Non-deliverable forwards: impact of currency internationalisation and derivatives reform

They are particularly prevalent in transactions with currencies from emerging market economies where volatility and regulatory constraints are more common. An example of an NDF is a contract between a U.S. importer and a Chinese exporter to exchange USD for CNY at a fixed rate in 3 months and settle the difference in cash on the settlement date. NDFs enable economic development and integration in countries with non-convertible or restricted currencies.

For the renminbi, deliverable forwards (DFs) have been displacing NDFs offshore. To gain exposure to these currencies without breaching the restrictions, market participants came up with ‘non-deliverable forwards’. As the name suggests, these are forward contracts but they do not involve the delivery of the underlying currency. NDFs and onshore forward and spot exchange rates are linked in long-run equilibrium relationships, as one would expect with at least partial market integration. Appendix 2 shows estimates for the long-run cointegration regressions in levels. Most intercepts are close to zero while the coefficients on the dependent variables are close to one, suggesting that onshore and offshore prices are close to equal in the long run.

NDFs and derivatives reform

We separately analyze the COVID-19 market stress episode using hourly data. Figures 10 through 15 present the difference in onshore and NDF implied interest rates over time. During the taper tantrum in 2013, large dislocations between onshore and offshore pricing occurred for IDR and INR with the offshore markets pricing large depreciations. Besides IDR and INR, the taper tantrum affected TWD offshore/onshore pricing, but had relatively little effect on the onshore/offshore pricing differentials of other Asian currencies. We innovate by exactly time-matching NDF and onshore price quotes, unlike most of the existing literature which uses end-of-day quotes across time zones.

Median volatility of Asian NDFs is larger than volatility of onshore deliverable forwards. Bank of England NDF volume data for London, the world’s largest NDF trading hub, is broadly in line with BIS data (Figure 3). In Tokyo, an important NDF trading hub in Asia, the KRW, INR, TWD, and IDR are the most widely traded NDF currencies (Figure 4).

NDF Currency Pairs

Non-deliverable forward (NDF) is a cash-settled contract, which means that the two parties to the contract do not actually exchange the currencies. Instead, they settle the contract in cash at the predetermined exchange rate on the settlement date. Non-deliverable swap (NDS) is a physically settled contract, which means that the two parties to the contract actually exchange the currencies on the settlement date.

They allow market participants to lock in a forward rate or bet on a future rate movement, managing their currency exposure or profiting from their currency views. NDFs are customizable, offering leverage and flexibility to suit different needs and preferences. Imagine you are a U.S. company that has secured a contract to supply machinery to a Chinese company. The total cost of the machinery is 10 million Chinese Yuan (CNY), and the payment is due in six months.

Pricing and valuation

At the same time, renminbi DFs are displacing the NDF, thanks to currency internationalisation. The displacement of the renminbi NDF by deliverable CNY trades has progressed furthest in the offshore centres that have traded the renminbi the longest. Asian centres enjoyed an early lead in renminbi trading under the strategy of renminbi internationalisation. Graph 5 shows that, as of April 2016, the Asian centres traded a mix of forwards that was very light in NDFs, compared with April 2013. One is a sudden liberalisation of FX trading and the capital account.

They will be able to establish the platform as a legitimate business for large retail traders and institutions. Moreover by implementing KYC they will be able to serve their platform to wider audience. As can be seen below, KRW leads the NDF trading in terms of turnover, followed by INR.

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So, unless one needs to do a customized trade specific to their needs or hedge a large FX exposure, futures are preferred over forwards. For example, trader A might have the view that EURUSD will go up while trader B might have the view that the currency pair price will go down. Trader A enters the contract with a long position and trader B enters with a short position with a $100,000 notional amount and both decide to close the contract at the end of 1 month. At the initiation of this trade, there is no exchange of cash flows which gives significant leverage to both parties as they don’t have to put any capital. Forward contracts are over-the-counter (OTC) derivatives, which means that they are not freely traded on the exchange but rather are traded directly among FX participants. In this contract, two parties decided to trade an underlying currency on a pre-decided date.

• Relative to other foreign exchange products—spot, outright forwards, swaps, options—NDF trading volumes are large for INR, KRW, and TWD (Figure 2).
• All NDF contracts set out the currency pair, notional amount, fixing date, settlement date, and NDF rate, and stipulate that the prevailing spot rate on the fixing date be used to conclude the transaction.
• Unlike a deliverable forward contract which involves the exchange of assets or currency at an agreed rate and future date, a non-deliverable forward (NDF) requires cash flow, not tangible assets.

The INR, KRW, and TWD accounted for 55% of total daily global NDF turnover of USD258 bn as of April 2019 (Figure 1). Outside of Asia, the Brazilian real (14%) and the Russian ruble (2%) have sizeable NDF markets. What is Crm NDF trading in INR, TWD, and KRW experienced the fastest growth since 2016, rising 204%, 168%, and 100%, respectively. The loss or profit gets calculated depending on the notional amount of the agreement.

Appendix 1: Realized volatility of onshore forwards and NDFs

Pricing differences can persist if there are access restrictions to onshore markets that constrain arbitrage between the two markets. Even without restrictions, arbitrage activity may not operate as fully and immediately as in the textbook case due to risk and costly capital (Shleifer & Vishny 1997). Non-deliverable forward (NDF) markets in many Asian emerging market currencies are large, rapidly growing, and often exceed onshore markets in transaction volume. NDFs tend to price significant depreciation during market stress episodes including COVID-19. Our analysis shows that influences tend to run both ways after controlling for differences in timezones between markets. For the COVID-19 pandemic there is some evidence of NDFs leading onshore markets for a few currencies.

They can also attempt to forbid facilitation of NDF transactions by foreigners through attestations of non-participation in the market as a precondition for domestic market access. MYR NDFs were stable during the taper tantrum, but pricing was very volatile in 2015 and after the central bank’s reinforcement of the NDF ban in November 2016. Chinese yuan NDF activity dropped amid the rise of the offshore deliverable forward market (CNH). KRW and INR are the most widely traded NDFs in London, the world’s largest market for NDFs. Daily NDF trading in three Asian currencies (INR, KRW, TWD) accounts for 55% of global NDF trading volume. NDFs are typically used by businesses engaged in international trade, and they are less common among individual investors.

IV. Volatility and Pricing of Onshore Forwards and Offshore NDFS

NDF markets in major Asian currencies are large, often with higher trading volumes than onshore FX markets. During market stress periods including the COVID-19 pandemic, pricing of NDFs often diverges from onshore FX markets. In most cases NDFs price more depreciation than onshore markets in the initial phases of markets stress. The sometimes very large deviations in NDF pricing can have consequences for the real economy and nonresident holdings of local currency assets by making hedging expensive.

Meaning you don’t have to submit your ID proofs to use these exchanges. This might be because of the emerging economies being more integrated with global trade. The United Kingdom is by far the most preferred location for NDF trading and a significant portion of it is done in the form of electronic trading. The United States and Singapore also see a significant amount of NDF trading. But rather than waiting for the contract to end after 1 month, both parties mark this profit & loss.