-market margins. This is possible even with non-standard OTC derivatives. Having such a system would help banks and customers manage risk better, even while dealing in complex products. And once there is a good risk management system in place, RBI needn’t bother about what products are sold and who’s dealing in them.
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