Risk Management and Inter-Bank Dealings - Foreign Exchange Risk Reserve

What new requirement has the RBI imposed on Authorised Dealers for certain INR-linked foreign-exchange derivative contracts?

The RBI has introduced a Foreign Exchange Risk Reserve, or FERR, for Authorised Dealers. It applies when they undertake certain foreign-exchange derivative contracts involving INR with users. The stated aim is to support the orderly functioning of the foreign-exchange market. The requirement takes effect immediately under the circular dated October 10, 2026.

The rule covers contracts used to hedge current account transactions when a user buys foreign currency against INR. It applies when the notional value exceeds USD two million equivalent. For each covered contract, the dealer must reserve cash equal to 20 per cent of the contract’s INR-equivalent notional amount.

The reserve must be deposited and maintained in cash in India with the Reserve Bank every day. It remains in place until the derivative contract terminates. Dealers must report their FERR details daily through the Reserve Bank’s Centralised Information Management System.

What is a Foreign Exchange Risk Reserve (FERR), and why must it be held in cash with the RBI?

A Foreign Exchange Risk Reserve is a dedicated cash amount that an Authorised Dealer must maintain for certain INR-involving foreign-exchange derivatives. The circular sets the amount at 20 per cent of each contract’s INR-equivalent notional value. It is not described as a fee or a payment to the user. It is a reserve linked to the derivative contract.

For example, if a covered contract has an INR-equivalent notional value of 100 units, the dealer must maintain 20 units in cash. The cash must be deposited and kept in India with the Reserve Bank. The dealer must maintain it daily, and the obligation lasts until the contract terminates.

The circular connects FERR with ensuring the orderly functioning of the foreign-exchange market. Holding cash directly with the Reserve Bank gives the requirement a clearly defined form and location. The article does not specify any return, release process, or separate penalty for non-maintenance.

Which contracts are covered, and how large must a transaction be before the FERR requirement applies?

The requirement applies to foreign-exchange derivative contracts involving INR that Authorised Dealers undertake with users. The transaction must be for hedging current account transactions. The specific direction is limited to cases where the user is purchasing foreign currency against INR. Contracts outside these stated conditions are not identified as covered by this paragraph.

The size test is based on the contract’s notional value, not simply an upfront payment. The notional value must exceed USD two million equivalent. For instance, a qualifying contract with a notional value above that threshold falls within the FERR rule, while the circular does not place a reserve requirement on one at or below the stated threshold under paragraph 2(ii).

The threshold is important because it identifies the contracts requiring the reserve. Users cannot evade it by dividing activity into multiple transactions with one or more Authorised Dealers. The circular says such attempts will be treated as violations of the Directions.

How much reserve must an Authorised Dealer maintain for a covered contract, and how long is the cash tied up?

For every covered derivative contract, the Authorised Dealer must maintain FERR equal to 20 per cent of the contract’s INR-equivalent notional amount. The calculation is made separately for each derivative contract. The circular does not set a single fixed rupee amount because the required reserve changes with the contract’s notional value and its INR equivalent.

Suppose a qualifying contract has an INR-equivalent notional amount of 500 units. The dealer would maintain 100 units as FERR, because 20 per cent of 500 is 100. This example illustrates the mechanism; the circular itself does not prescribe a particular rupee illustration. The cash must be deposited and maintained in India with the Reserve Bank.

The reserve is required daily, not just when the contract is entered. It must remain maintained until termination of the derivative contract. Dealers also have to report the FERR maintained each day through the Reserve Bank’s CIMS system.

What could happen to banks and users who split transactions across one or more Authorised Dealers to avoid the USD 2 million threshold?

The RBI has specifically addressed attempts to avoid the USD two million threshold. If a user undertakes multiple transactions with one or more Authorised Dealers to circumvent the requirement, that attempt is considered a violation of the Directions. The rule therefore looks beyond a single transaction when transactions are arranged to defeat the stated threshold.

For example, a user might divide a qualifying currency-hedging need into several smaller contracts and place them with different dealers. If the purpose is to avoid paragraph 2(ii), the circular treats the attempt as a violation. The FERR obligation itself is otherwise calculated for each covered derivative contract, using 20 per cent of its INR-equivalent notional amount.

The immediate practical effect is that dealers must pay attention to possible threshold-circumvention patterns and report maintained FERR daily through CIMS. The article does not state a specific fine, enforcement action, or penalty. It only establishes that the circumvention attempt violates the Directions.

What are foreign-exchange derivatives, and how do businesses use them to hedge the risk of buying foreign currency with rupees?

In general, a foreign-exchange derivative is a financial contract whose value depends on exchange rates. Common forms include forwards, futures, options, and swaps, though the circular does not name specific types. A business can use such a contract to hedge, or reduce uncertainty about, the rupee cost of buying foreign currency for a current account transaction.

For example, a business expecting to buy dollars may enter an INR-linked derivative designed to manage the exchange rate used for that purchase. If the contract meets the circular’s conditions and its notional value exceeds USD two million equivalent, the Authorised Dealer must maintain FERR. The reserve equals 20 per cent of the contract’s INR-equivalent notional amount.

The derivative helps the business manage currency exposure, while FERR applies to the dealer arranging the contract. The cash must be held daily with the Reserve Bank until termination. The circular does not explain the detailed pricing or settlement mechanics of individual derivative products.

Why can a bank’s exposure to currency movements create risks for the wider foreign-exchange market, and how can a reserve reduce those risks?

A bank that arranges foreign-exchange derivatives may be exposed to changes in currency values through its contracts and related obligations. If exchange rates move sharply, the value of positions can change and managing them can become more difficult. At a broader level, concentrated or poorly managed exposures can disrupt orderly foreign-exchange market functioning. These are general financial-market principles; the circular does not describe a specific bank failure or market event.

FERR addresses this concern by requiring cash for qualifying contracts. The reserve equals 20 per cent of each contract’s INR-equivalent notional amount. It must be deposited and maintained in India with the Reserve Bank every day. This creates a cash buffer connected to the contract rather than relying only on the dealer’s other resources.

The measure covers contracts above USD two million equivalent that hedge current account transactions involving a user purchasing foreign currency against INR. Dealers must report FERR daily through CIMS. The reserve stays in place until termination, supporting continuous compliance during the contract’s life.

Key Facts:

📌 RBI introduced a Foreign Exchange Risk Reserve for certain INR-linked derivatives.

📌 The reserve equals 20 per cent of each covered contract’s INR notional amount.

📌 Authorised Dealers must report FERR daily through CIMS.

📌 FERR is based on each derivative contract’s INR-equivalent notional value.

📌 The reserve must be held as cash in India with the Reserve Bank.

📌 FERR continues until the derivative contract terminates.

📌 Covered contracts must involve INR and hedge current account transactions.