Managed float: RBI has a better handle now on rupee management

livemint.com:

After declaring a crackdown on rupee derivatives traded on exchanges without underlying exposure to foreign-exchange risk, the Reserve Bank of India (RBI) extended its deadline for compliance. Circulated in January and slated to take effect from 5 April, RBI’s requirement for market position holders to affirm their need to hedge risk (and submit back-up proof above a point) has been pushed to 3 May.

Transactions had crashed as brokers asked clients to comply, though the basic rule remains the same. Rupee options and futures are meant for globalized businesses to shield their finances from the blows of exchange-rate flux.

So such positions can be held only by those with genuine forex exposure, a condition laid down all along by India’s Foreign Exchange Management Act. Deputy governor Michael Patra has elaborated that RBI had in 2014 permitted participants to take positions of up to a level without providing evidence of exposure.

That relaxation, however, was misinterpreted to conclude there’s no need for underlying risk, “which is not the case," he said, calling it “a violation of the law." Given signs of market turmoil in response to RBI’s move to enforce that rule, we could expect a significant scale-back in trading. The shake-up so far suggests a large chunk of these derivatives were being used by punters as a way to place bets in search of profits.

That some of these trades are done on margin money—as opposed to those for which full contract sums are paid upfront—could have acted as a lure. While wider participation in a market is usually an assurer of superior price discovery, this logic can get upended if an upsurge in trades is led by a mix of clever traders and rookies who know little of what makes a key price