The Reserve Bank of India (RBI) to inject Rupee liquidity for longer duration through long-term USD-INR Buy/Sell swap auction of $10 billion for a tenor of three years.

• This will be the second swap auction by the RBI in a month with it infusing  $5.1 billion through a six-month swap on January 31.

About the Details of the Swap

• Mechanism: The swap is in the nature of a simple buy/sell foreign exchange swap from the Reserve Bank side.
  • A bank will need to sell the U.S. Dollars to the Reserve Bank and simultaneously agree to buy the same amount of U.S. Dollars at the end of the swap period.
• The auction would be a multiple-price based auction, i.e., successful bids will get accepted at their respective quoted premium
• Bids: It will be placed in terms of the premium expressed in paisa terms up to two decimal places.
  • The auction cut-off would be based on the premium.
• Minimum Bid Size: It would be $10 million and in multiples of $1 million thereafter
• Eligible Participants: Authorised Dealers (ADs) – Category-1 banks will be the eligible entities to participate in the auction.
• First Leg: The bank will sell the U.S. Dollars to the Reserve Bank at FBIL Reference Rate of the auction date.
  • The settlement: It will take place on spot basis from the date of transaction with  the bidder delivering the U.S. Dollars into the RBI’s nostro account.
• Reverse Leg: Rupee funds will have to be returned to the Reserve Bank along with the swap premium to get the U.S. Dollars back
• Objective: 
  • Currency Stabilisation: The swap will have a short-term positive impact on the Rupee as it will help stabilise the currency by providing immediate liquidity support and mitigate the pressure on the rupee during periods of foreign fund outflows.
  • Exchange Rate Volatility: The swap mechanism will bolster market confidence and prevent excessive volatility in the exchange rate. 
  • To reduce inflationary pressures by sucking  out excess liquidity for an extended period of time and strengthen the rupee

About Currency Swap Auction Mechanism

• A swap is a financial agreement or derivative contract between two parties with the purpose of exchanging cash flows or liabilities
  • Swaps usually include cash flows based on notional principal amounts, such as bonds or loans, but the instruments might vary.
• Process: The Reserve Bank of India (RBI) allows banks to bid for the opportunity to exchange a set amount of Indian Rupees for a foreign currency (like US Dollars) at a predetermined exchange rate for a specified period.
• Method: The swapping is done through an auction system where banks submit bids to secure the swap amount at the most attractive rate
• Currency swaps are over-the-counter (OTC) financial instruments. This means they are not traded on a centralized exchange.
• Objective: 
  • Liquidity management: Injecting or absorbing liquidity in the forex market by providing access to foreign currency when needed. 
  • Hedging currency risk: Allowing banks and businesses to protect themselves against fluctuations in exchange rates.
• Limitations: 
• • Counterparty Risk: It means there is a risk that one of the parties may default on their obligations.
  • Complexity: Some financial institutions may find it difficult to use them effectively.
  • Significant Associated Costs: There may be significant costs associated with entering and managing the swap agreement, depending on the structure. These costs may be attributed to swap fees and hedging costs.
  • Limited Liquidity: It makes it difficult to enter or exit a swap agreement at a favorable rate.

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