The Securities & Exchange Board of India (SEBI) has recently permitted the NRIs to hedge their currency risk through the Exchange Traded Derivatives (ETD). Currently, ETDs are permitted in the form of futures and options on select currency pairs on hard currencies like the US Dollar, Euro and the Yen. Of course, the Dollar pair continues to be the largest trading currency. So, what does this new product mean for the NRIs?
Currently, NRIs are not allowed to participate in the ETD market. The three major exchanges viz. NSE, BSE and the MSEI are all offering a trading platform for ETD. NRIs were traditionally only permitted to hedge their risk through the OTC market. (The over the counter market is an informal telephone market among banks and large financial institutions. In the technical sense it is a forward market and not a futures market). By allowing NRIs into the ETD market, the NRIs will have access to trading their currency risk in a more transparent and market-driven manner. But first, why exactly do NRIs run a currency risk?
Currency risk for NRIs
The NRI run a currency risk while investing in India because they need to convert dollars into rupees at the time of investing and then convert the rupees back into dollars at the time of redemption. Let us understand this with a live example…
An NRI who bought 1000 shares of Reliance Industries in July 2013 at a price of Rs.950/share would have invested Rs.950,000. At the prevailing exchange rate of Rs.54/$ back then, he would have infused $17,593/- into his bank for the purpose of buying the shares. In July 2017, he sells the 1000 shares for a price of Rs.1450/- and realizes Rs.14,50,000/-. However, the exchange rate is Rs.66/$ and therefore in dollar terms he realizes $21,970/-. That means in INR terms he has earned 52.6% returns over 4 years which is a good return. But in dollar terms, he has just earned 24.9% over a 4 year period. In a nutshell, he has lost nearly 50% of his returns on RIL due to the depreciation of the INR. It is to protect this currency risk that NRIs need to hedge.
How NRIs can hedge their currency risk through ETDs
NRIs need to be aware of the following key terms and conditions pertaining to the hedging of currency risk using ETDs…
- All the dealings of the NRIs in the currency derivatives segment of the recognized stock exchanges will continue to be governed by the Foreign Exchange Management Act (FEMA) and will have to be routed through an Authorized Dealer only.
- NRIs cannot take speculative positions in the ETD market and that will invite penal provisions under the FEMA. Like before, NRIs can only use the ETD segment to hedge their underlying currency risk on rupee receivables in India.
- SEBI has also outlined the specific transactions and underlying that can be hedged through the ETD route. NRIs can hedge the currency risk arising out of their rupee investments in debt and equity instruments in India. Additionally, NRIs can also hedge their exposure due to dividends due from their holdings, interest receivable on bonds and the balances of their NRE accounts with authorized Indian banks.
- There are stringent provisions laid out for the purpose of monitoring of overall positions. For the purpose of limits as specified by FEMA from time to time, the overall exposure under the ETD segment and the OTC segment will be considered. NRIs will have to designate an authorized bank to monitor the combined positions.
- There is an additional catch in these provisions. While the bank can designate the bank to monitor the positions, the onus will be on the NRI to ensure that the limits are not breached. Therefore, in the event of any breach, the NRI will be personally liable for penal action under the FEMA.
A step in the right direction
For the NRIs it is one more product to hedge their currency risk in India. But the real problem could be the process and the multiple parties involved in the transaction. For example, the custodian will upload the exchange level exposure of the NRI client to the bank on an EOD basis and hence real-time information may not be available. However, the NRIs may still be liable for the breach, something that may not entirely be within their control and information ambit.
While the NRIs will surely welcome the additional avenue, the burden of compliance on the NRI may be a little too high. Expecting the NRI to take on the onus of monitoring the limits and the combined position may be a little too steep for the NRI. Most NRIs today prefer to hedge their risk either through the OTC market or through the offshore markets in Dubai and Singapore. Till the onus on the NRI investor is reduced in case of currency derivatives, the NRIs may still prefer the current arrangement. That is something for the regulators to mull over!
To know more in detail check our demat account opening procedure.