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MARGIN FOR DERIVATIVE CONTRACTS

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MARGIN FOR DERIVATIVE CONTRACTS
By: Mr. M. GOVINDARAJAN
May 15, 2021
All Articles by: Mr. M. GOVINDARAJAN       View Profile
  • Contents

Introduction

The Reserve Bank of India, vide Notification bearing number No. FEMA. 399/RB-2020, dated 23.10.2020,  introduced a new regulation called as ‘Foreign Exchange Management (Margin for Derivative Contracts) Regulations, 2020’ which came in force on 23.10.2020, which now allows margin to be posted and collected against permitted derivative contracts.

Derivative

Regulation 2(da) of Foreign Exchange Management (Permissible Capital Account Transactions) Regulations, 2000 defines the term ‘derivative’ as  a financial contract, to be settled at a future date, whose value is derived from one or more financial, or non-financial variables.

Margin

When it comes to exchange traded derivatives, one of the first things that need to be understood is the margin mechanism.  Margin trading is a risk management procedure.  a margin procedure is required since most of the contracts pertaining to exchange traded derivatives are highly leveraged.  The safety of the principal and interest of the borrowed money is guaranteed via margin trading.

The term ‘margin’ is defined under Regulation 2(iv) of Foreign Exchange Management (Margin for Derivative Contracts) Regulations, 2020 as the collateral that the parties to a derivative contract post with or collect from each other (whether directly or through a third party) to cover some or all of the credit risk that the provider of the collateral poses for the receiver of the collateral.

Permitted derivative contract

The expression ‘permitted derivative contract’ is defined under Regulation 2(v) as-

  • Foreign Exchange Derivative Contract undertaken in terms of the Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000 and Master Direction–Risk Management and Inter-bank Dealings, as amended from time to time,
  • Interest Rate Derivative Contract undertaken in terms of the Rupee Interest Rate Derivatives (Reserve Bank) Directions, 2019 (Notification No. FMRD.DIRD.20/2019 dated June 26, 2019), as amended from time to time,
  • Credit Derivative Contract undertaken in terms of Notification No. IDMD.PCD. No.10/14.03.04/2012-13 dated January 7, 2013, as amended from time to time, and
  • Any other derivative contract as may be specified by the Reserve Bank.

Foreign Exchange derivative contract

Section 2(v) of Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000 defines the expression ‘foreign exchange derivative contract’ as a financial contract which derives its value from the change in the exchange rate of two currencies at least one of which is not Indian Rupee or which derives its value from the change in the interest rate of a foreign currency and which is for settlement at a future date, i.e. any date later than the spot settlement date, provided that contracts involving currencies of Nepal and Bhutan shall not qualify under this definition.

Interest Rate derivative contract

An interest rate derivative is a financial instrument with a value that is linked to the movements of an interest rate or rates. These may include futures, options, or swaps contracts. Interest rate derivatives are often used as hedges by institutional investors, banks, companies, and individuals to protect themselves against changes in market interest rates, but they can also be used to increase or refine the holder's risk profile or to speculate on rate moves.

Interest rate derivative transactions carried out on exchanges shall be subject to the following directions:

  • Exchanges are permitted to offer any standardized Interest Rate Derivatives product.
  • The product design, eligible participants and other details of the IRD product may be finalized by the exchanges.
  • Exchanges shall obtain prior approval of the Reserve Bank before introducing any new IRD product or before carrying out modifications to an existing product.

Credit derivative contract

A credit derivative is a financial contract that allows parties to minimize their exposure to credit risk. Credit derivatives consist of a privately held, negotiable bilateral contract traded over-the-counter between two parties in a creditor/debtor relationship. These allow the creditor to effectively transfer some or all of the risk of a debtor defaulting to a third party. This third party accepts the risk in return for payment, known as the premium.

The Credit derivative includes-

  • Credit Default Swaps;
  • Collateralized debt obligations;
  • Total return swaps;
  • Credit spread options/forwards.

In all cases, the price of a credit derivative is driven by the creditworthiness of the party or parties involved. Often a credit derivative will be triggered by a qualifying credit event, such as a default, missed interest payment, credit downgrade, or bankruptcy.

The credit derivative, while being a security, is not a physical asset. Instead, it is a contract. The contract allows for the transfer of credit risk related to an underlying entity from one party to another without transferring the actual underlying entity.

The following persons shall be eligible to participate in credit derivatives market-

  • A person resident in India;
  • A non-resident, to the extent specified in the Directions issued by RBI.

Prohibition

With effect from 23.10.2020 no person shall post or collect margin for derivative contracts and pay or receive interest on such margin without the prior permission of the Reserve Bank.

Permission by RBI

The authorized dealers may-

  • post and collect margin, in India and outside India, on their own account or on behalf of their customers for a permitted derivative contract entered into with a person resident outside India, in the form and manner as specified by the Reserve Bank; and
  • receive and pay interest on margin posted and collected on their own account or on behalf of their customers for a permitted derivative contract entered into with a person resident outside India.

Directions of RBI

RBI, vide their Circular No.10, dated 15.02.2021 issued directions to Authorized dealers in this regard-

  • Authorized Dealer  Category - I banks may post and collect margin in India, on their own account or on behalf of their customers, for a permitted derivative contract entered into with a person resident outside India in the form of:
  • Indian currency;
  • Freely convertible foreign currency;
  • Debt securities issued by Indian Central Government and State Governments;
  • Rupee bonds issued by persons resident in India which are:
  • listed on a recognized stock exchange in India; and
  • assigned a credit rating of AAA issued by a rating agency registered with the Securities and Exchange Board of India. If different ratings are accorded by two or more credit rating agencies, then the lowest rating shall be reckoned.
  • Authorized Dealer Category - I banks may post and collect such margin outside India in the form of-
  • Freely convertible foreign currency; and
  • Debt securities issued by foreign sovereigns with a credit rating of-
  • AA- and above issued by S&P Global Ratings / Fitch Ratings; or
  •  Aa3 and above issued by Moody’s Investors Service.

If different ratings are accorded by two or more credit rating agencies, then the lowest rating shall be reckoned.

  • Authorized Dealer  Category - I banks may receive and pay interest on margin posted and collected on their own account or on behalf of their customers for a permitted derivative contract entered into with a person resident outside India.
  • Authorized Dealer  Category - I banks shall maintain a separate account in the name of persons resident outside India for the purpose of posting and collecting cash margin in India, and transactions incidental thereto.

 

By: Mr. M. GOVINDARAJAN - May 15, 2021

 

 

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