The Reserve Bank of India's new procedure for calculating reference rates for spot dollar-rupee and euro-rupee pairs may reduce the extent of volatility in the local unit but could also hurt market liquidity.
The RBI had said on June 24 it will poll select banks during a randomly selected five-minute window between 10:30 a.m. and 12:30 p.m. on weekdays to arrive at the reference rate. This will be effective from July 1.
The central bank now announces the reference rate by averaging the mean of the bid-offer rates polled by it from a few select banks around 12 noon every weekday.
For June 27, the central bank has set reference rates for the U.S. unit and for the euro at 45.10 and 63.75, respectively.
The new procedure will reduce arbitrage opportunities for banks in the forward dollar market, which will deter them from making such trades, dealers said.
"In my view, there will be a sudden fall in onshore/offshore arbitrage trades done against the fix since onshore banks will probably not execute spot orders at the fixing rate for a start," said Kenneth Kan, head of emerging markets - forex trading, Credit Agricole Corporate and Investment Bank, Singapore.
Under the old system, as the time-frame used by the central bank to set reference rates was public knowledge, it provided incentive for nudging the spot rupee rate in a particular direction, dealers said.
Contracts in the dollar-rupee non-deliverable forwards (NDF) market use the reference rate for settlement, they said.
"The other impact is there could be much more volatility on the shorter end NDF forward points since we won't get the huge arbitrage volume that has kept the points close to onshore levels," Kan said.
Of late, concerns over portfolio outflows by foreign funds have kept the rupee in a weakening trend. So far this month, the rupee has moved in 44.84-45.14 per dollar band, with foreign funds pulling out $288 million from Indian shares.
The new norms could also lower banks' risk-taking ability in the foreign exchange market as the reference rate market may now see reduced activity, traders said.
"When you don't know what time the reference rate is frozen, you won't know when to cover and it will be a big risk. So if there is an exactly opposing counterparty, only then can you fill a reference rate order," said a foreign exchange dealer with a large state-owned bank.
Many banks may stop taking reference rate orders from customers which could lead to a fall in trading volumes, dealers said.
In a reference rate order, the bank buys or sells dollars for customers at the central bank's reference rate, traders said.
However, despite RBI's best intentions of curtailing volatility, it may eventually hit the domestic currency market.
"RBI doesn't want the activity to be concentrated at a particular time. However, instead of keeping the time for the fixing uncertain, RBI could have taken the average of, say, an hour trading to arrive at the reference rate," said a dealer.