- Stocks Stocks
- Mutual Funds Mutual Funds
- Insurance Insurance
- School School
- Corporate Corporate
- Most Used Most Used
Onshore markets in currency trading are quite straight forward. If you trade currency futures on the NSE or BSE or if you buy a forward cover from a bank in India to cover risk, it is basically an onshore market. When the currency is traded vis-à-vis other foreign currencies within the shores it is called onshore currency markets. Normally, it is the onshore markets that are closely regulated by the nodal regulators like the RBI and SEBI.
Offshore markets are slightly more complicated. They are traded in a neutral country. For example, the USDINR contract is traded in over the counter (OTC) market in some principally large markets like London, Singapore and Dubai. This is popularly called the Non-Deliverable Forward (NDF) market. These are outside the purview of the RBI and SEBI, which is one of the reasons the regulators are wary of such offshore markets. These offshore markets also cannibalize a chunk of the onshore volumes. That is because; large traders and investors prefer to hedge their risk in the offshore markets considering that they are less regulated and the costs are much lower.
Non-Deliverable Forwards (NDF) are foreign exchange forward contracts traded in the OTC market at offshore destinations, generally major international financial centres. An NDF contract is similar to a regular forward foreign exchange contract but does not need physical delivery of currencies at the time of maturity. In fact, NDF contract is typically cash settled in international currency on a specified future date. Since the NDF market operates in overseas financial centres, it remains outside the regulatory purview of the local authorities.
Why does NDF market develop? You will typically find NDF markets in currencies where markets are less developed locally or the tax structure is unfavourable. An NDF market generally grows when the onshore forward market is either under-developed or its access for market participants is restricted. As market players’ interest grows in a particular currency with convertible restrictions, NDF market generally gains momentum in overseas financial centres. As emerging markets start to develop, foreign investors may find the need to hedge currency risk but may be stifled due to limited liquidity in forex markets locally. Such investors prefer to hedge their net positions in the NDF market. Major participants in NDF market include foreign investors, corporates doing business in countries with exchange controls, hedge funds, commercial and investment banks, currency speculators etc. Quite often, large players participate in the onshore and offshore markets at the same time. NDF currency markets also grow because of the support of carry trades.
Quite often the NDF market can be an important lead indicator. Ahead of the Asian crisis of 1997, interest in NDF trading had increased significantly, as devaluation in local currencies was widely expected in the market. This acted as a lead indicator. Even in the Indian context, when the Indian rupee crashed sharply in October 2018, the early indications were already there in terms of the short build up in the NDF market. In fact, nowadays even central banks and governments track the NDF market closely for advance signals which can help them pre-empt such currency challenges. Standard onshore forward exchange contracts are priced based on interest rate parity calculations (interest rate differential and current spot exchange rate). On the other hand, NDF markets also factor in other parameters like volume of trade flows, liquidity conditions, and counterparty.
In trading parlance, NDF contracts are outright forward or futures contract in which counterparties settle the difference between the contracted NDF price or rate and the prevailing spot price or rate on an agreed notional amount. It needs to be remembered that there is no counterparty risk guarantee in forward markets, unlike in futures market and the market largely runs on trust. That is why NDFs are more like bets than like contracts and that is why they are also known as forward contracts for differences. NDFs are prevalent in some countries where forward FX trading has been banned by the government as a means to prevent exchange rate volatility. For currencies, Dubai, London and Singapore are some of the popular NDF markets due to their extremely friendly regulator environment.
Which currencies does NDF market exist?
The NDF market is an over-the-counter market (deals struck on telephone). NDFs began to trade actively in the 1990s. NDF markets basically started off in emerging markets with capital controls, where the currencies could not be delivered offshore. Most NDFs are cash-settled and denominated in US dollars. The more active banks quote NDFs from between one month to one year, although some would quote up to two years upon request. The most commonly traded NDF tenors are IMM dates, but banks also offer odd-dated NDFs. NDFs are typically quoted with the USD as the reference currency, and the settlement amount is also in USD. That is one of the reasons a lot of global investors prefer to hedge their risk in the NDF market as the dollar denomination synchronizes with their underlying exposure, which is also normally denominated in US dollars. Let us now look at some of the popular currencies on which NDF contracts are available.
Some of the major currencies in the world where NDF market is available on dollar denominated differential trade are Chinese Renminbi, Indonesian Rupiah, Indian Rupee, South Korean Won, Malaysian Ringgit, Philippine Peso, New Taiwan Dollar, Vietnamese Dong, Egyptian Pound, Kazakh Tenge, Nigerian Naira, Argentine Peso, Brazilian Real, Chilean Peso, Colombian Peso, Costa Rican Colon, Guatemalan Quetzal, Peruvian Nuevo Sol, Uruguayan Peso and Venezuelan Bolívar.
An NDF is a short-term, cash-settled currency forward between two counterparties. On the contracted settlement date, the profit or loss is adjusted between the two counterparties based on the difference between the contracted NDF rate and the prevailing spot FX rates on an agreed notional amount. There is no delivery of currency in the NDF market and all transactions are only cash settled.
Key parameters of an NDF trade
Since NDF is a cash-settled contract, the notional amount is purely theoretical and is never exchanged. The only exchange of cash flows is the difference between the NDF rate and the prevailing spot market rate. Therefore to condense the idea into a formula:
Cash Flow = (NDF rate – Spot rate) × notional Quantity
While theoretically there is counter party risk exists in NDF contracts, it is closed market and participants tend to be wary of their credit rating and their standing and hence the defaults tend to be quite low. In an NDF both the parties to a transaction are committed to honour the deal. Nevertheless, either counterparty can cancel an existing contract by entering into another offsetting deal at the prevailing market rate.
NDF market attracts a cross section of participants from various sides of trades who try to either hedge their risk or purely make profits trading. Some of the key players are:
Trading in the Indian currency market has its own unique challenges in the onshore market. Here’s why:
One, quite often, the markets can be quite illiquid for large trades.
Secondly, the ready forward market in India is quite opaque and that is why many foreign investors prefer the NDF market in London, Dubai or Singapore.
Thirdly, the NDF markets are less regulated in terms of disclosures and limits.
Fourthly, the compliance requirements are much lower in the NDF market as compared to the onshore market.
Lastly, the NDF market is denominated in US dollars and that makes it a lot more convenient for global investors whose investment returns are typically measured in dollar terms.
The offshore market in currencies (NDF) market offers some key advantages to currency traders. A few such advantages are enumerated herein.