RBI releases derivative deal norms

The Reserve Bank of India on Monday issued draft guidelines for banks and primary dealers on derivative transactions.

In the guidelines, the regulator is of the view that every transaction should be marked to market or valued at the current market price, in order to demonstrate the valuation of these products.

Structured products should not contain any derivatives, especially second order products. Second order products are derivatives worked out on other derivative products and not on underlying financial products. The second order derivatives banned by the RBI are swaption, option on future, compound option, etc.

The marked to market derivative deals need to be cash settled and management of derivatives should be an integral part of the overall risk management policy of a bank.

A bank or any other entity regulated by the bank should not undertake a derivative transaction, which offsets the risk of its own subsidiaries, branches or group entities. Moreover, banks will have to maintain a cash margin, a collateral in respect of the market to market valuation.

While directives on rupee derivatives remain the same as regards products, users and market makers, the regulator has come out with changes in foreign currency derivatives.

Banks and corporates (importers and exporters with foreign exchange receivable and payable) are allowed to sell covered call and put options in both foreign currency, rupee and cross currency and they can also receive premia.

This means these entities can not only transact in these products for hedging their balancesheet but also trade in these products by selling them. A resident Indian can undertake foreign currency swap for hedging long-term exposure (residual maturity of three years or more).

However, these instruments - cross currency swaps, caps and collars and forward rate agreements - will be used only for purposes specified by the RBI. These include entities with borrowings in foreign currency under external commercial borrowings.

The bank has also laid out comprehensive guidelines for risk management practices to be followed by banks and corporate governance norms for the board of directors and senior management of a bank.

The risk management framework requires a bank to establish an institution's overall appetite for taking risk, define the approved derivative products, and stress testing, among other things.

An appropriateness policy has also been laid down according to which a market maker (bank and primary dealer) should document the pricing, analyse the expected impact of the transaction, ascertain the authority of the user to enter into the deal, ensure terms of contract are clear, and also explain why the deal is inappropriate for the customer, if at all it is.

The risk management system requires the bank to prescribe market risk limits in terms of notional or volume limits, stop loss or maturity limits etc.

Similarly, credit limits should be established both pre-settlement and after settlement of the trade. Liquidity limits should be worked out by incorporating derivatives into the overall liquidity policy of the bank.

Prudential limits for derivatives, capital adequacy, credit exposure and asset liability management will be as prescribed by the RBI.