Why in news?

The RBI has barred banks from non-deliverable derivative (NDD) contracts in the rupee, a segment often linked to speculative trading by large currency players.

This move signals a push for greater control and transparency in the forex market, aiming to curb speculation and strengthen the onshore market.

Following the directive, the rupee recovered sharply from below 95 to 93.10 per dollar, helped by reduced speculative pressure. The step is intended to stabilise the currency amid rising oil prices and capital outflows due to the West Asia conflict.

What’s in Today’s Article?

• About NDD Market
• Misuse of the NDD Market
• RBI’s Crackdown on Loopholes

About NDD Market

• Non-Deliverable Derivatives (NDDs) are financial contracts used to hedge or speculate on currencies that are not freely convertible — like the Indian rupee — without any actual exchange of the underlying currency.
• Instead of physically delivering the currency at settlement, the difference between the agreed contract rate and the actual market rate is settled in a freely convertible currency, typically the US dollar.
• Basically, NDDs are offshore currency contracts that allow participants to bet on the rupee’s future value without actual delivery of the currency.
• NDDs are traded outside India in global financial hubs such as: Singapore; Hong Kong; London; Dubai.
• These markets operate beyond the direct regulatory control of the RBI.
• NDD markets often act as a price discovery mechanism, shaping expectations about the rupee even before Indian markets open.
• How NDDs Work?
  • Cash-Settled Contracts - In an NDD, two parties agree on a future exchange rate for the rupee, but the contract is settled in cash (usually US dollars) instead of exchanging the actual currency.
  • Reason for Their Existence - Due to India’s capital controls, foreign investors cannot freely trade the rupee. This led to the development of offshore NDD markets.
• Who Uses the NDD Market?
  • Foreign investors and hedge funds
  • Global banks
  • Companies hedging currency risk
  • They use NDDs to speculate on or hedge against rupee movements without accessing the domestic market.
• Concerns and Criticism of NDD Market
  • Offshore sentiment can diverge from domestic fundamentals
  • Leads to distorted price signals and potential manipulation
  • Contributes to higher volatility in the rupee

Misuse of the NDD Market

• The NDD market, originally meant for hedging, was often misused by participants for speculative gains.
• Some traders would cancel and re-enter contracts to benefit from favourable currency movements, effectively turning a risk-management tool into a speculative instrument.
• During periods of global uncertainty, such as the West Asia conflict, large offshore traders took aggressive positions betting on rupee depreciation.
• These actions influenced the onshore market in India, increasing volatility and weakening the currency.

RBI’s Crackdown on Loopholes

• The RBI’s move aims to close regulatory arbitrage opportunities that allowed such practices.
• By restricting NDD-related activities, the central bank is tightening oversight and limiting misuse in offshore markets.
• Another key step is the restriction on transactions with related parties, addressing concerns over intra-group dealings that could hide actual risk exposure or shift profits across jurisdictions.
• Aligning rules with global accounting standards reflects RBI’s effort to improve transparency and credibility.
• In the short term, these measures are likely to reduce speculative activity and stabilise the rupee, leading to lower volatility and improved investor confidence in India’s forex market.