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A financial derivative is an agreement between different parties (two or more in number) and its value is calculated or derived from an underlying group of financial assets or a single asset. These underlying assets are instruments like market indexes, interest rates, currencies, bonds, stocks and commodities.
A brief history about the evolvement of the Derivatives Market in India and its performance
- In the later part of last century, volatile financial markets lead to a number of crisis situations worldwide.
- In order to circumvent such disasters in the global financial market, Futures and Options evolved as adequate financial instruments meant to protect business entities from market risks.
- Derivatives trading in India started formally in June 2000 with index futures.
- Stock futures were introduced in 2001.
- Over the years the F&O market volumes grew substantially than the cash market. In the last one decade the derivatives market at the global as well as in the Indian context has grown tremendously well.
Studies show that the Indian derivatives segment had registered phenomenal growth in the latter half of the last decade when compared to the global scenario. A quick look at the figures will help understand the same –
|Financial year||NSE derivatives value||Growth over the 5 year period||Global market||Growth over the 5 year period|
|2003-04||Rs. 2130610 crores||Almost 6 times||$ 8163 million||Almost 2 times|
|2007-08||Rs. 13090477 crores||$ 15187 million|
What was the scene in the Indian Derivative market before 21st March 2017 in context to foreign parent participation?
The Indian Derivative market did not have many interested companies who wanted to hedge their exposures because of lack of information and access to the right kind of technology. Even banks involved in the forex market did not have the right kind of staff and information to handle such operations. Also with plenty of ceilings and prohibitions on cross currency transactions in the overseas market the market suffered to a great deal with such constraints in place.
Foreign exchange has been controlled and administered by the apex bank – RBI – in India. For some time now the subsidiaries and their foreign parents have been requesting the Reserve Bank of India to consider and allow greater operational participation and flexibility to the MNC in relation to the currency risks that the Subsidiaries are exposed to. Two essential components of the parent company’s role was completely ambiguous till now –
- The parent MNC’s involvement in decision making in the above context
- The MNC’s actionable role on behalf of the Subsidiary in the Indian Derivative market
What does the Circular mention about the MNC’s role in the Indian Derivative market?
The turnover of the derivatives market in the Indian scenario had surpassed all expectations, with even exceeding the growth in the global market as is evident from the table above. Providing a vibrant and dynamic exchange-traded derivative market in the country, it was time that MNC parents in business relationships started playing significant roles too.
Multinational companies and their Indian subsidiaries engaged in current account transactions in India are invariably exposed to currency risks. The Reserve Bank of India took note of this and vide a circular dated 21st March 2017 it established certain amended rules so that parent MNC’s and their subsidiaries in the Indian terrain are able to operate flexibly in this context.
Under this amended circular –
- Multinational companies (MNCs) or its centralized treasury or its regional treasury located outside India have been given the right to entry to the Indian derivatives market representing their Indian subsidiaries.
- The amendment is in context of hedging activities that the MNC can indulge in on behalf of the exposures that its Indian subsidiaries are exposed to at the global market.
- The MNC can now partake in currency derivative transactions.
- They need to do so by working with the AD Banks in India.
- They are permitted to undertake all such transactions on behalf of their Subsidiaries in India that the Subsidiary was otherwise allowed to undertake, including Over-the-Counter (OTC) and exchange-traded transactions.
What the necessary requirements that needs to be met by the MNC and the Subsidiary under the amended circular?
- A mandatory clause is the tripartite accord between the Indian Subsidiary, the AD Bank and the foreign parent or treasury. This document needs to mention precisely the rights and duties of each party, the settlement details and the process of undertaking the transaction.
- The purpose behind this detailed agreement is the need to mention the finer details of the role of each participant, their relationship, their liabilities and obligations to enable such derivative transactions to happen smoothly.
- This document is separate from the ISDA agreement that the non-resident parent and the AD Bank needs to anyways maintain.
- It is also compulsory that the foreign parent is incorporated in a Financial Action Task Force (FATF) member country or a regional body styled on FATF pattern.
- The AD Bank is required to have the KYC/AML certification done in tune with the Master Direction on Risk Management and Inter Bank Dealings.
- The derivative contract can contain any product that falls under the contracted route or on past performance basis.
- The amended hedging circular also mentions that the responsibility for compliance related matters that are issued under the Foreign Exchange Management Act, 1999 and also other relevant laws in India lies with the Indian Subsidiary. On the other hand, the respective AD Bank needs to continually monitor all such transactions and also keep verifying that the Indian Subsidiary has underlying exposure to currency risks.
- The circular also details out the settlement of the Profit/Loss from such hedge transactions. It needs to reflect in the Indian subsidiaries’ book of accounts and bank account. The Bank has to mandatory obtain the audited annual certificate from the Indian Subsidiary to this effect.
- All such hedging contracts that fall under the purview of this circular need to be booked by the AD Bank to CCIL’s trade repository along with an exclusive identification tag.
- The business entities involved in the hedging transactions can open a rupee account through local banks.
What the distinct advantages of the higher flexibilities in the Derivative market?
The RBI circular has been appreciated for making the working in the Indian Derivative market easier.
- The foreign parent now can directly approach the concerned AD bank on behalf of its subsidiary – one that handles the foreign exchange transactions of the Indian subsidiary – for hedging currency risks by booking derivatives.
- It has enabled foreign partners and parents to keep a close watch on such derivative transactions at an international level.
- It has also helped the Indian subsidiaries to perform optimally as they are now more ably supported by their parent MNC. Before this, Indian corporates were avoiding the currency market not giving hedging a consideration or if did hedge, they did so using forward contracts only. Now the same Indian companies are able to strategically look at exposures and take hedging decisions assisted by their MNC parents. This has made the working more professional which is good news for the Indian derivative market.
Well, the Financial derivatives have nowadays become the most used tool for investment in the world market. It involves contribution at global level and gives a boost to the Indian Economy. However before investment one must have detailed knowledge about the financial derivatives.
To know more establish contact with the Swarit advisors.