After a decade, the Reserve Bank of India is set to lift the ban on ‘exotic currency derivatives’, the double-edged, fancy products that had left a trail of destruction in 2007-08 amid allegations of mis-selling and court battles when bets by corporates backfired as the euro, Yen and Swiss franc surged.
Over the past month, senior RBI officials have held multiple meetings with bankers to discuss ways to allow these products, albeit with certain safeguards.
“There is mixed reaction among bankers. Some are excited by the possibility of extra margins from sale of exotic instruments while others who took the hit and were dragged to court are apprehensive… particularly, the compliance guys. But everyone is surprised by RBI’s plan to open up the market,” a senior banker, who attended one of the meetings, told ET.
Hundreds of Indian corporates had entered into such tailor-made, over-the-counter derivative contracts with banks — mostly private and foreign lenders — to extract a better exchange rate on export earnings, prune loan costs and shore up bottom lines.
As the rupee surged, exporters were tempted to buy complex currency option packages instead of locking in gains through the conventional way of selling dollar income in the forward market. Treasurers, desperate to showcase their performance, signed synthetic contracts to swap high-cost rupee loans into much cheaper Yen or Swiss franc loans.
But all contracts — typical in high-risk, high-return deals — had deep downsides which the corporates failed to grasp, and later cried foul as the bets went awry. In many cases, such as businesses in SME clusters like Tirupur, the firms never had the wherewithal to stomach the losses.
What did these exotic derivatives look like? Here’s a description: An exporter, rattled by a falling dollar, knows that selling his expected dollar earnings would only fetch a marginally better rate of Rs 40 over the spot rate of Rs 39. So, the company enters into a series of option contracts (maturing monthly or weekly) with a bank which promises Rs 43 for every dollar. The company has an option that gives it the right to sell the dollars that it will receive from foreign buyers to the bank at Rs 43 each. But there’s a catch: when a company buys an option, it has to pay a premium to the bank. What’s the premiumRs Nothing, as long as some global benchmark rate stays within a particular range. But the moment it goes out of the range, either on the upper or lower side, the company has to fork out big money.
A decade back, when these instruments were allowed, many companies — to boost profits — had converted local rupee loans into yen or Swiss franc which carried a significantly lower interest rate. In many cases, corporates entered into option contracts to protect the risk on such swaps. But these call options were conditional risk protection products, better known as ‘KIKOs’ (knock in, knock out). For instance, one such contract said that as long as the Swiss franc did not appreciate beyond 1.05 against the dollar (i.e. $1 = 1.05 Swiss franc), the corporate could buy Swiss franc at a rate of $1 = 1.20 Swiss franc. But when the exchange rate breached 1.05 (to, say, 1.03, which it did in February-March 2008) the corporate could no longer get Swiss franc at 1.20. It then had to buy from the market, which had turned more expensive. Even as late as September 2007, few had thought the Swiss franc would touch 1.03.
In the case of leveraged products — which the RBI would soon define, according to the banker — the pay-ins or pay-outs could be three or four times. Here, the bet was a few multiples of the underlying. “It all began as banks found ways to package currency options to make them more attractive for clients. For instance, an exporter sold a call (or, the obligation to sell dollars) to offset the cost of simultaneously buying a put option (the right to sell dollars). While there is nothing wrong in such zerocost options, companies became greedy and bought more and more in-the-money options which commanded a higher premium and were thus riskier. Here, when the currency moved wildly, the losses were large,” said a market veteran.
After the derivative losses — where banks also took a hit when clients refused to honour deals — the RBI banned exotic products, allowing only plain-vanilla currency options.
“But now, at least as per the draft plan, the regulator is open to allowing all kinds of exotic products. Significantly, it is also proposed that foreign investors should be allowed to freely cancel and rebook contracts, which could bring some of the offshore demand onshore and may not be a bad thing,” said another banker. “The feeling we got is that the RBI does not want to stifle innovation. And it wants sophisticated players, i.e., companies with net worth of Rs 200 crore or more, to freely choose derivatives,” said the person.
A strong lobby is believed to be in favour of scrapping the ban, and the RBI, under governor Shaktikanta Das, is considered to be more receptive to suggestions. If it lets players decide whether or not to trade in exotic products, the RBI would be simply going by one of the court rulings in a derivative dispute, which said, “Though every wager is inherently speculative in nature, every speculation is not necessarily a wager”.