AD Cat-1 Banks Can Now Operate Inside India; Must Know Before Buying

The Reserve Bank of India (RBI), in a significant regulatory move on 22 September 2025, amended its Master Direction on Risk Management and Inter-Bank Dealings to allow Standalone Primary Dealers (SPDs), categorised as Authorised Dealer Category-III (AD Cat-III), to transact in non-deliverable derivative contracts (NDDCs) involving the Indian rupee. 

Earlier, only Authorised Dealer Category-I (AD Cat-I) banks, particularly those with International Financial Services Centre (IFSC) Banking Units (IBUs), were permitted to do so. 

This article examines what this change entails, the rationale behind it, its potential impact, and the risks, as well as policy considerations.

What are Rupee Non-Deliverable Derivatives (NDDCs) & Who Were Previously Eligible?

NDDCs (often also called Non-Deliverable Forwards/Swaps, etc.) are derivative contracts where one party hedges or takes a position on a future rupee exchange rate, but settlement is done in a freely convertible currency such as the US dollar rather than physical delivery of rupees. They are widely used by non-residents and residents alike when access to deliverable forward markets is limited or when seeking offshore risk management.

Before this change:

• Only AD Cat-I banks operating inside India, particularly those with an IFSC Banking Unit, could engage in rupee NDDCs.
   
• SPDs, classified as AD Cat-III, were not eligible to participate in such derivative contracts involving non-resident counterparties or offering to both residents and non-residents under those instruments.

The New RBI Notification: What Has Changed

The RBI notification (Circular No. RBI/2025-26/78 A.P. (DIR Series) — Circular No. 10) brings the following key changes:
 

• SPDs, when authorised as AD Cat-III, are now explicitly allowed to transact in rupee NDDCs with both residents and non-residents.
   
• SPDs will now stand alongside AD Cat-I banks (with IFSC IBUs) and overseas banks in being eligible to offer rupee NDDCs.
   
• The change is effective immediately from the date of the notification (22nd September 2025).
   

Why Did RBI Do This? Motives and Rationale

Analysing both the public statements and background, several motivations underlie this policy shift:

1. Deepening the Rupee Derivatives Market
   Broadening the base of market participants helps deepen liquidity and pricing efficiency. SPDs have historically been active in government securities (G-Sec) markets; enabling them in derivatives adds more players to currency risk-management tools.
    
2. Improving Hedging Access for Businesses
   Many corporates, importers/exporters, and financial institutions (both resident & non-resident) rely on hedges against currency risk. Allowing more entities to offer NDDCs can improve availability and reduce costs of hedging.
    
3. Reducing Offshore Reliance & Arbitrage
   There has been substantial activity in offshore markets (e.g. Singapore, other financial centres) in rupee NDFs. Wider participation by domestic regulated entities could help align onshore and offshore rates, reduce arbitrage where it is distortive, promote stability.
    
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The Expected Impact: Pros and Cons

Below is a table summarising the expected positive effects and potential risks or costs of this policy change.

Expected Benefits vs Potential Risks of SPD Participation in Rupee NDDCs
 

Data & Market Trends: A Look at Recent NDF Activity

To understand the context better, here are some recent trends in the rupee NDF market:
 

• In December 2024, NDF volume for USD/INR at offshore centres rose to $161 billion, a sharp rise (140%) from the previous year. Much of this was driven by arbitrage between offshore NDF and onshore deliverable forwards when divergences in rates appeared.
   
• RBI interventions are being detected in both NDF and onshore spot markets. For example, when the rupee weakened significantly (say, crossing ~₹ 88.40 per USD), the RBI sold dollars in the NDF market in past instances to stem depreciation.
   
• Implied volatility for one-month rupee rates has recently dropped to six-month lows, indicating that markets believe the rupee may be stabilizing somewhat. Regulatory changes like this one likely contribute to anchoring expectations.
   

These trends suggest that the rupee NDF market has been under stress (due to global uncertainty, trade policy shifts, etc.), and demand for hedging has been rising. The policy shift allowing SPDs could help accommodate some of this demand domestically.

How SPDs Fit Into India’s Foreign Exchange & Derivatives Regulatory Structure

To appreciate the significance, it helps to understand what SPDs (Standalone Primary Dealers) are, and what being AD Cat-III implies:

• Standalone Primary Dealers are financial institutions, approved by RBI, whose primary activity is dealing in government securities. They contribute to liquidity in the government securities market, help in borrowing programmes, and act as market makers in G-Sec. They are distinct from banks in that while they can hold banking licences or other permissions, their core business is in the government debt markets.
   
• AD Category III (AD Cat-III) is a classification under the RBI’s Authorised Dealer framework, which gives certain permissions in foreign exchange transactions but with more limited scope compared to AD Cat-I. Under AD Cat-III, entities cannot deal in broad forex transactions beyond a certain scope, or with non-resident parties, unless specifically permitted. Under this change, SPDs that are AD Cat-III get the specific permission to deal in rupee NDDCs.
   
• The Master Direction on Risk Management and Inter-Bank Dealings (2016) provides the regulatory foundation, specifying which entities can enter into what kind of FX or derivative transactions, their exposure limits, documentation, counterparty risk, etc. The current amendment is part of that regulatory master direction.

Challenges, Risks & What Needs Careful Monitoring

While this policy move brings many potential advantages, there are areas that require close oversight and risk management:
 

1. Counterparty Risk: SPDs entering into derivative contracts must manage counterparty credit risk, especially if dealing with non-residents or offshore entities.
    
2. Operational Infrastructure: SPDs will need robust systems for risk monitoring, settlement, accounting, compliance, and know-your-customer / anti-money-laundering (KYC/AML) procedures.
    
3. Regulatory and Accounting Challenges: How SPDs mark to market, hedge, or maintain collateral, and how these derivative exposures are disclosed will matter both for financial stability and for inter-institutional trust.
    
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