Foreign exchange non-deliverable forward (NDF) markets developed because of currency non-deliverability offshore and restrictions in onshore markets, particularly for non-residents.
Restrictions exist in many emerging markets and take various forms, including underlying asset requirements for currency positions, restrictions on participants in currency markets, prudential and documentation requirements, and regulation on permissible FX products.
Restrictions such as these are designed to safeguard financial stability, curb financial speculation and maintain control over currency onshore.
However, when the Global Foreign Exchange Committee (GFXC) met in September to discuss trading conditions, one of the issues it discussed was currency controls causing pricing disruptions in NDF markets.
Market players see great opportunities for taking NDF trading to the next level
Yue Malan, Aite Group
Asia is home to most of the heavily traded NDF currencies, including the Korean won, Indian rupee and Taiwan dollar, as well as the Indonesian rupiah and Chinese yuan.
Korea and Taiwan have imposed relatively few restrictions on onshore financial institutions’ participation in the NDF market, whereas Malaysia has taken a much stronger policy approach aimed at limiting ringgit trading to onshore markets.
“The more restrictions a country has, the more potential there will be for serious price disruption because local policymakers have more control over their onshore market,” says Henry Wilkes, head of FX at EdgeFX.
“Because the NDF market is based on onshore market dynamics as far as pricing is concerned, local currency controls can be a major issue for providers.”
However, this is not the only factor that impacts the ability to price NDFs effectively. Periods of market stress – a global pandemic, for example – can cause a big divergence between the pricing of NDFs and the local onshore FX markets.
In the initial phase of a crisis, NDFs will tend to price in more depreciation than onshore markets, something that can have notable consequences for the real economy and non-resident holdings of local currency assets because hedging becomes too expensive.
Weathering the storm
Despite these challenges, the NDF market appears to have weathered the coronavirus storm pretty well.
Paul Clarke, head of FX venues at Refinitiv, says that NDF volumes were subdued from April to August, but started to recover in September, while EM volumes also dipped in April but, in contrast to NDFs, gradually rose over the following months.
“However, after reaching around 400% of pre-Covid levels during March, NDF spreads have fallen back to almost normal – around 10% higher than before the start of the pandemic,” he adds. “In contrast, EM spreads peaked at around 300% above pre-Covid levels in March, and are still about 40% to 50% above the levels seen at the start of the year.”
Many more banks and non-banks are quoting prices
Curtis Pfeiffer, Pragma
EdgeFX’s Wilkes acknowledges that the market turmoil in March would have had a negative impact on daily NDF volumes, but describes this as a short-term phenomenon due to the fact that the market is in the early stages of electronification, a development that is likely to attract more market participants.
“As a result, most emerging-market currency NDF markets are likely to continue to flourish in the future,” he says.
That’s a view shared by Pragma chief business officer Curtis Pfeiffer.
“Many more banks and non-banks are quoting prices, which has resulted in greater liquidity and explains why there has been an increase in NDF volumes,” he says.
An Aite Group report published in April noted that growth in NDF trading has outpaced that of all other FX products during the last few years. The report also stated that non-bank liquidity providers will continue to provide stiff competition for banks as they further improve their flows.
“Although still much less active than FX spot, market players see great opportunities for taking NDF trading to the next level,” says Yue Malan, Aite Group senior analyst. “Traders can exploit these opportunities because pricing and liquidity are more robust.”
However, Wilkes also warns that NDF markets in Asian currencies tend to have higher trading volumes, deeper liquidity and longer trading hours than onshore FX markets and are often more volatile.
As a result, he believes they have the potential to be a destabilizing influence during times of market stress.
“My concern here is that NDFs appear to have a significant influence on onshore markets because the ability of policymakers to monitor and regulate trading in offshore NDF markets is extremely limited,” Wilkes concludes.
“The NDF market is able to price new information when onshore markets are closed.”
