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Commentary

RBI Bans Banks from Prop Trades in Exchange Futures, SEBI Doubles Forex Margins

The Reserve Bank of India (RBI) has decided that it is important, in the light of a falling rupee, that the problem can be solved even partially by stopping the “speculators”. In a notification, the RBI has ordered Authorized Dealer-1 category banks to immediately stop trading on their prop accounts in the exchange traded futures market.

Attention of Authorized Dealers Category – I (AD Category – I) banks is invited to the A.P.(DIR Series) Circular No.129 dated May 21, 2012 regarding participation in Currency Futures / Exchange Traded Currency Options markets.

2. On a review of the evolving market conditions, it has been decided that AD Category – I banks should not carry out any proprietary trading in the currency futures / exchange traded currency options markets.  In other words, any transaction by the AD Category – I banks in these markets will have to be necessarily on behalf of their clients.

3. These instructions shall come in to effect immediately and shall be in force till further orders.

Most banks trade through their AD-1 branches (see list) and therefore this pretty much means stop all prop trading on the exchanges for all banks.

But banks can take prop positions, in the OTC market (read: I call you, I ask price, we buy and sell – just not on the exchange). 

I don’t get this because banks are limited to 100 million dollars in exposure anyhow. Plus, it’s not like banks will stop trading, since they can go OTC – all this will do is reduce the trading on the forex exchange traded contracts (NSE, MCX and so on) for a short while.  

This is one step towards banning all trading completely, which if taken will be a very retrograde step. Already, many corporates have begun to create offsetting positions on the exchange rather than go to banks. It might actually be cheaper since you get a 6% higher price when you’re selling a 1 year forward rate. Banning future contract (or even options) will be hugely negative.

In a different and  related step, SEBI has doubled  margin requirements on exchange traded USD-INR futures immediately.

In consultation with RBI and in view of the recent turbulent phase of extreme volatility in
USD-INR exchange rate, it has been decided to curtail position limits and increase
margin requirements for Currency Derivatives as follows:

a. Margins: Initial and extreme loss margins shall be increased by 100% of the
present rates for USD-INR contracts in Currency Derivatives.

b. Client level position limits: The gross open position of a client across all
contracts shall not exceed 6% of the total open interest or 10 million USD,
whichever is lower.

c. Non-bank Trading Member position limits: The gross open position of a
Trading Member, who is not a bank, across all contracts shall not exceed
15% of the total open interest or 50 million USD whichever is lower.

(Applies from July 11, Thursday)

This takes the USD-INR contract margin to about Rs. 5,000 per contract (of $1,000) which is still less than 10% of the overall exposure ($1000 = Rs. 60,000) and gives you 10x leverage. (Earlier leverage was 20x). Such regulation is perfectly acceptable, since margins are taken to avoid the risk of default, and the higher volatility means a higher chance of default. Leverage provided is a function of volatility and the 5% margins earlier was justified due to less than 0.2% moves on a daily basis – now, we’re seeing much bigger moves (1 to 2%!) so the higher margins make sense. 10x leverage is STILL available.

(Some news reports have said the margin has been increased to 100%, which is wrong)

Position limits have been cut – earlier, client limits were 6% of total OI or 10 million USD, whichever was higher. (Non bank brokers had similar but 10% or $50 mm limit). Now the floor has been changed to a ceiling, by changing “higher” to “lower” – so all non-broker limits are $10 million (10,000 contracts) and broker limits are $50 million (50,000 contracts).
 
Current open interest is 25 lakh (2.5 million) contracts so the 6% and 10% limits are irrelevant (it’s the $ figure that sets the cap).
 
Essentially if you have more than 5 crores in margin, you’re going to have to cut your positions, or move to the EUR-INR or JPY-INR contracts.

My view on the limits is that the 6%/10% limits are fine, but the $10/$50 mm limits are too less. Not that I have that kind of money but it simply is too little, in these days, to have such micro limits. It can be overcome by hardcore traders by creating multiple entities to trade, so this is just erecting a temporary barrier.

Such interventions will get worse. Attempting to stop speculation is the worst kind of regulation, because speculation is not usually the problem, they just provide the last mile impetus for it. We could be stupid and say that if only speculators weren’t there, things would be fine. We could be stupid and say that we just need a few days of sanity in the exchange rate; because efforts to fix the fundamentals will take time. Or, we could be smart and say, let this happen, we’ll learn from it and get stronger. The way to stop the rupee falling is to be less dependent on flows, and more on lessening gap between exports and imports.