Clarification on Scope and Exclusions
The Reserve Bank of India (RBI) has released a set of Frequently Asked Questions (FAQs) to clarify the implementation of its 20 per cent Foreign Exchange Risk Reserve (FERR). The central bank specified that the reserve requirement applies to user contracts where the foreign currency equivalent exceeds $2 million. These contracts must involve the purchase of foreign currency against the rupee specifically to hedge current-account transactions.
Significant exclusions have been outlined. Contracts involving the sale of foreign currency against the rupee are not subject to the FERR. Furthermore, hedges for capital-account transactions are excluded. The RBI clarified that while interest on external commercial borrowings (ECBs), coupons on debt instruments held by non-residents, and dividends payable to non-residents are technically current-account payments, they arise from underlying capital-account transactions. Consequently, derivative contracts undertaken by users to hedge these specific flows are exempt from the reserve requirement. However, banks’ own qualifying hedges of currency risks arising from these exposures will continue to attract the reserve requirement.
Treatment of Options and Rollovers
The FAQs addressed the complexity of options trading. When two or more options are undertaken together as a single structure, the RBI stated that the entire structure shall be treated as one derivative contract. The option with the highest notional value within that structure will determine whether the $2 million threshold is exceeded and, consequently, the amount of FERR to be maintained.
Regarding contract duration, contracts entered into before the respective RBI directions were issued are exempt. However, rollovers occurring after October 10 and October 12, 2024, will be treated as fresh contracts. If these new contracts meet the prescribed conditions, they will attract the FERR. Banks are required to report the reserve daily through the RBI’s Centralised Information Management System.
Unresolved Banking Sector Concerns
Despite the clarifications, the RBI has not addressed the primary concerns raised by the banking sector. The Foreign Exchange Dealers’ Association of India (FEDAI) had sought a transition period to update internal systems and clarity on how to handle exposures spread across different banks or days. More critically, lenders had requested the removal of the $2 million threshold, arguing it could incentivize customers to split exposures to avoid the reserve. The RBI retained the threshold and cautioned against structuring transactions to circumvent the rules.
Banks had also proposed alternatives to the non-interest-bearing cash reserve, such as a direct charge on foreign exchange derivative transactions. The FAQs did not permit such substitutions. The reserve must be maintained daily in banks’ current accounts with the RBI, over and above their cash reserve ratio (CRR) and other obligations. It earns no interest and cannot be counted as a high-quality liquid asset under the liquidity coverage ratio framework. This requirement ties up cash with the central bank, potentially increasing hedging costs for both banks and their customers.
Background and Intent
The RBI introduced the FERR on October 10, 2024, as part of broader measures to curb speculative activity and manage excessive demand for dollars amid pressure on the Indian rupee. On October 12, the central bank extended the requirement to include banks’ own qualifying hedges of currency risks on their assets and liabilities. While the FAQs provide operational clarity, the core 20 per cent requirement and its associated funding costs remain unchanged.