| COMMENTS ON RBI'S GUIDELINES ON DERIVATIVES |
RBI has issued a draft paper revising existing guidelines on use of derivatives. (ref for details: www.rbi.org.in)
From the perspective of the users, some of the important changes proposed by RBI are given below (existing regulations are cited wherever necessary in brackets):
The guidelines are with reference to over-the-counter (OTC) derivatives, where the participants are:
User, with an underlying risk exposure and
Market-maker, the counter-party bank, who provides continuous bid-offer prices to users and other market makers.
Users can undertake derivative transactions only to hedge an existing identified risk, or for transformation of risk exposure, as specifically permitted by RBI.
Market makers may offer generic derivative instruments (e g put / call options) or a combination of permitted cash and generic derivative instruments. They should be able to demonstrate valuation of constituent products of the structure, based on observable market prices. Second order derivatives like swaptions, options on futures, compound options etc. are not permitted. (Banks are currently not required to disclose pricing of structured products)
A user should not have a net short position, either on a stand-alone basis or in a structured product, except to the extent of permitted covered calls and puts.
Users, such as importers and exporters having crystallized (evidenced by firm order, opening of LC or actual shipment), un-hedged foreign exchange receivables and payables in respect of current account transactions may write covered call and put options in both foreign currency/ rupee and cross currency and receive premia. (currently net receipt of premium is not permitted)
Market makers may offer plain vanilla American foreign currency - rupee options. (currently not permitted)
Market makers may write cross-currency options.
Cross-currency / rupee swaps are permitted only for hedging long term exposures, which have residual maturity of three years or more. (currently no such restriction)
Market makers can only take up residual positions, but can not run a book, in foreign currency rupee swaps. (currently banks have trading positions in swaps - it is not clear if this is to be discontinued)
Market-makers and users regulated by RBI should not undertake any derivative transaction involving the rupee that partially or fully offset a similar but opposite risk position undertaken by their subsidiaries/branches/group entities at offshore location(s).
Market-makers should have a 'Suitability and Appropriateness Policy' vis-à-vis users in respect of the products offered, on the lines indicated in these guidelines.
Market-makers may maintain cash margin/liquid collateral in respect of derivative transactions undertaken by users on mark-to-market basis, irrespective of the latter's credit risk assessment. (currently there is no such compulsion)
All risks arising from derivatives exposures should be analysed and documented.
Corporate governance for users:
The management of derivatives activities should be an integral part of the overall risk management policy and mechanism. It is desirable that the board of directors and senior management understand the risks inherent in the derivatives activities being undertaken.
Detailed guidelines on corporate governance emphasise appropriate oversight by the Board of Directors and senior management, adequate risk management process, comprehensive internal control and audit process. The Management should encourage stable and durable return performance and discourage high, but volatile returns.
Each market-maker should adopt a board-approved 'Customer Appropriateness & Suitability Policy' for derivatives business.
Market-makers should undertake derivative transactions, particularly with users with a sense of responsibility and circumspection that would avoid, among other things, misselling. They have greater responsibility for due diligance, for examining the risk management policy of the users and advise them on the appropriateness of the offered products with detailed analysis of risks.
In general, market-makers should not undertake derivative transactions with or sell structured products to users that do not have properly documented risk management policies that include, among other things, risk limits for various risk exposures. Furthermore, structured products should be sold only to those users, which follow prudent accounting and disclosure norms, that provide for, among other things, marking the derivative exposures to market.
A market maker should document how the pricing has been done and how periodic valuations will be done. In the case of structured products, this document should contain a dissection of the product into its generic components to demonstrate its permissibility, on the one hand, and to explain its price and periodic valuation principles, on the other. This document should be shared with the user concerned.
There are detailed guidelines for market makers to manage their derivative risks by means of various risk limits, stress testing and sensitivity analysis. These guidelines are also highly relevant for corporate treasuries.
Mecklai Financial's comment
The draft guidelines on one hand further liberalized the use of derivatives by permitting sale of covered put / call options and American options, and on the other hand, tightened the regulatory requirements for prudential use of derivative products. All the users must have a Board-approved risk management policy with continuous risk monitoring of MTM valuations and risk limits. Regulatory requirements with regard to due diligence, price-transparency and appropriateness norms on the part of market makers is timely and a welcome development.
We request our clients to go through the draft guidelines along with draft accounting norms (AS 31) recently circulated by the Institute of Chartered Accountants of India - both of which have great bearing on the risk management and in particular, use of derivatives.
We offer our services to our clients for formulating risk management and derivative policies, with implementation support. We also assist in compliance with domestic and global accounting norms, including MTM valuations and hedge documentation.
