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JC - Article - Commodity Hedging - The Next Version!

Article

30 Mar 2018

Commodity Hedging - The Next Version!

The Reserve Bank of India (“RBI”) on 12th March 2018, issued the Hedging of Commodity Price Risk and Freight Risk in Overseas Market (Reserve Bank) Directions, 2018 (“Commodity Hedging Directions”). These Commodity Hedging Directions revamp considerable portion of the present laws in relation to commodity derivative transactions being undertaken on a cross border basis. This also withdraws previous circulars issued by the regulator in relation to such commodity derivative transactions.

Brief background:

The RBI has always followed a cautious approach in relation to commodity hedging. In 2003, RBI had permitted only those residents in India having import / export related exposures, to enter into commodity derivative transactions on a cross border basis, subject to specific approval being obtained from RBI. Over the years, RBI has permitted other entities (having domestic exposures to commodities as well) to enter into these commodity derivative transactions. In 2012, RBI further delegated the power to grant permission for entering into commodity derivative transactions to hedge commodity exposure to authorised dealer category I banks (“AD Banks”) in India.

The increasing interest in the Indian markets for commodity hedging especially vis-a-vis commodities falling under the approval route, led RBI to the realisation that there is need for opening up the commodity hedging for a wider range of commodities. This led to the constitution of the Working Group by RBI, on 14th September 2016 (“Working Group Committee”) for reviewing erstwhile guidelines for commodity hedging, identifying gaps and recommending a modified framework in this regard.
 
This has led to the issuance of the Commodity Hedging Directions.

Key Changes under the Commodity Hedging Directions

The Commodity Hedging Directions by written letter of law capture the market expectations as regards commodity hedging, by providing the following key changes:

1)      Nature of exposure:

The Commodity Hedging Directions split the nature of exposure into direct and indirect. The Commodity Hedging Directions set out a detailed explanation on what would fall under either of the categories.
(a)       Direct Exposures:
In case of direct exposures, RBI has permitted hedging in all commodities except gold, gems and precious stones.
(b)       Indirect exposure:
Those products, which contain commodities whose price is not linked to an international benchmark will fall under the category of indirect exposure. Hedging permission under this section is restricted to only the following commodities: aluminium, copper, lead, zinc, nickel and tin.

2)      Nature of commodity derivative products:
RBI has also widened the scope of the derivative transactions which can be entered into for hedging commodity exposures by permitting both (i) generic products such as futures and forwards, vanilla options and swaps and (ii) structured derivative products. For structured products, additional conditions apply.

3)      Broadened list of hedge providers:
RBI has now permitted commodity derivative transactions to be booked with (i) a bank or (ii) non-bank entities which are permitted to offer such derivatives by their regulators. The Foreign Exchange Dealers Association of India has, through circular issued to its members on
21st March 2018, laid down the criteria for determining the acceptable jurisdictions for commodity hedging.

And what next?

The Commodity Derivative Directions are enabling and aligned with the idea of a more flexible commodity derivative market for users in India.

The report of the Working Group Committee has laid out other suggestions in its report, such as possibility to permit users to hedge their risks on the domestic exchanges as also the possibility to permit AD Banks to act as hedge providers. These have not been adopted
under the Commodity Hedging Directions. In terms of revamping of commodity derivative transactions related norms in India, will this be it, or will further steps be taken based on the Working Group Committee report, these questions will remain unanswered for a while. But for now, what needs to be seen is whether the current measures will be as effective in practice as they seem in theory.

This article has been written by Nikita Chawla, Aashka Shah and assisted by Mahak Saboo.

This article was first published in bar & bench.